U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

1

76–171 CC

" ! JOINT COMMITTEE PRINT 107TH CONGRESS

1st Session

S. PRT.

2002

107–50

RUSSIA’S UNCERTAIN ECONOMIC

FUTURE

COMPENDIUM OF PAPERS

SUBMITTED TO THE

JOINT ECONOMIC COMMITTEE

CONGRESS OF THE UNITED STATES

DECEMBER 2001

Printed for the use of the Joint Economic Committee


congress.#13

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FOREWORD

By Senator Robert F. Bennett

Russia’s economy has rebounded significantly since the crisis of

1998. Economic growth has resumed, unemployment has fallen,

and production, consumption, and investment have all expanded.

At the same time, Russia has initiated a series of promising economic reforms, including strengthening its banking system and enacting fundamental tax reform.

These improvements illustrate Russia’s potential for a strong economic future. At the same time, memories of past economic difficulties demonstrate the risks that Russia faces if its reforms do not

succeed.

Russia’s economic future is of great importance to the United

States. To assist American citizens and policymakers in thinking

about that future, I asked the Congressional Research Service to

commission a collection of expert reports on the Russian economy.

The resulting reports review the recent history of the Russian economy, analyze current policy issues, and consider possible futures.

The reports were prepared by experts—in academia, the private

sector, and government—who represent a wide diversity of professional perspectives on the Russian economy. The reports thus reflect a broad range of opinions on the challenges and opportunities

before Russia. The views and conclusions in these reports are those

of their authors, not those of the Joint Economic Committee or any

of its individual members.

I hope that these reports will contribute to our ongoing efforts to

understand the Russian economy. I thank the Congressional Research Service for its efforts and the authors for sharing their expertise.

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C O N T E N T S

Page

Foreword, by Senator Robert F. Bennett ............................................................... iii

Historical Note ......................................................................................................... vii

Highlights, by John Hardt ...................................................................................... ix

Overview, by John Hardt ........................................................................................ xi

PAST ECONOMIC PERFORMANCE AND INSIGHTS FOR FUTURE PROSPECTS

Russia’s Economic Performance: Entering the 21st Century, by William H.

Cooper ................................................................................................................... 3

RUSSIA’S ECONOMIC CHALLENGES

Removing Barriers and Providing an Incentive System ........................... 25

The Russian Economy: How Far from Sustainable Growth?, by Ben Slay ........ 25

Unlocking Economic Growth in Russia, by Vincent Palmeda and Bill Lewis .... 47

Administration and Reform of the Russian Economy, by Paul Gregory and

Wolfram Schrettl .................................................................................................. 81

Russian Crime and Corruption in an Era of Globalization: Implications for

the United States, by Jonathan M. Winer and Phil Williams ......................... 97

Financial Reform: Taxes, Budgets and Banks .............................................. 125

Tax Reform in Russia, by Z. Blake Marshall ........................................................ 125

Putin’s Dilemma: Austere Budgeting in a Poor State, by James A. Duran,

Jr. .......................................................................................................................... 141

Russian Defense Spending, by Christopher J. Hill ............................................... 161

Russian Financial Transition: The Development of Institutions and Markets

for Growth, by David M. Kemme ........................................................................ 183

Breakup of Monopolies: Energy, Transportation and Agriculture ......... 213

The Russian Energy Sector: Current Conditions and Long-Term Outlook,

by Matthew J. Sagers .......................................................................................... 213

Agricultural Reform: Major Commodity Restructuring but Little Institutional

Change, by William Liefert ................................................................................. 253

Human Capital and the Social Contract ........................................................ 283

Russia’s Demographic and Health Meltdown, by Murray Feshbach ................... 283

Social Welfare: A Social Contract, by Judyth L. Twigg ........................................ 307

LONG-TERM PROSPECTS FOR RUSSIA’S ECONOMIC GOVERNANCE

Long-run Prospects for the Russian Economy, James R. Millar ......................... 329

Russia’s Evolution as a Predatory State, by Peter J. Stavrakis .......................... 347

RUSSIA’S ECONOMIC FUTURE AND U.S. INTERESTS

U.S. Bilateral Assistance to Russia, 1992–2001, by Curt Tarnoff ....................... 369

Arms Exports and Russia’s Defense Industries: Issues for the U.S. Congress,

by Kevin P. O’Prey ............................................................................................... 385

U.S.-Russian Trade and Investment: Policy and Performance, by Inga

Litvinsky, Matt London, and Tanya Shuster .................................................... 411

Russia and the International Financial Institutions: From Special Case to

a Normal Country, by Jonathan E. Sanford ...................................................... 425

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HISTORICAL NOTE

This study belongs to the series of committee prints for the Joint

Economic Committee by the Congressional Research Service and its

predecessor, the Legislative Reference Service, dating back to the

1950s, on the economies of the Soviet Union and successor states,

the People’s Republic of China, and Central Eastern Europe. In November 1959, the Joint Economic Committee held a week of hearings that highlighted the publication entitled Comparisons of the

United States and Soviet Economies. These hearings were a continuation of the committee’s past interest in this subject that had

resulted in the publication of two studies prepared for the committee by the Legislative Reference Service of the Library of Congress—one, in 1955, entitled Trends in Economic Growth: A Comparison of the Western Powers and the Soviet Bloc, and the other,

in 1957, entitled Soviet Economic Growth: A Comparison with the

United States.

The first study on the People’s Republic of China, An Economic

Profile of Mainland China, was released in 1966, after the initiation of the Cultural Revolution. The first volume on Central Eastern Europe, Economic Development in Countries of Eastern Europe,

was released in 1970, following the Soviet invasion of Czechoslovakia. Other studies followed at regular intervals.

The most recent study in this long series was China’s Economic

Future: Challenges to the U.S. Policy, released in 1996. The most

recent study on Eastern Europe was East-Central European Economies in Transition, released in 1994, which was preceded by a twovolume study, The Former Soviet Economies in Transition, released

in 1993.

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1 John P. Hardt, Senior Specialist in Post-Soviet Economics at the Congressional Research

Service, is author of the Highlights, the Overview and coordinator of the volume.

HIGHLIGHTS

By John Hardt 1

The authors in this volume analyze the present state of the Russian economy and its future possibilities. Vladimir Putin has committed himself to economic reform in his 2 years as Russia’s president. The opportunity for a transition to a democratic market economy is more likely now than at any previous time in Russian history. This volume explores the opportunities offered by this transition and the obstacles it faces, with particular reference to Putin’s

reform agenda. The main findings of the volume are as follows:

• Sustained economic growth will be crucial to all reform efforts.

Russia’s recent performance since its financial crisis in 1998

has been positive in terms of both its annual growth of gross

domestic product (GDP) and its balance of payments. Whether

this recent performance represents a new trend line of sustained growth or is a part of a cyclical pattern of prosperity

and crisis remains unknown. • Putin’s unfinished reform agenda features changes critical to

the development of a pluralistic market system under the rule

of law, such as the establishment of market-friendly administrative and judicial systems and the introduction of an effective

banking system. Bureaucratic inertia and lingering corruption

continue to hinder these reform efforts. • Putin’s reform policies will be decisive only if they result in redistribution of political power that controls economic decisionmaking along with revision of budgetary priorities. Restructuring the power of Russian financial and governmental elites and

reducing populist subsidies will prove difficult, however, because that may erode Putin’s power and popularity.

• Russia’s economic competitiveness and growth potential would

be greatly enhanced by the breakup of monopolies in three key

sectors: energy, transportation and agriculture. Such reforms

are underway, but they have not been completed.

• Russia’s human capital has become a depreciating asset. Without appropriate legislation and budgets, Russia is facing a ‘‘demographic and health meltdown.’’ Russia is not yet living up

to Putin’s commitments to the Russian people; welfare entitlements, pension funds and education needs are all underfunded.

The path of Russia’s economic development will make a significant difference to the United States. U.S. policy, in turn, will play

an important role in Russia’s future economic development.

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• Russia may become a major trading and investment partner

with the United States in spite of its modest bilateral trade

and investment in the past. • The United States may benefit from reduced Russian sale of

arms to countries who may be a threat to U.S. security interests. • U.S. support could facilitate Russia’s integration into the global economy and its eventual accession to the World Trade Organization in spite of the noncompetitive nature of most Russian enterprises and strong protectionist sentiments. • The United States may take an effective lead in helping Russia

manage its external debt burden, even though the majority of

its external debt is held by other countries.

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1 John P. Hardt is a Senior Specialist in Post-Soviet Economics at the Congressional Research

Service. References to authors from the volume are made in the text of the Overview. References

to authors not in the volume are made in footnotes. 2 Communique ́s of Washington/Crawford Summit, Washington File, State Department.

OVERVIEW

By John Hardt 1

Russia’s uncertain economic future is of special concern to U.S.

as well as Russian policymakers. This was highlighted by the

Bush/Putin Summit in Washington, DC, and Crawford, Texas, November 13–15, 2001, as Putin moved to align Russia more closely

with the western market economies.2 The range of possible economic developments in Russia is greater now than in the past.

This volume includes articles that present four approaches to the

overarching question: Where is the Russian economy going?

• A discussion of Russia’s past performance and insights for future growth. Is extrapolation of Russian past economic performance useful for projecting Russia’s economic future? Will current

opportunities for improved growth lead instead, as in the past,

to economic crises? • A discussion of the reform policy issues that challenge the

leadership of President Vladimir Putin to make choices that

may determine economic governance in Russia. What policy decisions would best advance the reform agenda and the necessary redistribution of power and financial resources? Will

Putin prove to be an effective democratic reformer or yet another

promoter of strong state power? • A discussion of the range of possible outcomes for long-term development of Russia’s political and economic system. Is Russia

likely to abandon its historical pattern of autocratic governance

in favor of the western model of democracy and market economy? Is either of these antithetical outcomes inevitable or subject to change?

• An assessment of U.S.-Russian economic issues that materially

affect U.S. interests. Does it make a significant difference to the

United States how Russia develops economically? Can and

should the United States influence or effectively manage the

outcome?

This volume is divided into four sections: past performance and

insights for future prospects; Russia’s economic challenges; longterm prospects for Russia’s economic governance; and Russia’s economic future and U.S. interests. What follows is a summary of the

authors’ responses to the above questions, supplemented by commentary provided by the volume’s coordinator. The contributors to

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3 European Bank for Reconstruction and Development (EBRD), ‘‘Cross-Border Capital Flows,’’ Transition Report Update, April 2001; John P. Hardt, Russia’s Economic Policy Dilemma and

U.S. Interests, CRS Report RL30266, January 23, 1999; Alexander Boulatov and Mark Silveira, ‘‘Capital Flight and Foreign Direct Investment,’’ Working Paper, Washington, DC, August 2001.

this volume offer contrasting perspectives on these questions. They

consider that Putin turning out to be an effective reformer rather

than an authoritarian leader to be crucial to the development of

Russia’s economic future. While these contributions do not represent the views of the Congressional Research Service (which does

not take positions on public issues), nor necessarily of the Joint

Economic Committee of the U.S. Congress, they do reflect schools

of thought in the professional community in the United States and

abroad.

PAST ECONOMIC PERFORMANCE AND INSIGHTS FOR FUTURE

PROSPECTS

Past performance in quantitative terms is useful but not definitive in understanding the past and in forecasting its future. While

progress in reform made in the early 1990s provided some expectation of improved growth, Russia suffered a severe recession from

1992 through 1998. By 1998 gross domestic product (GDP) was 70

percent that of 1992. After the financial crisis in 1998, Russia experienced unprecedented short-term economic growth, with real GDP

growth expected to reach 5 percent in 2001.

William Cooper, in his performance assessment, finds that making accurate projections of Russia’s economic future is difficult:

‘‘The current economic growth could be short lived but it has generated political support and thus presents President Putin and his

team with a ‘window of opportunity’ to promote economic reform.

The current upswing in economic growth is favorable but not sufficient to assure sustained growth.’’

RUSSIA’S ECONOMIC CHALLENGES

Ben Slay reports: ‘‘Huge current account surpluses and unprecedented growth and reserves are welcome developments in the last

3 years. However, capital flight has not abated and foreign direct

investment that would help modernize and recapitalize Russian industry is conspicuously absent in Russia.’’ Ben Slay adds that large

capital flight and minuscule foreign direct investment mirror each

other as symptoms of failure of institutional reform in Russia.3 In

this context it may be just as difficult to substantiate that Russia

has ‘‘turned the corner’’ toward sustained economic growth and is

now a market economy as it was earlier to document that Russia

was a failing transitional economy.

Past performance shortfalls provide a road map for the difficult

reform path ahead. Future reform requires development of an incentive system, a working financial system, competitive enterprises, and adequate attention to the quality of life.

Russia’s current economic challenges are summarized in Putin’s ‘‘unfinished agenda.’’ Slay argues, along with many other specialists, that only the radical reforms in the Putin agenda will be sufficient to create a market-friendly system. While a turning point toward development of a market system may be more likely than at

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any time in Russian history, implementation of reform policies on

the Putin agenda can be decisive only if they result in redistribution of the political power that controls economic decisionmaking,

along with a revision of budgetary priorities.

Central to reform implementation, in the view of this report’s

contributors, will be the character of President Putin as a reformer.

President Putin has used his vision of Russia’s economic future as

the theoretical basis for his reform agenda. Putin’s vision is for

‘‘rapid and comprehensive’’ institutional reform, to ensure that Russia will not fall further behind the developed countries in economic

performance. Putin, as an advocate of reform, has prescribed the

reform medicine favored by western economic specialists, but it remains to be seen whether Putin, as President, administers this

medicine. By restructuring the power of Russian financial and government elites and reducing populist subsidies, Putin may erode

his own popularity and power. While many reforms may have an

immediate impact, the full benefits from successful reform may accrue to Putin’s successors. If Putin is unable or unwilling to be

proactive on his reform agenda, then, in the view of Jonathan

Winer and Phil Williams, political elites will continue to dominate

the political and economic future of Russia.

Putin’s difficulty in supporting reform may be characterized as a

twofold dilemma arising from the necessity to bring about a redistribution of power and a change in budgetary priorities. On the redistribution of power that is a prerequisite for reform, Putin has

the classic Machiavellian constraint that he must utilize the full

force of his leadership against the wishes of strong, entrenched opponents because the proponents of change are weaker and less ardent.

Budgetary priorities need to promote the market system rather

than cater to the state and political elites. Winer and Williams consider the political elites satisfied that the fruits of reform and their

preferential share can be retained through the use of state power.

Putin, as a reformer, may have to effectively use his leadership

role to maintain both the elite and popular support needed for implementing reform. For example, in restructuring Gazprom, the energy conglomerate, Putin may have to convince its administrators

and stockholders that being a global enterprise, and conforming to

the requirements of the world marketplace, would protect their

wealth and assure their future income, more than would retaining

their privileged domestic position under an autocratic model of governance. Were Gazprom to become a model of corporate governance, the likely increase in wealth and profit for its shareholders

might influence other oligarchs to support infrastructure monopoly

reforms.

There are some recent indications that other enterprises may be

seeking profits instead of rents. Ben Slay notes that the consolidation trend in industry has recently led many cash-rich enterprises

to raise the level of corporate governance in lossmaking enterprises

they have acquired. Responsiveness to market forces may thus be

seen as beneficial to some Russian industrial elites by assuring

protection of their wealth and prospects for profitability. Profit

seeking beneficial to the Russian economy as a whole may prove

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4McKinsey Global Institute, Unlocking Economic Growth in Russia, October 1999.

more favorable economically to some industrial elites than rent

seeking that only feathers their own nests.

In reducing subsidies to housing and utilities, Putin may need to

design a support program that does not sink Russian urban dwellers further into poverty and generate opposition to reform but that,

instead, offers prospects for future improvement in the quality of

citizens’ lives. By developing a new social contract supporting education and a meaningful social safety net, as suggested by Judyth

Twigg, Putin might generate more reform support from the developing middle class and the populace. Some need-based income

maintenance programs may be both economically and politically

more successful than traditional subsidies.

Without a proactive policy, the benefits of market transition toward sustained economic growth are unlikely to be forthcoming.

There is uncertainty about implementation of reform in Russia because Putin must face difficult decisions that will involve political

risks and economic costs. Reform would reduce the direct political

and economic power of the financial and governmental elites, including the Putin presidency. The marketplace, foreign investors

and government regulators would take over important economic decisionmaking functions and change the basis for wealth accumulation from political to economic criteria.

Even with more revenue in a growing economy, relative shares

of the budget would need to shift away from national security, politically popular or populist subsidies, and debt servicing. A

market-friendly budget would need to fund necessary reforms: a

new civil service, a working financial system, infrastructure improvement, and social welfare. These are both very costly and inimical to the interests of the entrenched elites. Budget priorities that

favor the interests of the middle class and the populace as a whole

may gain broad support for reform over time, but reduction of populist subsidies and uncertainty of future growth may lead to shortterm popular sentiments against reform.

REMOVING BARRIERS AND PROVIDING AN INCENTIVE SYSTEM

The authors in this section stress the importance of removing

barriers inherited from the previous Soviet system in order to assure development of a market-based incentive system. In the indepth studies of Russian economic performance in the 1990s, Vincent Palmeda and Bill Lewis conclude that the productivity potential of key sectors and the economy as a whole have been constrained by the lack of an incentive system.4 Palmeda and Lewis,

in updating their assessment to 2001, conclude that with marketoriented changes in economic institutions, Russia’s economy might

expect to sustain a GDP growth rate of 8 percent per annum.

In their essay, Paul Gregory and Wolfram Schrettl note that the

Russian economy denies itself the benefits of its full productive potential by the lack of a market-friendly administrative system that

incorporates rule-of-law concepts, establishes property rights, and

enforces laws through a competent judicial system. Such an administrative reform would require a professional civil service. Gregory

and Schrettl opine that economic rationality should lead Putin to

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give priority to administrative restructuring and adequately rewarding a new civil service in Russia as a condition for effective

reform. However, they are not optimistic that Putin will overcome

the political barriers to implementing these administrative reforms.

Winer and Williams are even more doubtful that the current administrative system based on cronyism, crime and corruption will

change. The necessary reforms, they argue, ‘‘require Russia to undertake steps that threaten those whose power depends on discouraging rule-of-law, including criminals, exploitative business persons

and corrupt bureaucrats.’’

FINANCIAL REFORM: TAXES, BUDGETS AND BANKS

An efficient monetized economy is essential for operation of a

market economy. To promote these objectives, a variety of financial

reforms are required:

• Generation of sufficient tax revenue that may be used to fund

reform programs; • A shift of budget priorities sufficient to promote market reform

initiatives; and • Creation of banks that are attractive to savers and banks that

efficiently convert savings to investment.

According to Z. Blake Marshall, tax reform currently under way

will remove the onerous taxes of the past authoritarian command

economy and replace them with taxes that do not place undue burdens on domestic and foreign enterprises. The new tax code, if fully

implemented, will go far toward encouraging a market-friendly system.

Budgets have recently become important instruments of Putin’s

policymaking, according to James Duran. The current priority

budgetary outlays, however, do not support effective reform. Three

appropriations are scheduled to absorb the major share of the 2002

budget: external debt servicing, subsidies for holding down apartment rents and utility fees, and defense spending. Duran says reform may not be implemented effectively without a radical change

in these budget priorities. Even if adequate expenditures for reform

are mandated, there may continue to be unfunded mandates because of the likely over-commitment of future budgets and the continuing pressures toward funding traditional claimants.

On the issue of debt servicing, Putin accepted in 2001 the foreign

creditors’ requirement that debt be fully serviced. External debt

servicing will peak in 2003 and continue at a high level thereafter

unless Russia receives major debt relief.

Closing down popular subsidies for holding down rents and utility fees is proving to be politically difficult, as indicated by current

parliamentary debates. Putin’s civilian budget policy may be

doomed to a robbing Peter to pay Paul policy of partially funding

reform-related programs.

In the area of defense spending, Russia continues to allocate a

higher percentage of GDP than any NATO countries, and spends

more in absolute terms than all NATO countries except the United

States, according to Christopher Hill. Under current defense plans,

maintaining and developing some new weapon systems and

downscaling military manpower will require additional spending.

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5 Christopher Davis, ‘‘Defense Sector in the Economy of a Declining Superpower: Soviet Union

and Russia, 1965–2001,’’ Defense and Peace Economics, Overseas Publishers Association, 2001. 6Steven Rosefielde, ‘‘Back To The Future: Prospects for Russia’s Military Industrial Revival,’’ Conference on Eurasia’s Future Landpower Environment, Washington, DC, July 10–11, 2001.

Hill states that in order to re-emerge as a modern and powerful

presence on the world scene by 2010, total defense spending needs

to increase by about 3.5 percent per annum in terms of real increase in GDP. Other Russian defense economic specialists say that

fulfilling Putin’s defense policy requirements for the decade will require defense spending increases that exceed the rate of GDP

growth.5 Still other analysts do not see that increasing defense

spending necessarily reduces civilian allocations to meet reform

needs. They believe that Russia can establish market conditions in

its civilian economy that would attract foreign investment and generate increased growth that could permit increased defense spending and also generate funds for necessary reform.6

On the issue of financial reform, David Kemme considers development of a functioning banking system the key to Putin’s plan to

generate increased investment in order to promote sustained

growth. ‘‘While the number of financial institutions has increased

dramatically, the state structure still dominates the financial sector,’’ reports Kemme. Because of a lack of legal and regulatory development in banks, savers do not trust banks, banks do not convert savings to investment, and conflicts of interest are rampant

throughout the banking system. At this stage of Russian development, banks are far more critical than stock and bond markets for

assuring economic growth, according to Kemme. The best indicator

for success in banking reform, according to Slay, would be purchase

and control of some major Russian banks by large western banks,

such as Deutsche Bank or Citibank. Only multinational banks possess the resources and the size needed to resist political pressures

to lend, Slay asserts.

BREAKUP OF MONOPOLIES: ENERGY, TRANSPORTATION AND

AGRICULTURE

There are three major monopolistic sectors Putin’s reform policies seek to break up: energy, transportation and agriculture. Enhanced competitiveness in these sectors would facilitate increased

economic growth.

Opening the energy industry by restructuring Gazprom and the

Unified Energy System (UES) would provide the benefits of

globalization, larger markets, more foreign direct investment and

better corporate governance. The energy sector accounted for about

16 percent of GDP, 48 percent of federal budget revenue and 54

percent of foreign exchange earnings in 2000, according to Matthew

Sagers. Energy, especially gas and oil, may be the primary engine

of future Russian growth. Long-term investment necessary for

growth in the energy sector is largely dependent on comprehensive

reform, according to Sagers. A major increase in foreign direct investment (FDI) may be channeled early on to the oil and gas sectors if current reforms lead to one or more foreign investment success stories, e.g., joint oil and gas developments in Sakhalin, expansion of the Caspian pipeline consortia, or increased foreign investment in a reformed Gazprom and UES.

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7 Boris Fyodorov, Interviews and Correspondence.

Overall, the saying ‘‘As Gazprom goes, so goes the economic reform of Russia’’ has some merit. If domestic and foreign shareholders have a larger say in decisionmaking and corporate governance

improves, Gazprom may become a global enterprise and a major

spur to overall reform. Gazprom, as a competitive global enterprise,

might be the largest industry or sector contributor to future Russian GDP, revenue, and export earnings.7 Increased revenue from

gas and oil sales might then serve to loosen budget constraints that

limit funding for reform programs.

Putin wants the railroad system to follow the same reform pattern projected for Gazprom and UES. The current partially

privatized rail transport system is inefficient and a burden on the

Russian economy as a whole.

Although not directly bracketed in Putin’s reform agenda with

energy and transportation monopolies, Russian agriculture is another key monopolistic system from farm to market. Agriculture is

ticketed for restructuring and clarification of property rights

through a new Land Code for agricultural land. Only 5 percent of

agriculture is privatized. While the Russian Parliament has passed

a Land Code providing for property rights for urban centers, legislation has not yet extended the Land Code to include agricultural

land. Providing for secure land ownership for Russian farmers

would permit equity financing in the agriculture sector. Some vertical consolidation, ‘‘joint stock companies,’’ may hold promise for

more efficient farm-to-market agriculture, according to William

Liefert.

Overall, demonopolization in the Russian economy may serve to

shift the structure of the Russian economy toward value-added

manufacturing and processing enterprises, according to Palmeda

and Lewis. Oil, gas and other commodity output might substantially increase in absolute terms. Sectors such as general merchandising, food processing and distribution would then likely increase their relative share of GDP, moving Russia over time toward

a developed economy structure and away from the commoditybased pattern of a developing economy.

HUMAN CAPITAL AND THE SOCIAL CONTRACT

Russia’s large, literate and skilled labor force has traditionally

been considered a strong asset for improving productivity. As Murray Feshbach and Judyth Twigg graphically demonstrated, Russia’s

human capital has become a seriously depreciating asset. Population decreases caused by the ‘‘burden of decades of destructive

practices that have had a direct, harmful impact on public health’’ make addressing demographic and health concerns a national priority, according to Feshbach. With a projected escalation of HIV/

AIDS and tuberculosis, infectious diseases may reach calamitous

proportions in Russia. However, there has been no appropriate legislation addressing what Feshbach calls the ‘‘demographic and

health meltdown.’’

The quality of human capital, such as skilled workers and scientists, also has been sharply deteriorating due to lack of social security measures. In the Soviet era, workers had some degree of staVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00021 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.000 CRS1 PsN: CRS1
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8Strategy for the Development of the State to the Year 2010, Moscow, 2000. Cf. John Hardt,

CRS Report RL30266, op. cit.

bility through a social safety net that provided minimal but predictable benefits. This represented an implicit social contract between the state and the citizenry. In post-Soviet Russia, this minimal commitment of the state to the citizens has not been fulfilled.

Twigg notes the deleterious effect this has had on the development

of human capital: ‘‘Sudden withdrawal of meager but comprehensive programs covering health care, pensions, employment, housing

and other services has resulted in widespread poverty and disillusion.’’

Putin has introduced ambitious and, if funded, expensive programs for social welfare entitlements, pension funds, and education

to meet human capital needs. Duran notes that Putin also supports

expensive legal reform that would stimulate enterprise efficiency

and protect workers’ rights. Unless there is more revenue and a

change in budgetary priorities, these mandates will be underfunded.

LONG-TERM PROSPECTS FOR RUSSIA’S ECONOMIC GOVERNANCE

Many Russian specialists subscribe to one of two differing schools

of thought on Russia’s future beyond 2010. One envisions a market

economy, the other foresees rule by a predatory elite. James Millar

sees an ‘‘inexorable trend’’ toward a complete market economy and

away from the past autocratic economic governance model, especially the Soviet development pattern. This judgment is based on

Russia’s commitment to attain sustained economic growth that can

only come from transition to a market system. Peter Stavrakis, on

the other hand, projects a predatory model for Russia that rejects

liberal democracy and postulates retention of only a patina of a

democratic market system. ‘‘Free markets and civil society,’’

Stavrakis claims, ‘‘are thus hostage to political elites who are free

to intervene whenever and wherever this appears financially profitable and politically useful.’’ In his view, Russian state leadership

would continue to support the powerful predatory elites.

Russia’s predatory elites favor a continued state role in governing the economy. The ‘‘directive economy’’ plan supported by Viktor

Ishayev, governor of Khabarovsk, calls for continued state control

of economic decisionmaking in investment and allocation of resources.8 Through state control of economic decisions on investment

and production, Ishayev’s group promises results comparable to

those projected for Putin’s unfinished reform agenda without reducing the direct economic power of the state and the political elites.

The Ishayev program also promises to increase the size and influence of the middle class. Some members of Putin’s state apparatus

appear to be inclined toward supporting the Ishayev plan. There is

concern that adoption of the Ishayev plan would support the views

of Stavrakis that Russia’s future governance will be based on a

predatory, political elite system.

The authors in this volume consider it necessary that Putin take

a strong leadership role in reform and make the necessary decisions reducing the role of the state in economic decisionmaking.

xix

Whether Putin is able to fulfil this strategic role is still to be demonstrated.

Proponents of these contrasting views expect Russia’s future to

be determined by long-term historical processes without major policy changes in the short run up to 2010. Both Millar and Stavrakis

consider that the choices of Russia’s future economic governance

are at this point largely pre-ordained. Millar cites ‘‘reform fatigue’’

as a reason for not expecting effective reform soon. Moreover, a

functioning market system would require across-the-board comprehensive reform that would not come quickly even if Russia adhered to the accession process of the European Union (EU). Effective compliance with the transition requirements of the EU would

be a lengthy process for Russia.

Stavrakis finds the autocratic trend resistant to reform. He sees

the entrenched ‘‘financial oligarchy now competing with the state

elites using standard Russia-style methods: corruption and cronyism dominate and society has withdrawn from the political and economic arena.’’ Moreover, he argues that the autocratic model is

more consonant with Russia’s imperial legacy. Stavrakis sees a pattern of historical crises, ‘‘times of trouble,’’ characterized by recurring resistance of Russia to western democratic market models accompanied by increasingly authoritarian, inward-directed governance.

RUSSIA’S ECONOMIC FUTURE AND U.S. INTERESTS

In considering Russia’s economic future, U.S. policymakers may

recognize not only the diverse possible outcomes for Russia, but

also the varying effects those outcomes may have on U.S. interests.

Russian success and U.S. interests may not converge, but they are

not necessarily opposed. Curt Tarnoff notes that ‘‘three overarching

interests are involved: security, stability and humanitarian concerns.’’ Successful reforms may provide considerable reduction in

the threats to U.S. security if reform leads to decreased defense

spending, reduced weapons inventories, non-proliferation of weapons of mass destruction, and reduced arm sales. However, a stronger economy may also permit re-establishment of military forces in

Russia that might be considered a threat to U.S. security. Market

reform may lead to a stable and profitable commercial relationship

with Russia. However, a reformed Russia may be a stronger competitor in the world market and an increased threat to U.S. national security interests. The rule of law needed for effective market reform may contribute to development of a more civil, humane

Russian society. However, the absence of effective reform may have

negative effects on the human rights interests of the United States.

SECURITY ISSUES

The United States has tried to discourage Russia from making

foreign arms sales, especially to states that are perceived to be

threats to U.S. security. The current expansion of Russian arms

sales appears troublesome to the United States, as Kevin O’Prey

notes, because ‘‘more sophisticated weapon systems have been supplied to countries that may be a threat to U.S. interests.’’

xx

9Steven Rosefielde, op. cit.; and Vitaly Shlykov in Voennyi Vestnik (Military Herald) #8, Moscow, April 2001. 10 John P. Hardt, Russia’s Paris Club Debt and U.S. Interests, CRS Report RL30617, updated

June 6, 2001; John P. Hardt, Putin’s Economic Strategy and U.S. Interests, CRS Report

RL31023, June 19, 2001. 11The Biden-Lugar-Helms S–1803, Russian Federation Debt Reduction for Nonproliferation

Act of 2001. James Fuller, Debt-for-Nonproliferation, Pacific Northwest Center for Gloval Security and Defense Nonproliferation Programs. Paper delivered in Moscow, Russia, December 10,

2001. 12 EBRD, Transition Report Update, April 2001.

U.S. policymakers may also be concerned that the income from

arms sales might be used to revive and expand Russia’s military

industrial base. While 1,600 defense enterprises continue to operate at minimum production levels, only 6 to 10 of these enterprises

benefit from cash sale of arms. Moreover, even with more arms

sales and increased defense spending, O’Prey doubts that Moscow

could resume the cold war arms race with the United States. Russia’s military complex does not have the capability to compete in

high-technology weapons, especially because of backwardness in

electronics. Even in the worst-case scenario, Russia could return

only to manufacturing large quantities of older generation weapons, according to O’Prey. Others consider it possible for Russia to

fund reform and increase defense spending, thereby having the resources to rebuild its war mobilization base sufficient to compete

with the United States.9

Promotion of nuclear and chemical non-proliferation has also

been a centerpiece of U.S. security relations with Russia. If the

United States felt assured that Russian budget priorities would

shift to funding reform, some mutually beneficial debt swaps might

be in order.10 Security and stability interests of the United States

and Russia may be linked by debt for non-proliferation swaps that

might dampen the proliferation threat and reduce the heavy debt

service burden from Soviet-era debt. U.S. leadership in debt management negotiations might influence other creditors to follow

suit.11 Germany has been considering debt for assets swaps in negotiating some inherited Russian Paris Club debt since the

Schroeder-Putin summit in April 2000. The European Bank for Reconstruction and Development (EBRD) has offered to support debt

swaps that might encourage nuclear power plant safety and discourage weapons proliferation in the former states of the Soviet

Union.12

STABILITY ISSUES

Programs favoring development of a democratic market system

may support domestic stability in Russia and its integration into

the global marketplace and international institutions. In the Department of Commerce paper in this volume, Inga Litvinsky and

Matt London note, ‘‘The U.S. administration would like to see business become the bedrock of U.S.-Russian relations . . . Thus, U.S.

and Russian interests are in alignment to commence a new bilateral commercial era.’’ Bilateral trade and investment ties in the

past have been small and concentrated in a limited number of sectors, according to Tanya Shuster. Were Russia to reform and enter

the process of accession to the World Trade Organization (WTO),

U.S. commercial relations with Russia might substantially expand

xxi

in volume and scope. The Economic Dialogue, with its private sector initiative, undertaken after the Bush/Putin June 2001 Summit

may encourage favorable trade and investment developments. Successful energy investments might top the bilateral commercial

agenda. Litvinsky and London further note, ‘‘As Russia moves closer to WTO membership, the United States will need to re-examine

our domestic trade laws.’’ Permanent normal trade relations

(PNTR), more access of Russian steel and other commodities to the

U.S. market, and greater Export/Import Bank financing might then

be placed on the U.S. legislative agenda.

Favorable developments in the bilateral commercial environment

are contingent on Russia completing Putin’s unfinished agenda.

Thus, reform may have to be the horse leading the bilateral commercial cart.

HUMANITARIAN ISSUES

Human and civil rights in Russia have been of continuing concern to the United States. The conduct of the war in Chechnya violates many of the humanitarian principles of the United States.

Threats to freedom of religion in Russia have drawn continuous

U.S. monitoring and concern. Freedom of speech, imperiled by state

intervention and control over television, radio and print media, has

troubled U.S. policymakers. Human and civil rights and stability

interests have been adversely affected by persistent crime and corruption in Russia.

Russian crime, corruption and money laundering have all

plagued U.S.-Russian relations and deterred market reform. Capital flight and money laundering have had a disruptive effect on

the U.S. banking system and encouraged international crime and

terrorism, in the view of Winer and Williams. A peaceful, prosperous, market-oriented Russia might become more democratic and

more sensitive to civil and human rights, but the record to date is

mixed.

Thus, in summary, policymakers in Russia and the United States

face prospective benefits and costs as well as the uncertainty inherent in Russian policy options. The current policy of renewed dialogue and engagement adopted by both sides at the Bush-Putin

Summits of 2001 may generate a forum within which prospective

Russian economic reform measures may be influenced by the interaction of Russian and U.S. policymakers. The analyses in this volume do not provide definitive answers to the questions posed at the

outset of this overview or to the overarching question, where is the

Russian economy going, but they may offer a carefully reasoned

range of U.S. policy choices.

The United States, in concert with other western countries, may

influence the direction that Putin pursues in economic reform. Policies needed for the reform process pose difficult decisions for the

Russian leadership, some of which could lead to a different distribution of power and resources in Russia, contrary to the vested

interests of powerful elites. These decisions may be influenced by

U.S. policymakers and western allies of the United States. The

United States and Germany may encourage or discourage Russian

reform measures by use of leverage from debt management policy.

By engaging in debt restructuring the United States may be able

xxii

to use its leverage to push Russia toward more effective nonproliferation measures. Germany, as Russia’s leading western trading partner and creditor, may play a leading role in economic policy

with Russia, if it chooses to take the initiative. An economic dialog

between the Bush and Putin Administrations could be an important stimulus for broader agreements that would enhance our mutual national interests. Similarly, WTO accession discussions might

benefit both countries. However, caution may be required to assure

that the Russian economic reform process leads to concrete developments rather than promises that remain unfulfilled.

The IMF, World Bank, EBRD and other international institutions may play a continuing but less critical role in Russian economic development. If debt rescheduling is put on the policy agenda, the IMF would need to be involved. Jonathan Sanford notes

that after a decade of programs from international financial institutions (IFIs) treating Russia as a special case for aid and advice,

the IFIs now plan to treat Russia as a normal country.

(1)

PAST ECONOMIC PERFORMANCE AND

INSIGHTS FOR FUTURE PROSPECTS

(3)

RUSSIA’S ECONOMIC PERFORMANCE: ENTERING

THE 21ST CENTURY

By William H. Cooper 1

CONTENTS

Page

Summary .................................................................................................................. 3

Introduction .............................................................................................................. 4

Macro-economic Performance ................................................................................. 5

Output ............................................................................................................... 5

Inflation ............................................................................................................. 7

Structural Economic Performance .......................................................................... 7

Dominance of large unrestructured enterprises ............................................ 7

Structural problems in the banking sector ..................................................... 8

Living Conditions ..................................................................................................... 9

Real income ....................................................................................................... 9

Unemployment rate .......................................................................................... 10

Poverty .............................................................................................................. 11

Life expectancy ................................................................................................. 12

Income disparity ............................................................................................... 12

External Economic Performance ............................................................................ 13

Foreign trade .................................................................................................... 13

Foreign investments ......................................................................................... 14

Foreign debt ...................................................................................................... 16

Analyzing Russia’s Economic Performance ........................................................... 17

Policy Implications for Russia ................................................................................ 19

Implications for the United States ......................................................................... 20

Appendix A: Notes on the Data .............................................................................. 21

Appendix B: The 1998 Financial Crisis ................................................................. 21

Symptoms .......................................................................................................... 21

Causes ............................................................................................................... 22

1William H. Cooper is a Specialist in International Trade and Finance from the Foreign Affairs, National Defense, and Trade Division of the Congressional Research Service (CRS).

SUMMARY

Russia enters the 21st century potentially in better shape economically than it was during the last decade of the 20th century.

It has not only survived several financial crises, including its most

severe crisis in 1998, but has also enjoyed 3 straight years of economic growth and rising income for the average Russian citizen.

But the improvement comes after more than 7 years of severe economic contraction that left many Russians worse off than they had

been during the Soviet era, at least in economic terms. The economy and its people have been the victims of the lingering Soviet

legacy of central planning and of misdirected and incomplete economic reforms of post-Soviet Russian leaders.

Some analysts have suggested that recent economic growth indicates that the Russian economy is on the road to sustained economic growth. However, the recent growth may be fragile and short

4

term. An examination of Russia’s recent economic performance suggests that one might be cautious about predicting Russia’s longterm economic prospects based on the past 3 years. The factors

that have generated growth—high world commodity prices and

ruble devaluation—are by nature ephemeral and subject to the vagaries of world markets. Furthermore, the economic growth has

run neither deep nor wide. Some regions have benefited much more

than others, and the disparity in income distribution within the

Russian population has widened over the years.

Whether short term or more sustainable, Russia’s economic

growth presents President Putin and his policy team a ‘‘window of

opportunity’’ to address the structural problems of the Russian

economy by completing the reform process to help ensure long-term

growth. In addition, Putin and his team must preserve the ‘‘accomplishments’’ attained during the past 10 years. For example, maintaining macro-economic stability, a crucial condition for gaining investor confidence and attaining sustainable economic growth, remains a challenge for Russia. The recent 20 percent inflation rates,

while moderate by post-Soviet standards, are still high by conventional standards.

INTRODUCTION

By the end of the 1980s, the Soviet Union was declining economically, rapidly falling behind the industrialized West and even slipping behind some of the advanced developing countries of East

Asia. The Communist system of central planning, under which the

Soviet Union undertook rapid industrialization during and after

World War II generated high economic growth rates through the

1960s. Eventually, however, the system led the Soviet Union into

a period of economic stagnation in the 1970s and decline in the

1980s with few prospects of improvement. This dismal outlook was

a factor in Mikhail Gorbachev’s decision to undertake perestroika

to try to save the Soviet system through reform. The system proved

beyond reform, and Gorbachev’s perestroika led to the collapse of

the Soviet Union by the end of 1991. For the next 10 years, Russian leaders, Presidents Boris Yeltsin and Vladimir Putin, and

their respective governments, have had to lead Russia through the

transition from a central planned economy to what many hope and

expect to be a market economy. The transition remains a work in

progress and not always linear.

The 10 year economic performance of post-Soviet Russia has been

mixed at best. For most of the decade, the Russian economy shrank

and, with it, the standard of living of the average Russian citizen.

The economy has been burdened by the legacies of central planning

and by misdirected and incomplete government reform efforts of its

leadership. But Russia enters the 21st century potentially in better

shape economically than it had been during the last 7 years of the

20th century. It has not only survived several financial crises, including its most severe crisis in 1998, but also has enjoyed 3

straight years of economic growth and rising income for the average Russia citizen. However, the Russian economic recovery may

not be long term under present conditions.

Russia’s record of economic performance suggests that Russian

leaders face a formidable challenge in turning Russia into a modVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00030 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.001 CRS1 PsN: CRS1
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2These calculations are based on CRS-constructed production indices of Goskomstat data.

ern industrialized economy. The performance has critical implications for the Russian leadership and for U.S. policymakers as well.

MACRO-ECONOMIC PERFORMANCE

Russia’s economic performance during the past decade has largely been disappointing at best and destabilizing at worst. This is

evident in examining the output of the Russian economy measured

by real gross domestic product (GDP) and Russian inflation rates.

It has also been uneven with some regions of the country hit harder than others. Yet, the performance during the last 3 years has

shown tentative signs of recovery.

OUTPUT

GDP is one of the most comprehensive measures of a nation’s

economic activity and health. An economy must grow in order to

improve, or at least maintain, the living standards of the population. A contracting economy, especially over an extended period

of time, can threaten a nation’s political as well as its economic

foundation.

The Russian economy, measured in real (adjusted for inflation)

GDP, has contracted since the collapse of the Soviet Union (1992–

2000). The level of real GDP in 2000 was less than 80 percent of

what it was in 1992 (see Figure 1). The sharpest decline occurred

early in the transition, between 1992 and 1996, when the economy

shrank 27 percent, before the economy grew modestly (1 percent)

in 1997.

The economic contraction affected sectors across the economy,

some much harder than others. On the production side, industrial

production declined 28 percent between 1992 and 2000 and agricultural production declined 29 percent. On the expenditure side, fixed

investment, a crucial factor for future growth, declined 49 percent

between 1992 and 2000.2

The economic slide, especially in the early years of the transition,

was not entirely unexpected. An economy, like Russia’s, that is

going through a wrenching transition will certainly contract. Much

of Russian economic output during the Soviet period was of little

economic value. It was directed toward heavy industry to supply

the military and military-related industries. Soviet production in

the consumer sector, for example, clothing, prepared foods, and

passenger cars, was of poor quality as Soviet producers faced no

competition. Once the Russian economy opened its borders to trade,

domestic producers were unable to meet the foreign competition,

and production collapsed. Therefore, the decline was inevitable as

market forces began to take hold and rationalize investment and

production. But if the decline was inevitable, it was longer than in

other economies going through post-Communist transitions in East

and Central Europe.

In 1997 real GDP increased 1 percent. However, the positive

news proved not only modest but ephemeral. In 1998, a financial

crisis hit. (See note in appendix B for background on the crisis). As

a result of the crisis, GDP plunged 4.9 percent. The downturn hit

6

3 As of June 2001. Russian Economic Trends. October 2001. p. 14. 4 Ibid.

5Goskomstat.

all sectors of the economy, setting back economic progress. Many

analysts speculated that 1998 would be just the beginning of a new

phase of Russian economic decline because Russia would be cut off

from capital markets and the weaker ruble would discourage consumption. Instead, Russia experienced growth in 1999 (3.2 percent)

and in 2000 (7.7 percent). The Russian economy continued to grow

in 2001 in terms of real GDP at an estimated rate of 5.1. percent.3

FIGURE 1.—INDEX OF REAL RUSSIAN GDP, 1992–2000

[1992 = 100]

Index constructed by CRS based on Goskomstat data.

Despite the recent growth, the 10 year record of economic performance suggests that the Russian economy still has much room

to grow. In 2000, Russian real GDP was less than 80 percent of its

level in 1992, just after the collapse of the Soviet Union. Its level

of fixed investment was only 51 percent of the 1992 level. Similar

gaps are prevalent throughout the economy.4

Russian economic growth has been unevenly distributed among

the regions of the country. In 1999, the per capita nominal GDP

for the entire Russian Federation was 15.81 thousand rubles. In

the oil-rich Tyumen region, per capita GDP was 64.49 thousand rubles and was 37.49 in the Moscow region. In contrast, the per capital GDP for North Ossetia in the Caucasus was only 5.66 thousand

rubles.5


76171.023
7

INFLATION

Compounding the problem of declining growth were very high inflation rates. In 1992 alone, Russian consumer prices rose 2,509

percent and 840 percent in 1993. Inflation robs individuals of their

savings and lowers their standard of living. Hyperinflation, accompanied by declines in output, can create political and social unrest.

Fortunately, except for an increase in workers’ strikes, Russia

avoided massive social upheaval. But the Russian people began to

lose faith in their transition to the market economy. By 1997, inflation rates declined to 11 percent, but rose to 84 percent in 1998 as

a symptom of the financial crisis. By 2000 they had declined to 20

percent, a manageable, but still unstable rate. As Russia enters the

21st century, inflation remains a persistent problem for the economy, although much less so than at the beginning of the economic

transition.

TABLE 1.—RUSSIAN INFLATION RATES, 1992–2001

[Annual percentage change in consumer prices]

Year Inflation rate Year Inflation rate

1992 ................................ 2,508.8 1997 ................................ 11.0

1993 ................................ 839.9 1998 ................................ 84.4

1994 ................................ 215.1 1999 ................................ 36.5

1995 ................................ 175.0 2000 ................................ 20.2

1996 ................................ 21.8 2001 1 .............................. 20.0

1 As of September 2001.

Source: Goskomstat data in Russian Economic Trends.

STRUCTURAL ECONOMIC PERFORMANCE

Underlying the weak macro-economic performance in Russia during the 10 years of the transition have been structural economic

problems. Many of the problems affect the efficiency of the economy, that is, the productivity of its labor and capital. These inefficiencies make it difficult, if not impossible, for the economy to

achieve long-term growth. They also affect the distribution of income among regions and within the population. Two critical areas

of the economy that suffer from structural problems are the business sector and the banking sector. The problems in these sectors

are symptomatic of structural problems throughout the economy.

DOMINANCE OF LARGE UNRESTRUCTURED ENTERPRISES

The Russian Government privatized most of the state enterprises

in several phases. Nevertheless, the current profile of Russian business suggests that while Russia has made some progress in restructuring, it remains incomplete. Large enterprises that are legacies of the Soviet period continue to dominate the Russian economy. The top 20 Russian companies accounted for 30 to 35 percent

of Russian GDP and for 70 percent of Russian exports in 1999.

These companies are largely in the natural resources and infraVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00033 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.001 CRS1 PsN: CRS1
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6 European Bank for Reconstruction and Development (EBRD). Strategy for the Russian Federation. Paris. October 2000. p. 15. 7 Ibid. p. 47.

8One report estimates that 80 percent of household deposits are held by Sberbank. Talskaya,

Marina. Russia Misled Western Creditors. Vremya. September 13, 2000.

structure sectors (energy, transportation, etc.).6 Small- and medium-sized enterprises accounted for only 30 percent of the total

number of enterprises and 10 percent of the workforce. In contrast,

small- and medium-sized companies accounted for 50 percent of the

employment in the transition economies in Central and Eastern

Europe and for 65 percent of the employment in the European

Union. Furthermore, the number of small- and medium-sized Russian firms has remained constant since 1995 indicating little

progress in business restructuring and development.7 The stalled

restructuring impedes productivity as it signifies barriers to the

exit of inefficient firms and the entry of new firms to the market.

These barriers prevent the efficient use of resources and diminish

productivity.

STRUCTURAL PROBLEMS IN THE BANKING SECTOR

A viable banking sector is critical to an economy. Its primary

function is to operate as an intermediary funneling capital between

savers (households) and borrowers (businesses, consumers, etc.)

thereby facilitating the efficient use of financial resources. Without

banks, businesses and others would be hard pressed to raise funds

to finance investment to replace outdated equipment and technology or to expand production capacity. Banks also allow individuals to take out mortgages to invest in housing and to purchase

big-ticket consumer goods. A weak banking sector can impede economic growth. An important principle for a banking sector to be

credible is to maintain an ‘‘arm’s-length’’ relationship with borrowers so that loans are extended at market-determined rates and that

borrowers are deemed acceptable risks.

A number of private Russian banks emerged just prior to the collapse of the Soviet Union in response to the Gorbachev reforms.

The number accelerated during the Yeltsin period. However, the

ownership of the vast majority of these banks was closely tied to

emerging private enterprises and functioned as conduits of soft

credits from the government to those enterprises. Some of the larger banks belong to the financial conglomerates controlled by the socalled oligarchs. Such a conglomerate may consist not only of a

bank, but a major enterprise, usually a raw material producer

(nickel, diamonds, oil), or a news media outlet (television, newspaper). Most of the banks survived because of subsidies from the

government or because they were part of an oligarch’s conglomerate. In addition, some of the oligarch-owned banks made money

by holding deposits for the Russian Government and investing the

funds. They were not operating as financial intermediaries.

In the mid-1990s, many banks, including the larger ones, sought

returns by heavily investing in Russian Government treasury bills

(GKOs) that were paying high interest rates; they were not making

money lending funds.8 Households have placed most of their savings deposits in the state-owned and -operated Sberbank, which is

9

9 EBRD. Strategy for the Russian Federation. Paris. October 2000. p. 16. 10 Central Bank of the Russian Federation (Central Bank of Russia or CBR). Bulletin of Banking Statistics. No. 7. 2001. p. 64. 11 Economist Intelligence Unit. September 2000. p. 31. 12 Jamestown Foundation Monitor. August 6, 2001.

the only institution whose deposits are insured by the state.9 The

weakness of the banking sector was exposed when the government

was forced to default on the GKOs in August 1998 forcing most of

the banks into virtual bankruptcy. As a result, the Russian Government under Vladimir Putin has ostensibly made restructuring

the banking industry a major priority. The government established

the Agency for Restructuring Credit Organizations (ARCO). Its job

was to ensure that those banks that had no hope of surviving

would disappear while recapitalizing potentially viable banks

under conditions that would make them profitable.

However, few banks have closed. At the end of the third quarter

of 1998, the height of the financial crisis, there were 2,473 commercial banks in Russia. By the end of the second quarter 2001, only

398 banks had been closed.10 Most of the remaining banks are not

viable, and the sector remains under-capitalized.11 Unless the

banking sector is restructured and banks are in a position to lend,

the expansion of the business sector, and consequently of the economy as a whole, is stymied. Russian enterprises have relied on retained earnings as a source of investment, rather than banks,

thereby severely limiting industrial expansion.

LIVING CONDITIONS

The macro-economic performance and the structural economic

problems in Russia have had a direct impact on living conditions

for the average Russian. These conditions have deteriorated during

the past 10 years. The conventional measures of living standards—

real disposable income, unemployment, poverty, and life expectancy—indicate that the transition has adversely affected the average Russian, although here, too, experts differ on the significance

and accuracy of the data.

REAL INCOME

Russian real disposable income, a basic measure of economic welfare or purchasing power, has fluctuated during the 10 year period,

but has declined appreciably overall. According to official government data, from 1992 through 1994, the level of real income increased. Between 1994 and 1996, real income declined substantially (16 percent) before recovering modestly in 1997, mirroring

the upturn that year in real GDP. However, the data in Figure 2

indicate that the 1998 financial crisis had a major impact on the

buying power of the average Russian. Between the end of 1997 and

the end of 1999, the level of real disposable income declined 27 percent and rose only modestly (9 percent) in 2000. The data suggest

that despite the recovery in the last 2 years, Russian real disposable income was still 21 percent below its level in 1997, before the

financial crisis, and remained slightly below its level when the

transition began in 1992. Preliminary figures show that during the

first 6 months of 2001, real disposable income rose 4.4 percent.12

10

FIGURE 2.—INDEX OF REAL RUSSIAN DISPOSABLE INCOME, 1992–2000

[1992 = 100]

Index constructed by CRS based on Goskomstat data.

UNEMPLOYMENT RATE

Russia has had to confront the phenomenon of unemployment in

the post-Soviet period. Under the Soviet system, everyone had a

job, although much of that labor was redundant. Economic changes

in the last 10 years have forced Russian firms to rationalize their

business practices, in order to compete. They have had to layoff

workers or, in some cases, firms have had to close down thereby

eliminating jobs. The unemployment rate has risen, accordingly, although some specialists argue that standard indicators do not accurately measure the magnitude of Russian unemployment. In some

cases, the unemployment rate may not take into account redundant

labor as some firms are forced to retain workers because the firms

remain the primary distributor of housing, food, and other necessities, even though the employees may not be actually working. In

other cases, the unemployment rate may not take into account laborers who work in ‘‘the shadow economy,’’ in jobs not captured by

official statistics.

The data in Table 2 show that the economic transition has taken

a toll on workers. The rate of unemployment had risen since the

beginning of the economic transition period in 1992, peaking at

12.6 percent in 1999. As a result of the recent economic expansion,

the unemployment rate has declined since 1999 but is still above

the rates of the early 1990s and is almost double the rate in 1992.

The increase in unemployment may prove beneficial to the Russian

economy, if the economy is shedding unproductive labor. While

painful to the individual worker in the short run, the process can


76171.022
11

13 At the end of 2000, the official subsistence level was around 1,285 rubles, or about $44, per

month. 14For example, the methodology was changed in 1994 which biased the rate downward. The

change accounts for some of the step drop in the poverty rate that year. One study estimates

that the poverty rate would have risen to around 34 percent if the methodology had not been

changed. Similarly, the government changed it again that added an upward bias. Ovtcharova,

Lilia. What Kind of Poverty Alleviation Policy Does Russia Need. Russian-European Center for

Economic Policy. Research Paper. May 2001. pp. 4–5.

improve overall labor productivity in the economy. The economy

then can create more employment through growth, which seems to

be the case in the recent drop in the unemployment rate. But the

process also draws on government resources to provide unemployment insurance and other safety net benefits to assist unemployed

workers through the transition.

TABLE 2.—RUSSIAN UNEMPLOYMENT RATE, 1992–2001

[Percentage of workforce, International Labor Organization definition]

Year Rate Year Rate

1992 ................................ 4.7 1997 ................................ 10.8

1993 ................................ 5.5 1998 ................................ 11.9

1994 ................................ 7.4 1999 ................................ 12.6

1995 ................................ 8.5 2000 ................................ 10.4

1996 ................................ 9.6 2001 1 .............................. 8.2

1 As of August 2001.

Source: For the 1992–1994 data—Goskomstat. For 1995–2001—Russian Economic Trends, October

2001.

POVERTY

The Russian statistical committee measures poverty as the percentage of the population that lives below an officially established

subsistence level. The government calculates the subsistence as the

cost of purchasing a set basket of goods and adjusts that level annually.13 The Russian Government has also revised its methodologies for calculating the poverty rate, at times making the construction of a consistent data series somewhat difficult.14 The Russian

Government changed the methodology in 1994 and 2000, partially

accounting for some of the abrupt downward shifts in the poverty

rates in those years.

The data indicate, however, that the poverty rate declined somewhat between 1994 and 1997, but that the financial crisis in 1998

eliminated these gains as the poverty rate increased markedly by

1999. This trend is in line with the dramatic decrease in real disposable income and the rise in the unemployment rates in those

years as noted in Figure 2 and Table 2. The growth of poverty is

another sign of deteriorating living conditions in Russia. The Russian people are well known for managing to survive with little income through subsistence farming on private plots and through

barter. Nevertheless, the low officially-determined level of subsistence means that a significant number of individuals may be living

well below what would be considered subsistence in many other

countries. Other data indicate among those that are considered livVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00037 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.001 CRS1 PsN: CRS1
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15WHO. World Health Report 2000. http://www.who.org.

ing in poverty are a number of people who live substantially below

the official poverty level.

TABLE 3.—RUSSIAN ANNUAL RATE OF POVERTY, 1992–2000

[Percentage of population]

Year Rate Year Rate

1992 ................................ 33.5 1997 ................................ 21.2

1993 ................................ 31.5 1998 ................................ 24.6

1994 ................................ 22.4 1999 ................................ 39.1

1995 ................................ 26.2 2000 ................................ 33.7

1996 ................................ 21.4 2001 1 .............................. 31.3

1 As of June 2001.

Source: Goskomstat, Russian Economic Trends.

LIFE EXPECTANCY

A significant indicator of the deterioration of living conditions in

Russia has been the decline in the life expectancy of the average

Russian, especially the Russian male. In 1991, life expectancy for

males was 64 years and 74 years for females. By 1999, it had declined to 59 years for males and 72 years for females placing Russia among developing countries in that category. Increases in alcoholism and other diseases, some of which like tuberculosis have

been nearly eradicated in developed countries, have contributed to

the decline. It is also explained by the poor and deteriorating

health system which has been slow to adjust to the transition from

central planning. A World Health Organization (WHO) report

ranks the Russian health care system 130th in the world, below

that of even many developing countries.15

INCOME DISPARITY

The distribution of income within Russia has become increasingly unequal during the post-Soviet period. A standard measure of

income distribution is the Gini coefficient (or index) which is on a

0.00 to 1.00 scale. The lower the number the more equal the income distribution. Thus, 0.00 is perfectly equal income distribution,

while 1.00 is totally unequal.

According to Table 4, the Gini coefficient for the Russian population has increased. This conclusion is underscored by a second

measure of income distribution, which shows how income has been

distributed at various income levels of Russian society. These data

show that in 1991, before the collapse of the Soviet Union, the richest 20 percent of Russian the Russian population accounted for

30.7 percent of Russian income while the poorest 20 percent accounted for 11.90 percent. By early 2000, the richest 20 percent

held 48.6 percent of the income while the poorest 20 percent’s

share had declined to 5.9 percent. The middle 60 percent of the

population’s share had declined from 57.4 percent in 1992 to 45.4

13

16Goskomstat. 17 Calculations based on International Monetary Fund (IMF) data in International Financial

Statistics. July 2001. pp. 702, 704, 706. Trade data are expressed in dollars, while GDP data

are in rubles. The ruble figures were converted into dollars using an exchange rate of 2.19 rubles per dollar for 1994 and 28.1 rubles per dollar for 2000. 18 IMF. Direction of Trade Statistics. June 2001. p. 214.

percent by early 2000.16 The two sets of income distribution indicators mean that some segments of the Russian population have suffered more than others as living conditions in Russia have deteriorated during the past decade.

TABLE 4.—RUSSIAN INCOME DISTRIBUTION

[Gini coefficient]

Year Rate Year Rate

1992 ................................ 0.289 1997 ................................ 0.375

1993 ................................ 0.398 1998 ................................ 0.379

1994 ................................ 0.409 1999 ................................ 0.394

1995 ................................ 0.381 2000 ................................ 1 0.401

1996 ................................ 0.375

1 Estimate.

Source: Goskomstat.

EXTERNAL ECONOMIC PERFORMANCE

Russia’s foreign economic has driven recent economic growth.

However, Russia has also proved vulnerable to the vagaries of foreign markets, which could eventually undermine the growth.

FOREIGN TRADE

The role of foreign trade in the Russian economy has increased

since Russia embarked on its transition. According to some rough

estimates in 1994 (the earliest data available) exports were equivalent to 24 percent of Russian GDP. By 2000, the percentage had

grown to 42 percent. Russian imports were equivalent to 18 percent

of Russian GDP in 1994 and in 2000.17 Furthermore, Russian trade

is largely conducted outside of the former Soviet Union. By 2000,

only 14 percent of Russian exports and 30 percent of Russian imports were with former Soviet republics. In 2000, Russian exports

were split 50–50 between the industrialized countries (Canada, the

United States, Europe, Japan, Australia, and New Zealand) and

developing countries. Developing countries accounted for approximately two-thirds of Russian imports and industrialized countries

account for the remaining one-third.18 These figures indicate that

the Russian economy has changed from one that operated under

the closed system during the Soviet period where most trade was

conducted within the Soviet bloc, including Central and Eastern

Europe, to one where trade has become geographically diverse.

However, Russian trade particularly Russian exports, is highly

concentrated in a narrow group of commodities. In 2000, 50 percent

of Russian exports were in oil and oil products and natural gas.

The share of commodities increases to over 65 percent, when exVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00039 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.001 CRS1 PsN: CRS1
14

19Russian Economic Trends. June 2001. p. 22. 20 IMF. International Financial Statistics. July 2001. pp. 704, 706. 21 Central Bank of Russia. Balance of Payments Data. http://www.cbr.ru. 22OECD. The Investment Environment of the Russian Federation-Laws, Policies, and Institutions. p. 194. Paris. 2001.

ports of other raw materials, such as metals, are included.19 These

figures suggest that Russian trade is highly vulnerable to the often

volatile world market prices for energy and raw materials. They

also indicate that after 10 years of transition, the manufacturing

sector of the Russian economy remains uncompetitive.

In 2000, the Russian current account (trade in goods and services, plus investment income, and unilateral transfers) had a surplus of $46.3 billion, soaring from $24.6 billion in 1999 and from

$0.7 billion in 1998. The surplus has allowed the Central Bank of

the Russian Federation (Central Bank of Russia or CBR) to build

up foreign reserves to $24 billion by the end of 2000 (not including

gold reserves).20

FOREIGN INVESTMENTS

With outdated infrastructure and other modernization requirements the Russian economy needs financial capital. Other economies in transition, such as Hungary and Poland, have proved ripe

targets of foreign investors. Yet, Russia has run up large capital account deficits indicating minimal confidence of foreign investors in

the long-term prospects of the Russian economy.

Both the Yeltsin and Putin governments have promoted foreign

direct investment (FDI). Loosely defined, FDI is long-term investment in plants and real estate. Through FDI, foreign investors establish a presence in the economy that often includes transfers of

technology, management skills, and other intangible assets. The

Russian economy so far has failed to attract much foreign investment during the post-Soviet transition. From 1992 to 1999, total FDI flows into Russia were $19.8 billion

(see Table 5), one-third of which occurred in one year, 1997. In

comparison, total FDI flows into Poland were $31.0 billion. The

Russian FDI level was more comparable to that of Hungary ($17.8

billion), an economy that is much smaller than Russia. Moreover,

the trends are not improving despite economic growth. In 2000,

$2.7 billion in FDI flowed into Russia, down from $3.2 billion in

1999. In fact, FDI outflows from Russia in 2000 exceeded inflows

by about $500 million. During the first half of 2001, $1.2 billion in

FDI flowed into Russia, while $1.5 billion flowed out of Russia.21

(These recent numbers are preliminary and subject to revision.)

The regional distribution of FDI into Russia has been highly uneven. According to Goskomstat data reproduced by the Organization for Economic Cooperation and Development, as of January 1,

2000, Moscow and its environs accounted for 48.9 percent of the

stock of FDI in Russia. Sakhalin region was next with 5.1 percent.22

Portfolio investments are all other foreign investments besides

direct investments—government bonds, corporate stocks and bonds,

treasury bills, etc. By their nature portfolio investments do not represent as firm a commitment and are an indicator of short-term investors’ outlook for an economy. Russia has not done well in atVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00040 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.001 CRS1 PsN: CRS1
15

tracting portfolio investments, either, especially since the 1998 crisis. Table 6 shows that portfolio investments surged, in 1997 to $46

billion. In 1998, the year of the crisis, $8.9 billion still flowed to

Russia. But in 1999 and 2000, Russia incurred a disinvestment of

foreign portfolio assets, $1.3 billion and $9.9 billion, respectively.

During the first half of 2001, portfolio investments into Russia

were only slightly negative.

TABLE 5.—FOREIGN DIRECT INVESTMENT (FDI) IN RUSSIA, 1992–2000

[In billions of dollars]

Year Rate Year Rate

1992 ................................ $0.7 1997 ................................ $6.6

1993 ................................ 1.2 1998 ................................ 2.8

1994 ................................ 0.6 1999 ................................ 3.3

1995 ................................ 2.0 2000 ................................ 2.7

1996 ................................ 2.5 1992–2000 ...................... 19.8

Source: Central Bank of the Russian Federation (Central Bank of Russia or CBR).

TABLE 6.—PORTFOLIO INVESTMENT FLOWS INTO RUSSIA, 1994–2000

[In billions of dollars]

Year Rate Year Rate

1994 ................................ ¥$0.1 1998 ................................ $8.9

1995 ................................ ¥0.7 1999 ................................ ¥1.3

1996 ................................ 4.6 2000 ................................ ¥9.9

1997 ................................ 46.0

Source: Central Bank of Russia.

The trends in foreign direct and portfolio investments in Russia

indicate that investor confidence in the Russian economy weakened

rather than strengthened. This conclusion is reinforced by the problem that Russia has had with ‘‘capital flight.’’ Capital flight is an

abnormal flow of funds whose holders seek safe havens from financial uncertainty and taxation or to launder proceeds from illegal activities. Russian capital flight is a longstanding problem with very

negative consequences for the Russian economy. It deprives the

Russian economy of critical investment and tax revenues that

might be used for restructuring the pension system and other social security programs. More importantly, capital flight indicates a

lack of confidence by Russian and foreign investors in the Russian

ruble, in the Russian financial system, and more generally, in the

Russian economy. Capital flight signifies that Russia’s transition to

a market economy continues to be incomplete and far from sustainable.

Estimates of the amount of Russian capital flight vary according

to definition and context. Most estimates suggest that between

1992 and 1999, $150 billion of capital left Russia as capital flight.

Furthermore, the problem of capital flight has remained the same

or may have worsened. According to one estimate, Russian capital

16

23This estimate is from the Ministry of Finance’s Economic Experts Group and is cited in the

Economist Intelligence Unit. Country Report: Russia. March 2001. p. 39. 24This analysis of the Russian debt burden is drawn from work by Patricia Wertman, Specialist in International Trade and Finance, CRS, and various IMF reports.

flight was $28 to $29 billion in 2000, an increase from $24 billion

in 1999.23

FOREIGN DEBT

The Russian Government carries a rather heavy burden of foreign debt. Much of this debt was inherited from the Soviet Union.

As part of an arrangement with the other former Soviet states,

Russia agreed to accept the obligations of servicing the Soviet debt

in exchange for control over Soviet official assets abroad, such as

embassy facilities. As Table 7 below shows, much of the Soviet debt

was in the form of credits extended or guaranteed by foreign governments to finance Soviet Government purchases of equipment for

major projects. Since the Soviet Union’s collapse, Russia has incurred its own foreign debt obligations particularly in the form of

loans from the International Monetary Fund (IMF), the World

Bank, and the European Bank for Reconstruction and Development

(EBRD).

TABLE 7.—RUSSIAN FOREIGN DEBT, 2000

[In billions of dollars]

Post-Soviet Russian debt ................................................................................ $44.5

Debt inherited from the Soviet Union ............................................................. 97.7

Total federal government ....................................................................... $142.2

Russian regional authorities ........................................................................... 2.0

Central Bank of Russia ................................................................................... 3.4

Russian private sector debt ............................................................................ 27.9

Total ............................................................................................... 175.6

Source: Central Bank of Russia, Economist Intelligence Unit.

Various measures are used to determine the burden of foreign

debt on a nation’s economy. It is not the absolute size of the debt

that is critical but its term structure, composition, and size relative

to the economy’s ability to meet the servicing obligations.

IMF data (see Table 8) show the level of Russia’s long-term debtservice payments and the ratio of these payments to the level of

Russia’s exports for the years 1997 to 2005.24 Data for the years

2000 through 2005 are projections. Although debt service payments

are projected to remain roughly stable between 2001 and 2002,

they are projected to rise in 2003 to $23.3 billion, equal to 20.6 percent of goods and service exports, the highest percentage share

since 1999, when they stood at 23.9 percent.

17

25 IMF Country Report: Russian Federation. No. 01/102. July 2001. pp. 17, 25, 26.

TABLE 8.—RUSSIA’S FOREIGN DEBT SERVICE BURDEN, 1997–2005

Year

Debt-service payments (in billions

of dollars)

Debt service/exports (in percent)

1997 ............................................................................ $15.4 24.9

1998 ............................................................................ 17.5 20.0

1999 ............................................................................ 20.3 23.9

2000 ............................................................................ 15.7 13.8

2001 ............................................................................ 18.2 15.8

2002 ............................................................................ 18.2 16.1

2003 ............................................................................ 23.3 20.6

2004 ............................................................................ 17.4 14.9

2005 ............................................................................ 19.2 15.7

Data for 2001 through 2005 are projections.

Source: IMF, Russian Federation: Post-Program Monitoring Discussions—Staff Report and Public Information on the Executive Board Discussion. IMF Country Report no. 01/02. July 2001.

Russia is projected to face a debt servicing burden ballooning in

2003. Nevertheless the IMF projects that Russia should be able to

service the burden from its own resources. The IMF forecast assumes that declining oil prices will be offset by an improved domestic economic climate that will encourage foreign investment and the

return of capital. In addition, the structural reforms, the IMF assumes, will allow Russia to boost non-energy exports cutting its dependence on oil and natural gas exports. Any dramatic negative

shifts in these assumptions would affect Russia’s debt forecast, and

therefore the projections are subject to revision.25 The trends in

foreign investment and capital flight for 2000 and 2001 noted

above would indicate that Russia’s international financial situation

may be deteriorating rather than improving.

ANALYZING RUSSIA’S ECONOMIC PERFORMANCE

The decade of economic transition has taken a large toll on the

Russian economy and its people. Individual Russian data series

may not accurately measure the economic performance. However,

by examining the economic performance from a variety of perspectives, it is accurate to conclude that the Russian standard of living

has declined considerably over the last 10 years. In some respects,

the average Russian citizen is worse off now than he or she was

prior to the end of the Soviet Union, and the depth of economic decline will require Russia to generate high growth rates over a significant period of time in order to regain what its people have lost.

The data on Russian poverty levels, life expectancy, shrinking population, and health-related conditions point to an economic decline

that has left deep roots and long-term problems.

Furthermore, the burden of the economic contraction has fallen

disproportionately on some segments of Russian society and on

some regions of the Russian Federation. The income gap between

the richest and poorest segments of the Russian population has

widened significantly in the last 10 years. In addition, the available

18

wealth in the Russian economy has been concentrated in the larger, more politically influential regions of Moscow and St. Petersburg and in those regions naturally endowed with oil and other

commodities. Other regions, such as those in the Caucasus, are

much poorer and have been hit much harder by the effects of the

transition.

Russia has shown signs of economic recovery since 1999, and

that recovery appears to be generated in most sectors on the demand and supply sides of the GDP equation. Of particular importance has been the surge in investment in equipment and machinery. Russia’s infrastructure in both the public and private sectors

is sorely outdated, so new investment is a welcomed and necessary

trend. Russian living standards have also shown signs of improving

in the last 3 years with modest increases in real income and consumption.

Furthermore, Russian terms of trade have improved significantly

boosting current account surpluses and Russian foreign currency

reserves. This trend has allowed Russia’s to meet its immediate

foreign debt service obligations without incurring more debt. However, the large and increasing outflows of capital, especially in the

form capital flight, strongly suggest that investors, both foreign

and Russian, are skeptical about the depth of Russia’s economic recovery.

What lies behind Russia’s economic performance? In general, as

many observers have pointed out, Russia’s transition away from

central planning was bound to be more difficult and longer than

that of the Central and East European states. The Communist system was much more entrenched in the Soviet Union than it was

in the rest of the Soviet bloc. Furthermore, Russia does not have

a legacy of market economy to draw on as is the case with some

of the Central and East European states. Russia has had to deal

with the legacy of a Soviet economy that was administered to meet

the needs of the military while civilian production and investment

were given low priority.

However, the Soviet legacy aside, Russia’s economic problems

were also grounded in policy failures during the transition. These

failures included loose monetary and fiscal policies early in the

transition period. They have also included structural problems such

as poorly developed and executed privatization programs that have

left many potentially productive assets in the control of enterprise

mangers from the Soviet period or in the hands of a few politicallyconnected individuals (oligarchs) who extracted the value from

many of these assets rather than making them commercially viable

for the long run. In addition, an inefficient banking system, the

lack of private land ownership protection, the absence of a adequate system of commercial laws, and an inefficient and corrupt

government bureaucracy inhibited economic growth and development.

Despite the setbacks and the challenges for Russian policymakers, it is important to keep in mind what Russia has accomplished in terms of economic reforms during the last decade:

• The government has eliminated price controls on most goods

and services. This reform has been important because it allows

the market forces of supply and demand to guide producers

19

26See, for example, Aslund, Anders. The Bear Turns Bullish. World Link. July–August 2000.

pp. 49, 51, 53–54. (Available on the Carnegie Endowment for International Peace Web site:

http://www.ceip.org/files/Publications/aslund/). Another expert who subscribes to this point of

view is Yegor Gaidar, the former Russian Prime Minister. The Political and Economic Situation

in Russia. Remarks to the Carnegie Endowment for International Peace. January 29, 2001.

http://www.ceip.org/files/events/.

and consumers on purchasing, production and investment

making the economy more efficient. Controls have remained on

some important items, such as energy, housing, and transportation, but these, too, are scheduled for removal. • Russia has opened its economy to foreign trade and investment. • The structure of Russian production more closely resembles

that of an open economy than of a militarized economy. For example, the service sector accounts for a much larger share of

national output than does the goods sector. • The ruble is convertible, and Russian residents may hold hard

currency assets which can be a hedge against inflation and

help protect Russian savings. • The private sector accounts for roughly three-fourths of national output.

The economic growth that Russia has experienced since 1999 has

been largely driven by favorable trends in the Russian balance of

payments. The sharp depreciation of the ruble in 1998 cut demand

for imports and encouraged domestic production of goods. A rapid

increase in world oil prices boosted revenues from Russian exports.

Those factors are by nature ephemeral, subject to sudden changes.

Indeed, the ruble has recently been appreciating in real terms

causing imports to increase and reducing the price competitiveness

of Russian goods. Nevertheless, the Russian economy in terms of

real GDP continues to grow in 2001 at an estimated 5.5 percent

rate suggesting that domestic demand may be driving some of the

growth. It is difficult to estimate how long this trend will continue.

POLICY IMPLICATIONS FOR RUSSIA

Sustainable economic growth is critical to Russia. Among other

things, it is necessary in order to improve the standard of living

of the average Russian, and, as the above analysis has indicated,

the standard of living needs improvement. In addition, sustainable

economic growth is necessary in order to generate tax revenues to

meet growing pressures on the government sector.

The question of whether Russia’s current economic growth is sustainable over the long term or just short term has significant policy

implications for Russia. If the answer is the former, then Putin and

his team could give the economy lower policy priority and delay undertaking politically challenging structural reforms.

Some specialists have suggested that Russia’s period of economic

growth indicates that the Russian economy has turned the corner

and is on the road to sustained economic growth.26 However, the

above analysis suggests that one must be cautious in extrapolating

long-term trends from the record of the past 3 years. The analysis,

instead, indicates that the economic growth is fragile and that

without continued economic reforms it may not be sustainable.

Many of these reforms would be aimed at increasing investor conVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00045 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.001 CRS1 PsN: CRS1
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27OECD. The Investment Environment in the Russian Federation: Laws, Policies, and Institutions. Paris. 2001. pp. 36–37.

fidence in the Russian economy. They would include, banking reform, tax reform, land policy reform and the protection of property

rights, government regulatory reform, and legal reform.27 The

Putin government and the Russian Duma have proceeded with introducing and passing some of these reforms which are part of the

Putin team’s economic strategy for the next decade. Some of these

reforms are difficult because they will entail fundamental changes

in the way of life for Russians. At the same time, the Putin leadership will have to preserve the ‘‘accomplishments’’ of past years. For

example, macro-economic stability, that is low inflation and a stable exchange rate, is critical to gaining investor confidence and ensuring an environment conducive to sustainable economic growth.

Economic reforms will require political support. The current period of economic growth is a ‘‘window of opportunity’’ for the Putin

leadership to undertake these reforms because it has provided Russians with some relief from the adverse impact of the transition

and has generated popular support for Putin.

IMPLICATIONS FOR THE UNITED STATES

Russia’s economic performance has significant implications for

U.S. interests. How Members of Congress and other policymakers

view Russia’s economic performance in relation to U.S. national interests is a function of their views of the fundamental nature of the

U.S.-Russian relationship.

In some respects, an economically weakened Russia has benefited the United States by greatly reducing it as a military threat.

Some might argue, therefore, that a weak Russian economy will

help to prevent the threat from reemerging. The military sector

will have to compete with other domestic needs for limited resources helping to keep military spending down. In addition, Western creditors could maintain some financial leverage over Russia

which might help to manage any threat to U.S. interests. This view

is held by many of those who still see Russia as primarily a security threat, albeit a weakened one.

On the other hand, others believe an economically strong Russia

better would serve U.S. interests. Many in the business and financial communities and those who analyze the U.S.-Russian relationship within an economic framework hold this view. It can be argued, for example, that an economically efficient and expanding

Russia enhances U.S. and global economic welfare. Russia is

viewed by many as a trade partner and target for U.S. investments, and these opportunities will grow as Russia becomes

healthier economically. Furthermore, an economically strong Russia would be less likely to have to export arms to states whose policies are adverse to U.S. national interests. Some also hold that an

economically stable Russia would mean a politically stable Russia

which would benefit the United States, its allies, and the countries

surrounding Russia.

21

28This is a brief discussion. For more analysis of the financial crisis see CRS Report 98–578,

The Russian Financial Crisis: An Analysis of Trends, Causes, and Implications, by William H.

Cooper. 29 Central Bank of Russia data published in Russian Economic Trends. September 15, 2000.

p. 29.

APPENDIX A: NOTES ON THE DATA

This survey of Russia’s economic performance relies on official

Russian Government data published by the Russian Government

State Committee on Statistics (Goskomstat), the Russian Ministry

of Finance, the Central Bank of Russia, and the Russian Economic

and Trade Ministry. These data are derived directly from these

agencies through their online sites or through secondary sources,

such as Russian Economic Trends. Russian economic data, as with

the Russian economy, has been going through a major transition

since the collapse of the Soviet Union. Soviet data and early versions of Russian official data were notoriously unreliable.

Russian Government data-collection methodologies have improved over time and with them so has the quality of data. Russia’s

participation in international organizations, such as the IMF and

the World Bank, and its bid to join the World Trade Organization

(WTO), have required Russian data collectors to conform to international standards. As many analysts continue to point out, the

current versions of economic data still suffer shortcomings, for example, under-reporting of some activity in the ‘‘grey economy.’’

Nevertheless, the data do allow analysts to measure trends and

changes in magnitude and thus to construct an informative survey

Russia’s economic performance over the last decade. Possible shortcomings in the official data will be noted in the survey.

APPENDIX B: THE 1998 FINANCIAL CRISIS

The 1998 financial crisis proved to be a pivotal event in Russia’s

transition to a market economy. It exposed many of the weaknesses

of Russian economic policies and the need for economic reform.28

SYMPTOMS

The crisis culminated in August 1998, when the government of

then-Prime Minister Sergei Kiriyenko abandoned its defense of a

strong ruble. It also defaulted on official domestic debt forcing its

restructuring and imposed a 90 day moratorium on commercial external debt payments. The crisis led to the demise of many Russian

banks, owned by oligarchs, which had held government debt. The

crisis also led to Kiriyenko’s firing by Russian President Yeltsin

who replaced him with Prime Minister Primakov.

Symptoms of the crisis developed months before August.

• Interest rates soared.—Yields on GKOs rose sharply in a matter of months—to 135.3 percent by the end of August 1998.

The CBR refinancing rate skyrocketed from 30 percent at the

end of April to 150 percent by the end of May. The CBR’s overnight interbank lending rate increased from an average of 45.3

percent in August to 135.3 percent in September 1998.29

22

30 Ibid. p. 30. 31Furthermore, the ruble continued to decline losing 71 percent of its value from April to the

end of 1998. Measured on a real effective exchange rate basis (adjusted for inflation), the ruble

depreciated 41 percent between April and December 1998. CRS calculations based on data in

Ibid. 32 Ibid. 33 Ibid. p. 22.

• Stock market values plummeted.—The Moscow Times (MT)

index of stock prices declined 79 percent from the end of April

to the end of August 1998.30

• The value of the Russian ruble sank.—Between the end of July

1998 and the end of September 1998, the ruble lost 60 percent

of its (nominal) value in terms of the dollar.31

• Foreign reserves declined sharply.—Between the end of July

1998 and August 1998, the reserves, including gold, dropped

from $18.4 billion to $12.5 billion.32

• Real GDP dropped 4.9 percent in 1998 after a modest increase

in 1997 and inflation soared to 84.4 percent from 11.0 percent

the year before.33

CAUSES

The immediate cause of the crisis was the accumulation of Russian Government short-term debt in the form of GKOs and bonds

(OFZs), to finance burgeoning budget deficits. As long as the Russian Government could service the debt, it managed to maintain

large budget deficits without incurring inflation and was able to

keep the ruble stable.

But beginning in 1997 and into 1998, a number of forces came

into play that placed Russia in a financially vulnerable position:

• World prices for oil and other commodities, on which Russian

depends for much of its foreign currency earnings, plummeted,

putting downward pressure on foreign currency reserves and

making it more difficult to service the debt and defend the

ruble.

• The Asian financial crisis made investors much more wary of

holding risky short-term securities such as GKOs.

• The decline in demand for Russian debt and declining world

commodity prices put downward pressure on the Russian

ruble, making foreign debt servicing much more expensive.

Foreign economic shocks that hit a financially vulnerable Russia

largely explain the suddenness of the 1998 financial crisis. The effects of the crisis are still being felt. But analysts explain how Russia got to this point of vulnerability by citing more fundamental

problems with Russian economic policy and economic structure.

These included the failure to institute tax reform, property rights,

and bankruptcy laws and procedures.

(23)

RUSSIA’S ECONOMIC CHALLENGES

(25)

Removing Barriers and Providing an Incentive

System

THE RUSSIAN ECONOMY: HOW FAR FROM

SUSTAINABLE GROWTH?

By Ben Slay 1

CONTENTS

Page

Summary .................................................................................................................. 25

Introduction .............................................................................................................. 25

Russian Macro-economic and Political Economy Trends, 1991–2001 ................. 27

Russia’s External Trends ........................................................................................ 33

Russia’s Unfinished Reform Agenda ...................................................................... 37

Reform of infrastructure sectors ..................................................................... 38

Financial system ............................................................................................... 39

Leading Indicators for the Future of Russia’s Transition .................................... 44

Business formation ........................................................................................... 44

Labor force participation rates ........................................................................ 45

Commodity composition of exports .................................................................. 45

FDI levels and composition .............................................................................. 45

The ‘‘Putin factor’’ ............................................................................................. 45

1 Ben Slay is Director, Regional Support Centre, United Nations Development Programme’s Regional Bureau for Europe and the CIS, Bratislava. The views in this paper do not necessarily

reflect those of the United Nations. Much of this paper was written while the author worked

as senior economist at PlanEcon, Inc., the Washington-based economics consultancy. The author

acknowledges his gratitude for the PlanEcon data and analyses that underpin this paper. 2 Aaslund, A., How Russia Became a Market Economy, Washington, DC, 1995, The Brookings

Institution.

SUMMARY

The consolidation of capitalism in Russia during the 1990s was

difficult, but reform initiatives ultimately succeeded in stabilizing

prices and restoring economic growth. Most markets have undergone significant liberalization, and the bulk of the enterprise sector

is in private hands. But the consolidation of these changes is likely

to require important structural reforms that comprise Russia’s ‘‘unfinished reform agenda.’’ In the short run by 2010, institutional reform, particularly in the infrastructure and financial sectors, would

be necessary to establish a well-functioning market economy with

sustained growth. If reform is not completed by 2010, Russian leadership could still finish the unfinished agenda.

INTRODUCTION

Russia has had a capitalist economy since the mid-1990s. 2 Market forces set most prices, and the bulk of Russian enterprises are

privately owned. International economic integration has proceeded

26

3 All data are taken from the official monthly and annual publications for the Russian State

Statistical Office and the Central Bank of the Russian Federation (Central Bank of Russia or

CBR) (or from their Web sites) unless otherwise indicated. Indicators on poverty and inequality

trends are taken from Human Development Report 2000: Russian Federation, UNDP, Moscow,

2001. 4Osnovnye napravleniya sotsial’no-ekonomicheskogo razvitiya Rossii na dolgosrochnuyu

perspektivu (Gref program), Ministry of Economy and Trade, Moscow, 2000 (http://

www.economy.gov.ru/program/soderzanie.html). 5See Russia’s Physical and Social Infrastructure: Implications for Future Development, National Intelligence Council, Washington, DC, December 2000.

apace: exports of energy, metals, and raw materials play a key role

in determining Russia’s external creditworthiness and growth prospects. The imperative of fiscal balance has played a key role in federal budget policy since 1999, while monetary and exchange rate

policies reflect the tradeoffs between price stability and exchange

rate competitiveness faced by central banks everywhere. Although

elite commitment to democracy remains an open question, the inevitability of capitalism is widely accepted across Russia’s political

spectrum. And after years of sharp reported declines in output and

incomes, the Russian economy has recorded growth in 4 of the past

5 years. The 14 percent cumulative expansion in gross domestic

product (GDP) reported in 1999–2000 was Russia’s best growth

performance since the 1970s.3

But if Russian capitalism is here to stay, it is far from wellfunctioning. The creation of efficient markets supervised by regulatory institutions applying best international practices remains

years (if not decades) away in many sectors. Most enterprises have

passed out of full state ownership, but problems of corporate governance, the judicial system, and land ownership continue to distort property rights. Market forces determine prices, but administrative decisions keep key tariffs for energy, transport, and communal services well below market levels. Although the federal government reported an impressive fiscal adjustment during 1999– 2001, sub-national fiscal policy leaves much to be desired.

Unaddressed consequences of the August 1998 financial collapse

continue to plague Russia’s banking system, and foreign capital

inflows remain minuscule. While Russia is fully servicing its sovereign external debt in 2001, this is only the second year (after

1997) since the Soviet collapse in which Moscow has not stiffed its

creditors. The strong economic growth reported during 1999–2000

was due in part to such transitory factors as high world prices for

key energy exports, and the temporary effects of the ruble’s sharp

devaluation after August 1998. The signs of a slowdown were apparent in the first half of 2001, when industrial and GDP growth

slowed to around 5 percent. And despite the strong growth recorded during 1999–2000, much of the country still lives in poverty.

Like most transition economies, the Russian economy has markets, private enterprise, and is growing. But in contrast to the

leading Central European and Baltic transition economies, Russia’s

development prospects remain constrained by sharp institutional

divergences from best international practices. As the Russian Government itself has admitted,4 the economy is unlikely to find a sustainable development path unless these divergences are narrowed

significantly. Russia also faces some worrisome demographic, public health, and infrastructure trends that raise troubling longerterm questions.5 While the economic development program for

27

6For a provocative investigation of the differences between actual and reported declines in

output in Russia and other transition economies during this time, see Aaslund, A., ‘‘The Myth

of Output Collapse After Communism,’’ Carnegie Endowment Working Paper 18, 2001,

Washington, DC, Carnegie Endowment. (http://www.ceip.org/files/Publications/

wp18.asp?from=pubauthor) 2001 7 Blasi, J.R., M. Kroumova, and D. Kruse, Kremlin Capitalism: Privatizing the Russian Economy, Cornell University Press, 1997, Ithaca and London.

2000–2020 promulgated by Economics Minister German Gref and

approved by President Vladimir Putin acknowledges these problems, prospects for their effective resolution are far from certain.

This paper addresses these issues in the following manner. First

is a brief narrative of key macro-economic and political economy

trends since the Soviet collapse. Special emphasis is placed on the

causes and implications of the August 1998 financial crisis, and the

drivers of the economic expansion that followed. Next is an investigation of external trends, paying particular attention to developments in the commodity composition of Russian trade, the balance

of payments, foreign investment, capital flight, and relations with

the country’s creditors. Following that is an examination of key

issues in the unfinished reform agenda, with particular emphasis

on the infrastructure monopolies and the financial system. Last are

some concluding remarks and some leading indicators on prospects

for sustainable growth in Russia.

RUSSIAN MACRO-ECONOMIC AND POLITICAL ECONOMY TRENDS,

1991–2001

The official data in Table 1 show that Russian macro-economic

trends during the 1990s closely resembled patterns apparent in

other transition economies. An initial period (1991–1994) of systemic collapse and deep structural changes was accompanied by

triple- and quadruple-digit inflation and sharp declines in reported

output and employment.6 This was the period in which many

prices and commercial activities were liberalized (although not with

Central European decisiveness), and ownership of thousands of

state enterprises passed into private hands.7 It was also the period

of deep political transformation (if not necessarily democratization),

in which President Boris Yeltsin forcibly suppressed an insurrection in October 1993 orchestrated by the Communist and Nationalist opposition. A constitution was approved (in highly inauspicious

circumstances) by plebiscite shortly thereafter, codifying the basic

outlines of electoral democracy and a federal system.

The introduction of a quasi-fixed exchange rate mechanism (the

currency corridor) in July 1995 marked the end of the chronic

macro-economic instability that characterized the first period of the

Russian transition. The exchange rate’s nominal peg and growing

financial assistance from the International Monetary Fund (IMF)

and World Bank helped inflation rates to fall sharply after mid1995. Reduced financial instability helped attenuate the reported

contraction in economic activity: annual declines in GDP fell to 3

to 4 percent during 1995–1996, and stopped in 1997. Slowing inflation, the appearance of economic growth, better relations with its

creditors, Yeltsin’s re-election in 1996, and propitious conditions on

international capital markets caused the Russian stock market to

boom.

TABLE 1.

—MACRO-ECONOMIC TRENDS, 1991

–2000

1991 1992 1993 1994 1995 1996 1997 1998 1999 

Dollar GDP (at purchasing power parity exchange rates,1 in billions) ....................... $1,063 $909 $830 $726 $696 $672 $678 $645 $680 

Per-capita dollar GDP 2 ................................ 7,200 6,100 5,600 4,900 4,700 4,500 4,600 4,400 4,700 

Real GDP growth (in percent) ......................

¥5.0

¥14.5

¥8.7

¥12.7

¥4.1

¥3.4 0.9

¥4.9 5.4 

Growth in personal consumption (in percent) .........................................................

¥5 ¥3 0

¥3 ¥7 ¥5 5

¥3 ¥4 

Growth in gross fixed investment (in percent) .........................................................

¥16

¥40

¥12

¥24

¥10

¥18

¥5 ¥10 5 

Federal budget balance (percent of GDP) ... NA

¥3 ¥1 ¥5 ¥3 ¥4 ¥5 ¥3 ¥1 

Consolidated budget balance (percent of

GDP) ......................................................... NA

¥4 ¥5 ¥10

¥3 ¥4 ¥7 ¥4 ¥1 

Consumer price inflation (annual average,

in percent) ................................................ 96 1533 881 322 196 48 15 27 93 

Unemployment rate (by ILO standards, in

percent) .................................................... NA 4.9 5.5 7.5 8.2 10.1 12.2 13.3 12.2 

Gini coefficient (income inequality) ............. 0.26 0.29 0.40 0.41 0.38 0.38 0.38 0.40 0.40 Population with below-subsistence incomes

(in percent) .............................................. NA 34 32 22 25 22 21 24 39 

1 PlanEcon estimates.2 Ibid.

NA

—Not available.

29

8For more on August 1998, see Komulainen, T., and I. Korhonen, eds., Russian Crisis and

Its Effects, Helsinki, 2000, Kikimora Publishers. 9Stiglitz, J., ‘‘Whither Reform? Ten Years of Transition,’’ Washington, DC, The World Bank,

1999.

Some $50 billion in foreign direct and portfolio investment

poured into the country in 1997, as emerging market investors increasingly saw Russia as a transition economy on the verge of

‘‘turning the corner.’’ After years of deterioration, social indicators

of poverty and inequality also began to improve in the mid-1990s.

After rising from 0.26 in 1991 to 0.41 in 1994, Russia’s Gini coefficient of income inequality dropped to around 0.38 during 1995– 1997. And the share of the population with incomes classified as

below the poverty line dropped from around 33 percent during

1992–1993 to about 20 percent in 1997.

The calumnious events that led to the currency, debt, and banking crisis of August 1998 brought an end to the second phase of the

Russian transition, and revealed the optimism engendered by developments in 1996–1997 to have been premature. The federal government in that month defaulted on its domestic debt and began

accumulating arrears on its rescheduled external debt obligations

inherited from the Soviet period. The government and the Central

Bank of the Russian Federation (Central Bank of Russia or CBR)

halted their defense of the quasi-fixed exchange rate, permitting

the nominal exchange rate to collapse from 6.2 rubles per dollar to

21.1 rubles per dollar by the end of the year. The ruble’s collapse

led to renewed price pressures: year-on-year consumer price inflation rates had returned to triple-digit levels by mid-1999. Almost

all of Russia’s private banks collapsed after the devaluation, leaving the state savings bank, Sberbank, the only domestic financial

institution of any consequence. The ‘‘reformist’’ Western-oriented

governments that had ruled Russia since 1992 were replaced in

September 1998 by a cabinet that drew its support from the Communist Party of the Russian Federation, the largest party in the

parliament.8

The shock waves generated by the ‘‘Russian crisis’’ were felt

throughout the world. Investment bankers hawking the ‘‘Russian

boom’’ gave way to pundits claiming that Russia’s economic and political transitions had failed, or that Russia was a failed state. In

Washington, opponents of the policies pursued by the Clinton administration and the IMF and World Bank vis-a`-vis Russia explained the Russian crisis as the inevitable result of ideological orthodoxy and/or political opportunism.9 Coming on the heals of the

East Asian crisis that began in mid-1997, Russia’s financial crisis

contributed to the global emerging market rout that led the Federal Reserve to sharply cut interest rates in order to avoid a global

liquidity squeeze in late 1998. It also added new urgency to the

search for a ‘‘new international financial infrastructure’’ to deal

with such problems as financial contagion and money laundering.

Rather than marking the inevitable failure of the Russian transition, the August 1998 financial crisis reflected a confluence of unfortunate domestic and external factors. Some of these were avoidable, others of which not. Moreover, the storm clouds generated by

August 1998 also weakened or removed many of the causes of the

crisis, which helped pave the way for the strong GDP growth that

30

10 Hellman, J., ‘‘Winners Take All: The Politics of Partial Reform in Postcommunist Transitions,’’ World Politics, 50 (January 1998), pp. 203–234.

took hold in 1999–2000. The recovery of 1999–2001 marks the third

phase of Russia’s economic transition, which is marked by the challenge of transforming the growth that took hold since August 1998

into sustainable economic and social development.

Two domestic causes of August 1998 were paramount. First, Russia’s macro-economic policy framework was plagued by inconsistencies between the quasi-fixed exchange rate regime and large fiscal deficits that were financed by foreign borrowing. Russia’s consolidated government budget (i.e., the balance on the federal, regional, and municipal government budgets) reported deficits of 5 to

7 percent of GDP during 1996–1997, and through mid-1998. The

borrowing required to finance these deficits created increasingly

unstable foreign- and domestic-debt dynamics that by mid-1998 undermined the credibility of the monetary and exchange rate policies.

Second, the implementation pace of Russia’s market reform agenda slowed noticeably after 1995. Virtually no major improvements

in economic policy or institutions were introduced during 1995–

1998. This resulted in part from a lack of leadership at the top, due

first to the 1996 presidential election campaign and then to President Yeltsin’s growing infirmity that culminated in his surprise December 1999 resignation. But the stagnating market reform agenda

also reflected the political economy of transition, which has produced what the World Bank’s Joel Hellman has termed ‘‘low-level,

partial reform equilibria’’ in many transition economies. As

Hellman points out, the successes of the initial stages of the economic transition—the partial liberalization of prices and commerce,

the first waves of rapid privatization, and the devolution of power

from the central to regional authorities—create new interest groups

who are opposed to further market reforms.10 In Russia, the

‘‘oligarchs’’ who benefited from the rent-seeking opportunities created by the incomplete liberalization of prices and trade, and then

from quick and dirty privatizations of key state companies, were instrumental in securing Yeltsin’s re-election in 1996. Yeltsin’s reliance on Russia’s regional leaders in his battles against the Communist opposition allowed the regions to pursue policies that balkanized Russia’s large domestic market and weakened Russia’s fiscal coherence. Measures to strengthen the financial system, improve regulation of infrastructure monopolies, or provide a level

playing field across Russia’s economic space, generally went nowhere after 1995.

The Russian economy in 1998 was also hit by three highly unfavorable developments over which it had no control: a bad harvest,

an oil price shock, and financial contagion from East Asia. Bad

weather in various parts of the country caused a 19 percent reduction in value added contributed by the agricultural sector in 1998.

The dollar prices of Russian exports dropped 15 percent in that

year, as oil exports were selling for only $7 per barrel in December

1998 (according to official data). Export prices dropped another 4

percent in 1999 as well. This terms-of-trade shock pushed overall

exports down from $88 billion during 1996–1997 to $74 to $76 bilVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00056 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.002 CRS1 PsN: CRS1
31

lion in 1998–1999. Russia’s current account balance, which registered surpluses of 2 to 3 percent of GDP during 1995–1997, had

fallen into deficit by mid-1998. At the same time, foreign investors

who were burned by the East Asian financial crises in 1997 became

increasingly unwilling to risk investing in Russian securities in

1998. This ‘‘repricing of Russian risk’’ combined with the collapse

of Russia’s current account surplus would have posed daunting policy challenges even for a country with a robustly pro-reform political elite.

The August 1998 crisis did significant damage to Russia’s financial system, to the country’s external creditworthiness, and to living standards. Financial intermediation by private banks essentially stopped in August 1998, and has not been renewed since.

With only a handful of exceptions, private- and public-sector borrowers in Russia effectively lost access to international capital markets and have not regained it since. After years of small improvements, Russian indicators of poverty, inequality, and social hardship deteriorated anew during 1999–2000.

But August 1998 also made possible the rapid GDP growth that

was reported in 1999–2000. The ruble’s sharp devaluation set the

stage for an import-substituting industrial recovery led by

privatized firms in the metallurgical, light industrial, and machine

building sectors. The banking collapse and the low oil prices of

1998–1999 weakened the oligarchs, while the collapse of the domestic debt market deprived the federal and regional governments

of sources of borrowing. Russia therefore got fiscal religion: regional governments were forced to start running budget surpluses

in 1999, and the federal budget has been in surplus since early

2000. While these surpluses were due in part to reductions in debt

servicing, they also reflected improvements in tax collection. The

share of GDP collected as consolidated government tax revenues,

which had dropped below 20 percent in 1998, rose to 21 percent in

1999 and 24 percent in 2000. And in contrast to 1998, when as

much as a third of federal and half of regional tax revenues were

collected in non-monetary forms, all federal tax revenues since

early 2000 have been collected in cash. The crisis of arrears, barter,

and monetary surrogates that seemed to be choking the Russian

economy in 1998 has largely melted away.

Other factors besides the bounce from August 1998 facilitated

Russia’s recovery during 1999–2000. High oil prices were obviously

one of these: thanks to 65 percent growth in the prices of export

crude and refined oil products, Russia’s dollar export prices rose by

26 percent in 2000. But high world prices for energy and other exports do not explain the strength of Russia’s recovery during 1999–

2000. For one thing, 5.4 percent GDP growth was reported in 1999,

even though Russia’s export prices fell 4 percent overall in that

year. Sharply lower relative prices for energy and transport services also played an important role in promoting the Russian recovery. Thanks to regulatory decisions that held energy and transport

prices in check in the aftermath of the August 1998 financial crisis,

the relative prices of gas, transport, and electricity dropped by 20,

23, and 39 percent respectively (calculated vis-a`-vis the industrial

producer price index on an end-year basis) during 1998–2000.

Energy-intensive companies in chemicals, ferrous metallurgy, and

32

11See Rutland, P., ‘‘Putin’s Path to Power,’’ Post-Soviet Affairs, Vol. 16, No. 4 (December

2000), pp. 313–354.

other manufacturing branches were able to re-export this cheap energy in the form of highly price-competitive exports. The economy

also benefited from Boris Yeltsin’s relatively painless departure

from the Russian presidency in December 1999, and from the rapid

consolidation of power by his successor Vladimir Putin.11

Russia’s growth in 1999 was driven largely by foreign demand.

Whereas exports in volume terms rose by some 7 percent in that

year, import volumes dropped by nearly a third. This sharp growth

in net exports compensated for a decline in domestic demand, as

personal consumption dropped 4 percent. In sector-of-origin terms,

growth in 1999 was powered by the industrial sector (an 11 percent

increase was reported in industrial value added) and agriculture

(which, recovering from the poor harvest of 1998, reported a 17 percent increase in value added in 1999). By contrast, the declines in

imports and personal consumption kept growth in the service sector flat, as value added generated by the trade sector dropped 3

percent in 1999. In 2000, on the other hand, domestic demand became the driver of the 8.3 percent GDP growth reported for that

year. Personal consumption was reported up 9 percent, while fixed

investment rose 16 percent. Russia’s recovery in 2000 was also

more balanced sectorally: the 12 percent growth in value added reported for the industrial sector was complemented by 11 percent

growth in construction and 10 percent growth in the trade sector.

While export volumes reported healthy 11 percent growth in 2000,

import volume grew by some 20 percent. Average inflation rates

also dropped sharply in 2000, while the unemployment rate at the

end of the year had fallen to 9.6 percent, down from 13.3 percent

at the end of 1998.

With a few exceptions, these trends continued into 2001. While

growth in production volumes in the industrial and construction

sectors slowed to 6 percent during the first half of the year, retail

trade turnover continued to surge, with 10 percent growth was reported during the first half. Consumer price inflation stopped falling, however, and averaged nearly 25 percent in year-on-year terms

during the first half of the year. This inflation was due primarily

to very loose monetary policies. Inflows of foreign exchange produced by the continuing large current account surpluses, combined

with unsterilized CBR intervention, kept growth in the monetary

base and M2 in the 50 to 60 percent ever since the second half of

1999. While the demand for rubles grew strongly during 1999–2000

thanks to Russia’s strong output growth and sharp reductions in

the use of monetary surrogates, the supply of rubles in 2001 had

clearly begun to outpace demand. Inflation in the 25 percent range

combined with an essentially stable nominal exchange rate to further boost the value of the ruble in real effective terms; and the

firmer ruble in turn helped boost imports and slow growth in the

manufacturing sector. A long-delayed correction in the relative

prices for energy and transport services also took hold in 2001, further slowing industrial growth.

Despite these problems, 4.9 percent GDP growth was reported for

the first quarter of 2001, and gross output trends suggested a simiVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00058 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.002 CRS1 PsN: CRS1
33

12Slay, B., ‘‘The Polish Economic Transition: Outcome and Lessons,’’ Communist and PostCommunist Studies 33 (2000), pp. 49–70.

lar or slightly higher rate of growth for the second quarter as well.

These are hopeful signs for Russia’s economic prospects. But Russia’s development during the 1990s suggested that a return to

growth was at some point inevitable. Output trends in virtually all

Eurasian transition economies—ranging from success stories like

Poland and Estonia to laggards like Belarus and Tajikistan—show

that a third, ‘‘recovery’’ phase eventually follows an initial period

of macro-economic disorganization and contraction, and then a second period of stabilization and austerity. Russia’s great misfortune

was that the first two phases lasted nearly 10 years, whereas Poland managed to get through the first two phases of its economic

transition in only 2 to 3 years.12 The challenge now facing policymakers in Russia—as in many other Commonwealth of Independent States (CIS) economies—is to transform the recovery of 1999– 2000 into sustainable economic and human development.

RUSSIA’S EXTERNAL TRENDS

The dramatic improvement of Russia’s external position during

1999–2000 is among the most hopeful post-August 1998 changes.

The current account deficit reported at mid-1998 gave way to a surplus of nearly $46 billion—nearly 19 percent of GDP—in 2000. Official reserves tripled from $11 billion in March 1999 to $35 billion

as of mid-2001—more than double their previous high recorded in

late 1997. Russia in 2001 returned to fully covering its external

sovereign debt after rescheduling a portion of its Soviet-era obligations to the London Club of commercial creditors in 2000. In contrast to the 1990s, Moscow is not dependent on credits from multilateral or private lenders, and in contrast to 1997–1998 there is

very little ‘‘hot money’’ in the country. If prior to August 1998 Russia was on IMF life support, Moscow was able to reduce its obligations to the Fund from $19 billion in 1998 to around $10 billion as

of mid-2001.

To be sure, these improvements came at a high cost. The sharp

reductions in household incomes and personal consumption recorded during 1998–1999, coupled with sharply higher unemployment, were the price Russian households paid for the restoration

of external balance. Serendipity has also helped strengthen Russia’s external position, in the form of sharply higher export prices

in 2000 (when Russian received an estimated 33 percent terms of

trade windfall). The extent of this improvement could face a sharp

test in 2003, when Russia’s sovereign foreign debt obligations are

slated to rise from $9 billion in 2000 to some $19 billion.

Still, the unprecedented growth in reserves, the huge current account surplus, and the shift in Moscow’s fiscal priorities in 2001 to

allow for full coverage of external debt obligations, suggest that

Russia’s external position can weaken but still remain quite strong

compared to pre-1998 levels. The risks associated with the debt

spike in 2003 are being addressed by a host of policy measures, and

others can be employed in the future. Moscow in late 2000 and the

first half of 2001 used undisclosed amounts of surplus budget revenues to repurchase its heavily discounted sovereign debt. These

34

13These data come from national bank publications or Web sites for the countries in question.

pre-payments reduce Russia’s debt burden and make full coverage

of future obligations less burdensome. Despite the sharp increase

in debt-service payments in 2001, the CBR’s foreign exchange reserves rose from $28 billion at the end of 2000 to $34 billion as of

mid-2001. A joint government/CBR declaration on economic policy

through 2004 released in May 2001 calls for reserves to grow to

$37 billion by the end of this year. This target seems eminently

feasible—especially since reserves in mid-July had climbed close to

$36 billion. The CBR’s target of $45 billion in official reserves by

the end of 2002 therefore seems quite attainable.

Russia’s sovereign domestic debt at the end of 2000 stood at only

$20 billion, less than 10 percent of GDP. Strong ruble liquidity in

the Russian financial system should allow Moscow to borrow domestically to repay foreign debt during 2001–2002. The Finance

Ministry in June 2001 auctioned off 5 billion rubles’ ($175 million)

worth of 3 year domestic debt instruments. This issue, which was

snapped up by cash-rich Russian banks, marked the largest such

sale of government debt since the August 1998 financial crisis.

Should Russia’s external position deteriorate due to a terms-oftrade shock, the Paris Club of sovereign creditors has declared its

willingness to consider restructuring Russia’s obligations. The IMF

ostensibly stands ready to provide financing during 2002–2003

through a precautionary framework, should this prove necessary—

and if Moscow can meet its conditions. Additional revenues for foreign debt repayment can be raised from sales of precious metals,

from issuing new eurobonds, or by arranging non-securitized loans.

But protection against a balance-of-payments crisis is not the

same as sustainable growth. The commodity composition of Russian exports, Russia’s problematic record with foreign investment,

and continued large capital outflows are particularly worrisome in

this respect. As Table 2 shows, fuels made up half of Russia’s export basket in 2000—a higher share than in 1993. By contrast, machinery and equipment comprised only 11 percent of total exports

in 2000, down from 14 percent in 1993. Attempts to parley Russia’s

comparative advantages in metallurgy, armaments, aerospace, and

IT into a more competitive engineering sector have not achieved

spectacular results. This contrasts sharply with the export-driven

industrial restructuring that occurred in the leading Central European transition economies during the late 1990s.

The foreign direct investment (FDI) that has driven Central Europe’s industrial modernization is conspicuously absent in Russia.

Russia through 2000 had attracted $23.5 billion in cumulative inward FDI, or $160 on a per-capita basis. By way of comparison,

per-capita inward FDI in Hungary—the leader among transition

economies—was nearly $2,500. The Czech Republic reported $2,000

in per-capita FDI, Estonia registered $1,500, and Poland had $780.

Among CIS countries, Russia’s per-capita FDI compares quite unfavorably with Azerbaijan’s $620 and Kazakhstan’s $580. Even Armenia—a country with virtually no energy reserves, and which has

faced an economic blockade for more than 10 years—reported higher per-capita cumulative FDI ($170) through 2000 than Russia.13

35

TABLE 2.—EXTERNAL TRENDS, 1993–2000

1993 1994 1995 1996 1997 1998 1999 2000

Exports (in billions of dollars) $59 $68 $81 $89 $88 $74 $76 $106

Percent share of fuel exports in total .................. 40 42 38 43 44 38 41 50

Imports (in billions of dollars) 44 51 61 69 73 59 40 45

Trade balance (in billions of

dollars) ................................ 15 17 20 20 15 15 36 61

Percent share of GDP .......... 8 6 6 5 4 6 19 24

Current account balance (in

billions of dollars) ............... 13 8 7 12 2 1 25 46

Percent share of GDP .......... 7 3 2 3 1 0 13 19

Percent change in terms of

trade .................................... 3 7 3 7 ¥3 ¥14 ¥4 33

Inward FDI (in billions of dollars) ..................................... 1 1 2 3 5 3 3 3

Net portfolio investment (in

billions of dollars) ............... 0 0 2 4 46 9 ¥1 ¥1

‘‘Capital flight’’ (in billions of

dollars) 1 .............................. 10 9 13 24 30 17 11 15

Percent share of GDP .......... 5 3 4 6 7 6 6 6

Gross foreign debt (in billions

of dollars) ............................ 121 132 143 152 167 191 181 172

Percent share of GDP .......... 65 48 42 36 39 70 95 68

Official reserves, end year (in

billions of dollars) ............... 8 7 14 15 18 12 12 28

Import coverage (months) ... 2 2333 3 48

Percent change in real effective exchange rate 2 ............ 169 79 40 39 8 ¥32 ¥29 22

1 Calculated as the sum of: (1) Russian purchases of foreign exchange; (2) export contracts that have

been concluded but for which revenues have not been received; (3) import contracts that have been concluded but for which payment has not been made; and (4) net errors and omissions. 2 Unweighted average of annual changes in real effective exchange rates vis-a`-vis domestic, euroland,

and dollar consumer and industrial producer price trends.

Russia’s energy and non-ferrous metallurgical bounty suggests

that industry, and energy and metals in particular, should have attracted the bulk of the country’s inward FDI. This has not been the

case. Only $3.6 billion—one-sixth of Russia’s inward FDI—went

into the energy sector during 1993–2000. Virtually all of this went

into crude oil extraction. Ferrous and non-ferrous metallurgy combined accounted for less than 2 percent of total FDI during this

time, while virtually no FDI went into natural gas or electric

power. The industrial sector as a whole attracted 47 percent of

total FDI, with manufacturing accounting for 31 percent. The food

processing branch was manufacturing’s leading recipient, with 18

percent ($4 billion) of total FDI. Since food processing accounts for

at most 3 percent of Russian GDP, the sector’s strong FDI performance is somewhat surprising. The explanation is largely political:

foreign investment in food processing generally remains ‘‘below the

radar screen.’’ By contrast, Russian elites are generally unwilling

to permit significant amounts of foreign capital into ‘‘strategic’’ sectors such as oil, gas, electric power, diamonds, nickel, and aluminum.

36

Rather than attracting foreign investment, Russia is instead becoming an important source of FDI for other CIS countries. The

CBR registered some $3.1 in outward FDI in 2000, which exceeded

the $2.7 billion in inward FDI reported. Cash-rich Russian oil companies took control of three of Ukraine’s six major oil refineries

during 1999–2000, while the Russian Aluminum conglomerate acquired Ukraine’s Mykolayivsky Hlynozemny Zavod, Europe’s largest alumina maker. Russian acquisitions were not limited to the

CIS, however: Lukoil in late 2000 spent $70 million to acquire

Getty Oil’s retail outlets in the United States. After recording large

inflows during 1997–1998, net outflows were reported on Russia’s

portfolio investment balance during 1999–2000 as well.

Russia’s strong economic recovery during 1999–2000 was paradoxically accompanied by a steep acceleration in capital outflows.

After posting positive balances during 1995, 1997 and 1998, Russia’s financial account swing heavily into deficit, posting net out- flows of $17 billion in 1999 and $48 billion in 2000. But in many

respects, trends on Russia’s financial account offer a misleading

guide to capital flows. For one thing, substantial negative sums are

reported every year on ‘‘net errors and omissions.’’ During 1995– 2000, this balance was fairly stable, averaging—$7 billion annually. These large negative balances are commonly viewed as indicators of illicit capital flight and as such they should be considered

part of Russia’s net outflows. But not all transactions reported as

net outflows on the financial account reflect transfers of assets

from Russia to other countries. Some reflect portfolio management

choices by Russian households and companies. Decisions to increase dollar cash holdings (for savings or working capital) in the

informal sector, at the expense of ruble assets in official bank accounts, boost net outflows reported on the financial account even

though these funds do not leave Russia. Likewise, export receipts

that are left in off-shore accounts in order to finance imports may

appear on the balance of payments as a capital outflow, even

though they function as working capital.

Russia’s external accounts do not distinguish ‘‘capital flight’’ that

reflects illicit, speculative, or hedging purposes from ‘‘normal,’’

transactions-based capital outflows reflecting the liquidation of

Russian assets held by non-residents. A commonly used measure of

capital flight in the Russian case is the sum of: (1) Russian purchases of foreign exchange; (2) export contracts that have been concluded but for which revenues have not been received; (3) import

contracts that have been concluded but for which payment has not

been made; and (4) net errors and omissions. This measure shows

Russian capital flight falling from $30 billion in 1997 to $11 billion

during 1999, before rising to $15 billion in 2000. As a share of dollar GDP, this measure of capital flight has remained at 6 to 7 percent ever since 1996.

An alternative perspective on Russian capital flight comes from

comparing gross capital inflows (changes in the gross liabilities recorded on the capital and financial accounts) and outflows (changes

in the gross assets in Russia’s capital and financial accounts, plus

net errors and omissions). Gross outflows as a share of GDP rose

from 9 percent during 1996–1997 to 13 percent in 1999, before

dropping back to 12 percent in 2000. By contrast, gross capital

37

14 Balcerowicz, L., ‘‘The Interplay Between Economic and Political Transition,’’ in Zecchini, S.,

ed., Lessons From Economic Transition: Central and Eastern Europe in the 1990s, 1995, pp.

153–167.

inflows essentially dried up after August 1998, falling from 9 percent of GDP in 1997 to below 1 percent in 1999–2000. This suggests that the sharp acceleration in net outflows on the financial

account during 1999–2000 were not due primarily to capital outflows per se, but rather to foreign investors’ post-1998 aversion to

Russia.

Russia’s poor track record on attracting FDI may not last. Foreign investment in transition economies typically lags a few years

behind recoveries in GDP and domestic investment. Still, a comparative assessment of Russia’s FDI performance to date can not

help but cast a shadow over future prospects for sustainable

growth. Making Russia more attractive to investors—foreign and

domestic alike—requires significant reforms in the financial and

legal systems.

RUSSIA’S UNFINISHED REFORM AGENDA

Arguments about links between growth and market reform in

transition economies—particularly in Russia—often reflect two implicit propositions: (1) the far-reaching institutional reforms needed

to create a well-functioning market economy are necessary and sufficient conditions for growth; and (2) transition economies’ shortterm growth prospects are closely tied to progress in market reform. The record of the 1990s shows that both assertions are at the

very least exaggerations. Instead, the liberalization of prices and

commerce, the creation of stable monetary, fiscal, and exchange

rate environments, and some measure of privatization, are generally sufficient to create the ‘‘critical mass’’ of institutional and

policy changes needed to end the transition recession.14 Albania,

for example, recorded annual GDP growth during 1993–1996 and

1998–2000 of 8 percent or above, despite a large unfinished reform

agenda. Azerbaijan’s growth performance during the second half of

the 1990s was far superior to the Czech Republic’s, despite the fact

that market reforms were much farther advanced in the latter

country than in the former. Many factors besides the extent and

pace of market reforms—including location, size, resource endowment, political stability, economic policies, and state capacity—have

an important impact on growth in economies—transition or otherwise.

Still, there can be little doubt that progress in market reform—

understood as measures to remove barriers or threats to growth

that were inherited from the Soviet-type system, or which appeared

during the course of transition—has a key influence on prospects

for sustainable growth and development in transition economies. If

banks do not become effective financial intermediaries, capital will

continue to be poorly mobilized and allocated. If infrastructure monopolies do not face competition or charge prices that cover their

costs, the provision of basic public services can come under threat.

If investors can not rely on courts to protect and clarify property

rights, some investments will not be made. If bureaucratic connections are more important for entrepreneurs than competitive adVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00063 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.002 CRS1 PsN: CRS1
38

vantage, companies will continue to invest in ‘‘relational capital’’ rather than in fixed assets. All of these problems stand in the way

of sustainable growth, and—as the Gref program acknowledges— Russia suffers from all of them.

During Boris Yeltsin’s second term, initiatives to address these

problems made little headway. Upon becoming president, Vladimir

Putin promised rapid and decisive steps in these areas. Some

progress was made in Putin’s first year, and as of mid-2001 the

government had succeeded in pushing a raft of market reform initiatives through parliament. Still, much remained to be done, and

many of the salient results anticipated from these changes will

take decades to materialize.

REFORM OF INFRASTRUCTURE SECTORS

Thousands of urban dwellers in Siberia and the Far East spent

much of winter 2000–2001 without adequate supplies of heat and

electricity. In many places Russia’s infrastructure for heat, power,

and communal services simply buckled. The sharp declines in

human welfare stemming from these problems prevented many

Russians from experiencing the benefits of the strong economic

growth recorded in 2000. While a number of factors—including a

particularly cold winter and ineptitude on the part of the local authorities—contributed to the deep freeze, years of below-cost pricing and mismanagement by the Unified Energy Systems (UES) national electricity company and its subsidiaries played a critical role

in this debacle. Although Russia’s gas infrastructure remains relatively free of such problems, production at Gazprom—Russia’s gas

monopoly—dropped some 5 percent during 1999–2000, and the

company had to import significant quantities of gas from

Turkmenistan in order to meet its supply commitments. UES and

Gazprom management argue that tens of billions of dollars must

be invested in these sectors in order to maintain and expand output levels in the future. This seems to particularly be the case for

UES, since fixed investment in the electricity sector dropped by

some 30 percent during 1997–2000. Similar claims are made by

municipal administrations, who point out that household charges

for rent, sewer, and water cover less than half of the costs of providing these services. And Railroad Ministry officials argue that

billions more must be invested in Russia’s rail infrastructure, in

order to prevent the further decapitalization of Russia’s largest and

most important transport network.

According to the Gref program, the government intends to deal

with these problems by further marketizing these sectors, by: (1)

reducing administrative barriers, so as to promote increased competition and entry by new suppliers; (2) increasing relative prices

in these sectors, in order to bring tariffs closer to full cost-recovery

levels; (3) selling off state monopoly assets to private (and potentially foreign) investors; (4) introducing compensating payments for

those households (and other users) whose welfare is most threatened by step (2); and (5) introducing tighter controls over those monopolistic activities remaining under state control, via: (a) better

regulation of monopoly pricing; and (b) more active control by federal bodies—acting in their capacity as owners—over management

in these sectors.

39

As of mid-2001, measures embodying these themes had been approved for implementation in the electricity, gas, rail, housing, and

communal service sectors. To the surprise of many observers, Rem

Vyakhirev was replaced as Gazprom CEO by Putin loyalist Aleksei

Miller in May. Miller promised to halt the large-scale asset stripping at Gazprom that allegedly occurred during Vyakhirev’s tenure.

He also promised to afford independent gas producers access to

Gazprom’s domestic pipeline network, thereby increasing other

companies’ abilities to bring gas to market. After nearly a year of

haggling, UES CEO Anatoly Chubais in July 2001 struck a deal

with minority shareholders that cleared away some obstacles to the

sale of UES assets as part of the company’s competitive restructuring. Economics Minister Gref and Railroad Minister Nikolai

Aksyonenko by mid-year seemed to have agreed on a compromise

rail restructuring program that would divest the Railroad Ministry

of most of its commercial assets (i.e., rolling stock) and liberalize

the determination of rail tariffs and route structures. And the government in August approved legislation to create an omnibus regulatory agency, in which the regulation of monopoly price setting

would be centralized and (presumably) depoliticized.

These developments, combined with concurrent parliamentary

approval of other measures—including passage of legislation on

pension reform, the liberalization of the sale of non-agricultural

land, reductions in the number of burdensome licenses needed for

entrepreneurial activity, and banking reform—amounted to Russia’s most impressive flurry of market reform activity in nearly a

decade. If implemented as planned, these measures could significantly improve prospects for sustainable economic growth. But political and economic factors are likely to constrain the government’s

ability to implement these measures as planned. For one thing, the

sharp increases needed to quickly bring tariffs up to cost-recovery

levels are seen as too painful socially, particularly in light of Russia’s still-high (20 percent and above) inflation rates and the parliamentary and presidential elections scheduled for 2003 and 2004,

respectively. The bulk of these tariff hikes are therefore slated to

be postponed until after 2004. But new suppliers are unlikely to

enter these markets in significant numbers as long as (relatively)

low prices are maintained. Sales of assets in firms whose prices are

set below costs can be rightly seen as a asset stripping—as UES

minority shareholders frequently pointed out when explaining their

opposition to CEO Chubais’ competitive restructuring program. In

the meanwhile, the continued absence of competition from new suppliers is likely to result in higher costs and tariff hikes than would

otherwise be the case. Finally, the difficulties Russia’s ponderous

social welfare bureaucracies would face in identifying and subsidizing those households most at risk from the tariff hikes are unlikely

to be anything short of immense.

FINANCIAL SYSTEM

Russia’s financial system has recovered from the crash of August

1998—after a fashion. Economic growth, tighter fiscal policies, and

improved enterprise liquidity have reduced arrears and the use of

monetary surrogates. More retained earnings helped finance investment growth. A consolidation wave based in the oil and metVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00065 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.002 CRS1 PsN: CRS1
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15For more on the ‘‘virtual economy,’’ see Gaddy, C. and B.W. Ickes, ‘‘An Accounting Model

of the Virtual Economy in Russia,’’ Post-Soviet Geography and Economics, Vol. 40, No. 2, 1999,

pp. 79–97; and Slay, B., ‘‘A Comment on the Virtual Economy,’’ Post-Soviet Geography and Economics, Vol. 40, No. 2, 1999, pp. 110–113.

allurgical sectors that began in 1999 suggests that some of Russia’s

largest companies are becoming more interested in corporate governance. On the other hand, the government and CBR have done

little to restructure commercial banks or improve the foreign investment environment. Financial sector privatization faces stiff opposition from political and business elites. And the restructuring

driven by oil and metallurgical companies may do little more than

create a new class of oligarchs that do not differ fundamentally

from their predecessors.

The best news in the financial sector lies in the shrinkage of

Russia’s ‘‘virtual economy.’’ 15 After soaring in 1998, total arrears

(measured as the sum of wage and general government tax arrears

plus overdue enterprise payables to banks and other enterprises)

dropped by 55 percent during 1999–2000. In real terms, arrears fell

by three quarters during this time. The ratio of total arrears to

nominal GDP, which averaged 0.33 during 1998, fell to 0.07 in

2000. Most of this progress came from sharp reductions in wage arrears, which constitute more than 90 percent of the total. Wage arrears shrank 77 percent in real terms during 1999–2000, as publicsector wage arrears (which are now less than a fifth of total wage

arrears) fell 80 percent. While overdue enterprise payables to other

companies rose in nominal terms during 1999–2000, their real

value dropped some 38 percent. Similar trends are apparent in the

use of monetary surrogates—barter, promissory notes, and mutual

offsets of liabilities—accepted as ‘‘payment’’ by companies. Only 31

percent of total payments collected by Russia’s largest companies

were settled via these surrogates in 2000, down from 51 percent in

1999 and 63 percent in 1998. The 8 percent increase in the real

value of the stock of tax arrears to the general government in 2000

was the only significant exception to this trend.

Positive developments occurred in terms of corporate governance

as well. Minority shareholders, led by former Finance Minister

Boris Fyodorov who represents minority shareholders on the UES,

Gazprom, and Sberbank boards of directors, are increasingly wellorganized, and their demands for corporate transparency and accountability are increasingly difficult to dismiss. Minority shareholders in UES ultimately forced management to adopt a more

investor-friendly version of the company’s original competitive restructuring program. Fyodorov’s campaign against Gazprom management helped precipitate Vyakhirev’s removal, and tipped the

balance toward removing some of the controls over foreign purchases of Gazprom shares. Although the legal framework (especially Russia’s under-capitalized court system) continues to prevent

effective capital market regulation, the Federal Securities Commission (FSC) intervened on behalf of minority shareholders against

the managements of UES, Gazprom, and Norilsk Nickel. The FSC

also promoted discussion and (in some cases) the adoption of corporate governance codes in some of Russia’s largest companies.

More important corporate governance changes could be occurring

as a result of consolidation trends within Russian industry. CashVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00066 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.002 CRS1 PsN: CRS1
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rich oil, metallurgical, and other companies are increasingly investing big money in productive assets, and are increasingly worried

about getting their money’s worth from their investments. Lukoil’s

1999 $300 million acquisition of Komitek, and the Tyumen Oil

Company’s (TNK’s) $1 billion purchase of Onako in September

2000, are the most visible results of this trend. In food processing,

Wimm Bill Dann is using cash generated from dairy products to diversify into breweries. Severstal, Russia’s largest and one of its

best-run ferrous metallurgical companies, has acquired stakes in a

number of automotive producers. Open-market purchases last year

by Siberian Aluminium (Sibal) of equity in Nizhny Novgorod’s

Gorkovsky Avtomobilny Zavod (GAZ)—Russia’s second largest

automobile company—set off a bidding war for GAZ stock and

ended with Sibal’s acquisition of a controlling stake in the company.

These acquisitions have an international dimension as well. By

the end of last year, Russian companies had taken control of three

of Ukraine’s six major oil refineries: Lukoil owned the Odessa refinery; Tatneft was running the UkrTatnafta joint venture at

Kremenchug; while TNK owned the Lisichansk refinery. Thanks to

these investments, Russian companies supplied half of Ukraine’s

refined oil products last year. The Ukrainian subsidiary of the Russian Aluminum conglomerate (Rusal—which is itself the product of consolidation trends within the industry) spent at least $130 million during 2000 to acquire a controlling stake in Ukraine’s

Mykolayivsky Hlynozemny Zavod, Europe’s largest alumina maker.

Russian acquisitions were not limited to the CIS, however: Lukoil

in late 2000 spent $70 million to acquire Getty Oil’s retail outlets

in the United States.

This corporate shopping spree has many desirable properties.

First, acquirers like Severstal and Rusal now have an interest in

better corporate governance, in order to protect the value of their

purchases. Second, in contrast to the consolidation that followed

Russia’s first privatization wave in the early 1990s, the role of

state agencies and Russian banks in these acquisitions is very

small. These purchases are the result of hardheaded business calculations, and do not represent the misappropriation of other people’s money. Third, poorly managed companies and assets are generally being acquired by better-managed companies. This should ultimately boost efficiency. On the other hand, much of this consolidation violates the spirit (if not the letter) of Russian competition

and securities law. Political considerations may be less important

than in previous consolidation waves, but well-connected oligarchs

like Roman Abramovich (oil, aluminum), Anatoly Chubais (electricity), and Oleg Deripasko (aluminum) continue to use their influence in the government, the courts, and the media to advance their

corporate and personal interests. Russia’s commercial playing field

may be globalizing, but it is not necessarily becoming more level.

The August 1998 financial crash left most of Russia’s large, privately owned banks insolvent. Their owners took advantage of Russia’s unclear regulatory framework and transferred assets to other

‘‘bridge’’ banks, in the process defrauding creditors, depositors, and

minority shareholders. Rather than seeking their prosecution, the

CBR was more likely to refinance the oligarchs’ new bridge banks.

42

Since then, the CBR, the courts, and parliament have generally

been uninterested in closing the regulatory loopholes that facilitated these scams. Russian households and companies therefore

use the banks as a payments system, but continue to save and hold

working capital elsewhere.

The banking system has in some respects recovered from August

1998. Bank exposure to foreign-exchange risk continues to fall: the

ratio of commercial bank foreign-currency assets to liabilities rose

from 0.8 during 1997–1998 to 2.0 in 2000. Total commercial banking assets rose from a low of $49.1 billion in December 1998 to

$83.3 billion as of December 2000. ‘‘Overdue’’ bank credits at the

end of 2000 represented only 4 percent of total bank credits, down

from 11 percent in early 1999. Banks are now lending to companies: credits to enterprises grew by some 11 percent in real terms

in 2000, and this growth has continued into 2001. The authorities

in mid-2001 also succeeded in passing bank reform legislation that

had been long sought by the IMF, directed at tightening banking

supervision and cracking down on money laundering.

But there is little else to cheer about in the Russian banking sector. Despite the growth in total banking assets, the 0.34 ratio of

banking assets to nominal GDP at the end of 2000 was actually

below 1998’s end-year ratio of 0.38. The absence of significant improvement in commercial bank transparency and supervision

makes reported improvements in the quality of loan portfolios difficult to interpret. Key perpetrators of the August 1998 developments continue to play important roles in the Russian banking system. The Sberbank state savings bank seems to be the sole institution to enjoy minimal confidence on the part of the population.

Thanks to the fact that its savings accounts are guaranteed by the

federal government, Sberbank at the end of 2000 held some 40 million household savings accounts (87 percent of the total deposit

base).

These circumstances make it difficult to be optimistic about the

consequences of the rapid growth in bank lending to enterprises

that took hold during 2000–2001. This growth was extremely rapid

after mid-2000, averaging 72 percent in nominal terms and 25 percent in real terms. Much of this lending is now being done by

Sberbank—its share of total bank credits to enterprises rose to 37

percent in 2000—and is occurring at negative real interest rates.

When adjusted for changes in the industrial producer price index,

the interest rate on 12 month commercial credits averaged—24 percent in 2000, and—19 percent in 1999.

Since 60 percent of Sberbank’s equity is held by the CBR, and

since neither institution is a paragon of transparency, it is difficult

to assess the consequences of Sberbank’s lending offensive. (The

CBR’s latest target date for completing the commercial banks’ transition to international accounting standards is 2006.) Its

monopsonistic position on the household savings market (which affords Sberbank a healthy spread on its commercial loans) and the

reported declines in non-performing loans suggest that Sberbank’s

cash flow and profitability should be strong and improving. The

bank’s preliminary 2000 financial statement, which was computed

under Russian accounting standards and released in February

2001, seems to confirm this: profits were reported up 63 percent

43

from a year earlier. But Sberbank’s management also announced in

February that the bank’s capital-adequacy ratio had dropped below

the legally mandated 10 percent, necessitating a new share issue.

While its political and economic moxie make Sberbank’s bankruptcy highly unlikely, pressures on bank managers to ‘‘lend to the

real sector’’ combined with its opaque regulatory and ownership

framework make Sberbank a strong candidate for a future financial

crisis. Since its 40 million savings deposits are de facto liabilities

of the Russian Government, a run on Sberbank could be tantamount to a run on the federal budget. Experience in other transition economies shows that poorly regulated state-owned banking

systems are prodigious generators of financial crises. While the

timing and magnitude of Russia’s next banking crisis can not be

predicted, the probability of its occurrence is high.

The experience of other transition economies shows that the sale

of leading commercial banks to strategic investors is the only viable

solution to the problems. Only multinational banks possess the resources needed to straighten out messes like Russia’s and the size

needed to resist political pressures to lend. The banking reform

programs announced by the government and CBR during 2000– 2001 generally ignore these lessons, however, and instead emphasize continued state ownership over Sberbank and Russia’s other

large commercial banks (the Vneshekonom and Vneshtorg foreign

trade banks, and the Industrial, Agricultural, and Regional Development Banks). Federal government control over these institutions

is to be attained through the acquisition of 75 percent equity

stakes, large enough to prevent minority owners from assembling

blocking (25 percent plus one) stakes. Funds to purchase these

stakes are to be raised by selling off the state’s minority

shareholdings in up to 500 smaller banks.

In contrast to the dramatic post-1998 changes apparent in fiscal

policy and foreign debt management, or the (perhaps excessively)

ambitious market reform agenda apparent in the infrastructure

sectors, Russian policies toward the financial sector are characterized by benign neglect. The lending campaign conducted by state

banks, the continued sorry state of bank supervision, the official

disinterest in improving corporate disclosure and transparency—all

this has two strongly negative implications for Russia’s growth

prospects. First, it ensures that fixed investment must continue to

be financed primarily by retained earnings. In part for this reason,

investment growth had already begun to slow in 2001, as enterprise profits (reported under Russian accounting standards) actually fell in real terms during the first half of 2001. After soaring

18 percent in 2000, year-on-year growth in gross fixed investment

had dropped to around 5 percent by mid-2001. Second, the surging

growth in lending to companies by state-owned banks during 2000–

2001 suggests that Russia’s next banking crisis—if and when it occurs—will have a significant fiscal dimension. In light of Russia’s

heavy debt-service burden during 2003 and beyond, the implications of such a crisis can not be easily dismissed. The contingent

fiscal liabilities implied by such a banking crisis could undo much

of the post-1998 progress made in achieving fiscal balance, and

could lead to heightened capital outflows as well. And the unwillingness to open up the financial sector (and other sectors) to forVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00069 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.002 CRS1 PsN: CRS1
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eign investment and competition constitutes a major obstacle to

Russia’s timely accession to the World Trade Organization.

Russia’s unfinished reform agenda extends well beyond the financial sector and the infrastructure monopolies. The creation of

an appropriate legal framework for the long-delayed restructuring

of the agricultural sector (including passage of legislation to protect

and standardize agricultural land ownership, and to govern the

bankruptcy of Soviet-era state and collective farms), the modernization of Russia’s judicial system, the rationalization of Russia’s

quasi-dysfunctional fiscal federalism—these are all multi-year undertakings fraught with grave political, economic, and social risks.

To its credit, the government has pledged to address these barriers

to growth. But should these attempts fail—or should the implementation of its reform programs stretch out indefinitely—its

divergences from best international practices will continue to burden Russia’s economic prospects.

LEADING INDICATORS FOR THE FUTURE OF RUSSIA’S TRANSITION

Russian ‘‘exceptionalists’’ often reject the utility of comparisons

with other countries, claiming that Russia is ‘‘different.’’ While

such claims can of course be made for all countries, Russia as a

transition economy does stand out in a number of respects. Its immense size and ethno-regional diversity, its scientific potential, its

energy/natural resource base, the legacy of the large Soviet-era

military-industrial complex, Russia’s uncertain Eurasian geopolitical status, its federal nature, and (since 1998) its relative insulation from the international capital markets—the combination

of these features does give Russia a somewhat unique profile

among transition economies.

This combination suggests that not every lesson from the more

successful Central European and Baltic transition economies is relevant for Russia. For example, membership in the European

Union—the prospects for which have been a driving force behind

the leading transition economies’ success in introducing best international economic practices—is most unlikely to be an option for

Russia in the foreseeable future. As such, the justification for introducing these changes must be sought elsewhere. Its characteristics

as a transition economy—particularly the commodity composition

of its exports—also suggest that Russia’s short-term economic performance is likely to be less directly correlated with economic policies and reforms than other countries. Movements in world energy,

metals, and raw materials prices in particular are likely to have a

much greater short-term effect on economic performance in Russia

than in most other transition economies—despite Russia’s larger

size and nominally smaller ‘‘openness.’’

Trends in a number of key indicators (besides movement in real

output and incomes) are likely to be particularly revealing in demonstrating whether Russia is making progress toward sustainable

growth. These include the following:

BUSINESS FORMATION

The number of registered Russian companies per thousand inhabitants rose to 23 in 2000, compared to 1995’s 15 per thousand

45

figure. While this remains well below Central European levels, it

also shows the extent to which Russian businesses and households

continue to operate below the authorities’ radar screens. Moreover,

while the numbers of large and medium-sized firms continued to

grow in 2000, the creation of small enterprises seemed to come to

a standstill. Continuing this growth—which requires reducing the

administrative and tax burden on enterprises and households—will

be an important indicator (and source) of sustainable growth. Continuing stagnation in small business formation by contrast would

be a very bad sign.

LABOR FORCE PARTICIPATION RATES

During 1998–2000 Russia was able to offset accelerating population declines by boosting crude labor force participation rates (the

labor force divided by the population) from 49.4 percent to above

50 percent. Along with the sharp declines in unemployment recorded during this time (from a high of 14.1 percent in February

1999 to around 9.5 percent during the first half of 2001), rising

participation rates made possible the employment growth needed to

fuel Russia’s expansion. Since Russia’s population is expected to

shrink significantly during the next 15 years, prolonging the economic expansion will require continued increases in participation

rates. This need not prove impossible: the crude labor force participation rate was close to 51 percent in 1993, and was much higher

during the Soviet period. But boosting labor force participation will

require further reductions in the tax and regulatory burden on enterprises and households, in order to strengthen incentives to move

out of the grey sector.

COMMODITY COMPOSITION OF EXPORTS

The dominant role of energy, metals, and raw materials in Russia’s export basket makes Russia’s short-term economic prospects

hostage to world price trends. The leading transition economies

have succeeded in reducing this vulnerability by significantly increasing the share of engineering products—particularly machinery

and equipment—in total exports. Sustainable growth in Russia is

unlikely to occur if the share of primary products in total exports

does not shrink. A ‘‘petro state’’ afflicted with Dutch disease and

a dual economy would instead be the more likely outcome.

FDI LEVELS AND COMPOSITION

Industrial restructuring in the leading transition economies has

been driven by FDI into their manufacturing sectors. Long-term

improvements in Russia’s industrial and export competitiveness

are unlikely if FDI continues to remain at its anemic levels, and

remains concentrated in oil extraction and food processing.

THE ‘‘PUTIN FACTOR’’

President Vladimir Putin’s robust support for market reform initiatives is one of the most pleasant surprises of the past 2 years.

But this support—coupled as it is with his initiatives to strengthen

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tics—is a double-edged sword. The successful economic transitions

in Central Europe and the Baltics correlate unambiguously with

democratization, demilitarization, the flowering of nongovernmental organizations (NGOs), and through this progress in

establishing the rule of law. The creation of the rule of law in Russia that Putin’s Kremlin claims to seek is inconsistent with the authorities’ hostility—if not outright persecution—of NGOs, and with

their profound suspicion of independent media and environmental

activism. The perilous state of Russia’s environmental and demographic balance, as well as attempts at reducing excessive administrative discretion and increasing public accountability, are poorly

served by such hostility. The same can be said for Putin’s bloody

military solution to Russia’s ‘‘Chechen problem’’—a problem that

ultimately does not have a military solution, short of a genocide directed against a people (the Chechens) that also happen to be citizens of the Russian Federation.

Putin’s rule represents an attempt at strengthening order and

markets at the expense of freedom. This combination is troubling,

and not only because it contains strongly conflicting elements. Despite his support for market reform to date, Putin is not an economist, and as such he does not seem to value market reforms per

se. Putin instead sees them as a means to achieving certain ends:

namely, the rebuilding of Russia’s position on the world stage, and

sustained improvements in Russians’ living standards. Should

Putin become convinced that other economic policies are more conducive to meeting these ends, he could attempt to supplement or

replace them with policies that deepen, rather than narrow, the

gaps between Russian and best international economic practices. In

this sense, Vladimir Putin’s continuing evolution is itself a key indicator of Russia’s progress toward sustainable growth.

(47)

UNLOCKING ECONOMIC GROWTH IN RUSSIA

By Vincent Palmeda and Bill Lewis 1

CONTENTS

Page

Summary .................................................................................................................. 47

Introduction .............................................................................................................. 49

The productivity problem ................................................................................. 50

How Does Low Productivity Lead to Low Standards of Living ........................... 50

Low Productivity Performance in All Parts of the Russian Economy ................. 51

Main Operational Reasons for Persistent Low Productivity ................................ 54

The Direct Cause: Unequal Competitive Conditions ............................................ 56

Immediate Impact of Unequal Competitive Conditions ....................................... 56

Steel and cement .............................................................................................. 57

Oil ...................................................................................................................... 58

Confectionery .................................................................................................... 59

Residential construction ................................................................................... 59

Food and general merchandise retailing ........................................................ 60

Software ............................................................................................................ 60

Indirect Impact of Unequal Competitive Conditions ............................................ 61

Dairy .................................................................................................................. 61

Software ............................................................................................................ 62

Secondary Causes .................................................................................................... 63

Russia’s Growth Potential with Key Economic Reforms ...................................... 64

Sectors with the Highest Growth Potential ........................................................... 64

Large Amounts of Potentially Viable Spare Industrial Capacity ........................ 65

Benefits from Foreign Direct Investments (FDIs) ................................................ 65

Fundamental Barriers to Economic Reforms ........................................................ 66

Social Concerns ........................................................................................................ 68

Corruption ................................................................................................................ 68

Lack of Information ................................................................................................. 69

Appendix: Summaries of Sector Case Studies ....................................................... 70

1 Vincent Palmeda is the principal author of the McKinsey Global Institute study on Russia.

Vincent Palmeda holds an engineering degree from Ecole Nationale des Ponts et Chausse ́es and

an MBA from Northwestern University (Kellogg) in Chicago. Dr. Bill Lewis is the Director of

the McKinsey Global Institute. His doctorate is in theoretical physics from Oxford.

SUMMARY

Russia is in a dire economic situation. Unlike some other reformed ex-Communist economies—Poland or Hungary—where economic performance sagged in the early years of the reform, but

surged as reforms took hold, Russia experienced only decline to

1999. Gross domestic product (GDP) per capita has fallen by as

much as 40 percent since 1992 and is now at only 15 percent of

the U.S. level. Unemployment topped 12 percent, and many more

people are now engaged in subsistence forms of employment.

In an attempt to understand why economic reform has failed in

Russia, we looked at the performance of ten representative sectors—software, steel, general merchandise and food retailing, hotels, oil, housing construction, cement, confectionery, and dairy—

48

and related their performance to that of the overall Russian economy. We also gauged the productivity of those industries against

best practices around the world, determined why Russian companies lagged best practice, and identified what the government

should do in priority to provide them with the means and incentives to improve their operational performance and expand. We believe that this micro-economic analysis is the only way to build a

firm foundation for future economic policies and economic growth.

Our primary findings are:

Overall labor productivity is indeed very low. Our ten industries

averaged only 19 percent of U.S. productivity levels, with software

leading the group at 38 percent and cement at only 7 percent.

Soviet legacy assets—which were roughly 30 percent as productive as U.S. assets in 1992—have had their productivity halved.

This precipitous drop results from the fact that industries have not

restructured despite sharp drops in demand from Russian consumers who now have access to products from around the world.

Roughly 25 percent of Russia industrial capacity is currently in

sub-scale or obsolete assets, which are still operating and fully

staffed, but should be shut down.

Assets added since 1992 are surprisingly unproductive. Almost

no new capacity is being added in the oil and consumer goods industries, the sectors of the economy with the greatest potential for

fast performance improvement. New assets are either well below

efficient scale—as in housing construction and software, or undercapitalized—as in open-air markets.

Despite high competitive intensity, the competition is unequal

and it causes low productivity. Price decontrol and privatization did

successfully stimulate competition. Paradoxically, however, in Russia the more productive companies are often the least profitable.

Thus, more productive companies are not gaining market share

and not pushing less productive firms out.

In nine out of the ten sectors, the direct cause of low economic

performance is market distortions that prevent equal competition.

The distortions come from attempts to address social concerns, corrupt practices, and lack of information.

In the manufacturing sectors, regional governments channel implicit federal subsidies to unproductive companies. Such subsidies

take the form of lower tax and energy payments, and are allegedly

intended to prevent companies from shutting down and laying off

employees. This puts potentially productive companies at a cost

disadvantage, blocking investments and growth on their part.

In the service sectors, where employment should grow, investments by efficient companies are discouraged by the presence of

well connected unproductive incumbents who benefit from favorable regulations, weak law enforcement, and privileged access to

land or government procurements.

Furthermore, these sector level market distortions are key contributors to macro-economic instability, because they reduce government revenues and increase its expenditures. Macro-economic

instability itself is another important deterrent to investments.

We found the other often mentioned reasons for Russia’s economic problems to play a much smaller role (e.g., poor corporate

governance and lack of a transport infrastructure).

49

2 Bill Lewis, Director of the McKinsey Global Institute, reviewed the earlier detailed report

and concluded that in June 2001 the main findings and conclusions still remain. 3The full report (more than 400 pages) can be accessed on the Internet (www.mckinsey.com)

or obtained by faxing request to the Institute in Washington, DC (1-202-662-3218).

There are no natural or economic obstacles to high economic

growth in Russia, and the current situation need not be tolerated.

Russia can rely on a skilled and inexpensive labor force, large and

economically attractive energy reserves, and surprisingly, much

spare capacity in potentially productive industrial assets. Explicit

and targeted social policies combined with balanced and enforceable regulations (mostly at the sector level, involving taxes, energy,

land and red tape) would remove the most important market distortions. The payoff would be strong economic growth in Russia.

The findings and conclusions of this report have been largely

published by the Russian and international media, as well as extensively discussed with the current Russian Government.

Although economic reforms have accelerated in the last year in

Russia and economic performance has been markedly better since

the publication of our report in October 1999, we believe that its

main findings and conclusions still hold true.2

First, Russia’s strong economic performance in 2000 can be largely attributed to a rebound following the 1998 financial crisis and

subsequent devaluation of the ruble. Good economic performance

was further helped by the rapid rise in oil and gas prices. Furthermore, productivity growth (once adjusted for the cyclical increase in

capacity utilization) and business investments, notably from foreign

companies, are still at levels way below Russia’s potential.

Second, despite a sound economic plan, most of the key necessary

economic reforms outlined in our report have yet to be drafted,

passed through the Duma and/or enforced. Nevertheless, there

have been some promising starts with the tax and land codes as

well as with the reform plans of some crucial sectors such as

telecom, railways and electricity.

The U.S. Congress has a crucial role to play in helping Russia

to quickly join the ranks of the advanced democracies, and we hope

that it will find our report to be a useful contribution to that aim.

These findings are discussed in greater detail in the following

sections.

INTRODUCTION

This paper is the executive summary of a year-long project by the

McKinsey Global Institute, working closely with members of the

McKinsey’s Moscow office, on the economic performance of Russia.3

This report was first published In October 1999, but we believe

that its main findings and conclusions still apply to the Russian

economy of the year 2001.

McKinsey undertook this project as an important step in developing our understanding of how the global economy is working. The

failure of the reforms undertaken in Russia in the early 1990s to

generate good economic performance is one of the highest priority

problems in the global economy. We wanted to find out whether the

reforms were causing change at the micro-level that would eventually yield good economic performance. If not, we wanted to find out

why reforms had failed and how to improve the situation. We have

50

undertaken this work as an investment by McKinsey in knowledge

building, we would emphasize that the work is independent and

has not been commissioned or sponsored in any way by any business, governmental or other institution.

This project builds upon the previous work of the McKinsey Global Institute in assessing economic performance among the leading

economies of the world. Our earlier reports addressed separately

labor and capital productivity and employment, the fundamental

components of economic performance. Later, we combined these

components to address the overall performance of Sweden, Australia, France, Germany, The Netherlands, Brazil, Korea, the

United Kingdom, Poland, Japan and India.

As before the core of our work is conducting sector case studies

to measure differences in productivity, output and employment performance across countries and to determine the reasons for the differences. We studied in detail ten representative economic sectors.

Specifically, we examined why Russian companies are not restructuring and expanding faster, and why foreign companies are not investing more in Russia. This comprehensive micro-economic approach reveals the relative importance of the various problems,

which plague the Russian economy and thus helps set priorities

among the long list of economic policy changes recommended from

all directions.

In conducting the project, we have drawn on the counsel of an

external Advisory Committee. Chaired by Professor Robert Solow of

the Massachusetts Institute of Technology, it included Professor

Olivier Blanchard, also from the Massachusetts Institute of Technology, Professor Richard Cooper of Harvard University and Ted

Hall, Chairman of the McKinsey Global Institute Advisory Board.

THE PRODUCTIVITY PROBLEM

Market reforms so far have failed to improve Russia’s economic

performance. Although the efficiency (productivity) with which

companies produced goods and services in the Soviet era was already low compared to the best practice in the world, it has gotten

worse since the reforms started. By understanding the underlying

operational sources of the productivity gaps between Russian companies and global best practice, we are able to better understand

which factors in the external (regulatory) environment are causing

managers and investors not to make progress toward closing the

gaps.

The size and nature of the productivity gaps are discussed below

in this section, the main external factors stopping productivity

growth, and consequently economic growth, are discussed in the

next section.

HOW DOES LOW PRODUCTIVITY LEAD TO LOW STANDARDS OF LIVING

The material standard of living in a country is determined by the

amount of goods and services produced by the economy, referred to

as GDP. Russia’s GDP per capita is only at 15 percent of the U.S.

level. It is also falling behind many of the ex-Communist countries,

notably Poland, which, unlike Russia, has been rebounding economically since 1992 (Figure 1).

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The GDP (output) level is determined by the combination of two

factors: the amount of hours worked by the people (labor inputs)

multiplied by the amount of goods and services produced by an average hour of work (labor productivity). Because people in all countries work to make ends meet, labor inputs tend to be at similar

levels. In Russia, for example, despite high unemployment, labor

inputs per capita are still at more than 80 percent of the U.S. level.

Thus, labor productivity ultimately becomes the determinant of

economic performance. Russia’s labor productivity is very low at

only 19 percent of the U.S. level in 1997, down from around 30 percent in 1991 (Figure 2).

FIGURE 1.—GDP PER CAPITA AT PURCHASING POWER PARITY

[United States = 100 in 1995]

Source: Goskomstat, Polish Central Statistical Office; Organization for Economic Cooperation and Development (OECD), Economist Intelligence Unit (EIU).

LOW PRODUCTIVITY PERFORMANCE IN ALL PARTS OF THE RUSSIAN

ECONOMY

In this study, we have examined in detail ten economic sectors

which cut across manufacturing and services and together represent over 15 percent of total employment in Russia: steel, cement, oil, dairy, confectionery, residential construction, food retailing, general merchandising, hotels, and software. Agriculture and

government sectors, like defense, were not included in the scope of

the project. Our cases cover both heavy and light manufacturing,

the large core domestic sectors of construction and retailing, and

software, the largest of the new, high technology service sectors.


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FIGURE 2.—RUSSIA’S GDP PER CAPITA

[United States = 100 in 1995]

* Based on hours worked per capita.

** Fifteen percent in 1998.

Source: Goskomstat; EIU; Bureau of Economic Analysis; McKinsey analysis.

In each of these selected sectors we have compared the performance of companies operating in Russia (both Russian and foreign)

with those in the United States, selected as the benchmark country.

Our study reveals huge productivity gaps in all sectors of the

Russian economy, whose productivity ranges from 7 percent of the

U.S. level in cement to 38 percent in the new software sector (Figure 3). Moreover, in the sectors we studied, a long tail of unproductive enterprises co-existed with a few relatively productive ones,

dragging down the overall productivity (Figure 4).

Over the last 8 years, labor productivity in the old assets (put

in place before 1992) fell from 30 percent to 17 percent of the U.S.

level. This decline was not compensated for by a rapid growth of

a new and productive economy. New assets (put in place since

1992) employ less than 10 percent of the Russian workforce and,

surprisingly, achieve only 30 percent of the U.S. productivity level

on average (Figure 5).


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FIGURE 3.—AVERAGE LABOR PRODUCTIVITY BY SECTOR, RUSSIA 1997

[United States = 100 in 1995]

* Russia’s actual labor productivity is 25, but only 15 if measured on a geology-comparable basis.

** Weighted by employment share.

Source: McKinsey analysis.

FIGURE 4.—EMPLOYMENT AND LABOR PRODUCTIVITY IN FOOD RETAILING IN MOSCOW

Source: Case studies.


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FIGURE 5.—THE OLD AND NEW ECONOMY *

[United States = 100 in 1995]

* Estimates based on sector case studies.

Source: Goskomstat; EIU; McKinsey analysis.

MAIN OPERATIONAL REASONS FOR PERSISTENT LOW PRODUCTIVITY

We found three main operational reasons for persistent low productivity in Russia:

• Excess workers maintained in the old assets.—Customers

turned away from low quality products and services offered by

the old companies once they had to pay the full cash price for

them. The resulting 50 percent fall in the output of these companies was not matched by a similar reduction in employment,

which fell by ‘‘only’’ 20 percent. We estimate that 10 percent

of workers on average are redundant, while another 20 percent

are currently stranded in non-viable operations.

• Inefficient organization still prevailing in the old assets.—Although most of the former Soviet companies have been

privatized. They remain plagued by antiquated modes of organization: absence of marketing and sales skills, poor quality

control, lack of basic profit incentives and teamwork. Below are

three examples from the studied sectors:

• In steel, breakdowns or defects often go unreported because

workers fear being blamed for them.

• Sales and marketing departments at many confectionery

plants have extended their product portfolios well beyond an

efficient scope.

• In hotels, a team of receptionists could absorb the functions

currently performed by the dezhurnayas on each floor (e.g.,

key handling and surveillance).


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• Potentially profitable investments not made.—We discovered

that managers and investors forego investment opportunities

in covered upgrading existing assets and in developing new

ones. In markets covered with equal conditions of competition,

such investments would bring financial return in excess of 30

percent.

• Our sector studies show that almost three-fourths of the old

assets are still economically viable and could achieve up to

65 percent of the U.S. productivity with limited upgrade investments combined with modern forms of organization (Figure 6). The investments are primarily required to improve

the quality of output and/or energy efficiency. Examples include upgrading the wet/gas technology in cement, more

hydrofracturing in oil, more flexible production lines in panel

housing and conversion of gastronoms into mini-markets.

FIGURE 6.—LABOR PRODUCTIVITY POTENTIAL OF VIABLE OLD OPERATING ASSETS

[United States = 100 in 1995]

* Impact from favorable geology included.

Source: McKinsey analysis.

• Potentially high return and substantial investments in). The

developing new productive assets are also not made. For example, new oil fields should be developed in the economically

attractive proven reserves of Western Siberia. And, unlike in

Poland, very little new capacity has been developed in the

consumer goods industries. In these sectors, the demand for

quality goods is still being met largely through imports. In

food retail, there is strong evidence of unmet demand for


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high service (relative to open-air wholesale markets) formats

like supermarkets. These modern high productivity formats

are still almost entirely absent from Russia with less than

1 percent market share, against already 18 percent in Poland (growing fast) and 36 percent in Brazil.

We will now explain why managers and investors are not scrambling to seize these operational improvement opportunities, which

should, in a market economy with equal competition, lead to higher

profits.

THE DIRECT CAUSE: UNEQUAL COMPETITIVE CONDITIONS

Unequal conditions of competition at the sector level, caused by

the existing economic policies, are the most important reason for

the lack of restructuring and productive investment in Russia.

These inequalities tend to favor low productivity incumbents, protecting them from takeovers and productive new entrants. These

policies are often put in place to achieve social objectives, namely

protecting existing jobs, but in many cases, the suspicion is that

they also serve the personal financial interests of government officials in collusion with businessmen.

We show below how these distortions have both direct and indirect negative impacts on the economy.

IMMEDIATE IMPACT OF UNEQUAL COMPETITIVE CONDITIONS

In open markets with equal conditions of competition, the most

efficient (productive) company should be the most profitable. Being

more productive means that the company either uses less inputs

for the same output (i.e., it has lower costs) or produces better output with the same inputs (i.e., it makes superior products that

command higher prices). Higher profitability should enable productive companies to invest and grow at the expense of less productive

ones, which should be eventually forced to either improve their operations or shut down.

Studying the sectors of the Russian economy, we found that

while competitive intensity is usually high, the rules of the game

are different for different competitors. The rules are seriously distorted in favor of less productive companies. Often the regulatory

environment in which companies operate makes it difficult for the

productive companies to crowd out or take over their unproductive

competitors. As a result of unfavorable differential treatment, more

productive companies often struggle financially, while their less efficient competitors thrive.

These distortions tend to be sector-specific; they can take many

different forms such as:

• Different effective tax rates paid by the companies within one

sector

• Preferential access to land and government procurements

• Different effective energy prices paid by different players in

the same industry

• Variable degrees of red tape imposed on companies at the discretion of authorities

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• Differential law enforcement, e.g., in the area of intellectual

property rights or import tariffs

• Differential access to government-controlled export infrastructure.

Below are examples of the impact these market distortions have

on the development of the sectors covered by our study.

STEEL AND CEMENT

Obsolete (sub-scale and/or inefficient in their use of energy) steel

and cement plants are avoiding shutdowns by paying for only a

fraction of their energy bills—their largest cost component. Because

these companies are often the major employers in a town, municipal and regional officials go to great lengths to keep them operating (Figure 7). Regional governments channel implicit federal energy subsidies to these companies by letting arrears to federal suppliers (Gazprom and Unified Energy Systems (UES)) accumulate at

the local gas and electricity distribution companies. These energy

distribution companies are often under effective control of the regional governments; laws make their bankruptcy practically impossible. These subsidies slow down recovery in many manufacturing

sectors by preventing upgrading investments and industry consolidation in and around the viable industrial assets.

FIGURE 7.—COMPANY STEEL TOWNS

[Steel plant workforce as a percentage of town employment]

■ = Major social issue.

Source: Goskomstat.

Serving as a means of reallocation of resources to unproductive

enterprises, these subsidies may also be viewed as fines imposed on

healthy firms. As a result of the subsidies, financially sound comVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00083 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.003 CRS1 PsN: CRS1

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panies end up paying taxes and energy bills ‘‘for themselves and

the other guy.’’

OIL

Russia has large and economically attractive proven reserves

which can become a source of additional export and tax revenues.

Unpredictable economic policies impede investments into the development of new oil fields. Oil companies are reluctant to commit to

large long-term investments without stable and workable tax policies (the recently passed law on the production sharing agreement

is far from being operational) and without fully liberalized domestic

oil prices. But here again, the social objectives are pursued inefficiently. Policy makers deliberately limit oil exports to secure supply

of cheap oil to ‘‘strategic’’ customers like the agriculture and defense sectors. Combined with the current rate of depletion in the

existing oil fields, the export-limiting regulations may make Russia

a net importer of oil by 2009. Providing the necessary assurances

to investors, notably well financed foreigners, could enable oil production to double in 10 years (Figure 8). Such an increase would

be sufficient to meet the demand of a fast growing economy and to

increase oil exports by at least 50 percent. In addition, it would

provide additional tax revenues, which would be more than enough

to compensate strategic customers for higher oil prices.

FIGURE 8.—POSSIBLE SCENARIOS FOR FUTURE OIL PRODUCTION

[Millions of barrels per day]

Source: Mckinsey analysis.


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CONFECTIONERY

Investments into existing confectionery plants are also discouraged. Regional and municipal governments may effectively ban the

best practice companies from laying off excess workers and reaping

the productivity benefits of their investments. Local authorities

have the means to discipline disobedient managers by, for example,

subjecting them to troublesome fire, safety, health and other inspections, the number of which can reach 400 in a year for a single

company.

Regional governments, as in the steel and cement industries, can

support unproductive confectionery plants by effectively waiving

their local tax obligations and helping them to pay less federal

taxes. As a result, the few law abiding best practice foreign companies are less profitable (after taxes) than their inefficient domestic

competitors (Figure 9).

FIGURE 9.—CONFECTIONERY INDUSTRY DYNAMICS

* Excludes brownfield plants operated by multinationals (13 percent market share).

Source: Goskomstat; Institute for confectionery industry.

RESIDENTIAL CONSTRUCTION

More than half of residential construction in Russia is still financed by the government. Although government contracts are officially submitted to open tenders, they almost invariably end up

going to the same ex-Soviet companies closely affiliated with the

local authorities. As a result, these companies have no incentives

to increase their very low productivity (which they could quadruple

with almost no investments). On the contrary, one of their implicit

deals with the local government is to get the contracts in exchange

for no layoffs.


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FOOD AND GENERAL MERCHANDISE RETAILING

Productivity in the retail sector in Russia is low mainly due to

a very low penetration of modern formats: supermarkets, hypermarkets, malls and convenience store chains. Supermarkets—the

most productive format in food retailing—have less than a 1 percent market share in Russia.

The share of supermarkets is low because productive modern formats are treated unfavorably and, as a result, have a significant

cost disadvantage vis-a`-vis the much less productive sub-scale formats like open-air wholesale market stands and kiosks. The latter

benefit from much lower tax liabilities, less control on the origin of

their goods (which are often illegal imports or counterfeits), and

cheaper access to prime locations (Figure 10). Here again the official rationale for such distortions is social: many jobs are at stake

in small format operations, and open-air wholesale markets are the

way to get cheap food to the poor.

FIGURE 10.—ESTIMATED EFFECTS OF UNEQUAL TAX AND LAW ENFORCEMENT ACROSS

RETAIL FORMATS

[Indexed to price in gastronoms = 100]

Source: McKinsey price survey; McKinsey productivity survey; Gubernia, expert interviews.

SOFTWARE

Because the products of Russian packaged software companies

are systematically pirated, they lack the resources to invest into

the development of innovative products. This consequently limits

their productivity and growth potential (Figure 11).

The other sub-sector in the software industry, project services,

proves by reaching 72 percent of the U.S. productivity level that,

with equal conditions of competition, a whole economic sector can

reach high productivity. There are no market distortions in this


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sector for two reasons; first, it is completely new, with no incumbents to be protected, and second, its customized nature makes it

immune to piracy.

FIGURE 11.—EFFECTS OF SOFTWARE PIRACY ON PRODUCTIVITY

* Indicates total worth of software.

** Russia, 1998; other countries, 1996.

Source: Bureau of Statistical Analysis; International Development Corporation; ‘‘Russian Shield’’ Association; financial reporting; McKinsey analysis.

INDIRECT IMPACT OF UNEQUAL COMPETITIVE CONDITIONS

Negative effects of market distortions are not limited to the sectors where they appear. Barriers to higher economic performance

in key sectors of the economy block the growth of productivity, and

consequently output, in related industries via negative spillover effects, and fundamentally lead to macro-economic instability.

Negative spillover effects from problems in related sectors are

important in explaining the lack of productivity and investment

growth in four out of the ten studied sectors. Below are two examples:

DAIRY

Negative spillover effects plague the all-important food chain.

The absence of large modern retail formats leads to the dominance

of monopolistic wholesalers who squeeze retailers and dairy plants.

The cash-poor milk processors can neither invest in new equipment, nor pay the ailing dairy farmers. In response, farmers set up

their own dramatically sub-scale dairy plants and then distribute

the milk (including a large proportion of raw milk) directly to retailers and consumers.


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Recent development in Poland shows that the modern best practice supermarkets are interested in helping the local food industry

to improve efficiency and grow. They establish direct purchasing

agreements to leverage their scale and bypass monopolistic wholesalers. In turn, increasingly sophisticated Polish food processors

have, due to supermarkets, the financial resources to help develop

efficient farmers through contract growing agreements.

SOFTWARE

The growth of software companies in Russia depends on the

growth of their local business customers. In markets with equal

and intense competition, the largest software consumers (like

banks, supermarkets and telecommunication companies) constantly

require productivity enhancing software tools to help them beat

their competitors. Naturally, when productivity improvement is not

the primary way to financial success, as is the case in Russia, software services are in low demand. Russian companies spend only

0.1 percent of their output on purchasing software, against more

than 1 percent in the United States (Figure 12). The much smaller

size of output of Russian companies confounds the situation.

FIGURE 12.—ESTIMATED CONSUMPTION OF SOFTWARE BY SOME SECTORS OF THE

ECONOMY *

[Software spending as percent of output of the sector]

* Russia, 1997; other countries, 1996.

Source: International Development Corporation; OECD; EIU; interviews.

Barter transactions, which are prevalent in half of Russia’s economy, are fundamentally a result of these market distortions. Tax

evasion, energy subsidies and directed government procurements

are most often carried out through complex barter deals. The government and government-related companies conceal these subsidies

under unfavorable (if real market prices are applied) barter deals,

which also provide ample personal enrichment opportunities because they are put in place through short-lived and hugely profitable trading companies.

Macro-economic instability in Russia has been directly caused by

the fiscal deficit, which results from the fact that the government


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spends more than the taxes it manages to collect. This deficit has

to be financed by either printing money or by paying high real interest rates to attract private investors. Both ways of financing the

deficit introduce macro-economic instability: inflation becomes a

hidden tax on all holders of Russian currency, and high real interest rates paid on government debt lures private investment away

from the rest of the economy. The negative effects of macroeconomic instability could be seen in all the studied sectors, and

most notably in oil and hotels, where a long time is needed to recuperate large initial investments.

Unequal rules of competition are a fundamental cause of the

chronic budget deficit. Government expenditures are increased by

large implicit federal subsidies to inefficient enterprises in the traditional declining sectors (e.g., heavy manufacturing and construction), while tax collection from the unproductive but well-connected

firms in the new growing sectors (e.g., retail) is very poor.

The recent progress made toward balancing the budget should be

little cause for comfort. Around 40 percent of budget revenues still

depend on extremely volatile oil and gas prices, which have fortunately soared in 1999. Key government expenditures, like the

wages of law enforcement officials, are still grossly inadequate.

Capital flight, rational when economic policies discourage investment within Russia, continues. Finally, the rise in industrial production, which followed the August 1998 devaluation, should be

seen as a one-time adjustment due to a sudden increase in prices

of imports, rather than the start of a prolonged economic recovery.

Overall, the facts show that inequalities in the rules of competition at the sector level are the main roadblocks on the path of economic growth in Russia. Notwithstanding corrupt practices or plain

disbelief in the market economy, many of these distortions have

been put in place by the government to meet social objectives. Unfortunately, they keep Russia at a very low level of economic performance and thus damage the social provisions they were intended to improve.

We discuss in the last section which policies and dynamics could

unlock the current system of intertwined social, political and financial interests.

SECONDARY CAUSES

We found the other most often cited reasons for lack of growth

in Russia to be much less important than the sector level market

distortions described above.

Problems in the area of corporate governance, resulting from a

combination of privatization to insiders and the lack of shareholders’ rights, are often mentioned as key to Russia’s economic underperformance. The existing governance environment gives the current managers more incentives to divert the company cash flows to

their own trading firms, than to restructure or invest. Such cash

diversions have been commonly mentioned in the steel, cement and

oil sectors. However, in these industries, battles for corporate control are now coming to an end in most of the viable assets, allowing

management to focus on increasing long-term value of the company.

64

Restrictions on labor mobility may lead to social tensions in company towns, but do not limit the abilities of growing companies to

recruit workers. For example in Moscow, where the labor market

is allegedly tight, a large share of workers engaged in governmentfinanced housing construction could be easily made available for reemployment. Facilitating labor mobility, notably in the non-viable

company towns, would nevertheless help release the current pressure on regional and municipal governments to oppose restructuring of enterprises.

Lack of legal infrastructure to enforce commercial agreements.—

While the lack of a strong and independent judiciary does make it

difficult for productive companies to appeal against the inequalities

of competition, private parties are now finding ways to work out secured transaction arrangements (e.g., cash on delivery and employment of private third party negotiators).

Lack of an effective banking system.—Lack of trust in both the

ruble and the banks (especially following the August 1998 debacle)

leads people not to make their savings available for subsequent

lending by the banks (savings are mostly kept at home in dollar

notes, or outside of the country). Although this is certainly bad

news for Russia, it should be noted that the virtual absence of bank

lending in Poland did not prevent it from achieving a strong economic growth due to foreign direct investment (FDI) and retained

earnings, the main source of business investments in the West.

Poor transport and communications infrastructure, even with the

great Russian distances, did not emerge as an important barrier.

Most of the population and production facilities are located west of

the Urals, where distances are not as huge as in the Eastern part

of the country, and most of the European part of Russia can be

reached fairly quickly and inexpensively by truck or train.

RUSSIA’S GROWTH POTENTIAL WITH KEY ECONOMIC REFORMS

As described in the previous section, our investigation of sectors

of the Russian economy helped us identify the relative importance

of the reforms now being discussed. We concluded that the main

barriers to economic growth, unequal conditions of competition,

tend to be industry-specific. Thus, they have to be removed on a

sector-by-sector basis. Given the political difficulty of reform, this

process probably should start with the high growth potential sectors identified below.

Removing the market distortions, especially in the sectors with

high growth potential, could enable Russia to achieve and sustain

rapid economic growth. Eight percent per annum would be within

reach, allowing standards of living to double in less than 10 years.

This performance could be achieved due to a significant share of

potentially viable spare capacity, a sizeable pool of skilled and inexpensive labor, and crucially, a large inflow of FDI into Russia,

which can be expected once the inequalities are eliminated from

the conditions of competition.

SECTORS WITH THE HIGHEST GROWTH POTENTIAL

We have estimated the relative potential of output growth in

Russia’s economic sectors based on the experience of other counVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00090 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.003 CRS1 PsN: CRS1
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tries, Russia’s starting point and sources of comparative advantage

(Figure 13). This analysis shows that in addition to oil, where exports could sharply increase, output in light manufacturing (food

processing, consumer goods and automotive industries) should grow

to replace the current high share of imports. Demand for new services, like supermarkets, should also continue to increase. These are

the sectors where the market distortions should be removed first.

FIGURE 13.—RELATIVE OUTPUT GROWTH POTENTIAL OF RUSSIA’S SECTORS

[Percentage points of U.S. GDP in 1995 per capita]

* Oil expected to grow faster than gas and mining.

** Commercial and infrastructure construction to grow faster than housing construction.

Source: OECD; McKinsey analysis.

LARGE AMOUNTS OF POTENTIALLY VIABLE SPARE INDUSTRIAL

CAPACITY

Our sector analyses have shown that about 75 percent of Russia’s

inherited assets (put in place before 1992) would still be viable if

upgraded and managed according to modern principles. Generalizing from the sectors we studied and assuming equal market conditions, this upgrade would allow production in these assets to increase by 40 percent on average for a relatively small investment,

only around 5 percent of GDP per annum, for 5 years (Figure 14).

BENEFITS FROM FOREIGN DIRECT INVESTMENTS (FDIS)

FDI could be attracted en masse into the high growth sectors and

potentially viable assets, provided that the market distortions are

removed. Foreign companies would bring not only the dollars necessary to finance imports of machinery, but also the best practice

managerial skills indispensable to achieving high productivity.


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FIGURE 14.—SIZE OF UPGRADING INVESTMENTS

Source: Interviews.

In oil alone, foreign investment could amount to $80 billion over

the next 10 years, the equivalent of 3 percent of Russia’s GDP

every year. Foreign oil companies would also bring the expertise

and technologies, that would double drilling efficiency in new fields.

In Poland, which has no oil, direct foreign investment already

amounts to 7 percent of GDP, against less than 1 percent today in

Russia. FDI in Poland is concentrated in light manufacturing and

services, and in light manufacturing accounts for 60 percent of

total investment (Figure 15). Large inflows of FDI have been the

secret of Poland’s ‘‘economic miracle.’’ The Polish experience also

shows that if exposed to intense competition on an equal basis, foreign companies do not ‘‘milk’’ the country, but rather keep reinvesting profits and develop a pool of local management talent.

The Novgorod region of Russia is a rare positive example of what

can be done in today’s Russia by regional governments. It managed

to attract more FDI than almost any other Russian region, including nearby St. Petersburg, by removing red tape, facilitating access

to land and offering tax holidays to investors. As a result, the region has enjoyed economic growth since 1995, and over half of industrial output is now coming from productive foreign companies

(Figure 16).

FUNDAMENTAL BARRIERS TO ECONOMIC REFORMS

The drive toward establishing a market economy based on equal

opportunities for all competitors has essentially stopped in Russia

since 1995. Why has this happened? There are three fundamental

explanations for this: social concerns, corruption and lack of information. We discuss below how these factors interplay to lock RusVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00092 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.003 CRS1 PsN: CRS1

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sia at the current low level of economic performance and what

could be the ways to unlock it.

FIGURE 15.—POTENTIAL INCREASE IN BUSINESS INVESTMENT

[Percent of GDP]

* Includes automotive.

** Transport, communication, business and personal services.

Source: Goskomstat; Polish Analysis of Industrial Enterprises (PAIZ); McKinsey analysis.

FIGURE 16.—SUCCESS OF MARKET REFORMS IN NOVGOROD REGION

* Median of cumulative 1995–1997 FDI per capita of all regions.

** First quarter 1998.

Source: Goskomstat; interviews; Bureau of Economic Analysis; Institute of East-West Studies (IEWS); press

reports.


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SOCIAL CONCERNS

Many of the market distortions are kept in place in the name of

preserving existing employment. When justified, these social concerns would be better addressed with a system of explicit direct

subsidies to the workers, rather than through the current mechanism of implicit subsidies to companies, which also serves to enrich

government officials and company managers.

• Ill-founded social concerns.—Based on the experience of other

countries further ahead in their economic development, notably

Poland, and our understanding of labor productivity gaps in

Russia, we have estimated how employment would evolve by

sector if the barriers to economic growth were removed. We

found that employment should continue to grow in services and

remain roughly stable in light manufacturing and construction.

Thus, workers who would loose their jobs as a result of strong

productivity growth or shutdowns in these sectors should be

able to find new jobs of similar profile, especially if they are

around large urban areas. As a result there are no social reasons to keep in place the following barriers which have been

identified in the cases:

• Red tape limiting the restructuring of potentially viable

dairy and confectionery plants • Directed housing contracts to preserve employment levels in

the traditional (panel type) housing construction companies • Tax and other advantages given to open-air wholesale markets, kiosks and pavilions • Government ownership of hotels. • Alternative for addressing well founded social concerns. In the

heavy manufacturing sectors, productivity would grow faster

than output, leading to substantial employment losses. This

prospect does raise serious social issues, especially in doomed

company towns, because workers’ mobility is restricted by the

registration (propiska) system. In such cases, direct subsidies,

given to the workers to help them relocate would be much

more efficient than the current barter-based corrupt system of

implicit federal subsidies to unproductive companies. Doing

this would allow the removal of the following distortions:

• Unequal energy and tax payments slowing down modernization of viable industrial assets • Limits on oil exports to force cheap oil to be supplied to agriculture and defense, discouraging investment into new oil

production.

CORRUPTION

Our interviews with companies confirmed the common view that

pursuit of personal financial gains within the government and

government-related agencies or companies is pervasive in Russia.

Like in many other developing countries, the combination of arcane

laws, government control over key assets, low salaries of state employees and weak enforcement and control mechanisms provides

the means and incentives for corrupt practices. In Russia, virtually

every business is in violation of laws (primarily tax laws) and

hence the potential target of public or private shakedowns (priVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00094 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.003 CRS1 PsN: CRS1
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marily at the local level). We believe that in many cases corruption,

together with social concerns, is the main reason for the rules of

competition to be kept unequal.

• The conventional wisdom on how to fix corruption suggests

that the highest level of government, remaining untarnished,

should initiate the crackdown: ‘‘the fish rots from the head.’’

The salary level of key officials needs to be increased, laws

against conflict of interest passed and strong independent controls need to be put in place together with credible punishment.

• Based on our case studies, we believe that a potentially more

effective way to reduce corruption in Russia would be to remove the numerous means by which the federal and local governments can interfere with the markets to extract economic

rent. This would entail lower and simpler taxes, streamlined

red tape, reduced scope for government procurements (e.g., social housing) and privatization of remaining government assets

(e.g., land and hotels).

This suggests that corruption is not only a cause of Russia’s current economic problems but also a consequence of incomplete market reforms.

LACK OF INFORMATION

Such vicious dynamics have been broken in other countries

through the democratic process on the basis of fact-based policy debates. Facts about the Russian economy are difficult to obtain. We

hope to contribute a useful fact base to policy debates, as we show

with micro-economic analysis:

• The extent of the performance gaps for both the old and new

economy

• The absence of fundamental natural or economic obstacles to

high economic growth in Russia

• The economic sectors with the highest growth potential

• The often underestimated importance of services in stimulating

overall economic growth (e.g., supermarkets triggering positive

spillover effects down the whole food chain)

• The key role that could be played by FDIs, especially in a

‘‘strategic’’ sector like oil

• The most important economic reforms, to be pursued with priority in the high growth potential sectors

• How these economic reforms can be made compatible with the

pursuit of social objectives

• How these economic reforms would help reduce the scope for

corrupt practices

• The key role and responsibility of regional governments in fostering economic growth.

The changes described above require painstaking efforts in the

political process to overcome conflicts of interest and reach compromises. Today’s advanced democracies have taken decades to

achieve good economic policy, both at the macro-economic and sector levels. However, the result has been that they have achieved

the highest levels of economic performance in the world. Russia can

70

benefit from the hard lessons learned by others, but for historical

reasons, the obstacles in Russia are more difficult. How to lead a

democratic political process to overcome these obstacles is beyond

the scope of this project and beyond McKinsey’s experience and expertise. However, we have found no structural constraints on the

economic side that would prevent Russia from quickly joining the

ranks of the advanced economies.

APPENDIX: SUMMARIES OF SECTOR CASE STUDIES

Below we present summaries of each of the ten sector case studies. Each summary covers five topics: industry overview, productivity performance, reasons for productivity gap at the operational

level, external barriers to productivity and output growth, and to

conclude, policy implications and future outlook.

STEEL

Industry overview

In 1990 the Soviet Union was the largest steel producer in the

world. Following a 60 percent drop in domestic steel consumption,

not compensated for by an increase in exports, steel production fell

by 40 percent in Russia since the 1990 production peak. The more

than 100 Russian steel plants can be divided between the ‘‘Big

Three’’ integrated steel plants (mainly flat products), the ‘‘Medium

Six’’ (long products) and ‘‘Small Others.’’ Each group employs

around one third of the almost 400,000 steelworkers.

Productivity performance

With no shutdowns or layoffs, productivity fell by 40 percent to

28 percent of the U.S. level between 1990 and 1997. The Big Three

achieve around 45 percent of the U.S. productivity level, the Medium Six 25 percent and the Small Others only 10 percent of the

U.S. level.

The main reasons for the productivity gap at the operational

level for the Big Three and Medium Six are low capacity utilization, excess workers in logistics and overhead functions, and low

yields on energy and raw materials. These plants could achieve

more than 80 percent of the U.S. productivity level with very little

upgrading investments. Most of the Small Others, however, are not

viable because they use the outdated open hearth furnace and ingot

casting process, wasting energy and representing major environmental hazards.

The most important external barrier to productivity and output

growth is the implicit federal energy subsidy given, in the form of

arrears or advantageous barter deals, to many non-viable Small

Others, allowing them to remain in operation. There have been virtually no layoffs in the viable steel plants because wages are free

to adjust downward, as the prevailing registration (propiska) system curbs the ability of workers to travel in search of better jobs.

Poor corporate governance was a key barrier to growth soon after

the privatization (1993–1996) as managers concentrated their efforts on gaining control. Today, with the end of most shareholder

battles at the large productive plants, it is of secondary importance.

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Policy implications and future outlook

With adequate technology in most of its production capacity, and

relatively low labor and energy costs, Russia has a clear competitive advantage in steel. To allow the industry to realize its full potential, local governments should stop channeling implicit subsidies

to doomed plants in exchange for appropriate mobility provisions

and social safety nets to be provided by the federal government. At

the same time, a good way for the West to help Russia would be

to remove the current restrictions on Russian steel imports.

CEMENT

Industry overview

There are 50 cement plants in Russia employing around 40,000

workers. Cement production collapsed by more than 60 percent

since the 1990 peak; it is now at half the Polish level on a per capita basis. The industry has remained extremely fragmented since

privatization, and the three foreign global players present in Russia have yet to commit to significant investment.

Productivity performance

Despite the production collapse, there have been virtually no

plant shut downs or layoffs. Productivity has thus dropped from 20

percent of the U.S. level in 1990 to 7 percent in 1997. The best

Russian plant achieves 30 percent of the U.S. productivity level,

while many plants stand at 1 percent.

The main reasons for the productivity gap at the operational

level are very low capacity utilization, lack of multi-tasking, less

automation in packaging and delivery and inferior wet/gas technology leading to much higher energy consumption and lower cement quality. More than half of the cement plants could achieve 50

percent of the U.S. productivity level at full utilization, with best

practice modes of organization and a few targeted investments like

converting to semi-wet/gas technology.

The most important external barrier to productivity and output

growth is the flow of implicit federal subsidies in the form of cheap

energy, tax arrears and/or directed government procurements channeled to the weakest players by local governments anxious to prevent shut-downs. These subsidies and political constraints are also

preventing best practice companies from buying up excess capacity

to shut it down in order to increase capacity utilization and make

the necessary upgrading investments that are worthwhile in the

viable capacity. These subsidies do not only serve a social cause,

since allegedly, part of the subsidy flow is being diverted, via complex barter deals, to short lived and well-connected trading companies.

Policy implications and future outlook

A strong federal government could force the rapid restructuring

of the sector by cutting the flow of energy and tax subsidies and

replacing them with direct help to the workers wherever deemed

necessary. This would make more higher quality and cheaper cement available to major downstream industries, such as construction and oil.

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3 Including refining and transportation of crude and petroleum products.

OIL

Industry overview

While its employees accounted for only 1 percent of the Russian

workforce, the oil sector 3 sales represented 6 percent of GDP, 16

percent of exports and 22 percent of budget revenues in 1998 (despite relatively low oil prices). Oil production has halved since the

peak of 1988, with the fall in domestic demand and exports to

countries of the ex-Communist block. The industry has been

privatized to insiders with very little foreign involvement.

Productivity performance

The actual total factor productivity (the combined measure of

labor and capital productivity) of the Russian oil industry is 55 percent of that of Texas on-shore. Once adjusted for favorable geology

and younger oil fields in Russia, the productivity level falls to

about 30 percent.

The main reasons for the productivity gap at the operational

level are lower oil recovery due mostly to less hydrofracturing and

poor reservoir management techniques, and inefficient drilling because of low quality drill bits, cleaning muds and cement being

used. There are also more than 35 percent excess workers and a

large amount of idle drilling equipment resulting from the stoppage

of new field developments since 1991, despite attractive proven reserves in Western Siberia. The total production cost in these new

fields would be as low as $6 a barrel (against $20 a barrel for current world oil prices) with best practice operations.

The most important external barriers to productivity and output

growth are the lack of workable tax laws (the recently passed production sharing agreement is not yet operational) and distorted domestic oil markets with limits on oil exports. These limitations,

which discourage any significant investments, force the supply of

cheap oil to ‘‘strategic sectors’’ such as defense and agriculture.

Other, less important, factors include unresolved shareholder battles with weak minority shareholder rights protection, and widespread barriers to layoffs put in place by local governments in oil

company towns.

Policy implications and future outlook

If the main barriers to investment are not removed, Russia could,

with the current rate of depletion in the existing fields, end up

being a net importer of oil in 10 years. The social objectives and

national interest would be better served if further assurances were

given to investors, notably deep pocket foreigners who could pour

in 80 billion dollars’ worth of investment over the next 10 years.

Such assurances should include workable taxes as well as a fully

liberalized domestic oil market with open access to an enlarged export infrastructure. As a result production could double in 10 years,

thus meeting demand of a (hopefully) fast growing economy and increasing exports by more than 50 percent (keeping Russia’s market

share of world oil exports constant given current expectations of increasing future demand). Also, the additional tax revenues would

73

suffice to keep subsidizing (if deemed necessary) the oil purchases

for agriculture and defense customers and help relocate stranded

oil workers.

DAIRY

Industry overview

The industry consists of four functions: raw milk receiving, fluid

and non-fluid milk processing, and packaging. Dairy farming and

distribution are excluded from our study. The major processed

dairy products are fluid milk (the largest category), cream, butter,

cheese and milk powder. In 1997, 199,000 people were employed in

the Russian dairy industry across 1,753 plants.

Productivity performance

Labor productivity in dairy is at 8 percent of the U.S. level. Russian dairy plants produce one-fifth of U.S. output per capita using

more than twice as many people. Since 1990, labor productivity has

almost halved. Productivity differs by size of plant, since large

economies of scale are present in this industry: 72 large plants (capacity of 55,000 tons a year or more) employ about 20 percent of

the industry workforce and have 12 percent of the U.S. level of productivity; 1,681 small plants employ the rest, and operate at 7 percent of U.S. productivity level.

The main reasons for the productivity gap at the operational

level differ between small and large plants. Large plants (43 percent of industry capacity) could raise their productivity from 12

percent to more than 60 percent of the U.S. level without major investments, since the present gap is mainly due to low capacity utilization and inefficient organization of functions and tasks. The remainder of the gap comes from lack of automation and inefficient

relations with suppliers. These large plants, if utilized at 80 percent, could produce all current output of the industry by themselves. Small processors need major investments to reach minimum

efficient scale—an investment that will not be economical.

The most important external barriers to productivity and output

growth are problems in up- and down-stream industries, macroeconomic instability and local government interventions. Problems

in up- and down-stream industries hinge on monopolistic wholesalers, who force arrears onto dairy plants and set off a chain of

events leading to inefficient dairy farming and the emergence of

sub-scale mini-plants which do their own distribution. Macroeconomic instability manifests itself via a high cost of capital (discouraging investments into larger scale plants, and into shelf-life

enhancing technologies that could give dairy plants more bargaining power over wholesalers) and a low level of demand (leading to

reduced consumption of processed milk and lower capacity utilization of dairy plants). Local governments shield wholesalers from

competition from supermarkets by taxing the latter ones out, and

directly hamper restructuring of the dairy sector by deterring layoffs and bankruptcies of inefficient plants, thus creating unequal

conditions of competition in the industry.

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Policy implications and future outlook

For Russia to increase its productivity in the dairy sector, large

plants should expand, while small ones should exit. For this to

happen, barriers to growth of supermarkets need to be lifted (see

the summary of the Food Retailing industry), regulatory interventions against layoffs must be stopped, and bankruptcies of small

plants should not be artificially prevented. With these policies, the

sector would be able to achieve more than 60 percent of the U.S.

productivity level with limited investments.

CONFECTIONERY

Industry overview

The confectionery industry consists of four functions: raw material receiving: mixing; processing; and packaging. Farming and distribution are excluded from this study. Following the official Russian industry definition, biscuits and crackers are included in addition to regular confectionery. In 1997, 120,000 people were employed in the industry across 925 plants. This sector has been relatively successful in attracting best practice foreign companies, although these investments are still too small to make any significant difference to the overall sector’s performance.

Productivity performance

Labor productivity in the Russian confectionery industry is at 10

percent of the U.S. level, down from 13 percent in 1990. Productivity differs between large (capacity of 35,000 tons per year or more)

and small plants: 11 large plants achieve productivity of 22 percent, using 20 percent of total employment in the sector. The productivity of 914 small plants is 7 percent, using 80 percent of total

employment.

The main reasons for the productivity gap at the operational

level are low scale and capital intensity. Even the large plants that

have minimum efficient scale have to rebuild their multi-storied

structures in order to use new equipment. Large confectionery

plants already have a high capacity utilization and thus the potential for improvements is smaller than in the large dairy plants. The

productivity potential for large plants and small plants without

major investment-fixing capacity utilization, organization of functions and tasks and product proliferation/value added within category—is around 50 percent of the U.S. level for the large plants

and less than 30 percent for the small plants.

The most important external barriers to productivity and output

growth are low labor cost, an unfavorable tax structure, unequal

tax enforcement, and an inefficient wholesaling industry. The low

labor cost renders automation uneconomical even for multinationals with a low cost of capital. Deductibility of advertising expenses

for tax purposes is very limited, and advertising expenses can be

taxed in some regions. This discourages expansion of best practice

firms through brand building. The playing field is further distorted

when local governments deter layoffs by best-practice firms by subjecting them to numerous inspections, and condone tax arrears

from unproductive companies, which end up being more profitable

than their global best practice competitors. Rights of brand ownerVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00100 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.004 CRS1 PsN: CRS1
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ship are not enforced, further hampering investment into branding

and expansion, and the procedure for approving shelf-life claims

can be very slow and subject to undue influence. Due to the large

number of wholesalers in the confectionery distribution chain,

wholesale margins in Russia are twice the U.S. level, which protects local players by making cross-regional expansion more difficult for productive players.

Policy implications and future outlook

In order for the industry to increase its overall productivity restrictions on layoffs must be removed, taxes from all firms collected

equally, tax disincentives to advertising removed, brand property

rights enforced, and shelf-life approval process streamlined. Under

such conditions, the industry overall would be able to reach 30 percent of the U.S. productivity level (without major investments) and

compete more successfully against imports.

FOOD RETAILING

Industry overview

The food retailing industry employs 4 percent of the Russian

workforce and is one of the largest sectors in the economy. Since

food constitutes 45 percent of Russian household spending and food

retailing accounts for 20 percent of that cost, the sector affects 9

percent of total household spending. The sector has experienced a

dramatic transformation in recent years. Open-air wholesale market stands, kiosks, pavilions and agricultural markets have taken

shares away from Soviet-era formats (whose shares have declined

from 90 percent in 1990 to 41 percent in 1997).

Productivity performance

The Russian labor productivity is at 23 percent of the U.S. level.

Street vendors are at 9 percent, traditional Soviet-era formats (the

smaller gastronoms) at 24 percent, open-air wholesale markets at

24 percent, kiosks and pavilions at 26 percent, and supermarkets

at 78 percent of the average U.S. productivity.

The main reasons for the productivity gap at the operational

level can be grouped into two. First, Russia lacks modern productive formats such as supermarkets and hypermarkets. The market

share of modern formats is less than 1 percent in Russia compared

to over 70 percent in the United States. Second, format-to-format,

Russian stores suffer from over-manning, low scale of chains and

stores, and low capital intensity compared to their U.S. counterparts.

The most important external barriers to productivity and output

growth are those that prevent the penetration of modern formats.

Modern formats cannot gain share against the less productive

open-air wholesale market stands, kiosks and pavilions because the

latter benefit from lower tax liabilities, less control on the origin

of their goods (which are often illegal imports or counterfeits), and

cheaper access to prime locations. Inefficient Russian food processors also impede the entry of modern formats since best practice

firms will not invest in a country unless they can source quality

products domestically.

76

Policy implications and future outlook

If the main barriers are removed, modern formats should gain

substantial market share. For example, in the city of Obninsk in

Central Russia, supermarkets gained 15 to 20 percent market

share (compared to less than 1 percent for all of Russia) after the

local government provided equal opportunities (for supermarkets

and open-air wholesale market stands) in terms of land allocation

and tax/tariff/counterfeit enforcement. As another example, Polish

supermarkets and hypermarkets gained 18 percent market share

in less than 5 years—having started from a similar format mix as

Russia—after the government put into place equal tax legislation

and clear land allocation procedures.

GENERAL MERCHANDISE RETAILING

Industry overview

The general merchandising industry employs 2 percent of the

workforce and generates 2.5 percent of GDP in Russia. Between

1990 and 1997, general merchandising turnover dropped by 40 percent and the share of imports rose from 15 percent to 80 percent.

The share of Soviet-era formats declined from 100 percent to 20

percent, they were replaced by new more convenient or cheaper formats, especially open-air wholesale markets, which captured 65

percent market share.

Productivity performance

The Russian labor productivity is at 26 percent of the U.S. level.

Soviet-era multi-product stores are at 10 percent, Soviet-era singleproduct stores at 24 percent, open-air wholesale markets at 27 percent, kiosks and pavilions at 28 percent, and the few modern

chains (mostly in electronics) at less than 80 percent of the productivity level of their U.S. equivalent.

The main reasons for the productivity gap on the operational

level can be grouped into two. First, Russia lacks modern chains

that are more productive than non-chains. The market share of

modern chains is at 8 percent in Russia compared to 70 percent in

the United States. Nearly all the modern chains are consumer electronics chains. Second, open-air wholesale markets stands have low

productivity because they are both sub-scale and under-capitalized.

Finally, and much less importantly, Russian (consumer electronics)

chains have lower productivity than their U.S. counterparts because they do not use part-time workers to match demand fluctuations, and enjoy less economies of scale.

The most important external barriers to productivity and output

growth are those that prevent the penetration of modern chains.

Modern chains cannot gain share against the less productive openair wholesale market stands, kiosks and pavilions because the latter benefit from lower tax liabilities, less control on the origin of

their goods (which are often illegal imports or counterfeits), and

cheaper access to prime locations. In addition, the high cost of capital deters domestic investors from financing capital-intensive

hypermarkets or malls.

77

Policy implications and future outlook

If the main barriers are removed, modern chains should gain

substantial market share. Foreign multinationals can overcome financing limitations and are thus attractive candidates for investment. Such multinationals invested only $0.1 billion in Russian retailing (both food and general merchandise) compared to $2.1 billion in Poland (with another $2.7 billion in the pipeline), where the

playing field is much more level with serious law enforcement. As

a result, Poland enjoys a 22 percent market share for chains, while

bazaars (the equivalent of Russian wholesale markets) are in

marked decline, with only 10 percent market share in 1999.

HOTELS

Industry overview

Approximately 100,000 people are employed in about 5,000 hotels

located in Russia. Unlike most Russian sectors that have been

privatized, over 80 percent of hotels remain in the hands of municipal, regional or federal government. Recently four- and five-star

hotel foreign chain operators have entered the high-end segment of

the market; they currently account for 15 percent of turnover.

Productivity performance

Russian labor productivity in the hotel sector (for lodging only,

excluding food and beverage) is at 18 percent of the U.S. level. Russian chains (exclusively the four- and five-star hotels) are at 60

percent of the productivity of U.S. chains while Russian non-chains

are at 19 percent of the productivity of U.S. non-chains.

The main reasons for the productivity gap at the operational

level can be separated into three groups. First, comparing Russian

non-chains to U.S. non-chains, Russian hotels are less utilized, do

not implement multi-tasking of personnel, have lower value-added

rooms, and are more sub-scale. Second, comparing Russian chains

(managed by Western operators) to U.S. chains, Russian hotels are

penalized by the need to train their personnel (e.g., cleaning ladies). Third, Russia lacks chains, which are more productive than

non-chains (e.g., central booking leading to higher utilization);

chains account for only 15 percent of turnover in Russia compared

to 40 percent in Poland and 70 percent in the United States.

The most important external barriers to productivity and output

growth are also separated into three groups. For non-chains, government ownership stifles managerial incentives for improving efficiencies. Also, the collapse in demand has reduced capacity utilization, while low income has limited the demand for higher value

added rooms. For chains, lack of multi-tasking should be resolved

over time as a skilled labor pool is developed. Last, for chain penetration, collapse in demand, high cost of capital and country risk,

under-developed tourist attractions, high construction costs, and

red tape/corruption involved in land allocation have been the main

barriers.

Policy implications and future outlook

If the main barriers are removed, the Russian hotel industry

could achieve productivity of up to 60 to 65 percent of U.S. levels.

78

International experience shows that demand for hotels increases

rapidly as income per capita grows. Removing the barriers is likely

to increase investment in new hotels, especially in chains. Besides

the improvements in the format mix, this higher chain penetration

will also foster productivity in non-chains by increasing the industry’s competitive intensity.

RESIDENTIAL CONSTRUCTION

Industry overview

Residential construction is one of the largest economic sectors in

Russia accounting for about 5 percent of total employment and 3

percent of GDP. Output in the sector has declined by 25 percent

since 1990. Growth in the construction of privately financed brick

houses and apartments has not compensated for the 50 percent decline in the construction of government-financed traditional prefabricated apartment buildings.

Productivity performance

The overall productivity of the sector is estimated at around 10

percent of the U.S. level. Productivity fell to 10 percent of the U.S.

level in the traditional segment, as many companies did not adjust

their staffing levels to the fall in output. New entrants only achieve

20 percent of the U.S. productivity level, and furthermore, around

one-fourth of all construction is now being carried out ‘‘brick by

brick’’ by individuals (5 percent productivity level) as financing becomes available.

The main reasons for the productivity gap at the operational

level for the traditional companies are very low capacity utilization

at both the panel factories and construction sites, and complete

lack of incentives for workers to improve efficiency or quality levels. The new companies are mostly affected by both the lack of special trade companies and the small scale of privately financed housing programs.

The most important external barrier to productivity and output

growth is the fact that local governments systematically allocate

housing programs to the same (ex-Soviet) companies in exchange

for no layoffs. New private companies are also penalized by the fact

that large single family housing programs (the most productive

form of housing construction) are virtually impossible in the absence of an operational land code and mortgage financing.

Policy implications and future outlook

Government-financed housing programs should be limited to the

most urgent social needs (e.g., relocation of stranded industrial

workers) and carried out through open and equal tenders. The following would also help stimulate the demand for private housing,

appropriate legislation in the areas of land property and usage

rights, tenant rights, a mortgage system (with macro-economic stability as a prerequisite), removal of administrative barriers to labor

mobility (propiska system), and accelerated phasing out of the utility and maintenance subsidies in the existing housing stock.

79

SOFTWARE

Industry overview

We address two distinct sub-sectors in our software case: packaged software and project services, in total employing about 8,000

people in Russia (compared to more than 600,000 in the United

States).

Productivity performance

The overall labor productivity in the sector is 38 percent of the

U.S. level, an average of 13 percent for packaged software and 72

percent for project services (consulting, implementation and training in the information technology area). This latter sub-sector is

the most productive of all the industries we have studied in Russia.

The main reasons for the productivity gap at the operational

level for packaged software, a high fixed (development) cost business, are low scale (on average, Russian packaged software companies are 100 times smaller than their U.S. counterparts), and a low

value-added product mix. This latter factor is also responsible for

the (small) productivity gap in project services.

The most important external barriers to productivity and output

growth differ between sub-sectors. In packaged software, the causes

are the prevalence of software piracy and lack of leading-edge demand from business customers. The piracy rate is 90 percent in

Russia—one of the world’s highest, so Russian software firms lose

most of their resources to pirates and can not invest in research

and development of better products. Software-consuming sectors,

whose demand drives development of software firms, are both very

small in Russia and less interested in productivity-enhancing software tools than their Western counterparts. For example, banks,

important software consumers elsewhere, in Russia depend on relationships with authorities, rather than cost control or good service.

Kiosks, unlike supermarkets, do not consume software.

The customized nature of project services makes this sub-sector

immune to piracy. The low value-added service mix of Russian

project services firms, the main culprit of the (small) productivity

gap, comes from the low level of customer demand. The low level

of domestic demand can be partially overcome by serving overseas

customers via offshore programming. The Russian business of offshore programming is growing at 50 to 60 percent per year, although from a very small base. With time, this industry should be

able to obtain the requisite track record and international certification, and become a force in the world offshore programming market along with India.

Policy implications and future outlook

The following four policy measures should improve the economic

prospects for the software sector in Russia: removal of barriers to

productivity and output growth in the other (software-consuming)

sectors (see all other sector case studies), stepping up enforcement

of anti-piracy laws (which are already in place), support to ISOand SEI-certification initiatives (e.g., through setting up a number

of specialized certification centers to ease the process for Russian

companies), and removal of red tape in software export procedures.

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The future of the domestically oriented packaged software and

project services sub-sectors will depend on growth of the whole

economy. Offshore programming can be expected to continue growing output and employment at the current rate of 50 to 60 percent

per year.

(81)

ADMINISTRATION AND REFORM OF THE

RUSSIAN ECONOMY

By Paul Gregory and Wolfram Schrettl 1

CONTENTS

Page

Objectives of Russian Administrative Reform ....................................................... 81

Soviet Administration ............................................................................................. 82

The Administration of the Russian Federation ..................................................... 84

Federalism ................................................................................................................ 89

Liberalization, De-Bureaucratization, and Corruption ......................................... 90

Civil Service Reform ................................................................................................ 93

Are Putin’s Reforms Too Good To Be True? .......................................................... 94

1Paul Gregory is Professor of Economics, University of Houston. Wolfram Schrettl is Head,

Department of International Economics, German Institute for Economic Research, DIW Berlin.

The authors wish to thank Henning Schroeder for comments and suggestions on an earlier draft

of this paper and Carina Schulz for able research assistance. Wolfram Schrettl is grateful to

the KfW-managed TRANSFORM program of the German Government for financial support to

GLOROS (‘‘Global Economy and Russia. A Russian-German Dialogue’’), a project of DIW Berlin

(German Institute for Economic Research) and HSE Moscow (State University Higher School of

Economics).

The goal of Russian administrative reform is to create a ‘‘rule of

law’’ that encourages domestic entrepreneurship, foreign investment, and economic growth. Old planning institutions must be replaced by new state institutions that a market economy requires.

After more than 10 years of transformation, the major administrative changes have been the replacement of the executive, legislative, and judicial Communist Party monopoly with a strong presidency and a to-date weak legislature. Destatized large enterprises

have replaced the industrial ministries, and they represent a new

source of independent power. New agencies have been created but

they have not taken firm hold in the new administrative system.

President Putin has presented a comprehensive program of administrative reform. His regional reform has passed the legislature and

decides the federalism issue by centralizing power. His debureaucratization reforms seek to improve Russia’s business and

investment climate by reducing bureaucratic interference and arbitrary official behavior. Significant reforms remain to be implemented; namely, judicial reform and civil service reform. A key

question is whether these reforms are successfully resisted, as have

been earlier reforms, by those parts of the bureaucracy that stand

to lose income and power.

OBJECTIVES OF RUSSIAN ADMINISTRATIVE REFORM

A significant part of the transformation process is the creation of

a structure for the administration of a market economy to replace

82

the administrative structure of the planned economy. Such a transformation requires the government’s credible commitment to firm

legal ‘‘rules of the game,’’ a non-corrupt bureaucracy that enforces

and interprets these rules impartially, and a judiciary that independently interprets these rules and punishes violations. The term

administrative reform means different things to different people in

contemporary Russia. Changes in center-periphery relations, antibureaucratic legislation, and civil service reform all fall under the

category of administrative reform. In this paper, we interpret progressive administrative reform as any reform that creates new

legal rules of the game that will administered fairly and efficiently

by the bureaucracy. We describe the current Russian administrative system in terms of this general goal, and we use the Soviet legacy, which has left a strong imprint on the current system, as our

starting point.

SOVIET ADMINISTRATION

Figure 1 provides a schematic sketch of the Soviet-type administrative structure from which that of the Russian Federation

evolved. It shows that the legislative rules of the game were set by

the top leadership of the Communist Party in the Central Committee and Politburo. Formal decrees and orders were issued by the

state administration (called the Soviet order), but the top administration of both state and party comprised an interlocking directorate of key political figures that blurred distinctions between the

party and state at the highest level. This was a decree-based system in which national laws and instructions were issued by the

Council of Ministers, with the most important decrees issued jointly by the state and party. Decrees and orders were typically quite

specific, instructing some subordinate agency to fulfill a designated

task.

The Soviet Government was the Council of Ministers in which

the most important ministries and state committees were represented. Ministries consisted of two types: Industrial ministries

which supervised productive enterprises and functional ministries

that carried out the normal state functions, such as education, defense, internal security, justice, and public finance. State committees typically attended to functions specific to a planned economy

and usually not found in market economies. Gosplan drew up national plans, Gossnab prepared supply plans, Goskomtsen set

prices, Goskomtekhnika supervised research and development, and

Gosstroi planned construction. A monopoly state bank assumed all

functions of banking, and carried out, in particular, central banking and allocations of credit. Its monetary and credit policies were

subordinated to the plans prepared by other state committees, and

its main job was the distribution of credits according to plan.

This central administrative structure was replicated in the 15 republics, of which the Russian Republic was one, with Republican

governments answering to the Council of Ministers and Communist

Party. These Republican Party and state organizations supervised

local industries, they did not play independent roles, and their influence on national policy was felt primarily through the Republican leader’s influence within the party apparatus.

83

2 Boettke, Peter. Calculation and Coordination (London: Routledge, 2001).

FIGURE 1.—SOVIET ADMINISTRATION

[Schematic version]

The plan was ‘‘the law.’’ Given that there were a large number

of plans, many conflicting, the administration engaged in considerable negotiating, coercion, and compromising in the absence of

overall rules of the game. The party was the ‘‘leading institution’’ which gave it the primary role of negotiator, compromisor, and

facilitator. Administrators with authority to make resource allocation decisions (party, planners, ministers, etc.) were the distributors of the economic rents associated with the monopolistic structure of Soviet industry. Contemporary writers even argue that the

party’s main role was to distribute economic rents among society’s

players. 2 Those with power to distribute and use resources were

called fundholders. They actively traded resources among themselves by barter, plan instructions, and outright sales in a manner

that is still poorly understood.

The Soviet system used a nomenklatura system for administrative appointments, promotions and firings, which was managed at

the top by the party personnel department. The nomenklatura system had rather clearly stated rules concerning which agency (state

or party) was authorized to make personnel decisions. We do not

know to what extent the nomenklatura system was merit based.

Some appointments were made on merit; others through connections or family relations. The operations of the nomenklatura system were opaque and unlike the Western-style ideal of a transparent civil service. The notion of free access to administrative careers in the state or party through a well-defined set of rules was

totally foreign. In a society that lived drably, membership in the


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nomenklatura meant access to goods, perks, and services beyond

the reach of ordinary citizens. These perks and benefits could not

be purchased; they were linked to specific positions in the

nomenklatura.

THE ADMINISTRATION OF THE RUSSIAN FEDERATION

The Soviet administrative system collapsed along with the Communist Party monopoly in late 1991, which had been its foundation. The administrative-command economy collapsed with

Gorbachev’s withdrawal of administrative power from the branch

ministries in the late 1980s. Once Yeltsin and his reform team determined to abandon the Soviet command system, administration

had to change to meet the new circumstances of an economy that

was no longer centrally planned, in which there was considerable

market allocation, and significant privatization (or destatization) of

property. Conceptually, such an economy required creation of a rule

of law based upon a legislative framework to which the state was

‘‘credibly committed’’ as opposed to ad hoc decrees, which could

change with the whims of leaders. Also required was a well-defined

distribution of power among the executive, legislative, and judicial

branches with the legislature making law, the executive executing

that law, and the judiciary interpreting law and resolving conflicts.

The distribution of power, tax revenues and government expenditures, and property between the central government and regional

and municipal governments had to be agreed upon with non-contradictory and non-overlapping rules and regulations. Without such

‘‘federalism’’ agreements, state property could not be managed and

disposed of and businesses could not operate in a uniform market

with a level playingfield.

A series of new or improved government institutions was also required, including ‘‘normal’’ institutions for monetary and fiscal policy, such as a two-tiered banking system (with a quasi-independent

Central Bank of the Russian Federation (Central Bank of Russia

or CBR)) to replace the monopoly state bank and a system for orderly fiscal budgeting. Also new agencies required by a market

economy had to be created and agencies associated with planning

and administrative price setting had to be eliminated. Agencies had

to be appointed that would effectively manage property, either fully

or partially owned by the state, in the public interest.

In place of the party-directed nomenklatura, which was designed

to issue orders and distribute resources in an opaque fashion, a

Western-style civil service had to be installed. This civil service

should be appointed according to merit, be inculcated with a notion

of service to the public, and administer rules and regulations impartially.

Figure 2 provides a schematic sketch of the current Russian administrative structure. When compared with Figure 1, it shows the

substantive changes that have taken place over the past decade but

underscores the reforms that have yet to be made. The lack of full

resolution of the general objectives of administrative reform listed

above after more than 10 years is not at all surprising. A complete

restructuring of a society’s administrative structures and power relations requires considerable time, especially in the face of substantial and mostly concealed opposition.

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FIGURE 2.—ADMINISTRATION OF RUSSIAN GOVERNMENT

[Schematic version]

The most significant changes are the disappearance of the Communist Party as the leading institution and the conversion of

former industrial ministries into semi-independent corporations.

Although the Communist Party remains the largest single faction

in the legislature, it lacks the power to ‘‘order.’’ Earlier it had the

power to block, a power apparently lost under Putin. In the Soviet

era, the party was the ultimate source of legislative power and was

the ultimate enforcer of executive power, although most legislative

decrees were formally issued by state power; namely, by the Soviet

Council of Ministers. Given that all responsible positions were held

by party officials through the nomenklatura, the party also had the

power to punish and thus acted as well as a judiciary.

Figure 2 shows that the ‘‘legislative-executive-judicial’’ party has

been replaced by a President, who serves as the ultimate source of

executive power, but also can serve as a source of legislative power

through the use of presidential decrees—a device used frequently

during the Yeltsin presidency. The President has the power to

nominate the Prime Minister and hence oversees the top appointments to the executive branch, subject to approval of the legislature, the Duma, which can be forced to dissolve itself if the President’s nominee is not accepted. These procedures were put in place

in the 1993 Yeltsin Constitution, which affords the President considerable power in naming the government (pravitelstvo). Given

the strong presidency, a massive presidential administration of officials, advisors, and bureaucrats is associated with the office of the

President.


76171.020
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3Federalny konstitutsionny zakon o pravitelstve Rossiiskoi Federatsii. 31.12.97 N 3–FKZ. 4Spravochnik: Federal’naia vlast’ v Rossii. 5Putin’s replacement of Gazprom Chairman Vyakhirev with his own man, Miller, in June

2001, represents perhaps a watershed in the state’s relation with large destatized corporations. 6Pravitelstvo Rossiiskoi Federatsii, Struktura federalnykh organov ispolnitelnoi vlasti

(www.pravitelstvo.gov.ru). They are the anti-monopoly ministry, the property ministry, the tariff

committee, the securities commission, the bankruptcy commission, and the land registry committee. 7Parison, Neil. ‘‘Russia: Public Administration Reform: Issues and Options,’’ mimeo; a Russian

version appeared in E.G. Yasin (ed.), Investitsionny klimat i perspektivy ekonomicheskogo rosta

v Rossii (Moscow: Vyshaia shkola ekonomiki, 2001), pp. 202–213.

The appointment, confirmation, staffing, and responsibilities of

the government are defined in the constitutional law approved in

December 1997.3 The government is headed by a Prime Minister

and a number of Deputy Prime Ministers with specific obligations,

who preside over the various governmental agencies and ministries. The government, like its former Soviet variant the Council

of Ministers, continues to have a massive administrative apparat,

which competes in influence and size with the presidential administration.

Figure 2 shows that there have been major changes in the makeup of the Russian Government which consists of slightly less than

50 ministries, agencies, and committees.4 Previously powerful planning committees have been converted primarily into regulatory

agencies and agencies for devising economic policies and strategies.

Gosplan has become the Ministry of Economic Development and

Trade, which drafts industrial policy and regulations rather than

issuing directives. Some former industrial ministries have become

regulatory and licensing agencies such as the fuel and energy ministry and the geology ministry. Most significantly, most ‘‘production’’ ministries have been converted into non-state (at least partially privatized) enterprises in which the state continues to own

significant shares, such as Gazprom, Lukoil, and Unified Energy

System (UES). The conversion of industrial ministries from direct

controllers of branch enterprises into ‘‘destatized’’ companies has

been a significant change in Russian administration. The state’s

dealings with these companies remains in flux. It is unclear in

whose interests these enterprises are being run and whether the

state is able or willing to properly exercise its role as the largest

single shareholder.5 Other agencies of the Russian Government are

ministries common to all countries—education, defense, trade,

labor, ecology, justice, and internal security, although the power of

the Federal Security Service (FSB) may now be exceptional under

Putin, insofar as Putin himself was trained in the FSB’s predecessor organization, the State Security Committee (KGB).

Figure 2 also shows that new agencies required by a market

economy have been created. Of the 49 ministries, committees, and

agencies of the Russian Government, 6 are ‘‘new’’ agencies required

by a market economy.6 Skeptics note that these new agencies were

not part of the traditional power structure of the Soviet Union, and

they have not become credible centers of authority. Another feature

of the new Russian structure is the substantial overlap among

agencies, with several agencies responsible for taxes, security, construction, and technology.7 This overlap and duplication will presumably be a prime issue of contention in future administrative reforms.

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8Putin’s regional reforms, discussed below, phase out membership of governors in the Federation Council. But selected regional leaders will be members of the resurrected State Council

under the Putin plan. 9During its Spring 2001 session, for example, the Duma adopted 4 federal constitutional laws,

155 federal laws, ratified 27 international treaties, and considered 58 of 83 priority draft laws

scheduled for discussion. See RFE/RL Newsline, 16 July, 2001. 10The European Bank for Reconstruction and Development (EBRD) even compiles ‘‘state capture’’ indexes for the transition economies in their various transition reports.

The Russian legislature consists of two houses, the state Duma

and the Federation Council. The lower-house Duma is comprised of

elected deputies, while the upper house, the Federation Council, is

comprised of regional leaders or, more recently, of their representatives.8 Of the two, the Duma is the dominant legislative body. Unlike the Soviet system where power clearly derived from the Communist Party, Figure 2 shows the basic power conflict in the new

Russian administration—the potential of stalemate between legislative and executive power. The legislative branch has been dominated by the Communist Party, which has shared virtually no common goals with either Russian President. Legislation was passed

slowly in the Communist dominated Duma, if at all, and Yeltsin

sought to legislate by presidential decree—a poor substitute for legislation approved by the legislature. With the recent decline in

Communist Party power and Putin’s relatively easy election and

personal popularity, it appears that the legislative logjam is breaking and movement toward a legislative rule of law is gathering

steam.9

A second point of conflict is between the powerful administration

of the President and the official bureaucracy of the country; namely, the apparat of the government. Such conflicts are not uncommon in democracies, where officials close to the chief executive

often wield more power in specific areas than does the responsible

minister.

A third source of potential conflict is between the Russian Government (as represented by the legislature or the President) and

the quasi-independent large corporations, headed by former branch

ministry officials (Gazprom, Lukoil) and the financial industrial

groups headed by oligarchs who were not prominent members of

the old elite (Berezovsky, Abramovich, Gusinsky). These large industrial, raw material, and financial companies represent a new

source of power, whose relations with the state remain to be decided. Their predecessors, the industrial ministries, were indeed

powerful, but they were reined in by Gosplan, the Council of Ministers, and the Communist Party leadership. As major employers,

often the most substantial tax payers, and sources of liquidity,

these destatized corporations hold considerable unofficial power.

They can make campaign contributions, bribe regulatory officials,

acquire vast media empires, or ‘‘buy’’ their own members of the legislature. The balance of power between these large corporations

and the official holders of power (the legislature, the President and

the bureaucracy) is in flux and remains to be defined. The issue of

unofficial state power has become so acute in some transition

economies, including Russia, that experts question to what extent

the state has been ‘‘captured’’ by these unofficial interests.10

In many cases, the state continues to own substantial shares in

the destatized corporations, not only of the prominent companies

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11 ‘‘Ochen’ spetsialny auktsion,’’ Moskovskie novosti, 12–18 June, 2001. 12The power of a particular agency depends upon proximity and trust of the President. For

example, the Ministry of Economic Development and Trade has been very influential in the first

2 years of the Putin presidency and has spearheaded the reform process. 13Parisons, Neil. op. cit., pp. 202–213. 14 BBC Monitoring Service, Russian President’s Annual Address to Federal Assembly, April

3, 2001; translation of Vystuplenie presidenta RF V.V. Putina s poslaniem federalnomu

sobraniiu RF, 3 April 2001 (http://president.kremlin.ru/events/191.html).

such as Gazprom and Lukoil but also of regional and local

destatized companies. The ‘‘state’’ therefore has a natural means of

controlling such companies by exercising its rights as the largest

single shareholder. Putin’s recent replacement of Gazprom’s general director with a trusted subordinate provides a model. In less

prominent cases, such as smaller regional destatized companies,

management appears to have ‘‘captured’’ state officials who are

supposed to represent the state’s interests, and they escape effective state control. For example, at about the same time that Putin

was replacing the management of Gazprom, the GOK Combinat

was being ‘‘auctioned’’ to insiders for $20 million instead of its ‘‘expected’’ price of $100 million. Accordingly, the state budget seems

to have lost $80 million through this insider transaction.11

Some agencies have grown in power and others have lost power

compared to the Soviet period. Previously dominant agencies, such

as Gosplan, have been converted into a less-powerful Ministry of

Economic Development and Trade.12 The Soviet Ministry of Oil and

Gas Industry, which ran the U.S.S.R.’s vast energy complex, has

become a regulator and issuer of licenses as the Russian Ministry

of Fuel and Energy. The various tax collection agencies have grown

in importance now that taxes are collected from more independent

units rather than semi-automatically by the state banking system

from state enterprises. The property committee has been a powerful agency, particularly during periods of active privatization. It

had no predecessor in the Soviet period. The ‘‘new’’ ministries and

agencies required for a market economy (such as the Federal Securities Agency, the Federal Service for Financial Rehabilitation and

Bankruptcy) were grafted into the structure of government without

gaining much influence in government circles. They have been unable to attract sufficient funding or secure cooperation from other

ministries. Moreover, cuts in government agencies have been carried out uniformly, meaning that the new agencies, which tend to

be understaffed, become more understaffed, while traditional ministries, which are overstaffed become less overstaffed.13

Figure 2 lists one state agency, the State Bank, which by legislation of 1995, has become a quasi-independent agency. The Soviet

structure also lacked independent agencies. The most obvious candidate for future independence, the judiciary branch, may become

an independent branch of government if Putin’s declared reform

program is realized. Putin has made the creation of an independent

judiciary a priority of his state program announced in 2001.14

Putin argues that the investment climate of Russia cannot improve

without confidence in an impartial judiciary; hence an independent

judiciary is being proposed for quite pragmatic reasons.

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FEDERALISM

In the Soviet period, there was no debate about federalism—who

owned state property, how tax revenues were distributed, who regulated enterprises located in the region, etc.? Republics, provinces,

regions, and cities were clearly subservient to the national government. The Soviet budget was a unified budget prepared by the Soviet finance ministry; taxes were collected and credits allocated by

the state banking system; spending was allocated through the unified state budget. Nevertheless, the de facto owners of state property were known. The national ministries were the de facto owners

of the most important industrial assets; Republican ministries and

state agencies were the de facto owners of assets of lesser importance. Local governments were the de facto owners of enterprises

that worked for local markets, such as gravel and local building

materials. Regional, metropolitan, and local governments’ claims to

resources were largely dictated by the political position of the regional leader (whether or not the regional leader was in the Politburo or Central Committee). Appointments to republican, regional,

and local positions were made from Moscow through the nomenklatura list. The best and most promising people were transferred

to Moscow.

The federalism issue—how are power and resources to be divided

between the center and the periphery—has been one of the most

difficult tasks of Russian administrative reform. The lack of resolution of this issue should come as no surprise. Even highly stable

countries, like the United States, still argue bitterly over issues

like states’ rights more than 250 years after their founding.

Federalism asks whether power is to be decentralized to the regions or centralized in Moscow? Different countries have arrived at

different solutions that work well in practice. On a theoretical

level, a decentralized system encourages diversity, offers citizens

different choices, and allows for experimentation. On a practical

level, a well-defined rule of law requires sufficiently uniform and

consistent laws and regulations. Excessive divergences of regional

laws from national laws, or even contradictions of one by the other,

cause the national political space to subdivide into different markets, operating according to substantially different rules of the

game. Founding constitutions usually address rights of regions visa`-vis the center, but the 1993 Russian Constitution left many of

these issues to be resolved in practice.

Upon achieving independence, the Russian periphery consisted of

89 regions, each headed by a governor or equivalent. The governor

was elected, often with rigged elections, and could not be dismissed

by the President. President Yeltsin’s attempts to remove a regional

governor failed. Each region passed its own laws and regulations

and made claims to assets, such as oil fields or industrial assets

that were located on its territories. Taxes were collected mostly at

the local level, and the distribution of tax proceeds was a constant

source of conflict. Many regional laws and regulations were passed

chaotically without reference to the Constitution of the Russian

Federation, and a number of regions made claims to complete independence (including Chechnya, which led to a war between the center and this periphery).

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15 BBC, op. cit., April 3, 2001. 16Petrov, Nikolai. ‘‘Decentralization and Recentralization in Russia,’’ Carnegie Endowment for

International Peace, Russian and Eurasian Program, Vol. 2, October 25, 2000. 17 BBC, op. cit. 18Kommersant, June 27, 2001. 19 RFE/RL Russian Federation Report, Vol. 3, no. 20, July 2001. 20See e.g., the two volume study by E.G. Yasin (ed.), op. cit.

Putin’s legislation creating seven federal districts was passed by

the Duma and even by a compliant Federation Council (which the

measure emasculated) in spring 2000. Putin’s regional reform goes

a long way toward resolving Russia’s federalism issue in favor of

the centralized variant. Putin has called the passage of this measure ‘‘one of the most important decisions taken in 2000.’’ 15 This

legislation inserted seven federal regions, headed by a plenipotentiary regional representative appointed by the President, between the federal government and the regional governors. This reform enables the Russian President to appoint all representatives

of federal power within the district, control regional legislation,

monitor the carrying out of federal decrees, and increase control

over regional governors (even allowing the President to dismiss

governors under certain conditions).

Putin’s regional reform also redistributes tax revenue from 55

percent for the center to 70 percent for the center and makes the

region’s primary source of revenue the uncertain profits tax on enterprises on the theory that regional authorities can better gauge

enterprise profits than some national tax authority.16 A key feature

of the reform is the harmonization of regional laws and regulations

with national laws and the Russian Constitution. According to

Putin, more than 3,500 laws of the regions conflicted either with

the constitution or with federal laws.17 In the year 2000, prosecutors and Presidential envoys brought 90 percent of the regional

laws into compliance with federal laws,18 but the harmonization

work continues, especially on joint jurisdiction issues. The negotiation of 42 power-sharing agreements is still required, on which

more than 250 existing agreements are based.19

Putin’s success in resolving, at least for the time being, the federalism issue relates to his first-round election in early 2000, his

popularity associated with a rising economy, and his popular tough

stand on Chechnya leading up to the Presidential election.

LIBERALIZATION, DE-BUREAUCRATIZATION, AND CORRUPTION

Russia receives low rankings from international organizations

and agencies, such as European Bank for Reconstruction and Development (EBRD), Transparency International, and Heritage

Foundation, concerning its high corruption and limited economic

liberalization and economic freedom among the transition countries. Foreign investment is limited by the lack of a clear ‘‘rule of

law’’ as is domestic entrepreneurship.20 Excessive bureaucracy also

encourages businesses to operate in the shadow economy by making it too expensive to operate legally. Unclear or conflicting laws

encourage bureaucratic intervention. Tax complexity allows more

discretion by tax officials and hence encourages bribes to officials.

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21 A new administrative code passed the Duma in October 2000. It constitutes a 500 page document that updates the 16 year old Soviet administrative code. This code requires, among a

large number of regulations, Russian citizens to carry their passports, regulates fines for traffic

violations and sets the rights of police to impound vehicles, and levies fines on officials for giving

false information to citizens. It is unclear whether the new administrative code is an improvement in guaranteeing the civil rights of citizens. One of the fiercest debates in the Duma was

a provision (subsequently dropped) that would have allowed the traffic police to impound vehicles. On this, see ‘‘State Duma Lays Down the Law of the Land,’’ Moscow Times, October 6,

2000. 22Press Briefing By Minister for Economic Development and Trade German Gref, March 2,

2001 (www.fednews.ru/). 23 ‘‘Getting rid of bureaucrats will save $5.8 bln,’’ March 2, 2001 (www.strana.ru). 24Press Briefing By Minister for Economic Development and Trade German Gref, March 2,

2001, op. cit. 25 Yu. A. Tikhomirov, ‘‘Rol gosudarstva i prava v formirovanii blagopriiatnogo investitsionnogo

klimata,’’ in E.G. Yasin (ed.), pp. 213–218. 26Postanovlenie pravitelstva rossiiskoi federatsii No. 452, June 8, 2001. 27Kuzminov, Yaroslav. ‘‘Rol gosudarstva i prava v formirovanii blagopriiatnogo

investitsionnogo klimata v Rossii,’’ in E.G. Yasin (ed.), pp. 213–218.

A vague criminal justice system encourages the negotiation of sentences for fees.21

Russian writers depict endless inspections, certifications, and unnecessary restrictions on property rights. In many cases, the same

licenses are required by different agencies, making the cost of licensing excessively high. Examples of excessive bureaucracy and

corruption abound: The budget gets, for example, only 5 to 7 percent of the sum charged for licences. Regional administrations

issue unlawful licences for 600 types of entrepreneurial activities.

Licences serve as market barriers on the principle ‘‘pay to enter the

market and then do what you want.’’ 22 Expert calculations suggest that administrative barriers cost Russian families $18 a month in

the form of higher retail prices.23 Because of confusing and contradictory laws, practically every businessman is obliged to break

the rules and to pay bribes to get the exemptions required to operate the business.24

Economic analysts, both within and outside of Russia, argue that

the regulatory burden on Russian enterprises must be reduced significantly if the economy is to continue to grow and to attract foreign investment.25

The Putin government, as represented by the reform-minded

Minister of Economic Development and Trade, German Gref, issued

an ‘‘anti-bureaucracy’’ decree in June 2001 forming the ‘‘Commission of the Government of the Russian Federation for the Curtailment of Administrative Restrictions on Entrepreneurship and the

Optimization of Expenditures of the Federal Budget on State administration.’’ 26 This commission is charged with reducing the

amount of bureaucratic intervention in business affairs, ensuring

that laws are applied to business consistently, and combating corruption of officials. The government’s long-term development program assigns the anti-bureaucracy commission the following tasks,

among others: 27 The Commission must lower barriers to entry into

markets, remove technical barriers to the process of production and

trade, eliminate redundant administrative regulation of entrepreneurial activity, assure agreement between national and regional organs of authority, and eliminate redundant and ineffective

regulation in the sphere of arbitration. There should be one system

of licensing for the entire Russian Federation with a unified system

of forms and documentation based on a ‘‘one window’’ registration

procedure. Moreover, there should be a register of information on

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28Osnovnye napravleniia sotsial’no-ekonomicheskogo razvitiia rossiiskoi federatsii na

dolgosrochnuiu perspektivu, Moscow, 2001, Section 1.2.3. 29Shleifer, A. and R. Vishny. ‘‘Pervasive Shortages Under Socialism,’’ Rand Journal of Economics, Vol. 23, 1992, pp. 237–246. 30 Yasin, E.G. ‘‘Modernization of the Russian Economy: Problems on the Agenda, Modernization of the Economy of Russia,’’ Higher School of Economics, Moscow, April 30, 2001. 31Press Briefing By Minister for Economic Development and Trade German Gref, March 2,

2001, op. cit.

juridical persons that is available to all, and a sharp reduction in

the number of licensed activities. The licensing of investment

projects (such as major energy infrastructure projects) are also to

have a ‘‘one window’’ licensing procedure and cannot be required to

obtain licenses from multiple authorities. The Commission is also

charged with reducing the number of certifications, the number of

agencies that are allowed to make inspections; and the elimination

of duplication of inspections. Moreover, it is recommended that

more use be made of professional self-regulating organizations,

rather than government agencies.28

These anti-bureaucracy measures have considerable popular appeal and the support of both domestic and foreign entrepreneurs,

but they also face considerable opposition. The economic theory of

corruption states that an economy that is ‘‘over-regulated’’ with

rules, licensing requirements and bureaucratic interventions encourages corruption.29 A highly regulated economy creates opportunities for government officials to ‘‘sell’’ monopoly rents, or even to

charge businesspersons for carrying out their ‘‘normal’’ bureaucratic duties, like issuing a routine license. The more liberalized

the economy, the fewer the opportunities for officials to earn income by selling valuable rights or by charging customers for carrying out their normal duties. If the regulated domestic price of oil

is one half the foreign price, an oil export license provides the

owner of the license an opportunity to double his money. In a liberalized economy, the two prices would be the same and the export

license would not be valuable. If there were specific sentencing

guidelines in the criminal code, prosecutors could not sell lenient

sentences to criminals.30 If it did not take 6 months to obtain a

business license, the situation would not exist where the license

may officially cost 15,000 rubles but people actually pay

$400,000.31

The regional reform’s harmonization of regional and national

laws is intimately related to the anti-bureaucratic reform in that

much of the redundancy and duplication in matters of licensing

and certifications are related to conflicts between federal and regional statutes and regulations.

Putin’s anti-bureaucracy reforms, if implemented, attack the

heart of official corruption. A lower bureaucratic and regulatory

burden on businesses reduces the demand for official corruption.

The more liberalized the economy’s prices, international trade,

banking institutions, licensing procedures, and the like, the less opportunity officials have to sell monopolies to rent seekers.

Despite its popular appeal, these anti-bureaucracy measures face

considerable open and hidden opposition for the very reason that

they threaten the incomes of officials, who, more than likely, receive low nominal salaries for their official work. Any Russian official with the power to regulate, starting with a lowly traffic policeVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00118 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.005 CRS1 PsN: CRS1
93

32 BBC, op. cit. 33 Ibid. 34 Reuters, March 6, 2001. 35Parison, op. cit., p. 362.

man to the distributor of oil export licenses, stands to lose considerable ‘‘bribe’’ income if the anti-bureaucracy commission is successful. As in Soviet times, economic reform stumbled over bureaucratic

opposition; it remains to be seen whether Russia’s bureaucrats can

successfully block the current reform effort.

CIVIL SERVICE REFORM

Russia’s civil service administration is governed by the Civil

Service Law of 1995. Moreover, the Federal Constitutional Law on

the Government of the Russian Federation spells out rules of conduct for government officials, such as the conflict of interest rules

in article 11. Putin included a basic outline of proposals for civil

service reform in his 2001 agenda, but apparently no draft of the

civil service reform has been released. Its basic objectives, however,

were spelled out in Putin’s state of the union address of April

2001.32 According to Putin, ‘‘the efficiency of a state is determined

not so much by the amount of property it has under its control but

rather by the efficiency of the political and administrative mechanisms the state has to protect the public interest.’’ 33 In his address, Putin stated the following principles: The Russian administration is currently too large and needs to be trimmed. The federal

administration employed 882,000 in 1993 but employed more than

one million in 2001. The number of bureaucrats at all levels has

grown since Soviet days from 1.15 million in 1980 to 2.6 million.

In 2000 alone, the number of official chauffeur driven cars grew by

23,500 to 605,290.34

In line with the anti-bureaucracy measures, governmental agencies should be subjected to review to identify their functions and

presumably reduce the amount of overlap. All relations between

the state and business should be transparent, eliminating the possibility of arbitrary intervention and excessive regulation.

In its essence, Putin’s civil service reform outline aims to change

the Russian bureaucracy from its petitioning and strong control

structure of the Soviet past to a service culture.35 Position papers

prepared in anticipation of an eventual civil service reform state

the goal of creating a professional civil service based upon merit selection, civil service rules, and competitive salaries that reduce

bribe taking and corruption. Low pay of civil servants discourages

public service and limits the entry of young persons into public

service (the average age of employees in the ministry of economics

is over 50). The assumption is that Russian civil servants if properly compensated will reduce their intervention in the affairs of private businesses because they will no longer need bribes and other

payoffs to make ends meet.

Although not stated specifically, the need for higher salaries appears to be a reason why administrative reform is not scheduled

for the immediate future. If an average salary of, say, $1,000 per

month were agreed upon as one that would drastically limit graft

and corruption, this figure alone would account for about one-third

of all federal government spending or 20 percent of spending from

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36 In modern day Russia there are rumors and other evidence that high-level government positions an purchased. See Parison, op. cit., p. 363. 37These figures are from Stephen White and Olga Kryshtanovskaya, ‘‘Russia: Elite Continuity

and Change,’’ in Mattei Dogan and John Higley (eds.), Elite, Crises, and the Origins of Regimes

(Lanham: Rowman and Littlefield, 1998).

the consolidated budget. Clearly, if salaries are to be raised to such

levels, the size of the state bureaucracy has to be markedly reduced, which is a time consuming activity that goes against strong

vested interests.

In order for a public administration reform to be successful the

remnants of the old nomenklatura mentality must be removed. The

nomenklatura mentality was that public positions are to be obtained not through merit but through influence, connections, and

perhaps even outright purchase.36 The nomenclature or bureaucratic mentality also assumed that membership in the nomenklatura brought with it perks and privileges not accessible to others. When perks and privileges associated with public service declined, graft and bribe taking took their place.

ARE PUTIN’S REFORMS TOO GOOD TO BE TRUE?

The administrative reforms outlined in this paper are breathtaking in their rhetoric and scope. They surpass the 1992 reform

language of the Gaidar reform government. These measures appear

to move the country in the right direction, although one can disagree with Putin’s consolidation of power in the center. It could be

argued that a rule of law can be imposed on a country in chaos

only from the center and that regional experimentation and autonomy may have to be sacrificed in the process. Two significant

issues remain: Will Putin remain steadfast in his support of liberalizing reforms or will he, like his predecessor, Yeltsin, vacillate between liberalizing and de-liberalizing reforms with the passage of

time and fluctuations in his popularity. If Putin, as a relatively

young man, intends to be President for the next decade, he would

likely take a long-run view and realize that the Russian economy

cannot prosper without a rule of law, without domestic and foreign

private investment, and a reduction of corruption. Thus, Putin’s interests and the interests of economic rationality would coincide.

We, of course, cannot guess what Putin’s personal objectives are,

but we cannot rule out that they prominently include the long-term

economic growth and development of the Russian economy. The

second question is whether Putin, like decades of Russian and Soviet leaders before him, will be sabotaged in his reform efforts at

the grassroots level. In attacking bureaucratic excesses, corruption,

and barriers to entry, Putin is taking on powerful and largely unseen forces that have objectives inconsistent with the development

of an efficient economic system. It should be noted that the current

Russian nomenklatura is basically the old Soviet elite. During the

first half of the reform decade, the survival rate among the regional

administrative elite was 82 percent and 65 to 75 percent of the

former nomenklatura continued to occupy positions within the Russian post-Communist elite. Some have moved across institutional

boundaries, but most have continued to occupy their old positions

or similar positions.37 We cannot tell whether such vested interests

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forms. The thousands of administrative decisions that must be

made monthly or quarterly, such as auctions of government shares

in less visible companies or the implementation of debureaucratization rules at the local level, will determine whether

Russia operates by a rule of law or not. These decisions cannot be

taken by the President. They must be taken by thousands of faceless officials, who must somehow be motivated to decide in the

larger interests of the state. This is a daunting goal that only a few

‘‘civilized’’ countries have achieved. In this light, Russia faces an

uphill battle in its struggle for rational administrative reform.

(97)

RUSSIAN CRIME AND CORRUPTION IN AN ERA

OF GLOBALIZATION: IMPLICATIONS FOR THE

UNITED STATES

By Jonathan M. Winer and Phil Williams 1

CONTENTS

Page

Summary .................................................................................................................. 97

Russian Organized Crime: Economic Impact and Characteristics ...................... 99

Historical and cultural elements ..................................................................... 101

The element of violence in Russian organized crime and Mafiya businesses ............................................................................................................. 106

Typologies of Russian organized crime ........................................................... 109

Differences from Organized Crime Elsewhere ...................................................... 110

The Scope and Impact of Russian Organized Crime Activities Outside Russia . 111

Where is Russian organized crime? ................................................................ 111

What kinds of presence and how developed? ................................................. 112

The Impact of Russian Organized Crime on Russia’s Evolution ......................... 113

Money Laundering and Financial Crime ............................................................... 116

The gray economy, Russia’s tax system and capital flight ........................... 117

Poor accounting, auditing, and documentation requirements ...................... 118

Prominence and connection of organized crime to officials and official

structures ....................................................................................................... 118

Rent-seeking activity by government officials ................................................ 118

Ease of moving funds offshore ......................................................................... 119

Inadequate knowledge base, training, government capacity ........................ 119

Options for Reform in Russia ................................................................................. 119

Anti-corruption measures ................................................................................ 120

Increased press freedom ................................................................................... 120

Improving tax system ....................................................................................... 120

Financial sector regulatory reforms ................................................................ 120

Legal reforms .................................................................................................... 120

Money laundering legislation .......................................................................... 121

Policy Options for the United States ..................................................................... 121

1 Jonathan M. Winer, formerly U.S. Deputy Assistant Secretary of State for International Enforcement, is currently counsel at Alston & Bird, L.L.P. Dr. Phil Williams is a Professor in the

Graduate School of Public and International Affairs at the University of Pittsburgh and formerly

Director of the University’s Ridgway Center for International Security Studies. Certain elements

of this paper were originally prepared for the National Intelligence Council in spring 2001 in

separate presentations by each of the authors.

SUMMARY

While globalization and privatization have clearly fueled Russian

organized crime, organized crime has a lengthy history in Russia.

Among the most important elements of today’s organized crime are

liaisons between the nomenklatura, ethnic traders, and Russian

criminals. Important elements of these groups colluded during Russia’s transition to convert the resources of the Soviet Union’s command economy to their personal ownership and control. The mechanisms by which they accomplished this included ruble to dollar

98

credit manipulation, theft of natural resources owned by the government through false documentation, the exploitation of the state

to secure exemption from taxation and from oversight, bribery, extortion, contract killings, and money laundering. Triangular relationships between criminals, business persons, and officials exploit

the lack of clear distinctions in Russia between what is legal and

what is illegal; what is public and what is private; and what is permissible and what is prohibited. Closely linked to Russia’s organized crime is Russian money laundering, whose infrastructure

serves not only criminals but facilitates large-scale capital flight,

depriving Russia of fiscal resources, and fueling Russia’s shadow

economy.

The transformation of Russia to a country where free markets

and democracy are realities requires Russia to undertake steps

that threaten those whose power depends on discouraging rule of

law, including criminals, exploitative business persons and corrupt

bureaucrats. Russian organized crime will likely continue to oppose

Russian efforts to collect taxes in a fair manner, pay its civil service a living wage, maintain high caliber professionals in government, build effective self-regulatory organizations, and sanction

those who engage in unfair trade and business practices. Reforms

that would begin to provide an environment better suited for Russia to combat its organized crime problem would include effective

anti-corruption measures, increased freedom of the press, a fairer

and more effective tax system, financial sector regulatory reforms,

legal reforms, and effective implementation of the recently passed

money laundering legislation.

The investment that Russia has attracted over the past

few years is minuscule, compared to that which has flowed

to other transition economies, and to that which the country should attract, given its rich natural endowment and

its talent and educated workforce. If you deduct negative

investment, i.e., capital flight, the picture is a bit more discouraging. Capital flight is estimated at about $2 billion

per month. That amount attracted is meanwhile worse

than minuscule. As President Putin said in his April Address to the Federal Assembly, up to now the only investors who have come here are those who have to be here,

whether because they focused on Russia’s natural resources or are supplying Russia’s still fledgling consumer

industry . . . The reasons for this situation are the very

issues that the Russian government is now moving to confront. They include corporate governance abuses, the country’s weak judicial system, and inadequate defense of property rights, excessive bureaucracy and lack of transparency, and corruption. All of this further adds up to a

profound issue of the lack of trust in economic institutions

that continues to hinder normal economic relationships

and structures from developing. (Farewell speech, U.S.

Ambassador to Moscow, Ambassador James Collins, American Chamber of Commerce, June 15, 2001)

The excitement over reform in Russia—the passage of a

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2For the sake of length and clarity, this paper looks at Russian organized crime in terms of

criminal activity arising in and out of Russia itself, regardless of which Russian-speaking ethnic

group carries out the activity. In general, the observations within this essay would apply with

equal force to most other components of the former Soviet Union, including in particular

Ukraine and Kazakhstan, and to some extent Belarus, Georgia, Armenia, and the Baltics. The

tribal history and future of most of the other ‘‘stans,’’ which include the withdrawal of substantial components of the former Soviet presence, represent a distinct set of problems, including

Islamicism and poppy cultivation, which require separate analysis.

bility—is increasing among the international business

community. In fact, it seems that Russia will soon become

the darling of foreign investors, with political risk now

practically nil and state coffers overflowing with

petrodollars. But within this favorable situation, some critical factors remain largely ignored. The real environment

in which Russian business operates, at least those firms

that are profitable, lies within the shadow of criminal organizations with strong links to both the government and

bureaucracy . . . Since Russian crime syndicates do not

have the documented origins and family structure of the

Cosa Nostra—and are often loosely tied through backroom

dealings—statistics on how many Russian businesses are

actually under the control of the ‘‘Mafia’’ are virtually impossible to come up with. But the fact that almost all of

the thousand-odd contract killings of business people here

over the past seven years remain unsolved speaks for

itself. (Editorial, ‘‘A Culture of Crime,’’ Russia Journal,

July 23, 2001)

Average Russians continue to suffer abuse daily at the

hands of the militia, the traffic police, and corrupt bureaucrats. The state may try them more than once for a crime.

They may be detained without charges for seventy-two

hours or held in a tuberculosis-ridden pre-trial detention

center for years. Opening a business involves as much paperwork and bribery as ever. The mafiya still extracts dan

from entrepreneurs. The countrywide decay that began

during the Yeltsin years continues, with television towers

catching fire, nuclear submarines sinking, military aircraft

crashing to earth, apartment buildings exploding from

leaks in decrepit gas pipes, and entire regions of the country going without heat and electricity in winter months.

Thirty-six percent of the population, or 52 million people,

live below the subsistence level, set at a dollar a day. (Article, ‘‘Russia is Finished,’’ Atlantic Monthly, May, 2001, Jeffrey Tailer)

RUSSIAN ORGANIZED CRIME: ECONOMIC IMPACT AND

CHARACTERISTICS 2

There is widespread consensus that the weakness of the Russian

state, the existence of a pre-existing black market, and the corruption that pervaded the privatization process inhibited the development of formal legal standards and norms that would have exercised effective control over Russia’s rapid transition from a command to a market economy. There is less consensus about the role

played by organized crime in these problems. Some commentators

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3See e.g., L. Grigoryev, A. Kosarev, ‘‘Capital Flight: Scale and Nature,’’ February 24, 2000,

available from the International Monetary Fund (IMF), Bureau of Economy Analysis, arguing

that most of the money laundered out of Russia represents avoidance of currency exchange and

tax laws, rather than income obtained through drug trafficking, financial manipulations or racketeering. The authors argue that whereas in the west, the transferred funds would represent

theft of a company’s resources from owners or shareholders, in a Russian context, ‘‘owners and

managers oftentimes do not draw much of a distinction between cash belonging to the enterprise

and their own cash.’’ As argued below, the lack of such distinctions is one of the major problems

confronting Russia. 4This definition is taken from the 1998 ‘‘Organized Crime Impact Study,’’ of the Solicitor General of Canada. Other definitions include INTERPOL’s 1988 definition of organized crime as ‘‘Any enterprise or group of persons engaged in a continuing illegal activity which has as its

primary purpose generation of profits, irrespective of national boundaries,’’ from INTERPOL’s

First National Symposium on Organized Crime at St. Cloud, France, May 1988; the German

national police or Bundeskriminalamt (BKA) definition of organized crime as ‘‘Any group of people who have consciously and deliberately decided to cooperate in illegal activities over a certain

period of time, apportioning tasks among themselves, and often using modern infrastructure

systems, with the principal aim of amassing substantial profits as quickly as possible,’’ and the

current INTERPOL definition, ‘‘Any group having a corporate structure whose primary objective

is to obtain money through illegal activities, often surviving on fear and corruption.’’ The United

Nation’s Convention Against Transnational Organized Crime, signed in Palermo, Italy in December 2000, defines organized crime as actions undertaken by a group of three or more persons

in violation of national law for economic or financial benefit. Each of these definitions captures

the activities in Russia that are the subject of this article. 5 A report in St. Petersburg Times, June 25, 1999, suggested that contract ‘‘hits’’ were most

common in the oil and gas, metals and banking sectors. 6 ′′Criminal Business Undermining Economic Security of Russia,’’ February 7, 2001, RIA

Novsti.

seek to differentiate the economic impact of capital flight involving

corruption and theft of resources from traditional forms of organized crime, such as drug trafficking, trafficking in women, motor

vehicle theft, and extortion.3 However, standard characterizations

of organized crime tend to define the activity in ways that render

such differentiation meaningless: organized crime encompasses economically motivated illicit activity undertaken by any group, association or other body consisting of two or more individuals, whether

formally or informally organized, where the negative impact of said

activity could be considered significant from an economic, social, violence generation, health and safety and/or environmental perspective.4 Furthermore, even if one limits the definition of organized

crime to that activity involving illicit force or the threat of force by

non-state actors, such as contract killings or extortion, it remains

clear that Russian organized crime pervaded the Russian transition, affecting such important economic sectors as oil and gas, minerals and other extractive industries, financial services sector institutions; and substantial portions of Russia’s cross-border trade.5

Recent figures suggest that the influence of organized crime in

Russia’s economy remains a significant element of Russia’s economy, as well as its political life. On February 7, 2001, Alexander

Kulikov, the Chairman of the state Duma security committee announced that the shadow economy had become a matter of national

concern, as the level of criminal business was seriously undermining the economic security of the state. Citing statistics from Russia’s Interior Ministry, Kulikov stated that some 40 percent of Russia’s economy was engaged in the shadow sector through parallel

commercial structures involving ‘‘filial companies’’ and ‘‘dummy

firms,’’ in such sectors as alcohol, gambling and show business.’’ 6

According to Kulikov, between 50 and 85 percent of all banks operating throughout Russia are under the control of organized crime,

while revenues from the shadow economy making up 40 percent of

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7 Id.

8 Interview, Russia TV channel, Moscow, BBC Monitor, June 24, 2001,

9See e.g., ‘‘Think Again,’’ Anders Aslund, Foreign Policy, July/August 2001, arguing that the

44 percent loss of GDP in Russian from 1989 to 1998 is ‘‘grossly exaggerated’’ due to statistical

quirks; that the virtual barter economy is ‘‘marginal,’’ and that because privatization ‘‘permanently deprives public servants of public property . . . they can no longer charge money for the

privilege of using it.’’ Aslund states that the Russian investment climate remains poor because

of ‘‘excessive bureaucracy and corrupt law enforcement,’’ distinguishing these elements from

what he views to be essentially honest ‘‘privatization.’’ 10See e.g., CRS: RL30394: Russian Capital Flight, Economic Reforms, and U.S. Interests: An

Analysis, William H. Cooper, Specialist in International Trade and Finance, Foreign Affairs, Defense, and Trade Division, John P. Hardt, Senior Specialist in Post-Soviet Economics, Foreign

Affairs, Defense, and Trade Division, March 10, 2000, ‘‘Capital flight is a symptom of poor economic conditions in Russia. But it also re-enforces poor economic conditions as it deprives the

economy of the critical investment and budgetary resources to build sustainable economic

growth and finance social welfare programs.’’ See also testimony of U.S. Secretary of the Treasurer Larry Summers before House Committee on Banking, September 21, 1999, stating that

‘‘money laundering requires neither official corruption nor capital flight. However, the three

often come together where the rule of law is weak and confidence in the economy is low.’’ 11See e.g., ‘‘A State of Lawlessness, Corruption, Coercion Reign in Russia,’’ David Hoffman,

Washington Post, September 10, 1999, noting ‘‘throughout its history, from the czars to the Soviet Communist Party, Russia has no tradition of the rule of law. The legacy of previous generations runs deep and includes a chasm between state and society and a heritage of arbitrary and

unreachable authorities. Power was exercised ruthlessly and without recourse for its victims. Today’s Russia, despite the changes of recent years, still bears the deep imprint of this history.’’ 12While this assessment may not be true of the Putin government, the current structural elements of Russian organized crime are a continuing consequence of the conditions of their formation and operation during the Yeltsin period.

zens involved in such activities. Kulikov also claimed that ‘‘over the

last five years, the number of organized crime groups increased 17

times, while the number of groups with corrupt links rose 170

times.’’ 7

Notably, Russia’s economy ministries take a different view. Recently, Russia’s Economic Development and Trade Minister, German Gref, contends that conditions for investment in Russia by foreigners are ‘‘better than ever’’ and that a ‘‘silent revolution’’ has

taken place in Russia’s economy, making the picture for the future

positive.8 While the recovery has closely paralleled the worldwide

increase in prices for natural resources, in particular, oil and gas,

some analysts also contend not only that the impact of Russian

crime on Russia’s economy in the past has been overstated but also

that it is likely to diminish even further in the future.9 For the

most part, however, there is a consensus that capital flight, infrastructure decay, tax collection, loss of foreign investment, remain

current, not historical problems, and each problem has been exacerbated by Russian corruption and organized crime.10

HISTORICAL AND CULTURAL ELEMENTS

While globalization and privatization have clearly fueled Russian

organized crime, its presence in Russian society goes back to Czarist times, and endured throughout the Soviet period.11 Salient factors pertaining to the relationship between the Russian Government and Russian organized crime that have endured throughout

the 20th century include:

• Disconnection between the authority and legitimacy of the

head of state (whether the Czar, Stalin, or Yeltsin) and the actions of the often arbitrary or ineffective government operating

beneath the head of state, with the result that the head of

state has often acted to undermine the authority of key ministries and agencies.12

102

13 A comprehensive journalistic description of this phenomenon in the Yeltsin era is set forth

in ‘‘Comrade Criminal—Russia’s New Mafia,’’ Stephen Handelman, Yale University Press, 1995.

• Rulemaking and regulation which in practice and effect are experienced as arbitrary and capricious by the governed, making

their rationality, as well as legitimacy, questionable. • A lack of a developed and vigorous civil society. Social structures and institutions apart from the government are not only

weak but are accompanied by governmental structures that

function incompetently. • Corruption as a way of life for officials, whether motivated by

a desire simply to make ends meet or by greed. • Corruption as a way of life for the private sector, however

large or small that has been, to get its business done. • Little transparency in governmental operations, leading to inadequate oversight and lack of popular participation in governmental decisionmaking. • Collusion and even merger of key governmental officials and

structures with counterpart criminals and criminal organizations on the outside.13

• A tradition of governance that emphasizes the rule of people

or party and not the rule of law. Both the Czars and the Communists, in effect, were both above and beyond the law.

These conditions, which have undermined the Russian Government and strengthened Russian organized crime, are the heritage

of both Czarist Russia and the Soviet state. Lenin and Stalin built

power upon the delegitimatization of the Czarist state. The new Soviet Union was not an expression of a government in a traditional

sense, but of a system of governance that aimed to further the ends

of a political party, the Bolsheviks, whose means, if not their explicit goals, differed in scale but not in substance from those used

by organized crime the world over. Core values of criminals everywhere are disdain for rule of law and for democracy. Criminals

have no reason to adhere to either principle, except to the extent

that they are threatened by sanctions being enforced by those who

do adhere to those principles. The Russian Communist Party had

similar reasons to oppose both the principles of rule of law and of

democracy. Any increase in either of those two trends created a

concomitant and relatively proportional increase in the risks that

sanctions would be applied to the Communists and their relative

power in society would decrease.

During the Brezhnev stagnation, the ideological and patriotic fervor sustained by the victory over the Germans in World War II and

the grab for empire in Central Europe in the post-war period

waned. Significant elements of the Communist Party, the Soviet

Government, and the Soviet economy developed into a system of

‘‘mafiyas’’ that had a close resemblance to governance in Sicily. Favorites obtained territories that they were permitted to exploit. In

that corruption, lay what a number of commentators have described as the seeds of the criminalization of the modern Russia,

through the development of criminal practices, by three identifiable

classes of persons:

• Nomenklatura, whose access to resources and licenses provided

a means of trading access and permission for material goods

103

and special privileges. The nomenklatura consisted of both

state managers and members of the institutions of social control such as the KGB, the Ministry of Interior and even the Soviet military. • Ethnic traders, whose non-Russian status gave them greater

access to the West, western institutions, and capitalist activities at a time when direct participation in commerce would

have been ideologically risky for members of the nomenklatura

themselves. The traders, who included Jews, Armenians, and

Georgians, among others, formed the bow wave of this group,

acting as importers and exporters under the Soviet regime,

often in complex relationships with governmental enterprises,

elements of the nomenklatura, elements of Soviet intelligence,

and elements of the Soviet military; • Thieves in law and other Russian criminals who honed bureaucratic survival skills in the gulag; later these groups formed

close ties with those involved in Russian wrestling, hockey, and

other sports where physical strength provided a basis for prestige and power on the one hand, and for demonstrating the

ability to provide physical protection (or physical intimidation)

on the other.

During the 30 year period of the cold war (roughly, from the

death of Stalin through the death of Chernyenko), Geneva, Paris,

Vienna, and Tel Aviv became important entry points for covert financial activities by the Soviet Union. Riga, Kalingrad, and Crimea

developed port capabilities suitable for smuggling. Third world outposts in the Middle East, Africa, South East Asia, and during the

1980s, Central America, became opportunities for refining techniques of transporting prohibited goods through corrupt or weakened governmental mechanisms. False invoicing, fraudulent documentation, the use of shell companies and cut-outs, all essential

elements of the tradecraft of Soviet espionage, became techniques

widely known through the relatively small community of people

who handled the Soviet’s economic contacts with the West. These

techniques, together with a culture of non-transparency and corruption, would translate easily into post-Communist Russia, and

eventually play a substantial role in swallowing up reform. Indeed,

they inflicted profound systemic harm to Russia’s initial efforts,

from 1990 through 2000, to modernize its political and economic

system in a manner that would strengthen rule of law and democracy.

In this context, the Gorbachev reforms weakened the position of

the Communist Party in society and of the state itself. Glasnost

created the intended consequence of greater democratization and

strengthened those elements of society, such as the academic and

professional elites, the core of the then Russian upper middle class,

whose political and economic opportunity would increase with

greater democratization and strengthened rule of law. However,

the reform process had the paradoxical result of also strengthening

those elements of government that saw the weaker state as presenting a once-in-a-lifetime opportunity to seize control of important resources, and those elements of society that saw the weaker

state as an unprecedented opportunity to engage in predatory or

criminal behavior with little fear of retribution.

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14The initial devaluation of the Russian ruble in the early 1990s was far more profound in

its consequences than the more recent devaluation of 1999, which merely reduced the ruble’s

value by 75 percent, with the other three-fourths of the ruble’s value mostly going to the lucky

holders of Russian bonds who had been able to book the interest rates without holding as their

own the worthless notes once the IMF recognized the folly of being the guarantor of the integrity

of Russia’s banking system. The systemic misleading of the IMF by Russia’s Central Bank (Central Bank of the Russian Federation), including its long-term chief Central Banker, as evidenced

in the Financial Management Company (FIMACO) affair in spring 1999, prior to the ruble’s collapse, provided evidence that Russian financial services regulation did yet to meet global standards. 15Khodorkovsky declared his flagship bank, Menatep, bankrupt at the time of the Russian

ruble crisis, moving its assets to a second Menatep in St. Petersburg, and re-opening the Moscow offices of Menatep in the form of an oil company that he had purchased through manipulating Menatep’s assets. In the United States, this activity would constitute racketeering. In Russia, Khodorkovsky continues to be a successful businessman and financier.

The Communist Party and the Soviet State had historically functioned as mechanisms to divide up the wealth of whatever they

controlled as the arbiters of the command economy. With the

breakup of the Communist Party and the Soviet State as the entities which by right or might controlled all the wealth of the Soviet

Union, who had the right to the resources was an extraordinarily

open question. Not surprisingly, therefore, the three groups who

provided the basic components of a novel and distinctive form of organized crime—the nomenklatura (including important elements of

the military, law enforcement, and Soviet intelligence), the ethnic

traders, and the criminals and athletes—found enormous and lucrative opportunities to collude with one another to convert the resources of the Soviet Union’s command economy to their personal

ownership and control. The mechanisms by which they accomplished this were as myriad as the opportunities provided by the

transition from the Soviet economy to the so-called market economy. Some of the more significant included:

• The issuance of large quantities of ruble loans by Soviet financial institutions to well-placed persons who later became

known as oligarchs. These ruble loans, issued at interest rates

that were intentionally well below market, were immediately

converted into dollars. The mass conversion of these rubles into

dollars in turn facilitated the depreciation of the ruble against

the dollar, providing instant wealth the holders of the dollars,

who were able to repay their debts at a few kopecks to a ruble.

This activity had a massive impact in reducing the value of the

ruble against other currencies and its buying power within

Russia. It simultaneously provided a mechanism by which

those with the ability to borrow rubles (i.e., ruble debtors) had

a lever to convert a substantial portion of the inherited capital

of the Soviet Union into personal fortunes. The concomitant

corollary of this activity was the devaluation and the commonplace reduction to beggary of the millions of souls who had the

misfortune of actually holding rubles. These soon became

worthless and were exchanged at a ratio of 100 to 1 for new

rubles.14 Thus the wealth of a nation, such as it was, was efficiently converted into the capital of the few. Prominent examples of this class of oligarch/criminal include Boris Berezovsky,

Vladimir Gusinsky, Alexander Smolensky, and Mikhail

Khodorkovsky.15

• Chubais’ voucher-for-shares plan, which enabled the oligarchs

who had previously enriched themselves through dollar-ruble

105

manipulations to further secure the ownership of the vast preponderance of Russia’s wealth-generating industries, especially

those in oil and gas, metals, timber, and other extractive industries. • The sale of natural resources owned by the government to private persons through various mechanisms, including many involving false invoicing, false financing, false titling, and false

ownership, enabling those who were able to control the export

of any particular quantity of natural resources to steal most if

not all of its value without having to pay market prices for the

goods, taxes on the goods, funds to invest in the productive infrastructure to continue the goods, or any other costs besides

those associated with bribing or killing anyone who might prevent them from so exporting the goods. • The exploitation of the state to secure unique benefits, such as

exemption from taxation and from oversight, as was exemplified by Viktor Chernomyrdin’s effective stewardship over

Gazprom during the period he was Prime Minister of Russia.

Thus, collusion between those controlling Russia’s resources,

traders and brokers, and armed enforcers built the new system of

Russian governance and economics. Under Brezhnev and his successors, the Russian command economy had required coercion, extortion, theft, repression, and systemic corruption in order to function. In the Yeltsin period, this devolved into a new public-private

system for government that preserved most of these mechanisms

(i.e., coercion, extortion, theft, repression and systemic corruption)

but substantially privatized them, and made them even harder to

control: in short, Yeltsin’s reforms, taking place in the context of

a corrupted Soviet state, resulted in empowering a criminal class

to take over an economy, and in important areas, its government.

As a consequence of these structural and cultural features of

Russian life, Russian organized crime has not been simply about

the provision of illegal goods and services; it is also about the control of legal goods and services. In Russia there is not simply a

criminal-political nexus but a political-criminal-business troika,

consisting partly of dense network connections among key people in

the three sectors ands partly of some figures straddling the three

sectors, and engaging in politics, licit commerce and illegal business. These networks are ubiquitous. They have several dimensions: direct person to person relations; shared ownership of, or interest in, specific companies; and linkages through pivotal figures

who are clearly network connectors.

Russian organized crime is thus characterized by at least three

seamless webs—the seamless web between extortionists and security companies, the seamless web between licit and illicit business,

and the seamless web between criminals on the one side and political and bureaucratic elites on the other. Out of these seamless

webs has emerged a triangle of crime, business, and politics. There

are two major reasons why this triangular relationship is extremely strong and resilient. First, each of the participants brings

a different but complementary dimension to the table, thereby ensuring that the exchange relationships are beneficial to all. The political figures have access to the resources of government; the business figures bring both access to wealth and connections in the

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16The authors would like to thank Gregory Baudin-O’Hayon, a Graduate Research Associate

at the Ridgway Center, University of Pittsburgh and William Cook, formerly a Graduate Research Associate at the Ridgway Center, University of Pittsburgh for the ideas, research, and

network diagrams that have informed this part of the analysis. 17See William A. Cook and Gregory Baudin-O’Hayon, ‘‘A Chronology of Russian Killings’’ Transnational Organized Crime, Vol. 4 No. 2 Summer 1998 pp. 117–201.

worlds of commerce and finance; and the criminal organizations

provide coercive power and plausible deniability for the other two

groups.16 The triangular relationship is an alliance of convenience

rather than of natural affinity, but the benefits are so deep that,

in effect, the relationship has become institutionalized. Second, the

triangle is based on the lack of clear distinctions in Russia between

what is legal and what is illegal; what is public and what is private; and what is permissible and what is prohibited. Furthermore,

so long as there is no clarity in the borders among these areas, the

stability and durability of the triangle are likely to continue

unhindered.

THE ELEMENT OF VIOLENCE IN RUSSIAN ORGANIZED CRIME AND

MAFIYA BUSINESSES

It is often observed that in Russia those would limit themselves

to legitimate business activity in other countries must engage in

criminal activities such as tax evasion and money laundering in

Russia, in order to carry out legitimate business. While this observation may be true in the case of particular individuals, the magnitude of clearly criminal violence involving extortion has been an

impressive feature of Russia’s economic transition. During this

transition, cities as diverse as Yekaterinburg and St. Petersburg

have been characterized by clashes among rival groups that surpass anything that occurred in Chicago during Prohibition. One result of this has been the success of a new generation of Russian

criminals who do not accept the old rules of the vor-v-zakone and

see the rapid accumulation of wealth as their raison d’etre. The

criminals, however, have gone well beyond killing one another.

While rivalry in the criminal world is certainly not unique to Russia, what has been far more surprising is the diversity of the targets of Russian contract killings. The victims have included bankers and businessmen, journalists and reformist politicians, local bureaucrats, hotel managers, and anyone who poses a threat or presents an obstacle to criminal activities. In one prominent case,

American businessman, Paul Tatum was killed amidst reports that

he had been feuding with his Russian business partners in the

Radisson Hotel joint venture. Another prominent victim was Galina

Staravoitova, a leading Duma deputy active in combating organized

crime and corruption.17 Other victims in recent years have included: Ilya Waisman, economic and finance director of the Baltica

Beer Company, who, in January 2000, was shot and killed at his

home in St. Petersburg; Uralmash General Director Oleg

Belonenko who was killed in July 2000; and Alexander Volkovsky,

President of the Russo-Balt Petroleum Company, who was shot in

the entrance to his apartment building in January 2001. Not all

hits are successful of course. Among those who survived an attempted contract killing was Deputy Mayor of the Moscow city govVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00132 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.006 CRS1 PsN: CRS1
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18 Aleksandr Strogin ‘‘Contract Killings Being Cleared Up After All. One Has Already Been

60-Percent Cleared Up’’ Moscow Kommersant, 21 Mar 2001 p. 3. 19See St. Petersburg Times, June 25, 1999, ‘‘Russia’s economic woes have put the cut-throat

back into competition, with the first 5 months of 1999 seeing the incidence of contract killings

double, Interior Ministry officials said Thursday. Between January and May this year, 567 businessmen were slain on the orders of their competitors, compared to 232 such killings over the

same period last year and 599 contract killings for the whole of 1998, according to police figures.

The figures also show contract ‘‘hits’’ are most common in the oil and gas, metals and banking

sectors, said Akhmed Khairov, deputy head of the Interior Ministry’s major crimes section.’’

ernment, Iosif Ordzhonikidze, a figure with considerable reputation

as a facilitator for business.

Official statistics suggest some improvement in the situation,

with only 386 contract killings in Russia in 2000, a major decline

from the 500 to 600 that occurred each year through most of the

1990s.18 Obtaining accurate figures, however, remains difficult, not

least because different officials often release contradictory statistics. In June 1999, for example, senior Ministry of Interior official,

Akhmed Khairov, deputy head of the Interior Ministry’s major

crimes section told journalists that 567 people were murdered in

contract killings in Russia during the first 5 months of 1999—more

than double the 232 killed during the same period in 1998. Khairov

attributed the increase to the financial collapse of August 17, 1998

and the increase in unpaid debts.19 Yet in March 2001, Alexander

Kirushev, deputy chief of the Ministry of Interior’s Criminal Investigation Main Administration noted that the number of contract

killings in 2000, was only 386—down from the 591 committed in

1999. Unless the fall-off rate in the second half of 1999 was unprecedented (only 24 contract killings in 7 months), this seems to be

a considerable under-estimate for that year. Even allowing for the

discrepancy however, the overall trend does seem to have been a

marked reduction in the number of contract killings (accompanied

by an increased success rate in solving these murders). However,

the apparent trend should treated with some caution. An examination of the incidence of contract killings reveals a clear tendency to

cluster in particular industries or economic sectors for several

months (or in some cases 1 or 2 years) and then to disappear. This

can be explained in several ways. Perhaps the most plausible explanation is that contract killings cease when organized crime has

achieved its objectives and successfully infiltrated a particular sector such as banking or a particular industry such as aluminum. By

eliminating those who resist them, organized crime can have a

highly coercive impact on those who are left—without further killing. Similarly, the reduction in contract killings of vory-v-zakone or

criminal authorities suggests that internecine warfare in the criminal world has given way to an established pecking order in which

territories and markets have been divided up in ways that are

more or less acceptable. In short, the decline in contract killings

suggests not a decline in the power and influence of organized

crime but its consolidation.

Indeed, as the comments by Kulikov quoted above indicate, organized crime has had considerable success in infiltrating and controlling legitimate businesses and economic sectors. The methods

by which Russian organized crime has achieved this include contract killings but only as part of a complex mixture of guile and intimidation, political influence and acts of violent criminal intimidation. On the basis of an analysis of the Russian aluminum industry

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20Diego Gambetta, The Sicilian Mafia: The Business of Private Protection, Cambridge, MA:

Harvard University Press, 1993. 21See e.g., Federico Varese, ‘‘What is the Russian Mafia?’’ Low Intensity Conflict and Law Enforcement, Vol 5 No. 2, pp. 129–138. See also Varese’s forthcoming book on the Russian Mafia

published by Oxford University Press.

as well as the energy sectors in St. Petersburg, it is possible to

identify forms of behavior that tend to be present in all such cases

(and that provide ample warning indicators):

• Murder and other violent attacks on personnel in a particular

company or industry sector who might be an obstacle to the

takeover. • Equity or share purchases designed to obtain a controlling interest in a particular company. In some cases, shares are obtained through coercion and violence; in other cases where it

is necessary to avoid Russian anti-monopoly legislation they

are done through front companies that obscure the real ownership and interest. • Insertion of personnel into management positions or on to

boards of directors. Packing the board is also a means of ensuring that once the takeover has succeeded control is maintained • Obtaining support from corrupt links with politicians who are

visibly in favor of the takeover effort and lend their power and

prestige to at least those parts of it that are legal and transparent.

These apparently disparate tactics typically blend into a coherent

and effective strategy that facilitates at least short-term domination of an industry that in some cases is transformed into a longerterm pattern.

There is one view of mafia business, presented most fully by

Diego Gambetta that suggests that the mafia is really about the

business of private protection.20 Federico Varese has applied this

argument to Russia, and suggested that although in many cases

the relationship between criminal organizations and businesses are

purely parasitical, in other instances there really is protection for

businesses as the criminals developed a vested interest in their

success.21 In some cases the protection is requested; in others it is

imposed. Whatever form it takes, extortion appears to be the single

most important staple of organized crime activities at the local

level, particularly as rivalries have given way to more stable

spheres of influence among criminal organizations.

As well as ubiquitous protection rackets, Russian criminals traffic in a wide variety of products—stolen, regulated and illegal.

Trafficking in women, nuclear material, arms, endangered species,

drugs, icons, stolen cars, give the Russian organized crime scene a

comprehensiveness that at least matches and perhaps surpasses

that in Italy, China or Japan. In some cases Russian criminal organizations traffic commodities out of Russia; in other cases Russia

itself provides the market—as for drugs and stolen cars. The wide

portfolio is perhaps exemplified best by the Solntsevo group that

reportedly controls the University, and Cosmos hotels; several casinos; the Solntsevo car exchange; all non-food markets in the Southwest District of Moscow; and commercial transportation to and

from Vnukovo airport. In addition, about 300 commercial firms and

banks are believed to be under Solntsevo’s ownership or control.

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22For a useful discussion see Jeffrey Robinson, The Merger, London: Simon and Schuster UK,

1999.

These extend beyond Moscow to Samara and Crimea and even to

Hungary, Britain, and Israel.22

TYPOLOGIES OF RUSSIAN ORGANIZED CRIME

Organized crime historically has been first and foremost about

muscle. In the case of Russian organized crime this element is certainly not lacking. Yet there is also a high degree of sophistication.

A great deal of Russian organized crime is financial crime or what

has traditionally been categorized as white-collar crime rather than

the more mundane forms of organized crime. Sophisticated fraud

and embezzlement schemes, proximity to the banking sector, the

widespread use of front and shell companies to move money and illegal products across borders, and the extension of networks of

power and influence into the licit economy are all characteristics of

Russian organized crime that stand out. Even if the financial dimensions of Russian organized crime are not completely unprecedented, they are a much more important part of Russian organized

crime than the provision of illegal goods and services.

The Russian criminal scene is characterized by considerable diversity, and it is possible to identify at least six different kinds of

criminal groups in Russia:

• Businesses that are ostensibly (and in some instances perhaps

even predominantly) licit but with their origin in criminal activities and a residual tendency to use violence and corruption

to protect and promote their activities and to deal with competitors. • Criminal organizations that have close links with officials and

that are a key part of the competing administrative financial

criminal oligarchies that are one of the dominant forces in Russia today and that operate at local and regional levels as well

as nationally. • Ethnic criminal organizations that include Slavic, Azeri, Georgian, and Chechen groups and that often specialize in one of

more criminal activities. Although weakened somewhat by the

‘‘wars’’ with the Slavic criminals, these groups remain a significant part of the organized crime scene in Russia. • What might be termed umbrella criminal associations that encompass a wide range of smaller groups and engage in a wide

variety of criminal activities. Perhaps the exemplar of this kind

of association is the Solntsevo group. One of Moscow’s premier

criminal organizations, Solntsevo has several layers of strong

leadership, a well-established structure, a high level of professionalism, some 300 individual crime groups in its fold, and extensive transnational connections. • Predatory criminal organizations that essentially engage in

small-scale criminal activities such as localized extortion, car

theft and the like, and that do not have links with corrupt officials. These organizations are more like street gangs than organized crime, although the more successful ones evolve into

organized crime groups and develop links with the business,

political, and administrative elites.

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23See ‘‘Excellent Cadavers,’’ Alexander Stille, Pantheon, 1995.

• Specialized organizations including groups of contract killers

that are the equivalent of the old ‘‘murder incorporated’’ in the

U.S. mafia.

This diversity—although sometimes a source of conflict among

the different kinds of organization—makes the Russian criminal

world particularly difficult to contain. Tactics that work well

against some groups are less effective against others with different

characteristics.

DIFFERENCES FROM ORGANIZED CRIME ELSEWHERE

Russian organized crime has some features in common with organized crime elsewhere, including the interpenetration of organized crime with government corruption, its reliance on extortion

and bribery, and its provision of black-market goods and services

in prohibited economic sectors. However, for reasons of history and

culture, it also has distinct characteristics, even where it resembles

other recent models for widespread organized crime.

For example, in post-World War II Italy, organized crime flourished through a menage a trois between Italy’s political parties, especially the Christian Democrats, the Mafia, and Italy’s labor

unions, whereby the three groups traded jobs, business, and money

among one another to sustain the power of each for some 45 years

until the culture demanded a more law-based system.23 However,

even Italy’s heavily criminalized political class remained only a

strand, albeit a thick strand, in a broader set of political, social,

and economic institutions. While the Italian mob may have held

enormous influence with Italy’s political parties and its governmental personnel practices, especially at the local level, it never

dominated Italian business life or controlled a preponderance of

Italian resources. Legitimate businesses in the north were not

mobbed up. They controlled their own capital, and that capital was

invested in legitimate enterprise.

Similarly, other powerful criminal cultures in larger countries in

the world have tended to be limited to inhabiting portions of society, rather than a country’s heart. For example, Nigerian crime

features tribal predation. Criminal cells or families prey on innocents elsewhere in Nigeria, or outside Nigeria, but seldom their

own people. In China and Japan, particular criminal subcultures

maintain limited and unreliable ties to elements of the government

(Chinese triads, Japanese yakuza), but do not control vast components of their country’s respective national resources. In drug trafficking countries, such as Colombia, criminal enterprises can exercise enormous political and economic influence, and infiltrate governmental institutions and businesses, but the traffickers are

viewed by everyone as external elements to the institutions they are

corrupting, rather than as components of them as in Russia. In

most other countries, such as the United States, Canada, Western

Europe, and the Middle East, criminal groups exist almost entirely

as subcultures, often based on disaffected components of society,

segregated by and with resentments arising from economic class or

ethnicity.

111

24The authors are grateful to Gregory Baudin-O’Hayon for this observation.

In short, Russian organized crime has differed from organized

crime in other regions in being less of a subculture, and more central to what has always been a centralized state with relatively few

other political institutions to act as counterweights.

THE SCOPE AND IMPACT OF RUSSIAN ORGANIZED CRIME ACTIVITIES

OUTSIDE RUSSIA

Globalization has meant that the infrastructure of the western

democracies, for finance, information, telecommunications, governance, has rapidly spread throughout the world to constitute an

ever-thickening web of connectivity. Post-Communist Russian organized crime arose just as this infrastructure was becoming rapidly

more democratized through the proliferation of telecommunications

technologies and electronic networks of various kinds. With the

technical borders down, and the legal barriers against Russian contact with the west eradicated almost as rapidly as the Berlin Wall

was bulldozed into history, Russian organized crime found an infrastructure outside Russia well-designed to facilitate every form of

criminal activity, and ill-designed to investigate or prosecute it.

In considering the scope and impact of Russian organized crime

outside Russia, there are several questions that need to be considered. These include:

• Where is Russian organized crime going? What is it doing

there and what is it seeking to achieve? • How is the presence developed? What kind of criminal activities come with the presence?

WHERE IS RUSSIAN ORGANIZED CRIME?

There are four main answers to this question:

• Given the extreme cold of Russian winter, Russian organized

crime has often followed the sun.24 Among the locations that

Russian organized crime has become prominent are various

Caribbean islands, Israel, the Costa del Sol, the French Riviera, South Florida, and Thailand. The playgrounds of the rich

are very attractive for organizations and individuals whose primary activity is the accumulation of wealth through illegal

means. • Some Russian organized crime moved out of Russia but stayed

close to it. Budapest, Berlin, and Vienna, for example, all witnessed a significant increase in the Russian criminal presence.

In some respects these cities were natural haunts for Russian

organized crime as they were familiar from the cold war era,

and in the case of Berlin and Vienna provided convenient windows on the west while having the advantage of proximity. • Russian organized crime looks for opportunities that come with

an acceptable level of risk, engaging in what can be described

as jurisdictional arbitrage. One of Israel’s attractions, for example, until summer 2000, was the lack of any anti-money

laundering legislation. When this permissive environment was

combined with the law of return and the lack of questions

about the personal wealth that immigrants brought with them

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25 Analysts affiliated with the National Institute of Justice estimate that approximately 15

criminal groups arising out of the former Soviet Union are currently operating in the United

States, and that 8 or 9 of them maintain links to Russia. The analysts estimate membership

of those groups to be 5,000 to 6,000 members. Finckenauer, James O. and Elin J. Waring, Russian Mafia in America, Boston: Northeastern University Press, 1998.

it is clear that Israel was an attractive, low-risk destination for

Russian criminal organizations. The United States carries a

higher level of risk but also provides enormous opportunities

for criminals, particularly in areas such as Medicare, car insurance, and gasoline taxation where fraud schemes are very lucrative. The capacity to meld into the ethnic Russian communities also makes the United States attractive to Russian organized crime.25 Conversely, where ethnic communities of this

kind are not well established, Russian organized crime is less

likely to have a significant presence. Neither Britain nor Sweden, for example, has experienced the influx of Russian organized crime that was expected.

• Russian organized crime follows the Russian Diaspora. It is

sometimes argued that organized crime is extremely difficult to

transplant to other countries, particularly when it is based on

protection activities. Where and when organized crime can be

embedded in migrant ethnic communities, however, then a successful transplant is feasible. Most migrant organized crime,

initially, at least, preys on its own community, before subsequently expanding into the broader society and economy of the

host nation.

WHAT KINDS OF PRESENCE AND HOW DEVELOPED?

To date, Russian organization crime penetration of other countries has developed into variations of six models:

• Direct criminal presence in another country accompanied by a

full panoply of criminal activities, as demonstrated by Russian

organized crime in the United States, Israel, much of Western

Europe, and most formerly Eastern bloc countries in Central

Europe.

• More limited criminal presence for the purpose of using the

country’s services on a regular basis, to make it a reliable part

of the criminal organization’s infrastructure, as in the use of

Austria, Cyprus and Switzerland for financial and business

dealings; and the use of the Baltic countries, especially Latvia,

for smuggling.

• Criminal presence in a neutral (not a targeted or host) country

that offers opportunities for contacts and negotiations with

other criminal organizations rather than criminal activities per

se. Some Caribbean islands have been used in this way as a

meeting ground for Russian criminals and Colombian drug

traffickers.

• Modest (or largely indirect) presence through connections with

indigenous criminal organizations. In effect, the presence of

Russian criminals is designed merely to facilitate cooperative

relationships with the indigenous criminal organizations. Any

Russian criminal presence in Colombia, for example, would

likely be at the invitation of Colombian drug traffickers interVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00138 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.006 CRS1 PsN: CRS1
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ested in exploiting the burgeoning Russian drug market or in

obtaining arms.

• A purely ‘‘pass through’’ financial presence. The proceeds of

Russian crime often go through or are secreted in jurisdictions

in which there is little or no Russian physical presence. This

is certainly the case with some of the offshore financial centers

such as the Caymans, Nauru, Vanuatu, and Liechtenstein that

have been used by Russian criminal organizations to move,

launder, and hide their proceeds.

• Rest, relaxation, and consumerism. Russian criminals have

congregated in resort communities in Southeast Asia and

Western Europe, buying real estate and expensive goods, with

little impact on the overall environment of such communities,

which tend to accept money as money regardless of its provenance, with little change to the underlying culture of hedonism.

The extent of the Russian organized crime threat in a country

depends largely on the viability and effectiveness of the institutions

of governance. Where there is a viable, highly legitimate, wellfunctioning democracy based on the rule of law, then the threat is

predominantly a law and order one, with some residual concerns

over what might be termed the corrosion of institutions. Where

these conditions are absent then the threat is more serious. In host

states—as well as its home state—Russian organized crime uses

corruption as an instrument to neutralize law enforcement and the

criminal justice system, to co-opt support and buy impunity. Such

tactics have an insidious impact and when a state already has serious governance problems these will be exacerbated.

THE IMPACT OF RUSSIAN ORGANIZED CRIME ON RUSSIA’S EVOLUTION

Russian organized crime has been a major impediment to

progress toward democracy, the rule of law and free markets in

Russia. It will continue to be so. There are two closely interwoven

myths about Russian organized crime that have been perpetrated

largely by economists in the United States and Western Europe

and that continue to have some currency. They need to be dispelled. The first is that Russian organized crime is similar to the

robber baron phase in American history. In fact, the robber barons

built infrastructure and created wealth; Russian organized crime in

contrast has looted the country, imposed parasitical relationships

on licit business, driven out much legal entrepreneurship, and become an impediment to foreign investment. The second myth is

that Russian organized crime is a passing phenomenon that will diminish significantly as the process of free market reform continues,

that it is a temporary feature of transition rather than an enduring

feature of post-Communist Russia, simply a short term nuisance

unlikely to have long term impact. This ignores several characteristics of organized crime: it is a political as well as economic force,

it consolidates its power in ways that enable it to outlast the market conditions that initially facilitated its expansion, it creates

symbiotic linkages with politics and business that are difficult to

undo, and it is not simply dependent on rents from imperfect competition in the Russian economy. Indeed, Russian organized crime

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26 ‘‘Seize the State, Seize the Day—State Capture, Corruption and Influence in Transition,’’ Joel S. Hellman, Geraint Jones and Daniel Kaufmann, World Bank Institute, September 2000,

Policy Research Working Paper 2444. 27 Id.

represents a concentration of illegal power that is not going to go

away and will continue to hinder efforts to establish a strong legitimate Russian state, to eradicate corruption and to develop a system that is clearly based on the rule of law. Born in part out of

state weakness Russian organized crime aims to perpetuate this

weakness.

Some argue that Russia is going beyond the neutralization of the

state and is exhibiting symptoms of state capture. A recent paper

of the World Bank Institute suggests that in Russia oligarchs have

‘‘captured the state,’’ shaping the policy and legal environment to

their advantage at the expense of the rest of the country.26 The notion of state capture has the following components: (1) corrupt individuals have access to the resources of the state and are able to

exploit these resources for their own purposes; (2) the state can

only act effectively, at least domestically, when its actions do not

seriously impinge on the power and well-being of the corrupt individuals; (3) state institutions can be used as fronts for corruption

and extortion; (4) it is not clear where the state ends and the corrupt private-sector organization begins—or vice versa; and (5) the

corrupt organization usurps some of the functions of the state.

The process of usurping state powers is nowhere more obvious

than in the areas of business protection and taxation. Because the

state has not provided legal protection and arbitration for licit business, organized crime has filled the breach, in effect exploiting lack

of state capacity and filling the resulting functional holes. Organized crime provides contract enforcement and debt collection. In

the area of taxation, the problem in Russia is that the system is

not only burdensome and ineffective, but also provides perverse incentives for tax evasion and criminal behavior. Businesses typically

evade taxes; criminal organizations discover this (often obtaining

information through the banking system) and then extort businesses that find it cheaper to pay ‘‘taxes’’ imposed by criminal organizations than those imposed by the Russian state. Consequently,

Russia has failed to develop a tax base adequate to fund government services in a variety of sectors including law enforcement.

This then becomes one of several interlocking vicious circles: lack

of resources makes it difficult for the Russian state to combat organized crime; in turn organized crime becomes more powerful and

acquires more resources that would normally accrue to the state.

According to World Bank Institute analysis, countries with these

features, such as Russia exhibit increasing concentration of wealth

among the most corrupt firms, reduction in the ability of the state

to provide necessary public goods, and weakened economic

growth.27

To combat organized crime, most countries adopt a conventional,

predominantly law enforcement approach, in which investigations

lead to arrests, arrests to prosecutions, prosecutions to trials, and

trials to convictions of individuals and the eventual dismantling of

criminal organizations. In the case of organized crime in Russia

this is patently inadequate. It is necessary to adopt a much broader

115

28This phenomenon was most clearly demonstrated in the case of Sergei Mikhailov, head of

the Solntsevo organization. When the Swiss Government asked the procuracy in 1998 for information on Mikhailov’s criminal activities, which had previously been detailed to the Swiss by

an MVD general, the Procuracy stated it had no such information. Mikhailov was acquitted, and

the MVD general was forced to seek asylum in Switzerland. 29The current legal problems in Russia of formerly successful oligarch Vladimir Gusinsky provide a vivid recent example. 30One of the authors had numerous conversations in Moscow in 1997, 1998, and 1999 with

relatively senior Russian officials from Russia’s foreign ministry, the MVD, the Procuracy, the

VEK, the Customs, and the Tax Police concerning this issue in the course of his work for the

State Department. In summary, officials from each of these agencies stated that Russia was not

yet a normal country, and that anyone who put himself at risk as a result of investigating a

well-placed official or oligarch would have far more at risk than merely the loss of their job.

approach aimed at creating a far less congenial environment within

which organized crime has to operate. In Russia it is crucial to establish clear lines of demarcation between public and private, legal

and illegal, permissible, and impermissible activities. In addition,

it is necessary to correct a tax system that provides perverse incentives for criminality. Consideration might also be given to a strategy of legitimization that would provide incentives for the inflow of

flight capital—whether clean or dirty—and for the transformation

of businesses founded on criminal activity into legitimate businesses that would abandon old habits and patterns of behavior. In

effect, organized crime will be impossible to reduce unless major

changes are made in both the environment and in the payoff structures.

Putin inherited a Russia with limited institutional locations of

integrity from which one could theoretically construct a decriminalized government. Regional governors, like the Duma, heavily intersect with some of Russia’s most prominent criminals. Institutions

like the Procuracy routinely lie to western counterparts about the

information they have on Russian criminals, when the criminals

are sufficiently prominent.28 The Ministry of Internal Affairs

(MVD) undertakes effective prosecutions of lower-level criminals

who lack a sufficient krysha or roof to avoid sanctions, and is

equally effective at investigating the bad acts of oligarchs who have

been insufficiently adroit with the rulers of the day.29 However,

substantial areas of criminal activity and corruption are simply off

limits, even to MVD officials who would like to enforce the law.30

One factor in the prevalence of organized crime’s involvement in

Russia’s economy is the structural similarity between a command

economy, operating by force, and criminal activity, which similarly

relies upon force. Another factor is the merger between groups: in

Russia it remains often difficult to tell who is merely a businessman, and who is a criminal. It is not just a matter of appropriate

epithets: a careful link analysis of the business activities of most

of the oligarchs show social, economic, and personnel connections

with various members of the more prominent purely criminal

groups, such as Solntsevo, Mogilevich, and Ismailov. The difficulty

of distinguishing between the monopolists, the oligarchs and the

criminals in Russia was aptly illustrated in the Bank and New

York/Benex money laundering/capital flight case. The operation

laundered funds for prominent politicians, oligarchs, and criminals

alike. The countries of Nauru and Vanuatu performed similar functions, laundering the proceeds of narcotics trafficking, organized

crime, tax avoidance, and theft with the same legal and accounting

mechanisms.

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31For example, Chernoy was in business with, and sold assets to, oligarchs Boris Berezovsky

and Roman Abramovitch. The Moscow Tribune, February 16, 2000, ‘‘Russian Aluminum—When

Politics Melts Metal,’’ by John Helmer.

Within Russia, resources that once were available to anyone with

the will and location to secure them have now been converted to

a more stable form of ownership that remains, however, potentially

subject to further direction from the Russian state, as recent media

takeovers have demonstrated. These assets were and remain the

wealth of a command economy, not the wealth of a market economy. Those who converted these resources have primarily not been

persons operating through the mechanisms of a market economy,

but rather those operating through the decaying infrastructure of

the old command economy. The persons who secured the wealth

have not been faced in Russia with a system of rule of law or democracy that would confine their activities looking forward. For the

reasons set forth in the World Bank Institute study, having obtained wealth and power, Russian criminals and oligarchs are unlikely now to abandon the unfair business techniques upon which

they have built their empires. Generally, criminals and oligarchs

limit themselves to legitimate and legal activities to the extent that

there is no competitive threat to them when they do so. If other

unfair competitors remain to intrude on their turf, they unfairly

compete themselves. In Russia, individuals with extremely unsavory reputations, such as the Chernoy brothers, one of whom became a key figure in the aluminum industry amidst a spate of unsolved business killings, wind up having business dealings with a

wide range of the most powerful and prominent people.31

MONEY LAUNDERING AND FINANCIAL CRIME

Russia’s placement on the list of 15 non-cooperative countries by

the G–7 in summer 2000 reflected the enormity of its money laundering and financial integrity problems. The combined lack of

transparency and lack of integrity in Russia’s financial system

have made it a sieve for most forms of financial abuses, with catastrophic consequences for the safety and soundness of Russia’s financial system, for Russian tax collection, and for sustained foreign

investment commensurate with Russia’s potential economy. These

twin problems have facilitated not only money laundering and capital flight, but unfair competition, abusive business practices, the

theft of Russian natural resources, the depreciation of the Russian

ruble against hard currencies, and the creation of a business climate that is estimated by foreigners as among the worst in the

world. Russian elites, including important members of the former

Communist Party nomenklatura, pro-Western ‘‘reformers,’’ bankers, brokers, and traders, and heads of criminal organizations, have

collectively exploited the interface between Russian banking after

the fall of Communism with the global financial services infrastructure of the West to steal Russia’s wealth and commit massive

frauds that have repeatedly shaken Russia’s financial stability.

Moreover, the laundering over the past decade of the proceeds of

stolen Russian resources, profits made through the manipulation of

and devaluation of the ruble, the proceeds of drug trafficking, arms

trafficking, prostitution, alien smuggling, theft, and extortion, comVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00142 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.006 CRS1 PsN: CRS1
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bined with the proceeds of capital flight, have made Russia’s money

laundering problem a global one, affecting countries literally all

over the world. Russian money is laundered in former Communist

countries like Latvia, Hungary, Slovenia, Poland and Ukraine; in

the Middle East through Lebanon, the United Arab Emirates and

Dubai; throughout Western Europe, including substantial amounts

of activity in Austria, Cyprus and Switzerland; through the Russian community based in Israel; through off-shore havens such as

the British Virgin Islands, Cayman Islands, Isle of Man and the

Bahamas; through brass-plate institutions in the Caribbean (Antigua, Belize, Dominica) and the South Pacific (Nauru, Niue, Tonga,

Vanuatu); and through and into the world’s major financial markets in the United States and the United Kingdom. Russian money

has been also laundered in the Seychelles, which has some 600 offshore companies for Russian persons and entities, and South Africa, where Russian money laundering and illicit finance has become

a factor in the diamond business. Russian criminal groups involved

in money laundering have been active in Central America (Costa

Rica and Panama), engaged in money laundering and criminal activities in collaboration with Colombian and Bolivian criminals in

the cocaine business, and moved into purchasing illicit businesses

in the Pacific in places such as Thailand and Macao. In short, there

is evidence of illicit Russian money streaming throughout the

money-laundering infrastructure of the world, and the Russian

money has already had some impact in weakening regulatory and

enforcement structures in many locations, especially those involving poorer and smaller governments.

The persistence of large-scale capital flight, the legacy of an intrusive state bureaucracy, underdeveloped market institutions and

lack of fiscal resources further complicate the fight against money

laundering in Russia. Thus, Russia’s money laundering problem is

a subset of and simultaneously a contributing factor to Russia’s

governance problem, inexorably intermingled with it.

In Russia, no financial institution has ever been sanctioned for

laundering money. There remains no system for financial services

record keeping that is demonstrably enforced by bank regulators

and no obligations to report the true beneficial owner of bank accounts. Elaborate mechanisms have been established by Russian financial elites in collusion with Russian financial institutions and

in some cases with Russian officials that have successfully moved

billions of dollars a year in funds offshore where they cannot be

traced. Russia’s areas of vulnerability and deficiency extend to

every aspect of its financial services sector, and there may be no

other nation in which the lack of transparency regarding transfers

of funds plays a greater role in debilitating its economy. Significant

areas of special vulnerability include:

THE GRAY ECONOMY, RUSSIA’S TAX SYSTEM AND CAPITAL FLIGHT

Russian regulatory and law enforcement officials have estimated

that the gray economy accounts for some 40 percent of the total

Russian economy, although other estimates put the number as high

as 60 percent. Gray economic activity consists both of legal activities that are not reported to the tax authorities, leaving the income

untaxed and unreported, and illegal activities, which are also not

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reported to the state and therefore not taxed. The gray economy includes and rewards barter, avoids documentation, and facilitates

money laundering. It in turn has been created in part by Russia’s

complex tax system that has led to an environment in which many

businesses view total compliance with all assessed taxes and penalties to be incompatible with staying competitive. The introduction

of a flat rate social tax promises to simplify—and thereby improve—the tax situation in Russia. One difficulty, however, is that

the Tax Police has only 7,000 of the 13,000 personnel it believes

necessary to implement collection and to ensure that the funds

enter the government budget. The Russian business sector’s welldeveloped mechanisms for hiding funds from tax authorities will

continue to pose a challenge even to the best funded enforcement

agency.

POOR ACCOUNTING, AUDITING, AND DOCUMENTATION REQUIREMENTS

With no properly functioning regulatory mechanisms, such as effective banking regulators or an equivalent of the U.S. Securities

and Exchange Commission, and with poor civil enforcement remedies, Russia has lacked mechanisms to develop and to demand

high standards for accounting, auditing and documentation, even

as Russia’s tax system has driven businesses to develop methods

for false bookkeeping. The lack of authentic documentation, and

the ease of developing false documents make it easy for Russians

to launder money through the formal financial services sector, as

part of routine import-export activity.

PROMINENCE AND CONNECTION OF ORGANIZED CRIME TO OFFICIALS

AND OFFICIAL STRUCTURES

As noted above, the chaotic business environment of postCommunist Russia has facilitated the development of criminal organizations, such as the Solntsevo, Ismailov, and Mogilevich

groups, with close ties to government officials and official structures, that provide them protection from enforcement activity,

through a mechanism sometimes described as a krysha, or roof.

Significant criminal proceeds are generated in Russia, including

funds from narcotics trafficking, smuggling, tax evasion and tax

fraud, arms trafficking, extortion, theft of government property,

and corruption. The interpenetration of government and criminal

structures to engage in financial crime and corrupt activities provides a favorable condition for money laundering.

RENT-SEEKING ACTIVITY BY GOVERNMENT OFFICIALS

Low civil service salaries, corruption, the Communist heritage,

and cultural experience, have provided a foundation for widespread

payoffs of government officials in exchange for economic privileges

such as business permits, government contracts, exemptions from

taxes and customs duties, and protection from investigations. Each

of these activities plays a significant role in Russia’s money laundering problem.

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EASE OF MOVING FUNDS OFFSHORE

Collusion between those involved in capital flight, those involved

in organized crime, those involved in money laundering, and Russian’s major financial institutions has made it easy for criminals to

move funds offshore. Russian regulatory and law enforcement officials have estimated that since independence in December 1991,

more than $100 billion in illegal proceeds have been generated

from criminal activity and subsequently laundered. As noted above,

criminal funds leaving Russia have been transferred to financial institutions in the former Soviet Union, especially Latvia, Western

Europe, the United Arab Emirates, Cyprus, the United States, and

throughout the world’s offshore sector, including some of the havens in the South Pacific. The use of correspondent bank accounts

in foreign banks, in particular in the Baltics, Cyprus and offshore

zones, has been a significant problem, due to the ability of the

money launderers to commingle funds from many sources through

this mechanism.

INADEQUATE KNOWLEDGE BASE, TRAINING, GOVERNMENT CAPACITY

Russian law enforcement agencies have very limited experience

in investigating and prosecuting significant financial crime cases,

confront problems of integrity, training, capacity, and resources,

and have to contend with uncertain laws, duplicitous sources of potential evidence, and major gaps in the overall regime for combating money laundering, such as the failure to require currency reporting or mandatory suspicious activities report (SAR) reporting.

In this environment, passage by Russia of comprehensive money

laundering legislation, as was in process in July 2001, constitutes

a first step to money laundering reform in what would under any

circumstances be a lengthy journey.

OPTIONS FOR REFORM IN RUSSIA

The so-called new Russians who today control the most important elements of Russian wealth inherited from the Soviet Union,

its industries, its raw materials, its lands and its infrastructure

have demonstrated their ability to seize the resources of the former

Soviet state. These people have not, however, by and large demonstrated a capacity to build, to put people to work, to invent, to

improve, or to invest and maintain that which they have effectively

exploited. Rather, they are people who were able to exploit politics

to obtain wealth and power without regard for market integrity,

transparency, democracy, or rule of law. Strengthened civil institutions, greater transparency, and greater market integrity all would

create opportunities for others with less existing power and wealth

to become potential competitors with the criminals who now control

the vast preponderance of Russia’s wealth. Accordingly, Russia’s organized criminals have continued to slow the development of such

institutions.

The transformation of Russia from a criminalized country to one

where free markets and democracy are realities requires precisely

those steps that most threaten those whose power depends on discouraging rule of law: bad businessmen and incompetent, corrupt

bureaucrats. For Russia to evolve in a positive fashion, its governVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00145 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.006 CRS1 PsN: CRS1
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ment must collect taxes in a fair manner, pay its civil service a living wage, maintain an adequate number of high caliber professionals in government, supplement that government with selfregulatory organizations made up of businesses whose owners recognize that a level playing field is an essential element for keeping

the game going, and sanction those who engage in unfair trade and

business practices. These are formidable challenges for any country

in transition. In a Russian context, their viability remains threatened by most of the more powerful interests with power in the

country, including the oligarchs and the nomenklatura.

Accordingly, a package of reforms that would begin to provide an

environment better suited for Russia to combat its organized crime

problem would include:

ANTI-CORRUPTION MEASURES

Reducing the number of persons in government, increasing the

salaries of those remaining in government, and creating strong disincentives to taking bribes.

INCREASED PRESS FREEDOM

The essential oversight function of an open press remains a prerequisite for effective reforms; the recent consolidations of Russian

broadcasting under the control of the Kremlin has the potential for

sufficiently impairing oversight by the press as to render other

anti-corruption measures of little utility.

IMPROVING TAX SYSTEM

Strengthening the fiscal position of the federal government,

through enforcing and collecting federal taxes at a sustainable rate.

Recent changes to the Russian tax code, including a 13 percent flat

rate on federal income tax, strongly endorsed by the International

Monetary Fund, represent a potentially positive development.

FINANCIAL SECTOR REGULATORY REFORMS

Creating a modern capital market, strengthening the banking

system and banking supervision. Russian financial institutions continue to operate on a quasi-barter basis, with little long-term lending to independent borrowers. The Central Bank of the Russian

Federation (Central Bank of Russia) has had a poor track record

of safety and soundness regulation and supervision. Securities regulation, investor protection, and basic elements of corporate governance are further necessities for the recovery of the financial sector.

LEGAL REFORMS

In May 2001, Putin announced his intentions for a sweeping reform of the judicial system, which would curb the powers of prosecutors and police, introduce jury trials, and increase funding for

the courts. Creating transparent mechanisms with adequate and

fair process to resolve both criminal and civil cases are essential

elements of changing the environment to one less likely to facilitate

organized crime, by creating the possibility of alternatives to private dispute resolution systems involving extortion and protection.

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MONEY LAUNDERING LEGISLATION

Russia needs to complete passage of the comprehensive preventive law passed by the Duma in July 2001, to create clear legal obligations for customer identification and record keeping, and a

mandatory suspicious transaction reporting regime without any

monetary threshold. Related reforms would include clear legal provisions protecting financial institutions from criminal or civil liability in respect of disclosures made in good faith; much stricter controls on the licensing of banks and exchange houses; a clear timetable for the conversion of any existing anonymous accounts into

normal accounts subject to the usual customer identification requirements; regulations issued by the Central Bank of Russia to

ensure steps are taken to verify beneficial owners when an account

is opened or a transaction is conducted; and provisions to insure

that beneficial owners are identified and not hidden through intermediaries.

POLICY OPTIONS FOR THE UNITED STATES

In the post-World War II period, the United States has had a series of well-defined policies toward the Soviet Union, which roughly

can be divided into the periods of containment, during the Stalin

through Khruschev period of the cold war; competition and co-existence, during the period of Brezhnev through Chernyenko; and

growing cooperation during the Gorbachev era of perestroika and

glasnost. Following the collapse of the Soviet Union and the ascendancy of Boris Yeltsin, U.S. policy could be defined in brief as

one of constructive engagement, in which the United States aggressively and assiduously worked to secure Russian integration with

the world economy, Russian political, economic and legal reform,

and democratization.

Current policy toward Russia in the context of organized crime

could be seen as containing elements of each of these models. Existing U.S. policy in the area of international financial regulation, and

limitations on the issuance of visas to suspected Russian criminals,

could be seen as a form of containment strategy. Limited new assistance programs and new investment by the United States could

be viewed as a kind of co-existence strategy, one that lives side-byside with individual cases of cooperation in a law enforcement context, and constructive engagement through some forms of continuing assistance.

These strategic choices play out in practice through a series of

policy options for the United States, many of which may be seen

in the first instance as not relating directly to organized crime, but

which could have substantial impact on the Russian governance

issues that most directly would impact organized crime. These

could include:

• The level and nature of assistance to be offered Russia by the

United States, and the kinds of conditions imposed on such assistance. Such assistance could focus on rule of law, democratization, judicial training and reform, civil society and democracy programs, support for an independent press, and corporate governance, among those programs that could potentially have an impact on organized crime. Such programs could

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potentially be structured with conditionality, so that failures of

cooperation or follow-through could result in diminished assistance.

• U.S. policy toward balance of payments support from the International Monetary Fund, and the issue of conditionality. The

United States could take the position that further assistance to

Russia from the IMF depends on not only the enactment but

also the implementation of comprehensive financial services

regulatory reforms, with higher standards for auditing and accounting of businesses that include some mechanism for public

scrutiny.

• Promoting or limiting direct Russian access to the U.S. financial system. Currently, the Federal Reserve has not authorized

Russian entities to carry out banking services in the United

States, due to inadequate supervision within Russia. The

United States could set down an assessment mechanism and

schedule for further consideration of granting Russia greater

access to the United States as a result of Russia undertaking

further reforms. Alternatively, the United States could consider further limits on access by Russian financial institutions

to correspondent banking services by U.S. financial institutions; further enhanced scrutiny under Treasury regulations;

or multilateral sanctions, as could be imposed by the Financial

Action Task Force as a result of Russian failure to enact and

enforce anti-money laundering laws.

Other options for U.S. action that would focus more directly on

Russian organized crime could include:

• Allocating further resources to the creation of law enforcement

and intelligence data bases focused on Russian organized

crime; • Establishing better mechanisms for interagency cooperation

within the United States targeting those identified as major

Russian organized crime threats;

• Identifying priority cases involving Russian organized crime

for investigation and possible prosecution domestically, with

resources appropriately configured to ensure appropriate treatment of priority cases.

• Identifying priority cases involving Russian organized crime

for bilateral or multilateral or bilateral action involving relevant U.S. law enforcement partners. These could include more

focused attention by the United States to take advantage of the

capabilities of existing foreign law enforcement institutions, including the European Union’s Europol; data bases pertaining

to Russian organized crime at INTERPOL; possible further

harmonized efforts by the national Customs authorities

through the World Customs Organization; or a more case-oriented use of U.S. funded International Law Enforcement Academies, such as the Academy at Budapest. Such efforts could include initiatives aimed at disrupting criminal organizations in

situations where prosecution was not feasible.

• Upgrading existing efforts to establish names databases for immigration purposes, to prevent Russian criminals from securing entry into the United States.

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32 ‘‘World Bank Optimistic on Russian Reforms,’’ Reuters, August 10, 2001; See also ‘‘Russian

economy seen more robust, not out of woods, Reuters, August 9, 2001, describing the optimistic

views of various Western businessmen and economists regarding Russian reforms.

• Strengthening programs aimed at responding to the problem of

trafficking in women to create a strategy that targets the

criminal organizations engaged in the trafficking on an ‘‘endto-end’’ basis, similar to the ‘‘kingpin’’ strategy used to combat

Colombian cocaine drug traffickers.

• Enacting legislation in the United States to add foreign corruption as a predicate offense to U.S. anti-money laundering laws.

• Seizing the assets of Russian criminals through aggressive use

of forfeiture laws.

• Publicizing information pertaining to incidents of Russian corruption, theft of resources, or criminal activity, adopting a

‘‘name and shame’’ approach that could make it more difficult

for Russian criminals to do business in the United States and

other countries.

• Imposing higher standards of due diligence for investments involving U.S. guarantee programs or other assistance to insure

that U.S. programs do not inadvertently support corrupt individuals or entities.

• Using U.S. law enforcement, diplomatic reporting, or intelligence reporting, to create a black list of persons and entities

not eligible for benefits under U.S. guarantee programs, such

as those financed by the U.S. Export-Import Bank (Exim Bank)

and the Overseas Private Investment Corporation (OPIC).

Even if these measures are instituted and the United States does

develop and implement a well-coordinated strategy to combat organized crime and corruption in Russia, along with dealing with the

transnational dimensions of the problem, success will be measured

incrementally. The problem of Russian organized crime and corruption is a Russian problem which the United States can try to contain, influence, or combat but cannot hope to eradicate.

Some analysts continue to have a hopeful view regarding Russia’s ability to combat organized crime. They cite the recent passage of a series of economic and political reforms by the Duma

prior to its summer recess as evidence that under Putin, substantial further progress is not only possible, but likely. For example,

in August 2001, the World Bank’s chief economist for Russia,

Christof Ruehl, told Reuters he was ‘‘cautiously optimistic, with the

accent on optimistic,’’ regarding Russia’s medium-term economic future, due to the ‘‘good start made on the reform agenda’’ by President Putin.32

If this perspective were to be adopted, it would argue for the

kind of policy recently articulated by U.S. Secretary of the Treasury Paul O’Neill, who has focused on banking reforms, trade liberalization, and strengthening of accounting controls as mechanisms

to strengthen Russia’s economy and to bring it into line with world

standards. Under this approach, the United States would work

with Russia on a bilateral basis, and with the international lending

institutions multilaterally, to promote good practice in business

and in government in Russia’s regions, as well as in Moscow and

St. Petersburg. Secretary O’Neill has emphasized the importance of

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33 ‘‘How Russia Can Fulfill Its Potential,’’ Secretary of the Treasury Paul O’Neill, Wall Street

Journal, August 9, 2001. 34See e.g., Jeffrey Tayler, ‘‘Russia is Finished,’’ Atlantic Monthly, May, 2001.

reforms reaching the local level in addition to the federal level.

Other elements of the agenda would include advancing work on

WTO accession, consulting on market economy status for Russia,

cooperating on an anti-money laundering law, and exploring new

Export-Import Bank financing.33

Other analysts, describing Russia as ‘‘Zaire with permafrost,’’ believe that organized crime has become so central to the identity of

the post-Soviet Russian state that it is unrealistic to expect any

Russian Government, whatever its rhetoric, to combat organized

crime with a sustained and systematic strategy. They argue that

‘‘within a few decades Russia will concern the rest of the world no

more than any Third World country with abundant resources, an

impoverished people, and a corrupt government. In short, as a

Great Power, Russia is finished.’’ 34 From this perspective, the U.S.

Government must recognize the limits of the possible. The first decade of the Russian transition has underlined the limits of westernoriented reforms in a Russian context. Rather than an easy transition in Russia to a free market and liberal democracy, the Russian

transition has featured a state that has been both criminalized and

corrupt. For such analysts, there remain basic questions as to the

degree to which Russia may be capable of fundamental reform.

They point out that organized crime and corruption in Russia survived the Czars and outlasted the Communist Party, and will be

a likely feature of the Russian social, political, and economic environment for the foreseeable future, regardless of any steps undertaken by the United States and other countries.

If this perspective were to be adopted, it might imply a possible

strategic bifurcation for U.S. treatment of Russia: continued engagement with Russia within a national security context as a nuclear power and a mixture within the economic context of a policy

of containment of Russia to protect against contagion from inadequate regulatory and law enforcement systems, mixed with continued efforts, to be sustained over many years, to build a better climate for reform.

(125)

Financial Reform: Taxes, Budgets and Banks

TAX REFORM IN RUSSIA

By Z. Blake Marshall 1

CONTENTS

Page

Summary .................................................................................................................. 125

Policy Progress to Date ........................................................................................... 128

Tax Code: part I ................................................................................................ 128

Tax Code: part II .............................................................................................. 129

Personal Income Tax ............................................................................................... 129

Unified Social Fund Tax ......................................................................................... 130

Value Added Tax (VAT) .......................................................................................... 130

Turnover Taxes ........................................................................................................ 130

The Road Ahead: Next Steps for Policymakers ..................................................... 131

Profits tax .......................................................................................................... 131

Customs duties ................................................................................................. 133

Value added tax (VAT) ..................................................................................... 135

Administrative procedures ............................................................................... 136

Production sharing agreements (PSAs) .......................................................... 137

Conclusion ................................................................................................................ 138

1Dr. Marshall is the Executive Vice President of the U.S.-Russia Business Council.

SUMMARY

Of all the commercial policy issues brought to the fore during

Russia’s decade-long market transition, one has consistently topped

the list of investor concerns: the dire need for reform of Russia’s

complex, unpredictable and inefficient tax system.

Russia’s tax system remains a major obstacle to foreign investment and to business activity more generally, cited time and again

by companies as a primary obstacle impeding their business plans,

deterring new market participants and constraining Russia’s considerable economic potential. The number of taxes with which a

firm must comply, coupled with a perpetually changing compliance

regime, leaves companies operating in an atmosphere of uncertainty that compromises business planning. Dating from the excess-wage tax controversy of the mid-1990s (which was ultimately

abolished under pressure from business groups), corporate attitudes have reflected continual attempts to combat the imposition of

a (often redundant) new tax, an arbitrary interpretation of an existing obligation, or capriciousness and harassment in the audits

and penalties realm.

As Organization for Economic Cooperation and Development

(OECD) analysts point out, the difficulties experienced by businesses have not primarily been a function of the rates prescribed

by law: ‘‘Statutory tax rates were in fact not very high by world

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2OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, 2001, p. 121. 3 Ibid., p. 23.

4 Reuters, April 11, 2001.

5St. Petersburg Times, June 13, 2001. 6 Associated Press, April 5, 2001.

7 Agence France Presse, April 22, 2001.

8OECD Policy Brief, Economic Survey of the Russian Federation, March 2000, p. 5.

standards—other than in the case of wage taxes—even before the

recent tax reform. It has been more a question of the multitude of

different taxes levied and, primarily, the methods of determination

of the actual tax base.’’ 2

Efforts to rationalize and streamline the tax system are inextricably linked to the country’s fiscal health, as collection difficulties have plagued Russia’s attempt to balance its social commitments and foreign debt burden, topics that are addressed elsewhere

in this volume. Thus policy and rate revisions have an impact on

compliance—a widening of the tax base that complements reforms

aimed at improving tax administration and enforcement.

Given this dual importance, the business community has been

encouraged by the significant steps forward that Russia has made

in the past 2 years. For the better part of a decade, the average

company operating in Russia has been responsible for deciphering

and complying with a combination of roughly 50 taxes and social

fund payments levied at the federal, regional and local levels. As

a result of tax reforms put into effect for 2001, that number has

been cut in half.3

This progress has not gone unnoticed in the business community.

A recent Economist Intelligence Unit survey of 100 multinational

companies operating in Russia found that two-thirds of the firms

polled believe Russia’s tax environment to be improving, with a

mere 5 percent of the opinion that it is getting worse. It is not difficult to imagine that statistic’s relationship to another telling data

point: More than 80 percent of the respondents reported making a

profit last year (and greater than half of them expect their 2001

sales to grow between 10 and 25 percent).4

Regarding the budgetary impact of recent reforms on a gray

economy pegged at 30 percent, Deputy Minister of Economic Development and Trade Arkady Dvorkovich recently commented that

‘‘half of these companies might come out from the shadows purely

thanks to tax reform.’’ 5 The early evidence this year supports this

and similarly optimistic projections, as the government’s collection

rate rose to 90 percent in the first quarter of 2001, compared to

only 60 percent in the first quarter of last year.6

The amounts collected have soared in tandem, as receipts for the

first quarter of 2001 grew 36 percent year on year.7 In addition to

the increased receipts, ‘‘the federal government has managed the

difficult task of collecting all taxes in cash since the second quarter

of 1999. This contrasts with a strong reliance on various money

surrogates in the past.’’ 8 Figure 1 portrays the steady climb in tax

revenue as a percentage of gross domestic product (GDP), an important indicator of the Russian Government’s fiscal health.

Furthermore, there are clear indications that, contrary to the policy stagnation and stalled reforms that characterized much of the

late 1990s, the Putin Administration is taking this issue seriously

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9Gref, German O. Speech to the U.S.-Russia Business Council, April 3, 2001.

10 Bush, Keith. The Russian Economy in June 2001, p. 21.

and is committed to building on recent successes. Minister of Economic Development and Trade German Gref is clear on the priority

affixed to tax reform initiatives for 2001: ‘‘Our plans for this year

can best be described as Napoleonic—we would like, above all else,

to complete the next phase of tax reform.’’ 9 With further reforms

pursued in 2001–2002, this next phase will determine whether the

Putin team meets its goal of lowering the nominal tax burden from

43 percent to 35 percent of GDP by the end of 2003.10

FIGURE 1.—RUSSIAN GOVERNMENT TAX REVENUE AS A PERCENTAGE OF GDP

* Preliminary data for the first quarter of 2001.

Source: Ministry of Finance of the Russian Federation.

This paper will discuss the nature of Russia’s tax system from

the perspective of business interests. In doing so, it will document

the progress Russian officials have made in adopting constituent

pieces of the Tax Code, as well as the remaining tax policy and tax

administration challenges that are key to Russia’s realization of its

economic potential.

The progress to date covers both the enactment of part I of the

Tax Code and the adoption and implementation of significant

pieces of part II, including what could be fairly characterized as a

radical liberalization of the income tax, social funds and turnover

tax regimes. The adoption of four key chapters of part II last year

has set the stage for further legislative progress on the profits

tax—which, as discussed below, passed its second reading in the

state Duma just prior to the summer recess—and other significant

areas of importance to Western business.

Beyond the realm of rates and policies, the system of interpreting

and implementing legislation must also be addressed. A key determinant of the system’s evolving fairness and transparency is the

extent to which Russia’s 180,000 tax inspectors across the country

adhere to uniform standards applied on a consistent basis. The


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128

11 U.S.-Russia Business Council and American Chamber of Commerce in Russia, Commercial

Engagement with Russia: Policy Recommendations for the Bush Administration, March 2001. 12OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 115. 13 Ibid., p. 140. 14 American Chamber of Commerce in Russia Tax Committee, informal memoranda, March

1999.

same consistency should be fairly expected at the federal level from

the Ministry of Taxes and Levies. For several years now, the system of auditing taxpayers has relied upon targeting law-abiding

foreign companies when revenue shortfalls have to be remedied.

Clearly, Russia must strive to bring pure tax evaders into the system, rather than repeatedly targeting firms that are willing to comply with a stable, predictable system.11

POLICY PROGRESS TO DATE

TAX CODE: PART I

Part I of the Tax Code, the ‘‘tax constitution’’ of Russia, consists

of 142 articles that outline basic principles, key definitions, and

rights and responsibilities.12 In codifying the relationships between

taxpayers and the tax authorities, part I has had a far-reaching effect on the way the tax system is perceived, favorably impacting

the business environment and inspiring increased company confidence. For the first time in its post-Soviet transition, Russia has

arrived at a legislative framework with a fairer balance between

the tax authorities and taxpayers. By clearly setting forth taxpayer

rights and official responsibilities, it rid the system of unclear appeals procedures as well as a variety of punitive sanctions levied

without recourse.

The changes brought about by implementation of part I, which

came into force in January 1999, included several important provisions concerning both tax relief and enforcement. For example, part

I took the bold step of reversing, in effect, the burden of proof in

tax dispute between the tax authorities and the taxpayer—the latter is now presumed innocent until proven otherwise. The rights of

the taxpayer include protection against arbitrary penalties not justified by the tax authorities in a court of law, placing the burden

squarely on the Russian Government to prove taxpayer liability.

The 19 penalties prescribed in part I are much less severe than

their predecessors, and they also attempt to differentiate between

‘‘negligent’’ or ‘‘intentional’’ behavior and violations due to other

mitigating circumstances.13

Part I of the Code also included a provision allowing companies

to transfer certain assets to newly established subsidiaries as they

undergo restructuring. Previously, these asset transfers were taxable because they were considered trading transactions. That is no

longer the case, except in circumstances where there are sufficient

grounds to prove that the restructuring process was designed purely as an instrument for tax evasion.14

Also important to companies operating in Russia was the elimination of tax restrictions on sales below cost. Originally intended

to curb tax evasion, these measures instead had a debilitating effect on manufacturers. Their removal allows law-abiding firms to

pursue flexible marketing strategies that include selling at a loss.

129

15 Ibid. 16 Ibid. 17 Interfax, May 29, 2001. 18Ministry of Economic Development and Trade; and Interfax, June 13, 2001.

As a result of the part I implementation, tax collection has become the liability of the so-called agent who controls the source of

the taxable payments (such as an employer, in the case of income

tax). Prior to 1999, companies could simply refer the tax authorities to an entity that received a payment, thereby making tax collection difficult, if not impossible, if the receiving company happened to be located outside of Russia. The revamped policy establishes that an agent that fails to transfer the requisite duties can

be fined 20 percent of the amount due.15

Finally, part I also revised the definitions that apply to terms

such as the ‘‘arm’s length principle,’’ ‘‘related parties,’’ and ‘‘market

price.’’ These concepts were either undefined or received minimal

treatment in the preexisting Russian legislation. Thus part I of the

Tax Code sought to limit the tax-reduction tactics available to Russian companies via transfer-pricing schemes that allowed subsidiaries to minimize taxable profits and offshore parent firms to pay

rates lower than their Russian equivalent.16 The stricter definitions contained in part I allow officials to examine contracts to ensure that related companies (defined as having more than 20 percent cross-ownership) are acting in accordance with market conditions (acceptable percentage variations established for prices

charged) and not engaging in tax evasion. During the state Duma’s

fall session, the Ministry of Finance plans to introduce further

amendments to part I pertaining to transfer pricing.17

TAX CODE: PART II

Several important chapters of part II of the Tax Code were

adopted last summer by the Federal Assembly and signed by President Putin on August 6, 2000. When they came into force on January 1 of this year along with a law on implementing instructions

for part II, these chapters signified a huge stride forward in Russia’s efforts to rationalize it tax system and make it more closely

conform to international practice.

To put the magnitude of these accomplishments into perspective,

the four chapters adopted covering the flat income tax, social taxes,

excise taxes, and the value added tax (VAT) represent 60 percent

of the revenue side of Russia’s ledger, and revenues from these four

line items increased by 60 percent through the first 5 months of

2001 on a year-on-year basis.18 As Figure 2 indicates, when the

profits tax is added in, these taxes account for roughly threefourths of Russia’s tax revenue. In addition, companies welcomed

a long-awaited reduction in turnover taxes. Several of these sweeping changes are described below.

PERSONAL INCOME TAX

Perhaps the most attention has been given to the Russian Government’s introduction of a 13 percent flat income tax in place of

progressive rates ranging from 12 to 30 percent. The new flat tax

generated an immediate impact as soon as it took effect, as income

130

19Gref, op. cit. 20 RIA Novosti, June 19, 2001. 21Gref, op. cit.

tax revenues increased by 70 percent in the first quarter of 2001

compared to the fourth quarter of last year.19 According to Minister

of Finance Aleksei Kudrin, through the first 5 months of 2001, collections of the income tax were up 52 percent over the comparable

period in 2000.20

FIGURE 2.—TAX REVENUES AS A PERCENTAGE OF THE 2000 BUDGET

Source: Audit Chamber of the Russian Federation.

UNIFIED SOCIAL FUND TAX

The adoption of the unified social fund tax integrated four previously separate budgetary line items into one, a move that, according to Minister Gref, ‘‘had wonderful anti-corruption consequences,

making the revenue and expenditure sides of these funds more

transparent.’’ 21 In place of the previous 39.5 percent flat rate, the

new rates follow a regressive scale from 35 percent down to 5 percent.

VALUE ADDED TAX (VAT)

Several improvements to the VAT—the stable source of one-third

of Russia’s tax revenue (see Figure 2 above)—were introduced with

the adoption of chapter 21 of part II last year. Among the most important is the new exemption on capital construction that took effect on January 1. This provision eliminated the previously unrecoverable 20 percent charge on capital investment in Russia, and

its adoption was influenced by several years of sustained engagement on the part of both the U.S. Government and Western business groups.

TURNOVER TAXES

Turnover taxes such as the housing fund tax and the road users

tax have for many years been the primary example of Russia’s


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22OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 123. 23Putin, Vladimir V. State of the Nation Address to the Federal Assembly, April 3, 2001. 24OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 125.

penchant for taxes based on gross revenues rather than profits.

These charges have long acted as a major disincentive to investment, as they disproportionately impact new businesses and those

running operating losses. The conceptual underpinning of turnover

taxes encourages businesses to understate or suppress their actual

revenues, thereby gravitating into the infamous shadow economy.

This of course distorts competition by shifting the relative tax burden onto those companies that comply in a straightforward manner.

Last year, the Putin team sought the complete elimination of

turnover taxes but was forced into a compromise to orchestrate legislative approval of its tax package. Their overall reduction from 4

percent to 1 percent represented the outright elimination of the

housing tax (1.5 percent) and a decrease in the road tax from 2.5

percent to 1 percent until its planned abolition in 2003.22 In his annual address to the Federal Assembly in April, President Putin

stressed that ‘‘our strategic priority today is the consistent lowering

of taxation on non-rental income and the final elimination of the

turnover tax.’’ 23

THE ROAD AHEAD: NEXT STEPS FOR POLICYMAKERS

This section elaborates on additional strands of Russian tax reform, picking up where last year’s accomplishments left off. What

are the next steps as perceived by the business community, and

what are the relative priorities identified by the Putin Administration? In terms of the work remaining to be done by the Russian

Government to build on last year’s momentum, this section will

focus on five key areas: profits tax, customs duties, VAT, tax administration concerns, and tax provisions associated with production sharing agreements (PSAs) in the energy sector.

PROFITS TAX

Companies active in the Russian market have for several years

urged the Russian Government to move away from a variety of

revenue-based methods of taxation. One of the primary focal points

in this campaign has been an effort to make net profit, as defined

by international norms, the basis on which firms calculate the profits tax. The level of taxation is not the root of the problem, as Russia’s current 35 percent rate (43 percent for financial services

firms) is on par with, or even less than, the corporate rates in other

industrialized countries.24

Despite a multi-year lobbying effort to allow widely accepted

business deductions, the profits tax is still not payable on net profit. Advertising costs, training expenses, business travel, loan financing, and depreciation allowances are only deductible within

very restricted norms. For example, deductible domestic travel expenses are capped at $11.40 per day, and depreciation schedules

far exceed the economic life of certain assets (e.g., buildings spread

132

25 Ibid., pp. 126–127. 26 Ibid., p. 23. 27 Agence France Presse, June 22, 2001. 28St. Petersburg Times, op. cit. 29 U.S.-Russia Business Council and American Chamber of Commerce in Russia, op. cit. 30 Interfax, June 20, 2001. 31Financial Times, June 20, 2001.

over 250 years).25 As a result, as a recent OECD study points out,

‘‘the tax base for the Russian profits tax has been and still is larger

than the comparable corporate tax base in other industrialized

countries, often resulting in a higher . . . effective profits tax rate

than the nominal statutory rate.’’ 26

Fortunately, relief is on the way. The Putin Administration has

sought to build on last year’s successes by overhauling the profits

tax to stimulate business activity and recapture firms from the

shadow economy, making this initiative the top tax-related priority

for 2001.

In what Deputy Finance Minister Sergei Shatalov referred to as

an ‘‘essential measure that can bring about revolutionary changes

in Russia,’’ the state Duma voted just prior to the summer recess

to approve, by a vote of 339 to 6, chapter 25 of part II of the Tax

Code, ‘‘On the Tax of Profit of Organizations.’’ 27 The passage of

this second reading, the most critical of the three readings, means

the bill is expected to sail through third reading ratification early

in the fall session and should be signed into law to take effect on

January 1, 2002.

In addition to business-friendly provisions pertaining to thin capitalization rules and depreciation of fixed assets, the bill has produced two major accomplishments that will have a far-reaching impact on bottom-line performance when enacted next year: a considerable rate reduction and full deductibility of legitimate business

expenses. In allowing deductions for all ‘‘necessary, reasonable and

documented’’ expenses, the new law, according to Ernst & Young’s

Peter Arnett, ‘‘is moving away from the prescriptive Soviet approach, moving expense deductibility from an exclusive list to an

inclusive list.’’ 28

Furthermore, companies have been urging the Russian Government to promote both purchased and leased capital investments. To

do so, financing and depreciation norms have to be revised, so that

businesses are allowed to expense the full cost of fixed or leased

assets over a period that reflects the economics of the transaction.29

The final product, which lowered the tax rate from 35 percent to

24 percent, was yet another example of executive-legislative compromise. The Putin Administration, mindful that each percentage

point reduction equates to 25 billion rubles (approximately $850

million) in foregone revenue, had sought to lower the rate to 25

percent.30 The government proposal called for 8 percent to be allocated to the federal budget and the remaining 17 percent shared

among regional and local budgets, while regions would be allowed

to reduce the rate by up to 3 percent.31 The formula currently in

effect allocates 11 percent to the federal budget, with 19 percent

going to regions and 5 percent to localities. However, some regions

133

32 Ibid. 33Oganes Sarkisov, Taxation of Businesses in Russia: An Update, July 6, 2001. 34Troika Dialog, Duma Spring Term Report, July 2001. 35 Interfax, April 5, 2001. 36St. Petersburg Times, June 19, 2001. 37St. Petersburg Times, June 13, 2001. 38Gref, op. cit.

waive all but a fraction of a percentage point as an investment and

company registration incentive.32

Many in the state Duma, including a majority of the Budget

Committee, had favored setting the rate at 23 percent, while retaining tax privileges and investment incentives opposed by the

Ministry of Finance. Ultimately, the government agreed to split the

difference, settling on the 24 percent rate in exchange for the removal of the investment deduction and other exemptions. Of that

amount, 7.5 percent will go to the federal government and 14.5 percent to the regions, with the remaining 2 percent allocated to local

budgets.33 An incentive provision allowing regions to reduce the tax

by as much as 4 percentage points was also part of the compromise

version that passed.34

Businesses will feel the immediate impact of this changed environment in 2002, as the Finance Ministry estimates the enactment

of the profits tax chapter will reduce the overall tax burden by

some 100 billion rubles, or 1.1 percent of GDP.35 As Steve Henderson, a tax partner at Deloitte & Touche puts it, ‘‘there seems to be

a race on to see how much the economy will move when the profits

tax rate is lowered. Globally, there is a tendency toward more

consumer-based tax regimes. Companies will have more of their

money available to invest and optimize operations.’’ 36 The direct

correlation to investment growth is striking—according to Alfa

Bank, over half (54 percent) of capital investment in Russia is

funded by company profits, while bank financing accounts for only

3 percent.37

And, as Minister Gref points out, the Russian Government will

reap the rewards as well: ‘‘we have taken a long time discussing

this law with our businesses and with the State Duma, and if this

law is passed, it will provide a great stimulus to our economy. We

expect to increase revenue by 1.75 percent of GDP.’’ 38 The importance of the profits tax to the Russian federal budget is depicted

in Figure 3.

CUSTOMS DUTIES

Russia’s customs regime is an area where tremendous progress

has been made but significant challenges remain. The issues described below continue to hamper business activity and compromise

the system’s potential for revenue collection.

Customs duties evasion is a major policy dilemma for the Russian Government as well as for competition in the marketplace.

Tax evasion on goods coming in across the border costs the Russian

Government billions of rubles in lost in revenue. In addition, graymarket imports that avoid paying customs duties are clearly less

expensive than their domestically produced counterparts and legitimate foreign imports. This illustrates yet another example of instances in which companies that comply are competitively disVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00159 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.007 CRS1 PsN: CRS1
134

39 U.S.-Russia Business Council and American Chamber of Commerce in Russia, op. cit. 40Gref, op. cit. 41 Ibid.

advantaged, as the prices of their products obviously reflect higher

importation costs.

As Russia seeks to become increasingly integrated into the global

marketplace, it will have to ameliorate the conditions encountered

in cross-border trading activity: overly complex and contradictory

clearance procedures, ambiguous legislation pertaining to goods

classification, and—most troubling in some respects—the threat of

retroactive reassessment of goods imported many years ago. These

issues introduce additional risks and costs that often alter the commercial terms of the original trade transaction.39

FIGURE 3.—PROFITS TAX REVENUE AS A PERCENTAGE OF FEDERAL BUDGET

Source: Ministry of Finance of the Russian Federation.

Indeed these issues, and a variety of tariff barriers that are out

of sync with international norms, implicate Russia’s accession to

the World Trade Organization (WTO). Their WTO relevance has

provided an impetus to the Putin Administration’s pursuit of customs reform. In January, the Russian Government reduced duties

on one-fourth of all goods coming into the country, a measure that

yielded a 25 percent revenue surge in the first quarter of 2001 compared to the fourth quarter of last year.40

Importantly, the Russian Government has also taken steps to

unify and recategorize import duties, a move that has greatly simplified the quest to comply with customs procedures and may help

reduce both customs corruption and gray-market activity. Minister

Gref has labeled the 30 percent reduction in classification line

items (from 13,500 to 9,500) ‘‘an absolute revolution in customs tariffs’’ that will yield substantial benefits in the battle against corruption.41

Despite these recent accomplishments, much work remains for

Russia to fashion a customs regime that will facilitate—not

hinder—its aspirations to become a full participant in the global

economy. The concrete objectives for the remainder of this year and


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135

42Putin, op. cit. 43OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 129. 44 Ibid., p. 24. 45 U.S.-Russia Business Council and American Chamber of Commerce in Russia, Commercial

Issue Briefs, June 2000.

into 2002 include codification of chapter 26 of part II of the Tax

Code and the adoption of a new Customs Code.

President Putin himself has emphasized the importance of continued customs reform: ‘‘measures have already been taken to simplify and lower the level of import tariffs, but this is insufficient.

A radical change in the system of customs administration is necessary. The main task of the year in this sphere is the approval

of a new Customs Code, moreover as a law that has direct force.

Naturally, the code must correspond to the norms of the World

Trade Organization (WTO), accession to which remains our priority.’’ 42

VALUE ADDED TAX (VAT)

The VAT is intended to be a levy charged to the final consumers

of goods and services, not to firms producing these goods and services. Like the profits tax, its 20 percent rate and other statutory

features make the Russian VAT not terribly unlike European

variants, at least in theory: ‘‘Despite its superficial similarity to

other countries’ VAT laws, however, the Russian VAT does not

function in a manner consistent with a traditional VAT.’’ 43

In order to fulfill its intended purpose, businesses should collect

and pay VAT to the Russian budget at each stage of production,

and it should not be a cost to businesses themselves. Unfortunately, despite last year’s amendments to the VAT Law, this is still

not the case in Russia. Companies continue to grapple with a limited ability to fully credit VAT on purchases, making the Russian

variant, in effect, a tax on production: ‘‘The result is that the effective VAT rate is usually greater than the statutory VAT rate and

becomes a cost to business.’’ 44

For several years, companies in Russia have been required to

charge VAT on all exports to other Commonwealth of Independent

States (CIS) countries. Charging VAT at the point of origin on

intra-CIS trade, unlike the practice in other CIS countries, hinders

the export operations of Russia-based manufacturers and limits investment in Russia, as it decreases Russia’s attractiveness as a

manufacturing base for exports to CIS markets. Russia’s past reluctance to move away from the point-of-origin principle in favor of

the destination principle (having refused to ratify a CIS protocol)

has in part reflected serious concern over revenues derived from

oil, gas and electricity sales Russia’s CIS neighbors.45

Fortunately, as a result of lobbying efforts by both the Russian

private sector and foreign investors, Russia has recently acted to

remedy this problem. Moving to the destination principle for intraCIS trade, effective July 1 of this year, affords Russia the opportunity to encourage manufacturers to build and expand facilities in

Russia to supply CIS markets, thereby deriving the direct economic

benefits of job creation and budgetary revenues.

136

46OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 131. 47 U.S.-Russia Business Council and American Chamber of Commerce in Russia, Commercial

Issue Briefs, op. cit. 48OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 132. 49 U.S.-Russia Business Council and American Chamber of Commerce in Russia, Commercial

Issue Briefs, op. cit. 50 Ibid. 51OECD, The Investment Environment in the Russian Federation: Laws, Policies and Institutions, op. cit., p. 24.

Resolving several remaining issues would make the VAT system

more transparent and therefore better understood by investors. As

a result, businesses would be discouraged from avoiding VAT payments, which would be collected more easily from the end consumer (who has fewer means of tax evasion). Following are several

examples of the difficulties encountered by businesses.

• While last year’s changes contained in part II provide that

VAT is creditable when paid on certain nondeductible business

expenses, such is not the case in practice.46 VAT should be recoverable on all genuine business expenses (e.g., advertising)

irrespective of their treatment for other accounting purposes

(e.g., profits tax calculation).47

• There continues to be a considerable difference between the

provision of VAT refunds in theory and in practice. Business

experience has shown that a legal entitlement to a VAT refund

is not correlated to the timely issuance of that refund, if it is

processed at all. Certain companies such as PSA investors,

start-ups and export-oriented firms encounter great difficulties

in collecting their refunds notwithstanding the unambiguous

provisions in both part I of the Tax Code and the VAT Law.

Prior to last year’s adoption of chapter 21 of part II, interest

did not accrue on the refund amounts due, and firms were not

permitted to offset these refunds owed against other current

tax liabilities. Provisions were introduced beginning in January of this year to address these deficiencies, but they have not

yet been widely tested in practice.48

• Interpretation of VAT-related legislation still lacks clarity and

consistency (e.g., rules pertaining to when cross-border services

are subject to VAT).49

• Finally, because the requirement of moving from a cash basis

to an accruals basis for VAT poses substantial costs to businesses on a cash-flow basis, consideration should be given to

easing the practical burden of this transition.50

ADMINISTRATIVE PROCEDURES

While the Russian Government’s commitment to tax reform is

evidenced by numerous recent improvements in legislation, the application of Russian tax law remains inconsistent and arbitrary.

The OECD highlights three factors that contribute to this situation: a lack of modernization such as computers to track accounts,

inadequate training of tax inspectors, and limited knowledge of

market-oriented tax policy on the part of Russian judges.51 Clearly,

practical measures in these areas could yield substantial dividends.

137

52 Ibid., p. 141. 53 Ibid., p. 141.

In terms of the appeals process, the recourse available to companies is twofold. Firms can pursue an administrative appeal through

channels of higher local, regional and federal authorities, or seek

redress through a court action.52 Because there are no tax courts

per se in Russia, tax disputes involving businesses are currently

addressed in arbitration courts, where companies have been enjoying ever greater success: ‘‘Although precise statistics are not available, it is estimated that taxpayers win over 50 percent of cases involving disputes with the tax authorities.’’ 53

The Russian Government could demonstrate progress in the area

of tax administration by focusing on three key issues:

• The federal government should promote greater consistency by

exercising central control over regional tax bodies that adopt

inconsistent interpretations and apply inappropriate pressure

on firms in their quests for additional revenue. • While this year’s modifications to the VAT regime ameliorated

many previous inadequacies, it has not solved the problems

concerning repayment of excess VAT persist—the tax authorities must take steps to ensure that refunds are available with

minimum delay. • Finally, an effective mechanism for tax appeals outside of the

court process is sorely needed. A central ombudsman or a dispute resolution center would dispense with relatively uncomplicated tax disputes more efficiently and consistently than current administrative practice.

PRODUCTION SHARING AGREEMENTS (PSAS)

Russia’s tax-related progress in support of a viable PSA regime

has lagged behind its counterparts in the tax reform process. Exploiting the current window of opportunity offered by high oil

prices means ensuring that the new Tax Code will work fairly and

efficiently with respect to investors in the energy sector. Specifically, Russian policymakers should follow through on the enactment of the PSA law with specific Tax Code provisions that support

the PSA tax rules.

The Russian Government pledged to introduce the relevant chapter of part II of the Tax Code by June 20. The draft given a first

reading in the state Duma prior to the summer recess, however,

was the Duma’s version, not the draft under development by the

Ministry of Economic Development and Trade. It met with strong

objections by some deputies and executive branch colleagues striving to make the PSA regime operational. It remains unclear whether this Duma draft will be heavily amended or another draft might

be substituted and introduced in the fall session.

It is equally critical that other new chapters of the Tax Code reaffirm, rather than contradict, the tax regime currently contained

in the PSA law. Another possible test looming for the fall session

involves the draft of chapter 27 concerning taxation of natural resource production, which is designed to supercede the mineral replacement tax and certain royalty payments to the Russian Government.

138

54 Ibid., p. 122. 55 Interfax, May 29, 2001. 56 Interfax, June 20, 2001. 57St. Petersburg Times, June 19, 2001.

CONCLUSION

Russian tax reform has a beleaguered history over the past decade, with conflicts within the Duma and between the legislative

and executive branches slowing progress to a near halt for certain

intervals in the 1990s. For the most part, the failure to move more

expeditiously in establishing a fair, stable and transparent tax system has not been caused by a knowledge deficit concerning the

problems and their solutions: ‘‘Russian policymakers and experts

drafted a new Tax Code based on such principles as early as 1993,

but this and subsequent reform initiatives have for many years

been mired in political controversy, both at the federal and regional

level, often becoming hostage to other political bargains.’’ 54

Thankfully, the commercial policy area that has caused businesses the greatest frustration during Russia’s market transition is

now also exhibiting some of the most successful policy initiatives

and concrete accomplishments. The Finance Ministry’s Chief of Tax

Policy, Alexander Ivaneyev, projects that the Russian Government

will push through the final phase of tax reform in 2002, with the

adoption of measures covering property taxes, the use of natural

resources and a single agricultural tax to act as a companion to the

profits tax.55

To be sure, remaining tax, corporate governance and other structural reforms lend a cautionary note to the optimism unfolding in

the business community. But the recent track record on tax reform

may help Russia finally close the chapter on its post-crisis recovery—debates over lingering devaluation dividends and exogenous

factors such as commodity prices notwithstanding—and begin a

new chapter featuring truly sustainable, diversified economic

growth.

According to Peter Westin, chief analyst at ATON Investment

Bank in Moscow, when the income tax set at 13 percent combines

with a profits tax of 24 percent beginning next year, Russia will

suddenly have one of the lowest marginal tax rates in the world.56

And the revenue benefit from increased compliance and overall economic activity could be precisely the boon the Russian Government

needs to help manage its roughly $30 billion debt burden in 2002–

2003. Though the reduction in Russia’s profits tax is not as dramatic, the Irish rate-cutting example of a decade ago helps to illustrate the potential. When Ireland lowered its profits tax to 10 percent for the manufacturing and certain other sectors, its revenues

increased from $655 million in 1991 to $3.7 billion in 2000, with

the profits tax share of total revenue nearly doubling from 8 percent to 15 percent in that time.57

The continuing development of the Tax Code will provide tremendous economic benefits to Russia if it results in a tax system conducive to capital formation rather than one marked by investment

disincentives. The Russian Government would do well to capitalize

on the momentum of the past 18 months and ensure that the guidVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00164 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.007 CRS1 PsN: CRS1
139

ing principle for subsequent draft laws is that they are enacted in

a form that promotes business and investment.

Success will be defined by the extent to which the Tax Code gives

legal force to an equitable system of taxation that treats all businesses fairly. The creation of a level playingfield requires unambiguous laws that achieve their intended tax objectives and are consistently administered.

(141)

PUTIN’S DILEMMA: AUSTERE BUDGETING IN A

POOR STATE

By James A. Duran, Jr.1

CONTENTS

Page

Summary .................................................................................................................. 141

An Impoverished State with Limited Fiscal Resources ........................................ 144

Bargaining Over the Budget ................................................................................... 145

Building Budget Institutions .................................................................................. 147

Reducing Public Expenditures on Housing and Municipal Services ................... 150

Targeting Social Welfare Entitlements .................................................................. 153

Pension Fund Reform Scheduled To Be Enacted in 2001 .................................... 154

Executing Legal Reform .......................................................................................... 155

Raising Educational Standards .............................................................................. 157

Conclusion ................................................................................................................ 159

1 James A. Duran, Jr. is Professor Emeritus of History, Canisius College; Councillor of The

Atlantic Council of the U.S.; an author of the Atlantic Council’s Bulletin originally entitled

Perestroika Update: The U.S.S.R. in Transition, later retitled as The Russian Federation: Political and Economic Update, from 1992 through 1998.

SUMMARY

President Vladimir Putin and the Council of Ministers are pushing an ambitious program to restructure five non-defense institutions inherited from the Soviet era. They are obstacles to Russia’s

transition to a liberal market economy. A change in the basic institutional environment to which the population had become accustomed threatens the welfare of a poor population. Under the centrally planned economy (CPE), a form of social contract emerged.

The ‘‘nanny’’ state managed by a small elite created a broad network of social and economic benefits that provided a high degree

of certainty to the great majority of the citizenry. Employees’ wages

were low, but they received proportionately very high subsidies for

food, housing and municipal services, utilities, sports and cultural

facilities, education, health care, social welfare entitlements, pensions, etc. Since 1991 the challenge to the reformers has been to

restructure the social contract to one based on high wages giving

individual households the right to select the goods and services

they prefer in the market economy. Unfortunately, wages for most

households have remained low while prices for food, consumer

goods, and many services have risen sharply. A majority of households remain heavily dependent on subsidized institutions from the

old order. Russian leaders have hesitated to restructure these obligations in fear of provoking social disorder.

Putin’s dilemma is rooted in the lack of sufficient fiscal resources

to finance major reforms. The combined federal, regional, and local

142

2 Nina Pautola, ‘‘Russia’s External Debt, Solvency and Options for Alternative Capital Inflow,’’

Russian Economic Trends, v. 9, no. 1, 2000, pp. 30–38; Rossiyskaya Gazeta, 12 May 2001, FBIS–

SOV–2001–0514; Russian Economic Developments, no. 96, March 2001, pp. 6–7; John P. Hardt,

Russia’s Paris Club Debt and U.S. Interests, CRS Report for Congress RL30617, updated June

6, 2001; John P. Hardt, Putin’s Economic Strategy and U.S. Interests, CRS Report for Congress

RL31023, June 19, 2001; Vremya MN, June 15, 2001, FBIS–SOV–2001–0615; Andrei

Nesterenko, ‘‘The Modernization Challenge Facing President Putin,’’ Finance and Development,

A Quarterly Magazine of the IMF, vol. 37, no. 3, September, 2000, pp. 1–7; ‘‘IMF Concludes PostProgram Monitoring Discussion on the Russian Federation,’’ IMF Public Information Notice

(PIN) no. 01/68, July 18, 2001.

budgets fall far short of paying current obligations. Though currently enjoying the second consecutive year of growth, the Russian

Federation ranks only at about the level of Mexico in gross domestic product (GDP), i.e., fourteenth in the world. Since 1989 the real

GDP has fallen by an estimated 50 percent. With all levels of government taking about 40 percent of GDP in revenues, raising taxes

to finance further reforms would discourage entrepreneurs from investing in the nascent economy. Seventy-eight percent of GDP

growth in 2000 resulted from increased earnings in energy and primary commodities exports. Budget revenues would drop sharply if

world market prices were to plummet. Aware of this reality, the

central government has pursued an austere balanced budget policy.

In 2000 and 2001 the federal budget amounted to about $42.4 billion. Adjusting for purchasing power parity at the official rate of

exchange, that total would at most be around $170 billion. About

one-half goes to servicing debt, foreign and internal, and financing

the security forces. That allocation leaves little money for funding

the regular internal responsibilities of the federal government. In

2000 funds set aside for regional and local budgets were about 15

percent of GDP, the same percentage as the central government.

As this paper will explain, most regional and local governments

had insufficient resources to finance fully all their functions and in

particular federal mandates inherited from the old CPE system.

Ministers, academics, and analysts warn of a possible fiscal-budgetary crisis in 2003. Foreign debt servicing in that year is scheduled to rise to $18.2 billion, an increase of more than $5 billion

over each of the prior 2 years. If world market conditions deteriorate, the Russian federal budget will need assistance from the

International Monetary Fund (IMF) to sustain even current levels

of spending adjusted for inflation.2

The first two sections of this paper describes the fiscal conditions

of the Russian state and the institutional changes that have taken

place in the procedures for formulating and administering the state

budget. During the Soviet CPE era the budget was secondary to

the annual plan, the parameters of which were decided by a powerful Communist Party elite. Today the Russian Federation budget

determines the cash flows necessary for implementing desired policies. Intense political bargaining by vested interest groups is comparable to the debates that occur in most liberal democratic states.

With the help of bilateral and international agencies, the Russian

bureaucracy at the central federal level has been trained to formulate, execute and audit the revenues and expenditures in a radically different way than was done previously. Focus has now shifted to improving the competence of regional and local officials in the

administration of their fiscal affairs.

143

The succeeding sections of the paper analyze major policy debates on proposals to execute major reforms in five different sectors

that affect the livelihood of every Russian citizen.

(1) A major problem concerns the shift from financing basic expenditures such as housing maintenance, municipal services, and

utilities out of the budgets of local governments to individual

households. During the CPE period only 2 to 3 percent was paid

by the tenants with the rest being provided through state agencies

or enterprises. Much of that burden, amounting to 4 percent of

GDP, was transferred during privatization of enterprises to fiscally

strapped regional and local governments. While tenants now cover

up to 40 percent of charges, the government with lower budgets

and individuals with modest incomes lack resources to do much

more than deal with emergencies. Sixty percent of urban infrastructure has deteriorated so badly that billions of rubles need to

be expended on renovation and new installations.

(2) Another 4 percent of GDP is spent on a broad range of more

than 160 social welfare entitlements for which 47 categories of citizens are eligible regardless of need. Full payment would require an

estimated 22 percent of GDP. The federal government has made

the regional and local governments responsible for funding these

mandates without transferring adequate fiscal means to do so. The

question remains how to reduce the number of these commitments

and focus distribution of funds to the truly needy. An estimated

two-thirds of payments now goes to those above subsistence level.

(3) During this fall’s session of the Federal Assembly, legislation

to reform the old-age pension system funded by the extrabudgetary Pension Fund will probably be enacted. Inspired by the

Chilean model, a portion of each worker’s contributions will be

transferred into a savings account to be invested in bond or stock

funds. With a poorly developed financial services sector, finding

suitable investments represents a major challenge. The combination of very low birthrates and a large relative increase of retirees

constitutes a serious problem. Reform is essential if an already

austere state budget is to avoid an additional rapidly growing fiscal

burden beginning in 7 to 8 years.

(4) The fourth reform is designed to increase the confidence of

the public in the judicial system. President Putin and his government are making the reform of the judiciary and of the Criminal

Procedure Code a high priority and have proposed a large increase

in appropriations in the federal budget for 2002. Funds are sought

to increase dramatically the number of judges by 2003. In addition,

the new lower level of justices of the peace to handle relatively

minor cases is to be rapidly expanded. Such procedures as requiring that judges give prior approval to arrest warrants and the introduction of plea bargaining have the potential for significantly reducing the widespread abuse of prisoners held for long periods in

pre-trial detention centers.

(5) The final reform to be analyzed is the comprehensive restructuring of the educational system from bottom to top. Recent studies

have shown that the Russian work force is significantly less skilled

even than that of the People’s Republic of China. Even with the 50

percent raise proposed in the 2002 budget, teachers’ salaries on average will still be below the official subsistence level. One goal is

144

3 Russian Economic Developments, No. 96, March 2001, pp. 6–7; Nesterenko. op. cit., p. 2,

Padma Desai, ‘‘Putin’s bluff,’’ Financial Times, June 21, 2001, p. 16.

to expand the opportunity for graduates from regular secondary

schools to gain entry into higher education institutions through the

use of vouchers.

Prospects for approving most of the Putin Administration’s programs appear promising. The present state Duma is more supportive of the executive branch’s proposals than were the preceding legislatures during Boris Yeltsin’s two terms as President. There is

broad support for the restructuring of fiscal federalism. Too often

a balanced budget at the center has resulted in passing federal

mandates down to the regional and local levels which lack the

means to pay. Federal authorities who control sources of revenue

have been changing the rules virtually every year. Local officials

bear the brunt of criticism from citizens deprived of what they regard as their just due. Responding to considerable pressure, the

central government published a proposal on August 21, 2001, to set

out in statute a clear division of responsibilities and revenues until

2005. More needs to be done to improve budget practices on the

lower levels of government. Sound administrative practices are

vital when reforms change the institutional framework within

which citizens must live and are being implemented when resources are scarce.

AN IMPOVERISHED STATE WITH LIMITED FISCAL RESOURCES

Russian leaders face a dilemma in that they must operate within

austere fiscal limits. Although Russia encompasses a huge territory

and is richly endowed with natural resources and a relatively literate population of 147 million, the nominal GDP in 2000 was only

about $276 billion calculated at the official exchange rate. Of that

total, state authorities consumed about 42 percent in revenues.

Taxes collected to fund federal budget outlays amounted to 16.2

percent of GDP, regional and local budgets—15.1 percent, and the

four major social insurance funds (The Pension Fund, Social Insurance Fund, State Employment Fund, and Medical Insurance

Fund)—10.8 percent. The federal 2000 budget of $42.4 billion in

nominal terms approximately equals that of Finland. Since many

prices fall below their counterparts in advanced market economies,

estimates of purchasing power parity range from 31⁄2 to 4 times

more than the nominal rate of the ruble on international exchange

markets. The result is a federal budget about $170 billion.3

President Putin and the Council of Ministers understand that

businesses are too heavily taxed. Present exorbitant rates slow economic growth and stimulate off-the-books transactions and capital

flight. The reduction of the personal income tax to a 13 percent flat

rate effective January 1, 2001, has contributed to a 70 percent increase in this source of revenue during the first 5 months of 2001,

although the double-digit inflation of 16 to 18 percent reduced real

gain. On second reading the Duma has approved a reduction of the

tax rate on corporate profits from 35 percent to 24 percent effective

on January 1, 2002. Another measure under consideration is slashing the 29.6 percent combined social insurance payroll tax by a

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4 Ian Cochrane, Vladimir Gidirim, Tim Carty and Zhanna Dobritskays, ‘‘The Russian Tax System: Achievements in 2000 and the Possible Agenda for 2001,’’ Russian Economic Trends , v.

9, no. 3, 2000, pp. 17–21; ITAR–TASS, April 25, 2001, FBIS–SOV–2001–425; ITAR–TASS, April

23, 2001, FBIS–SOV–2001–0423; Kommersant, April 21, 2001, p. 1; Moscow Mayak Radio, June

19, 2001, FBIS–SOV–2001–0628; Rossiyskaya Gazeta, June 26, 2001, p. 1, FBIS–SOV–2001–

0626; Obshchaya Gazeta, June 14, 2001, FBIS–SOV–2001–0613. 5David Woodruff, Money Unmade, Barter and the Fate of Russian Capitalism (Ithaca, New

York: Cornell University Press, 1999), pp. 79–176; ITAR–TASS, May 22, 2001, FBIS–SOV–

2001–0522; Elena Romanova, ‘‘Pension Arrears in Russia: The Story Behind the Figures,’’ Russian Economic Trends, v. 8, no. 4, 1999, pp. 14–24; Sergei Guriev and Barry Ickes, ‘‘Barter in

Russian Enterprises: Myths vs. Empirical Evidence,’’ Russian Economic Trends, v. 8, no. 2,

1999, pp. 6–13; Padma Desai and Todd Idson, Work Without Wages, Russia’s Nonpayment Crisis

(Cambridge, Mass.: The MIT Press), pp. 2–23.

ning a surplus. Obviously, there is risk in supporting this supplyside policy, but incentives are essential in the effort to stimulate

economic growth.4

A reason for Putin’s continued popularity has been his insistence

that pensions and federally budgeted salaries be paid on time.

After years of uncertainty, some stability in household cash flow

represents a significant improvement for the recipients. For years

the state did not collect enough in rubles to cover these outlays. In

1996 nearly half the receipts for the ‘‘consolidated’’ budget, i.e.,

those of the central, regional and local governments, were in the

form of ‘‘mutual offsets,’’ i.e., barter in the form of goods and services, and monetary surrogates such as promissory notes, bills of exchange, local vouchers, etc. In addition, tax evasion was widespread. Cash was scarce. Salaries, wages, and allowances of

budget-funded civil servants and the military fell into arrears.

Delays in paying pensions were partly due to the failure of the government itself to pay the payroll taxes it owed to the Pension

Fund. Simultaneously, legislators pressed hard to increase pensions and salaries to match inflation, but the recipients by no

means received full indexing. Such privatization schemes as the

scandalous ‘‘loans for shares’’ occurred in part because desperate

leaders wanted cash to disburse to employees and pensioners, particularly as elections were approaching. As of July 2001, some arrears to civil servants and the military have yet to be paid.5

BARGAINING OVER THE BUDGET

The contentious but democratic haggling over budget assumptions and spending priorities among representatives of the executive branch, the state Duma deputies, and the Federation Council

senators who represent the regions is in itself evidence of transition to a new political system. Without the approval of the legislature, the budget cannot become law. Bargaining is prolonged since

there has been no disciplined, pro-government majority in the

Duma. Nominated by the President and confirmed by the Duma,

the Premier is primarily the President’s man. Putin’s Council of

Ministers is charged with managing economic and routine internal

affairs. The ministers are chosen not because they are prominent

figures with strong political support in the legislature, but mainly

for their technocratic skills. The Presidential Administration, comparable to the Executive Office of the U.S. President, is divided

into departments which oversee all state activities. The Security

Council and its staff responsible for security affairs, internal and

external, are directly responsible to the President, who chairs its

146

6 Andrei Kunov and Alexei Sitnikov. ‘‘The ‘Constitutional Economy’ of Russia: Political Roots

of Economic Problems,’’ Russian Economic Trends, v. 8, no. 4, 1999, pp. 6–14; Eugene Huskey,

Presidential Power in Russia (Armonk, New York, M.E. Sharpe, 1999), pp. 43–182; Steven S.

Smith and Thomas F. Remington, The Politics of Institutional Choice, The Formation of the Russian State Duma (Princeton, NJ, Princeton University Press, 2001), pp. 27–92, 116–160; Thomas

F. Remington, Politics in Russia (New York, Longman, 1999), pp. 40–57, 124–173. 7 Andrei Kunov and Alexis Sitnikov, ‘‘Economic Legislation of the Duma: The Role of Organizational Structure,’’ Russian Economic Trends, v. 8, no. 2, 1999, pp. 14–21; Interfax, May 3,

2001, FBIS–SOV–2001–0503; Rossiyskaya Gazeta, May 4, 2001, FBIS–SOV–2001–0508; Remington, Politics in Russia, pp. 124–173; The World Bank, Fiscal Management in Russia (Washington, DC, The World Bank, 1996), pp. 41–65, hereafter referred to as Fiscal Management in

Russia, 1996; Russian Economic Trends, v. 6, no. 1, 1997, pp. 9–11. 8 Kommersant, September 15, 1999, p. 2; Kommersant, September 24, 1999, p. 2; Kommersant,

September 25, 1999, p. 2; Izvestiya, October 27, 1999, p. 1; Izvestiya, December 4, 1999, p. 5,

Kommersant, December 4, 1999, p. 4; Rossiyskaya Gazeta, April 17, 2001, p. 3 in FBIS–SOV–

2001–0417; Moskovskiye Novosti, July 17, 2001, FBIS–SOV–2001–717; Remington, Politics in

Russia (New York, NY: 1999), pp. 124–173.

meetings. The ‘‘power’’ ministers running military, police, and intelligence affairs are also directly subordinate to him. Unlike in the

Soviet era, sharp public disputes occur among ministers and members of the Presidential Administration even as bargaining on the

budget is underway with the legislators.6

Leaders of the executive and legislative branches in the past decade have established procedures in the Budget Code for enacting

the annual state budget that basically conform to the standards of

the G–7. They understand that managing cash flows is central to

the implementation of desired policies. The Ministry of Finance is

the principal agency that enters into negotiations with the government departments and agencies as well as with governors of the 89

regions (oblasts, territories, and ethnic republics) composing the

Federation. The President lays out his priorities in the Annual

Budget address to the parliament in June or July. By mid-August,

the Cabinet presents its detailed proposal in the hope that the the

budget will be enacted into law before the beginning of the fiscal

year starting on January 1. The Duma Budget Committee and

other committees on matters that fall under their jurisdictions review the document and make their recommendations. The budget

bill must submit to four readings, one more than usual. The second

and third are the most important. Upon passage, the bill is sent

to the Federation Council for its review and approval by the Senators.7

Diverse coalitions representing various vested interest groups

form and dissolve in the quest for budget commitments. Ministers

engage in tough bargaining to gain support for their policies and

sometimes are forced to make distasteful compromises which often

cause an increase in budget obligations to ensure enactment. Disagreements between the two houses are resolved through a conciliation procedure involving Duma deputies, Senators, representatives of the Council of Ministers and the Presidential Administration. Finally, the President signs the budget into law. At a recent

meeting of the collegium of the Ministry of Finance, Putin complained that 3 months of the fiscal year had passed before the bureaucracy completed all the paperwork authorizing the disbursement of funds in 2001.8

This democratic process, although prolonged, for adopting the

budget sharply contrasts sharply with the document produced by

the highly centralized Soviet system. At that time the state-owned,

comprehensive CPE was directed by a tiny elite, the Communist

147

9Fiscal Management in Russia, 1996, 7–11; James A. Duran, Jr., ‘‘Russian Fiscal and Monetary Policy: A Tough Road Ahead,’’ The Former Soviet Union in Transition, U.S. Congress, Joint

Economic Committee. 103d Congress, 1st Session, S. Print 103–1, February 1993, v. 1, pp. 196– 217; Vremya MN, June 22, 2001, FBIS–SOV–2001–0622.

Party Politburo with its Central Committee secretariat and key

ministers. Priorities were decided in camera. The budget was merely an instrument for implementing the annual economic plan. It

also was a unitary system since the budgets of the lower echelons

of government were incorporated into the final product. A brief annual budget bill was passed by the U.S.S.R. Supreme Soviet after

a pro forma, carefully scripted debate. By mid-1988, Gorbachev’s

reforms freed some sectors of the economy which caused severe fiscal problems and rising inflation. In October the U.S.S.R. Minister

of Finance revealed a major state secret: namely, the Soviet Union

had been running a deficit budget since 1976 and the country had

plunged into a severe fiscal crisis. Records indicate that the deputies in the Supreme Soviet did not seem to understand the profound implications of this revelation. Before the U.S.S.R. dissolved

in December, 1991, this old CPE fiscal system had already collapsed.9

BUILDING BUDGET INSTITUTIONS

In 1991 leaders of the new Russian state faced the awesome task

of building an essentially new set of institutions to manage fiscal

affairs. With IMF assistance particularly since 1995, needed reforms have been put in place in the center which remains in a

dominant position. The Ministry of Finance has been reconstituted

and its staff retrained and expanded to play the central role in

state finances. Only in 1995 did Russia adopt the basic line-item

classification system developed as the standard for members of the

IMF. The Ministry of Economics, currently the Ministry of Economic Development and Trade, prepares medium- and long-term

forecasts, draws up detailed plans and estimates costs of proposed

reforms. Its current head, German Gref, is influential with President Putin. Under the old CPE system corporate managers and individual households did not have to worry about paying taxes to

the government as is customary in market economies. CPE accounting systems were rudimentary and centralized in the Central

Bank of the Russian Federation (Central Bank of Russia or CBR)

or the few specialized state banks. In moving to a market economy,

Russian managers and accountants have become obligated to meet

the rigorous reporting standards required by tax authorities. International accounting standards are scheduled to be fully in effect by

January 1, 2003. An essentially new state Tax Service had to be

established to extract revenue from a population with no taxpaying

tradition. Inspectors have often been harassed or even physically

attacked. Though their salaries are paid by Moscow, they remain

vulnerable to local pressure. Like most federal civil servants in

Russia, they are dependent on regional and local authorities for

housing and municipal services. The state Tax Police were established in part to protect these collectors. The present Duma has

made major market-oriented improvements in the Tax Code, but

debate still continues on revising additional chapters. Many Russian entrepreneurs as well as foreigners conducting business in the

148

10Fiscal Management in Russia, 1996, xxv–xxvi, 83–88; Russian Federation, OECD Economic

Surveys, March 2000 (Paris, France: OECD, 2000), pp. 118–120, hereafter referred to as OECD,

2000; Milka Casanegra de Jantscher, Carlos Silvani, and Charles L, Vehorn, ‘‘Modernizing Tax

Administration,’’ Fiscal Policies in Economies in Transition edited by Vito Tanzi (Washington

DC: International Monetary Fund, 1992), pp. 120–141, hereafter referred to as Fiscal Policies

in Economies in Transition; RFE/RL Newsline, June 22, 2001; Frank Gregory & Gerald Brooke,

‘‘Policing Economic Transition and Increasing Revenue: A Case Study of the Federal Tax Police

of the Russian Federation 1992–1998,’’ in Europe-Asia Studies, v. 52, no. 3, May, 2000, pp. 433–

455. 11 Rossiyskaya Gazeta, July 18, 2001, p. 2, and August 21, 2001, p. 4; OECD 2000, pp. 116–

149; Alexei M. Lavrov, Alexei G. Makushkin, et al., translated by James E. Walker, The Fiscal

Structure of the Russian Federation, Financial Flows Between the Center and the Regions

(Armonk, NY: M.E. Sharpe, 2001), pp. 1–8, 39–43, hereafter referred to as The Fiscal Structure

of the Russian Federation; Jorge Martinez-Vasquez and Jameson Boex, Russia’s Transition to

country will be pleased when comprehensive and relatively stable

regulations governing taxes and taxpayers’ rights have been instituted. As in any market economy, debate will continue as various

interest groups seek to alter the laws to their advantage.10

Recognizing the urgent need for reform, the government as instructed by President Putin published its ‘‘Program for the Development of Budget Federalism for the Period Until 2005’’ on August

21, 2001. A national commission is to prepare legislation for legislative enactment in 2002. The goal is to establish by statute the

specific revenues assigned to regions and the specific programs

which they are obligated to support. While Russia is constitutionally designated as a Federation, the center controls revenue

and has placed mandates on the regions that cannot fully paid

from their funds. Unlike in Western federal systems, the 89 regions

comprising the Federation at present have no separate taxing authority. Nor do local governments whose revenues are included

within the regional unit. The rates of virtually all revenues are set

by laws passed by the central legislature in Moscow. These include

the value added tax (VAT), corporate profits tax, turnover tax, personal income tax, sales tax, excises, export and import duties, levies on natural resources, social insurance contributions, land taxes,

licensing fees, etc. Budget debates in Moscow focus not only on the

rates, but also on the proportions to be allocated to the central

budget and to the 89 regions. Through 2000 the division between

the center and the regions was about 50–50. Recently President

Putin and the Council of Ministers pushed through a 56–44 formula for 2001. On the expenditure side, more than 80 percent of

regional expenditures are mandated by the center. Only by drastically underfunding most social welfare entitlements do lower-level

administrators gain some limited resources to meet emergencies.

About 1.7 percent of GDP is transferred through the Fund for Financial Support of Subjects of the Federation to poor regions that

register claims. Unfortunately, the criteria can be manipulated by

lobbying and do not take into adequate account the economic capacity of the region. Conscientious fiscal administrators are apt to receive the least amount. Thus, the present system of fiscal federalism puts lower officials in a very difficult position. Federal regulations and the outright fiscal unfeasibility of executing them lead officials to resort to informal practices to enhance their resources.

Given the very low salaries paid to civil servants, a degree of corruption is inevitable. For these reasons, major legislation to restructure the federal fiscal system will probably be enacted in

2002.11

149

a New Federalism (Washington, DC: The World Bank, 2001), pp. 1–54, 89–96, hereafter referred

to as Russia’s Transition to a New Federalism.. 12Rossiyskaya Gazeta, May 23, 2001, pp. 1, 3. FBIS–SOV–2001–0523; The Fiscal Structure of

the Russian Federation, pp. 4–6, 59–61; Fiscal Management in Russia (The World Bank, Washington, DC, 1996), pp. 77–78, 159–163, hereafter referred to as Fiscal Management in Russia;

Russia’s Transition to a New Federalism, pp. 51–52. 13Fiscal Management in Russia, pp. 83–88; Moscow News, No. 1–2, January 10–16, 2001, p.

2; A. Premchand and L. Garamfalvi, ‘‘Government Budget and Accounting Systems,’’ in Fiscal

Policies in Economies in Transition, pp. 268–290.

Managing revenues and disbursements efficiently presents a difficult challenge to any government. During the Soviet period, this

task was handled largely through accounts for all state agencies

and enterprises held in the CBR or specialized state-owned banks.

With the role of the CBR being steadily reduced to functions normal in Western market economies, a new institution, the state

Treasury, was initiated in 1993. All revenues were to be deposited

into its accounts and legally budgeted expenditures disbursed to

agencies as authorized by decrees of the Ministry of Finance. By

March, 1995, only 47 of the 74 regional offices were fully operational. Even then, a common electronic system had not been completed. The last regional office was established in Tatarstan only

in March, 2001. During the interim while the Treasury system was

being built, certain private, politically well-connected private banks

were authorized to administer official accounts. Many earned a bad

reputation by using these funds to speculate for private gain. During 2001 the seven regions possessing the largest budget deficits

were placed under special Treasury monitoring. Initial results indicate a dramatic improvement in their fiscal affairs.12

Implementation of a standard system of accounting in all ministries and government agencies has proven to be a time-consuming

task. Cash management, debt management, and procurement, relatively unimportant under central planning, are indispensable to

function in a market economy. By October 1, 2001, the books of the

Ministry of Defense, reportedly the last ministry remaining outside

the system, are supposed to be brought into compliance with Treasury requirements. The dismissal of the Ministry’s Colonel General

of Finance, General Auditor, and General Accountant for incompetence resulted from the installation of the new accounting procedures. These officials could not account for the disappearance in

London of $450 million in hard currency.13

Provision was made in the 1993 Constitution for an Accounting

Chamber headed by an Auditor General for a period of 5 years and

similar in function to the U.S. General Accounting Office. The

newly created office is responsible to the Federal Assembly. Its duties are to conduct budget evaluations and audits. The first Auditor

General was a professional, but, as a moderate Communist, found

himself at odds with the market reformers. He and his staff conducted hundreds of audits involving privatizations but their efforts

failed to reverse any privatizations resulting from breach of contract. Many of the new private owners had violated their contractual obligations to invest and to preserve jobs. Instead, they had

stripped assets for personal gain rather than honoring their contractual obligations to invest and to preserve jobs. Only one prosecution was initiated. In 2000 former premier Sergei Stepashin, a

prominent political figure during the Yeltsin years, became

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14RFE/RL Newsline, June 26, 2001; June 27, 2001; July 3, 2001; and July 10, 2001;

Rossiyskaya Gazeta, November, 15, 2000, p. 2; Kommersant, November 15, 2000, p. 3; Sevodnya, Nov. 9, 2000, p. 5 in The Current Digest of the Post-Soviet Press (hereafter referred to as

CDPSP), v. 52, no. 45, December 6, 2000, p. 14; Noviye Izvestiya, September 29, 2001, p. 2 in

CDPSP, v. 52, no. 39, October 25, 2000, p. 12. 15 ITAR–TASS, July 3, 2001, in FBIS–SOV–2001–0703; Interfax, June 5, 2001, FBIS–SOV– 2001–0605; Vremya MN, June 15, 2001, FBIS–SOV–2001–0615.

trations were to be strictly audited to ensure that government

funds were spent for authorized purposes. His first target was

Kalmykia, one of the most independent acting republics in the Federation. Stepashin has also advocated increasing the powers of the

Auditor-General to include the right to initiate prosecutions for

malfeasance rather than to depend on the independent ProcuratorGeneral (Attorney-General). So far, this suggestion has not been

approved. A proposal by Putin to place the Auditing Chamber directly under the President has not been met with enthusiasm by

many parliamentarians.14

Arguably, the first Russian federal budget that was fiscally

sound was enacted after the financial collapse of August 1998 and

implemented in 1999. The emerging fiscal crisis had precipitated a

rapid turnover of cabinet ministers between 1997 and 1998. Russia

was confronted with the pressing need to reduce expenditures in

order to match the revenues available to the government. Resort to

excessive internal short-term, high-rate borrowing complicated the

problem since the rapidly increasing expenditures outlays to service the debt crippled normal government fiscal operations. The leftdominated state Duma would not agree to sharp cuts in expenditures and other reform measures. After Asian stock markets

crashed and oil export revenues dropped sharply, foreigners lost

confidence in investing in the financial markets of developing countries including Russia. Consequently, the Federation defaulted on

its internal debt obligations and the ruble’s value fell by 80 percent. Without the crash of 1998 deputies in the Duma, particularly

the leftists, would not have been motivated to support the reduction of budget outlays and changes in tax laws. The crash of 1998

served as a harsh lesson to deputies in the Duma. The austere

budget for 1999 proposed by the outgoing Kireyenko government

was enacted into law with their approval. For the first time the

government was able to fund most commitments made in the budget fully without resort to major sequestration or excessive borrowing. The budgets for 2000 and 2001 are in the same category.15

REDUCING PUBLIC EXPENDITURES ON HOUSING AND MUNICIPAL

SERVICES

Despite progress toward fiscal accountability, entrenched institutions inherited from the Soviet period continue to drain precious

funds at an exorbitant rate. President Putin and his ministers are

wrestling with the difficult job of designing a strategy that would

shift part of the costs for financing housing and municipal services

to private consumers. At present, an estimated 4 percent of GDP

from the consolidated federal and regional-local budgets is allocated to cover the expenses for housing maintenance, heating and

water systems, waste disposal, utilities, and public transportation.

Currently, local governments allocate 24 to 34 percent of their

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16Rossiyskaya Gazeta, February 3, 2001, pp. 2, 6, in CDPSP, v. 53, no. 5, February 28, 2001,

p. 9; Trud, February 16, 2001, p. 1, in CDPSP, v. 53, no. 7, March 14, 2001, p. 13; ITAR–TASS,

August 21, 2001, FBIS–SOV–2001–0821; Interfax, August 14, 2001, FBIS–SOV–2001–0815. 17Kommersant, March 20, 2001, p. 8 in CDPSP, v. 51, no. 12, April 18, 2001, p. 8; Vremya

MN, June 1, 2001, FBIS–SOV–2001–0601; Rossiyskaya Gazeta, June 26, 2001, FBIS–SOV–

2001–0626; The Changing Social Benefits in Russian Enterprises (Paris, OECD, 1996); Andrea

Stevenson Sanjan, ‘‘State-Society Relations and the Evolution of Social Policy in Russia,’’ in

State-Building in Russia, The Yeltsin Legacy and the Challenge of the Future edited by Gordon

B. Smith (Armonk, N.Y.: M.E. Sharpe, 1999), pp. 177–199; Linda J. Cook, ‘‘The Russian Welfare

State: Obstacles to Restructuring,’’ in Post-Soviet Affairs, v. 16, no. 4, October–December, 2000,

pp. 355–378; Nigel M. Healey, Vladimir Leksin, and Alexandr Svetsov, ‘‘The Municipalization

of Enterprise-Owned ‘Social Assets’ in Russia,’’ Post-Soviet Affairs, vol. 15, no. 3, July–September, 1999, pp. 262–280.

ing money is barely sufficient to pay the salaries of their employees. Investment in renovation and installation of new infrastructure has remained at a near standstill for a decade because of lack

of funds. An estimated 60 percent of water and district heating systems are worn out and need replacement. Experts predict that

breakdowns such as occurred during winter 2000–2001 in the

North and Far East are likely to multiply in future winters unless

vital funds are made available. If a reform in this sector could reduce the budget burden by 1 percent of GDP, the solvency of regional and local budgets would be dramatically improved.16

This situation is an example of how reform is obstructed by the

unbalanced social contract inherited from the Soviet period. Employees were paid very low wages in cash, but through employers

received proportionately high benefits, i.e., housing and municipal

services, utilities, kindergartens, clinics, restaurants, sports and

cultural facilities, etc., for which they paid only 2 to 3 percent of

costs. That percentage was less than the average household spent

on vodka and cigarettes. The enterprise, ministry, academic or research institute, or other state organization took care of the expenses incurred by their employees, who essentially lived within

‘‘company towns.’’ Capital costs were funded through the annual

plan, not bonds which had to be paid off by real estate taxes. As

major enterprises were privatized and entered into the market

economy, the responsibility for funding many of these facilities and

services were shifted mainly to the jurisdiction of local governments. The latter in 1994 only received one-fourth of the federal

compensation theoretically authorized by privatization laws to

cover the additional budgetary obligations. Many citizens took advantage of the opportunity to privatize their apartments. Unlike in

western condominiums, owners of these apartments have not assumed responsibility for paying basic maintenance and capital expenses associated with their buildings. In most cases local governments continue to bear the responsibility for the most of the costs

incurred. Only slowly have payments made by tenants and owners

risen to cover an estimated 40 percent of the charges.17

The majority of households cannot afford a change in the system

that would raise their monthly bill for housing, municipal services

and utilities by 150 percent. The average monthly wage in 2000

was only 2,268 rubles ($78), which is less than the official subsistence for an adult and child. Increasing salaries would resolve the

problem by enabling the workers to pay for these basic living costs.

Several deputies successfully introduced an amendment to the proposed Labor Code mandating that the legal minimum wage equal

the subsistence level. Aleksandr Pochinok, the capable Minister of

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18 Vremya MN, June 1, 2001, FBIS–SOV–2002–0601. 19 Izvestiya, November 23, 2000, p. 6 in CDPSP, v. 52, no. 47, December 20, 2000, pp. 5–6;

Novyie Izvestiya, December 8, 2000, pp. 1–2 in CDPSP, v. 52, no. 49, January 3, 2001, p. 12;

Kommersant, January 24, 2001, p. 4; Rossiyskaya Gazeta, February 3, 2001, pp. 2, 6 in CDPSP,

v. 53, no. 5, February 28, 2001, pp. 9–10.

Labor and Social Development, cautioned that the government

could not implement this measure in the near future. The additional cost of increasing pay for government-funded employees

would be 800 billion rubles from the federal budget and almost 2.5

trillion rubles from regional and local budgets. That expenditure

would surpass total outlays of the consolidated budgets of all three

levels of government. The compromise version included the mandate, but provided that it would go into effect only after a separate

authorization bill was enacted.18

This complex issue is compounded by the problems of the Russian Unified Energy Systems (UES) and Gazprom, the monopolistic

electricity and natural gas companies who are owed 68 billion rubles by local consumers. Regional and municipal administrators

often have deliberately avoided their responsibilities to cover energy bills and have pressured regional regulators to set the rates

below costs. Even those charges were not fully paid. As a result,

UES power plants, particularly in the North and Far East, lacked

funds for essential coal supplies. Managers of some privatized

mines chose not to ship supplies to generating and heating plants

with overdue debts. So outages occurred in the midst of a hard winter. Successful reform and eventual privatization of the two great

natural monopolies is partly dependent on adjustments in the

housing and municipal services sector.19

No final decision on the strategy for reforming this sector which

affects the household budgets of Russia’s families. On March 15,

2001, the Council of Ministers approved a plan, but on July 5

switched to a ‘‘new model.’’ In the earlier session plans were approved to have the public pay 100 percent of their housing, municipal services, and utilities by 2003. If a family’s payments were to

exceed 22 percent of its total income, then they would be entitled

to a subsidy equal to the amount of payments above a threshold

percentage. The Chairman of the State Committee on Construction,

Housing, and Municipal Services estimated that 30 percent of citizens would be eligible for subsidies. President Putin later said a

majority could apply. Moscow’s deputy mayor immediately objected

to the proposed increase in coverage since the city would be required to spend an additional 18 billion rubles if the new system

were to be in effect. He called for its introduction in 2007 at the

earliest. The governor of Perm Oblast said that subsidies should

begin at 10 to 12 percent of family income. At the Cabinet session

of July 5, a new model gained support. The aim to keep the family

burden under 22 percent was honored and the deadline delayed.

However, direct subsidies to families would be replaced by a transfer of funds already allocated for housing and utilities to building

associations. These groups would then be free to contract with service providers instead of relying on the government-connected types

now in place. This important advance would create competition and

lead to lower charges for building maintenance. Critics point out

that such associations, though provided for in the law on

153

20Kommersant, March 20, 2001, p. 8; Moscow Mayak Radio, July 5, 2001, FBIS–SOV–2001–

0705; ITAR–TASS, 5 July 2001, FBIS–SOV–2001–0705; World Bank, Press Releases, December

21, 2000, March 27, 2001, and June 7, 2001; Rossiyskaya Gazeta, May 30, 2001, FBIS–SOV–

2001–0531; Rossiyskaya Gazeta, May 29, 2001, FBIS–SOV–2001–0529; ITAR–TASS, May 29,

2001, FBIS–SOV–2001–0529; Rossiyskaya Gazeta, May 31, 2001, in FBIS–SOV–2001–0521;

Obshchaya Gazeta, July 12, 2001, FBIS–SOV–2001–0712. 21OECD 2000, pp. 129–136; Moscow News, no. 24, June 21–27, 2000, p. 2; The World Bank,

From Plan to Market, World Development Report (New York: Oxford University Press, 1996),

pp. 77–84; The World Bank, Balancing Protection and Opportunity: A Strategy for Social Protection in Transition Economies, May 3, 2000 (Washington, DC, The World Bank, 2000), pp. 24–

29, 35–40, hereafter referred to as A Strategy for Social Protection in Transition Economies;

Vremya MN, March 14, 2001, p. 5, in CDPSP, v. 51, no. 12, April 18, 2001, p. 8. 22OECD 2000, p. 131.

privatizing housing, are poorly developed and often controlled by

small cliques who exploit their position for private gain. No final

decision has been reached on the question of how to deal with this

controversial issue. Meanwhile, the World Bank and the Russian

Government in the past 6 months have concluded three agreements

to provide $287.5 million for selected projects in housing and municipal services.20

TARGETING SOCIAL WELFARE ENTITLEMENTS

A debate has begun on restructuring the extensive system of social welfare entitlements established by the Soviet regime. The Soviet leadership of the ‘‘workers’ state’’ developed a system of more

than 160 entitlements that operated for seven decades and consumed over 4 percent of GDP. These benefits mandated by the center were paid primarily by regional and local governments at levels

far lower than promised. If the benefits were paid in full, they

would probably cost 22 percent of GDP. Approximately two-thirds

of the population qualified for one or more of the 47 categories.

Payments and costly privileges were awarded to veterans and their

children, pensioners, orphans, disabled, students, families with

many children, rural residents, victims of Chernobyl, victims of political repression, etc. Only about one-third of benefits go to those

individuals who are classified as needy. For example, municipal

bus companies can barely afford to keep their current operations

functioning and are required to permit nearly two-thirds of passengers to ride without charge or at reduced fares.21

Federal transfer payments have been grossly inadequate. After

1991 a key stratagem for reducing central government expenditures was to shift the financial burden down to the fiscally hardpressed regions. Regional leaders tried desperately to restrict the

growth of this burden on them through other means. Laws have

been in force since 1993 explicitly prohibiting the center from devolving responsibility for paying these mandates unless it provided

the funds to pay. However, eligible citizens in 1997 began to bring

suits in the courts against local authorities who refused to pay various entitlements. Typically, the judges ruled in favor of the plaintiffs since the statute governing federal transfers to the regions has

ambiguous language stating that mandates are calculated as part

of the formula for determining the sum to be awarded. The regions

have grudgingly paid when courts so ordered, but overall most of

these entitlements are at best partially honored.22

This whole system of social welfare entitlements needs to be restructured to reduce the number of entitlements and to redefine

154

23Text of Russian president’s annual address to the Federal Assembly, Russia TV, April 3,

2001, Johnson’s Russia List JRL #5185, April 4, 2001, p. 13 (hereafter cited as Putin’s State

of the Union Message); ‘‘Russian Federation President’s Budget Message to the Russian Federation Federal Assembly: On Budget Policy for 2002,’’ Rossiyskaya Gazeta, April 23, 2001, FBIS–

SOV–2001–0425, p. 5, hereafter cited as Putin’s Annual Budget Message; Rossiyskaya Gazeta,

April 24, 2001. FBIS–SOV–2001–0425. 24 Irina Denisova, Maria Gorban and Ksenia Yudaeva, ‘‘Social Policy in Russia: Pension Fund

and Social Security,’’ Russian Economic Trends, v. 8, 1999, no. 1, pp. 12–23; Sevodnya, September 23, 2000, p. 3, in CDPSP, v. 52, no. 39, October 25, 2000, p. 15; Obshchaya Gazeta, November 9, 2000, in JRL #4640, November 27, 2000; Putin’s State of the Union Message, JRL #5185,

4 April 2001, p. 12; Rossiyskaya Gazeta, May 30, 2001, FBIS–SOV–2001–0530; A Strategy for

Social Protection in Transition Economies, pp. 1–28; George Kopits, ‘‘Social Security,’’ in Fiscal

Policies in Economies in Transition, pp. 291–311. 25Sevodnya, March 6, 2001, p. 1, in CDPSP, v. 53, no. 10, April 4, 2001, p. 11; Izvestiya, April

19, 2001, p. 5 in CDPSP, v. 53, no. 16, May 16, 2001, p. 15.

the conditions for eligibility so that the needy are targeted. In his

annual budget message for 2002, the President declared that ‘‘unfunded federal mandates’’ need to be clarified as part of the project

to reform budgetary relations between the center and the regions.

Russian leaders are moving slowly because they understand the political risks when sensitive vested interests are at stake.23

PENSION FUND REFORM SCHEDULED TO BE ENACTED IN 2001

Prospects for enactment of old-age pension reform in 2001 were

good. After much debate, a solid majority of the leadership including the President supported changes in the system to ease the future burden on the state budget. Currently, the extra-budgetary

Pension Fund is receiving 82.5 percent of the 29.6 percent of the

payroll tax levied to support the four social insurance funds. It is

running a surplus. The Fund received about 8 percent of GDP.

Since 1990 old-age pensions have been reduced to approximately

the same level which is below subsistence for recipients regardless

of years in the work force or total contributions as a result of inflation. This pay-as-you-go (PAYG) system would need to be restructured since birthrates have fallen below replacement level for a

number of years. In Russia the ratio of pensioners to workers will

reach a critical stage in 7 to 8 years beyond which the Pension

Fund’s budget will operate at a deficit. That situation would require supplementary appropriations from the federal budget.24

Draft laws for changing the pension system in the medium- and

long-term were scheduled to be enacted in 2001. In March a major

dispute on the structure of the future system erupted at the Cabinet level on the eve of the first meeting of the presidentially appointed National Council on Pension Reform. The director of the

Pension Fund, Mikhail Zurabov, slated to be the rapporteur from

the Cabinet to the Council, differed with the newly defined terms

earlier agreed to by the Cabinet. He wanted to maintain the

present system, altering coefficients to provide a lower rate for pensioners. First Deputy Premier Mikhail Dmitriyev and Economics

Development Minister German Gref with the support of the President agreed to the introduction of a partially savings-based system

in which the Pension Fund would be obligated to turn over some

of its financial flows to investment and management companies. On

May 30 the National Council approved four draft laws and the ministries have begun to draw up detailed bills for consideration by the

Duma in September.25

155

26 Izvestiya, April 19, 2001, p. 5, in CDPSP, v. 53, no. 16, May 16. 2001, p. 15; Vremya MN, July 18, 2001, FBIS–SOV–2001–0718; Moscow News, no. 29, July 18–24, 2001, p. 3. 27Sevodnya, September 23, 2000, p. 3, in CDPSP, v. 52, no. 39, October 25, 2000, p. 15. 28Kommersant, April 20, 2001, p. 4.

Deeply influenced by the Chilean model, the system is predicated

on the principle that the rates of return from investment in stock

and bond mutual funds will yield higher returns in the mediumand long-term to pensioners than has historically been the case

from public systems. Six percent of the social insurance tax paid

by employers is to be transferred to individual pension accounts for

participants under 35 and 2 percent for those aged 35 to 50. Individuals over 50 would not participate in savings-based funds. Since

retirement age is set at 50 for women and 55 for men, their investments would lack time to accrue sufficient resources. Boris

Nemtsov of the Union of Rightists, Grigory Yavlinsky of Yabloko,

and Moscow Mayor Yuri Luzhkov of Fatherland supported the savings account system. They advocated that individuals be given the

right to decide whether to use private pension funds or insurance

companies instead of the services of a ‘‘government broker.’’ The

possible inheritance of the savings account by the worker’s legal

heir is also under consideration. Public opinion polls indicate that

60 percent of those questioned favor the reform.26

Advantages to implementing this updated system were numerous. A huge future burden on the state Budget could be avoided.

The steady flow of cash into investment funds could help provide

the badly needed capital to sustain the development of the financial services sector. National Council members understand that the

present lack of reliable investment options is a major deterrent to

economic growth. The initial investments anticipated early in 2003

will probably be in interest-bearing medium-term state bonds. The

stock markets are still too small to absorb so much money. A higher rate of return on investments in funds would potentially give

latitude to the government to reduce the payroll tax, all of which

is presently paid by employers.27

On April 19, 2001, President Putin submitted a bill to the legislature to tighten the system for administering pensions. Originally,

the Pension Fund was responsible for collecting its own revenues,

but the task was transferred to the state Tax Service on January

1, 2001. Eligibility and disbursements were handled at the regional

level. Unfortunately, some governors have been successful in pressuring lower officials to divert funds from their intended purpose.

Last year regions were given the right by Presidential decree to

transfer power to the central agencies who would determine eligibility and pay pensioners. About 30 regions reacted positively. The

President has now asked that this significant change of policy be

mandatory throughout Russia.28

EXECUTING LEGAL REFORM

At the opening session of the national congress of Russian judges

on November 27, 2000, President Putin stated that a high priority

over the next 2 to 3 years was to strengthen and reform the Russian judicial system. Businessmen needed to be assured that their

property and human rights will be enforced by the courts. Putin asserted that his aim is to adhere to international human rights

156

29 Izvestiya, Nov. 28, 2000, p. 3 in CDPSP, v. 52, no. 48, December 27, 2000, p. 10;

Nezavisimaya gazeta, November 30, 2000, p. 3 , CDPSP, v. 52, no. 48, December 27, 2000, pp.

10–11; ITAR–TASS, May 29, 2001, FBIS–SOV–2001–0529; Vremya MN, June 21, 2001, FBIS–

SOV–2001–0622; Moskovskiye Novosti, 26 June 2001, FBIS–SOV–2001–0628; Gordon B. Smith,

‘‘The Disjuncture Between Legal Reform and Law Enforcement, The Challenge Facing the PostYeltsin Leadership,’’ in State Building in Russia, The Yeltsin Legacy and the Challenge of the

Future, pp. 101–122. 30 Izvestiya, Nov. 28, 2000, p. 3, in CDPSP, v. 52, no. 48, December 27, 2000, p. 10; RFE/

RL Russian Political Weekly, vol. 1, no. 18, July 2, 2001, p. 7. 31Sevodnya, Nov. 28, 2000, p. 5 in CDPSP, v. 52, no. 48, December 27, 2000, p. 10;

Moskovskiye Novosti, June 26, 2001, FBIS–SOV–2001–0628.

standards. He cited inadequate funding of the courts as ‘‘a cause

of miscarriages of justice’’ and the arbitrary hearing of cases by

overworked judges. On June 28, 2001, 4 bills on judicial reform

passed the first reading in the Duma with more than 380 votes for

each. During the second reading the debate will focus on the limits

to be set on the tenure of judges. The goal is to implement the reforms by 2004.29

The courts are overburdened. Sixteen thousand judges heard

more than 5 million civil cases, more than 1 million criminal cases,

and 2 million administrative cases in 2000. Judicial workloads

have tripled in the last 6 years. One thousand judges are being

added in 2001. Though the federal government pays their salaries,

judges and their staffs remain dependent on regional and local authorities for professional facilities, housing, municipal services and

utilities. Putin proposes to terminate the requirement that judicial

appointments be cleared with regional officials. Many judges are

holdovers from the Soviet period and have not proven to be willing

or able to keep up with the rapid legal changes that have occurred

since then. The 1970s administrative code for the courts, though

much amended, is still in force.30

The dramatic increase in spending to finance the judicial system

in 2001 is a strong indicator that the Putin Administration is serious about enhancing the courts’ credibility. At 11 billion rubles

($367 million) in 2001, the request for 2002 is reportedly for 18.8

billion rubles ($630 million) in 2002. In addition to monies from the

regular budget line, additional sums are to be drawn from the

extra-budgetary Federal Targeted Program for the Development of

the Judicial System to be funded at the level of 44 billion rubles

($1.5 billion) over the next 4 years. Unfortunately, administration

of the court system’s budget still remains under the jurisdiction of

the Ministry of Justice which raises the question of separation of

powers. The judges prefer that responsibility be transferred to the

Supreme Court’s Administrative Department to ensure the independence of the judicial branch.31

When Putin withdrew proposed amendments to the Criminal

Procedural Code requiring prosecutors and security agencies to

seek an arrest warrant from a judge before taking an accused into

custody, critics viewed his decision as evidence of a return to authoritarian ways. The President justified his retreat by noting such

legislation would necessitate adding 3,000 judges and 6,900 court

employees at a cost of 1.5 billion rubles ($50 million) to implement

the new court procedures. The amendments have since been reintroduced over the strong objections of the Prosecutor-General,

Minister of Interior, and head of the Federal Security Agency.

157

32Sevodnya, January 23, 2001, p. 5, and Novyie Izvestiya, Jan 24, 2001, p. 1, both in CDPSP;

v. 53, no. 4, February 21, 2001, pp. 5–6; Kommersant, April 4, 2001, pp. 1–2; Moskovskiye

Novosti, June 26, 2001, FBIS–SOV–2001–0628. 33 Nezavisimaya gazeta, November 30, 2000, p. 3 in CDPSP, v. 52, no. 48, December 27, p.

10; Mayak Radio, June 28, 2001, in FBIS–SOV–2001–0628. 34Trud, October 18, 2001, p. 1, in CDPSP, v. 52, no. 43, November 22, 2000, p. 16; Sevodnya,

September 28, 2000, p. 6, in CDPSP, v. 52, no. 41, November 8, 2000, p. 20; ITAR–TASS, May

24, 2001, FBIS–SOV–2001–0524; Nezavisimaya gazeta, May 4, 2001. p. 4 in CDPSP, v. 53, no.

19, p. 4; Rossiyskaya gazeta, June 23, 2000, p. 9, in CDPSP, v. 52, no. 27, August 2, 2000, p.

8; Sevodnya, September 1, 2000, pp. 1, 3 in CDPSP, v. 52, no. 35, September 27, 2000, p. 14;

Sevodnya, September 28, 2000, p. 6 in CDPSP, v. 52, no. 41, November 8, 2000, p. 20; Novye

Izvestiya, August 9, 2000, p. 12, in CDPSP, v. 52, no. 32, September 6, 2000, p. 12; Hidden Challenges to Education Systems in Transition Economies, (Washington, DC; The World Bank, 2000),

pp. 2–5, 13–27.

Putin has also announced his support for introducing jury trials

throughout the country to be effective by January 1, 2003.32

Other measures to strengthen the judicial system have not fared

well. The President has complained about the unsatisfactory performance of the marshals (bailiffs), still under the Ministry of Justice, in enforcing decisions. The new justice of the peace courts designed to handle a large number of relatively minor matters have

been established in only five regions in the first year. While the

center is responsible for their salaries, the regions are supposed to

pay for office and hearing facilities as well as housing and municipal services. Putin has now proposed to take the whole justice-ofthe-peace system out of the jurisdiction of regional authorities and

included funds for this drastic step in the 2002 fiscal year.33

RAISING EDUCATIONAL STANDARDS

A comprehensive plan to restructure the educational system from

preschool through the university level is being implemented. While

Russians are a very literate population, the quality of education

has fallen behind that of advanced countries. Findings of a study

for the World Bank released in August, 2000, revealed that students in the former Soviet-dominated bloc now receive on average

5 years less education than is the norm for the Organization for

Economic Cooperation and Development (OECD) states. A study

frequently cited by Russian sources concludes that the proportion

of the Russian work force rated as highly skilled is now less than

10 percent compared with China at 28 percent, the United States

at 42 percent, and Germany at 54 percent. More than 1.5 million

Russian children between 7 and 15 are not attending school and 15

to 20 percent have low reading and writing skills. Another 36 percent are in schools operating in multiple shifts, which means that

school days are short and extra-curricular activities are minimal.

Vocational education programs and access to computer training are

urgently needed as well as modern equipment and qualified teachers. Since 1991 per capita spending for public school students has

dropped by 38 percent. Only 3.2 percent of GDP is allotted to education.34

In August 2000 the Council of Ministers approved the recommendations for school reform over the next decade presented by

Yaroslav Kuzminov, rector of the Higher School of Economics.

Based on British models the plan is to extend general education

from 10 to l2 years for all students and to upgrade the quality of

instruction. After the tenth grade they will be assigned to collegepreparation or vocational-education tracks. All curricula are to be

158

35Rossiyskaya Gazeta, June 23, 2000, pp. 8–9, in CDPSP, v. 52, no. 27, August 2, 2000, p.

9; Novye Izvestiya, Aug. 9, 2000, p. 4, in CDPSP, v. 52, no. 32, September 6, 2000, p. 12;

Sevodnya, September 28, 2000, p. 6, in CDPSP, vol. 52, no. 41, November 8, 2000, p. 20; Trud,

October 1, 2001, p. 1, in CDPSP, v. 52, no. 43, Nov. 22, 2000, p. 16. 36Sevodnya, February, 28, 2001, p. 2 in CDPSP, v. 53, no. 9, March 28, 2001, p. 13; Trud, April 20, 2001, p. 7 in CDPSP, v. 53, no. 19, June 6, 2001, p. 5; Trud, September. 21, 2000,

p. 7 in CDPSP, no. 52, no. 39, October. 25, 2000, p. 16; Obshchaya Gazeta, August 16, 2001,

FBIS–SOV–2001–0819.

revamped with more options for students. One goal is to connect

all schools to the internet over the next 4 years. Extensive retraining programs will be required for teachers, e.g., 276,000 in information technology alone. Vocational-technical education should be upgraded in equipment and instruction. Kuzminov advocates the doubling of budget expenditures from the present 3.2 percent of GDP.

He warns that the People’s Republic of China will overtake Russia

in trained professionals if a greater commitment is not made.35

Such a thorough transformation inevitably encounters hostility

and widespread opposition. On February 27, 2001, a demonstration

organized by the teachers’ union reportedly drew 300,000 protesters to demand payment of back pay which averaged 3 months in

arrears and a 50 percent increase in salary. The average pay of

teachers is below the minimum subsistence standard set at 1,285

rubles ($43) per month on January 1, 2001. The Deputy Premier

responsible for the sector promised to pay promptly any arrears

overdue for more than 1 month and to raise salaries in the first

6 months of 2002 by 20 percent. She claimed that the government

lacks the resources to pay teachers as much as other budget-funded

employees. Salaries are funded by the center. Municipal services

including utilities, many supplies and school buildings, i.e., twothirds of educational expenditures, are the responsibility of regional and local governments. Provision has been made to raise

teachers’ pay by 50 percent in the proposed 2002 federal budget.

That will not calm all their worries about change. Equally striking

was the signature of 1,988,232 teachers in a petition opposing proposals to restructure the educational system from top to bottom in

February. Many fear that the new system will deprive their own

children of a chance for higher education by sharply reducing the

number of student stipends.36

The rectors of most universities are bitterly against the implementation of proposals that will affect their institutions’ admissions procedures and financing. The rector of the prestigious Moscow State University stated bluntly: ‘‘Our triumphant system of

higher education must not be put under the complete control of the

‘invisible hand of the market.’ ’’ In his State of the Union message,

Putin endorsed new policies designed to increase opportunity for

young people of humble origin living in the provinces. Differentiation by social class already exists as 82.5 percent of students at

prestigious universities come from a small number of elite secondary schools. Only 6.5 percent are from ordinary public schools. The

old Soviet system of admissions still dominates whereby each higher education institution designs and administers its own tests for

admission. Since most state institutions give the entrance tests

only once per year in the city where they are located and on the

same day, failure to attend means postponing entry into higher

education for a year, taking a second test offered later by a less

159

37 Nezavisimaya Gazeta, September 1, 2000, p. 15, in CDPSP, v. 52, no. 35, September 27,

2000, p. 14; Moskovskiye Novosti, no. 47, November 28–December 4, 2000, p. 19 and Noviye

Izvestiya, December 8, 2000, p. 2, both in CDPSP, v. 52, no. 49, January 3, 2001, p. 14; 3 articles

in Kommersant, April 26, 2001, p. 8, in CDPSP, v. 53, no. 19, June 6, 2001, pp. 1–3;

Nezavisimaya Gazeta, September 1, 2000, pp. i, 3 in CDPSP, v. 52, no. 35, September 27, 2000,

pp. 14–15; Izvestiya, January 27, 2001, p. 5 in CDPSP, v. 53, no. 4, February 21, 2001, p. 16. 38Kommersant, June 23, 2000, p. 8 in CDPSP, vol 52, no. 27, August 2, 2000. pp. 8–9;

Moskovskiye Novosti, no. 47, November 28–December 4, 2000, p. 19 in CDPSP, v. 52, no. 49,

January 3, 2001, p. 14; Kommersant, April 26, 2001, p. 8 in CDPSP, v. 53, no. 19, June 6, 2001,

pp. 1–2. 39Rossiyskaya Gazeta, June 23, 2000, pp. 8–9 in CDPSP, v. 52, no. 27, August 2, 2000, p.

9; Kommersant, April 26, 2001, p. 8, Nezavisimaya Gazeta, May 4, 2001, p. 3 and Trud, April

20, 2001, p. 5, all three in CDPSP, v. 53, no. 19, June 6, 2001, pp. 1–2, 4–5.

prestigious institution, entering the workforce with poor qualifications, or going into the military. The Ministry of Education has initiated a pilot project to give a national high school graduation/college admission exam comparable to the U.S. Scholastic Aptitude

Test (SAT) which is to be conducted by outside examiners at 20

sites in each of three regions. Opportunities to collect substantial

fees for special tutoring and bribes to influence decisions on admissions may be considerably reduced.37

Even more threatening to the rectors is a radical initiative to

issue full or partial tuition vouchers to the best achievers on the

national examination. These students will be able to take their

vouchers to any institution of higher education of their choice. Provision will be made for living allowances to children from poor families. Those not qualifying for vouchers will have to pay their own

way. As is the case now, those possessing dollars are likely to gain

entry. Whether or not an institution flourishes will depend to a significant degree on the competition to attract students with vouchers.38

The acquisition of resources to maintain higher education standards has been a serious problem for rectors since 1991. State funding for higher education amounts to only 0.6 percent of GDP. That

sum compares unfavorably with 5.2 to 5.5 percent allotted in

France, Germany and the United Kingdom. The state will continue

to fund salaries, the physical plant, utilities and equipment on

campuses. In addition, the rectors will be encouraged to raise

money from private sources with the state offering matching

grants. Already substantial sums have been acquired from the private sector by renting out facilities or winning research contracts.

Now the government is mandating that these revenues be reported.

It is hoped that 50 percent of operating revenues will eventually

come from non-governmental sources as well as individual students

paying their whole tuition. Budget resources are unlikely to increase significantly in the next few years.39

CONCLUSION

As explained in this paper, the Putin Administration is engaged

in executing an ambitious agenda of reforms targeted at overcoming institutional obstacles inherited from the Soviet CPE era.

Budget resources will remain very scarce in the years immediately

ahead. Some changes, e.g., reduction of subsidies in the housing

and municipal services sector as well as social welfare entitlements

would recast basic elements of the old social contract still in place.

Restructuring the pension system is imperative to lessen the future

160

burden on the Federation budget and to channel the flow of much

needed resources into the financial services sector. Strengthening

a reformed judicial system is taking place and the charge will be

a relatively light burden on the Treasury. An expensive upgrading

of the quality of education is essential for Russia to be competitive

with G–7 states in global markets and to sustain economic growth.

Unlike in the early years of the transition, a system of institutions for the sound management of fiscal affairs now exists at the

federal level. Even without a formal agreement with the IMF,

sound budget policies are being implemented. Too often the center

has achieved the macro-economic goal by shifting financial responsibility for support of federal agencies, including the military and

social welfare entitlements, to lower levels of government. Simultaneously, the center has repeatedly changed the share of revenues

assigned to subordinate authorities which lack the means required

to pay obligations in full. This uncertain situation makes the implementation of sound budget practices difficult and often impossible.

Inevitably, governors and mayors are accused of arbitrariness as

they reduce payments to match available funding. Under considerable political pressure the Putin Administration in August, 2001,

proposed a legislative act to distinguish the responsibilities belonging to the center and those to the regions and local governments.

The agency responsible for a particular function should be able to

fund it from its own resources. In addition, the division of revenues

should be set until 2005 to make possible reasonable budget management.

The President and his ministers understand that the key to retaining the support of a majority of the population for market reforms is dependent on significant improvements in the standard of

living. The ‘‘socially oriented’’ 2002 budget proposal submitted to

the state Duma has at its core a dramatic increase in the salaries

of civil servants and the military by 50 to 70 percent. However,

households will have to expend part of their higher income on increased charges for housing maintenance, municipal services, and

utilities. As these expenses are phased in, expectations of the public about the proper responsibilities of the state will likely change

to be comparable to those in the ‘‘social market’’ societies of Western Europe. Such a trend is positive for the interests of the United

States.

(161)

RUSSIAN DEFENSE SPENDING

By Christopher J. Hill 1

CONTENTS

Page

Summary .................................................................................................................. 161

Introduction .............................................................................................................. 162

The Russian Defense Budget .................................................................................. 162

Defense Spending Outside the Official Defense Budget ....................................... 166

Trends in Defense Spending ................................................................................... 167

The Allocation of Russian Defense Spending ........................................................ 169

Allocation by branch of service ........................................................................ 169

Allocation by function ....................................................................................... 171

Financial Aspects of Weapons Production ............................................................. 174

The Defense Burden ................................................................................................ 175

Defense Spending in Dollars ................................................................................... 176

Prospects ................................................................................................................... 177

1Dr. Hill has worked in a number of government offices in the United Kingdom. He is currently head of the Defense Economics branch of the Ministry of Defense (MOD). His doctorate

is from Manchester University.

SUMMARY

The published Russian defense budget is an inadequate guide to

the country’s total defense spending because many items which

would be incorporated in any Western calculation are ignored. The

true level of outlays last year was approaching twice the acknowledged figure.

Despite an increase of around 16 percent after inflation in the

last 2 years, overall defense expenditure in 2000 was well under 40

percent of that in 1992 and just 15 percent of that of the Soviet

Union at its 1988 peak. Moreover, last year almost three-fifths of

the money was spent on personnel, leaving a hopelessly inadequate

level of funding for weapons research, development, procurement

and maintenance. As orders for new weapons have dried up, defense industries have been hard hit and many, perhaps most, are

now by any normal measure bankrupt.

Russia devotes well over 5 percent of its gross domestic product

(GDP) to defense, twice the North Atlantic Treaty Organization

(NATO) average, but because of inadequate accounting procedures,

both the political and military leadership is of the view that the

burden is under 3 percent. Total defense outlays in 2000 were

equivalent to around $50 billion, the third largest in the world.

The Russian Government hopes to double Defense Ministry

spending per serviceman by 2005 and to triple it by 2010. Despite

plans for substantial cuts in the size of the armed forces, these

goals are unlikely to be realized. The overall weapons inventory

162

will fall during the rest of this decade. Only thereafter will capability gradually improve.

INTRODUCTION

This paper looks at the financial resources which the Russian

Government has made available for defense over recent years. It

examines what the authorities in Moscow have themselves said

about the level of such spending and assesses the comprehensiveness and reliability of those statements. Alternative ruble valuations are then offered as well as a judgment on the likely real

trend in defense outlays once inflation has been taken into account.

This is followed by some thoughts on the allocation of those funds

both by branch of service and by function. After a short digression

on the financial state of Russia defense industries, the report returns to its main theme, exploring the burden defense spending

currently places on the Russian economy, comparing that both with

the past and with other countries. In recognition of the problems

many readers have with the use of rubles, an attempt is also made

to convert Russian military spending into dollars via specially constructed ruble-to-dollar defense exchange rates. Finally, the piece

offers a scenario for defense spending over the next decade and

considers whether it will be sufficient to support any major resurgence in military capability during that period.

THE RUSSIAN DEFENSE BUDGET

Every year Russia compiles a defense budget. There are extensive discussions over available funding and priorities within the

Ministry of Defense (MOD) and between that organization and both

the Presidency and the Ministry of Finance before the government

determines its spending plans, usually in the summer or fall. The

figures are then submitted to the Duma where they are subjected

to close scrutiny and in some years substantially revised. With the

calendar and Russian fiscal years coinciding, the aim is to secure

final approval of the budget before the end of December though

this has not always been achieved.

Table 1 shows the defense budget allocation approved by the

Duma in each of the last 10 years. Massive increases have occurred

in all but 1 year, with an average annual rise over the entire period in excess of 100 percent.

Unfortunately, the funding actually given to the MOD, now usually published on a monthly basis, rarely bear much relation to the

figures in the original budget. Outlays have regularly been revised,

formally or informally, during the course of the year because of

changed expectations on inflation, problems in securing budget revenues or altered perceptions of MOD requirements. This change

has not always been in the same direction. In 1998, for example,

the budget allocation was 81.8 billion rubles but, with the economy

in trouble, the MOD was ultimately allowed to spend only 65.1 billion rubles. The following year the defense budget as approved by

parliament foresaw outlays of 93.7 billion rubles but this was later

increased to 109 billion rubles while the final count showed that

over 116 billion rubles had actually been spent. In 2000 the budget

was revised upward from 143 billion rubles to 154 billion rubles

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and outlays finally topped 190 billion rubles. Annual budget outlays for all years since 1992 and monthly outlays for 1998 through

2000 are given in Tables 2 and 3.

TABLE 1.—THE OFFICIAL DEFENSE BUDGET 1992–2001

[In billions of rubles]

1992 .......................................................... R0.384

1993 .......................................................... 3.116

1994 .......................................................... 40.626

1995 .......................................................... 48.577

1996 .......................................................... 80.185

1997 .......................................................... 104.300

1998 .......................................................... 81.765

1999 .......................................................... 93.702

2000 .......................................................... 143.000

2001 .......................................................... 218.924

TABLE 2.—OFFICIAL DEFENSE BUDGET OUTLAYS, 1992–2000

[In billions of rubles]

Year Approved defense

budget allocation

Reported final defense budget outlays

Under/overspend

in percent

1992 ............................................... R0.384 R0.855 +123

1993 ............................................... 3.116 7.210 +131

1993 Revised ................................. 8.327 7.210 ¥13

1994 ............................................... 40.626 28.028 ¥31

1995 ............................................... 48.577 47.800 ¥2

1995 Revised ................................. 59.379 47.800 ¥20

1996 ............................................... 80.185 63.900 ¥20

1997 ............................................... 104.300 79.700 ¥26

1997 Revised ................................. 83.000 79.700 ¥4

1998 ............................................... 81.765 65.100 ¥20

1999 ............................................... 93.702 116.800 +25

1999 Revised ................................. 109.000 116.800 +7

2000 ............................................... 143.000 190.800 +33

Even when these adjustments have been carefully noted, headline figures on defense spending are of themselves of limited worth

without clear evidence on their coverage and composition. After

decades during which Moscow effectively refused to provide any

meaningful commentary on, or justification for, its claimed level of

outlays, glasnost led to a gradual opening of the database and by

the mid-1990s intended expenditure in a whole range of subcategories was being published. The analysis this generated from

both Russian and overseas scholars appears, however, to have

alarmed some in the Kremlin and thereafter tighter censorship was

exercised. Last year the initial allocation for all of the activities of

the MOD and for the Ministry of Atomic Energy’s work on nuclear

weapons were together summed up in just four published line

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items. Funding for maintenance of the armed forces and for military procurement was put into appendices which were classified.

No information has been supplied on how final spending levels differed from those planned even in the broadest categories.

TABLE 3.—OFFICIAL DEFENSE BUDGET OUTLAYS BY MONTH, 1998–2000

[In billions of rubles]

1998 1999 2000

Monthly

outlays

Total to

end of

month

Monthly

outlays

Total to

end of

month

Monthly

outlays

Total to

end of

month

January ............................. R3.7 R3.7 R3.0 R3.0 R11.6 R11.6

February ........................... 3.6 7.3 4.3 7.3 10.2 21.8

March ............................... 3.6 10.9 9.0 16.3 20.1 41.9

April ................................. 4.0 14.9 8.3 24.6 14.0 56.0

May .................................. 2.5 17.4 7.9 32.5 14.1 70.1

June .................................. 4.8 22.2 8.1 40.6 12.1 82.2

July ................................... 2.5 24.7 8.7 49.3 9.8 92.0

August .............................. 3.5 28.2 8.6 57.9 16.9 108.9

September ........................ 5.4 33.6 13.1 71.0 12.5 121.4

October ............................. 5.5 39.1 12.9 83.9 22.8 144.2

November ......................... 8.7 47.8 9.6 93.5 19.5 163.7

December ......................... 17.3 65.1 22.6 116.8 27.1 190.8

After an outcry from deputies in the Duma and others, this policy of concealment was partially reversed for the 2001 budget and

the breakdown of intended expenditure was made available (see

Table 4).

Although a significant advance over the previous year, the 2001

budget still leaves over one-third of the defense budget expenditure

unexplained. The vast majority of the money is almost certainly intended for the state defense order which covers primarily the research, development and procurement of weapons and spare parts.

However, detailed information in this area remains classified.

There has been no revival of the data provided through 1997 on the

percentage allocation of procurement spending by branch of service

and the costs of individual weapons programs are rarely mentioned. Moreover, comparisons with earlier years are difficult because of structural changes. As the government eventually, and reluctantly, conceded, most of the apparent rise in defense spending

in 2001 is the result of nothing more than a decision to fund international peacekeeping activities, military reform and the railway

troops out of the defense budget rather than, as previously, other

parts of the government budget. Nor are such structural changes

unique to this year. In 1995, for example, some hitherto

unacknowledged research and development outlays were transferred for the first time into the defense vote. Then, in 1998, military pensions were moved in the opposite direction, a decision

which explains most, though not all, of the apparent decline in

nominal planned spending in that year. In 2000, part of the MOD’s

165

civilian pay bill was apparently met from outside the defense budget though whether this continued in 2001 is unclear.

TABLE 4.—THE OFFICIAL DEFENSE BUDGET, 2001

Budget line item Billions of

rubles

Percentage

allocation

Personnel maintenance ...................................................... R91.6 41.8

Monetary allowances including wages for civilian

personnel ............................................................... 62.5

Food ........................................................................... 17

Uniforms .................................................................... 3.6

Holiday pay and assignments for health care ......... 3

Benefits and compensations ..................................... 1.4

Combat training and logistics ........................................... 37.51 17.1

Housing maintenance and repair .............................. 15.9

Payment for and storage of special fuels ................ 12

Transportation ............................................................ 5.7

Maintenance, operation and repair of property and

installations .......................................................... 1.8

Other expenditures ..................................................... 1.9

Atomic energy program ...................................................... 5.129 2.3

Mobilization and reserve training ...................................... 2.277 1.0

CIS collective security and peacekeeping .......................... 2.715 1.2

Education and health care expenditures ........................... 2.15 1.0

Insurance guarantees ......................................................... 1.5 0.7

Central military command .................................................. 0.912 0.4

Defense industries .............................................................. 0.302 0.1

Other (unspecified) ............................................................. 74.829 34.2

Total defense budget ........................................ 218.924 100

Although the Ministry of Finance has in recent years exercised

considerable power over the amount of money actually released to

the MOD through the defense budget, it seems thereafter to have

had little ability to monitor its usage. The MOD has operated

through special accounts in the Central Bank of the Russian Federation (Central Bank of Russia or CBR) to which others have had

little, if any, access. Funds have been switched between objectives

with minimal consultation or transparency, opening the MOD to

accusations of non-accountability, corruption, waste and political

manipulation. The Ministry of Finance has been trying to wrestle

control of detailed defense budget spending from the generals since

at least 1997 but only over the past year has its campaign begun

to bear fruit. President Putin has now, against the MOD’s wishes,

insisted that in future all of the Ministry’s payments must be processed by federal treasury bodies which will be expected to ensure

that monies are spent only in accordance with the budget law. To

assist them a new budget code and stricter accounting practices are

being introduced. The appointment in March 2001 of Lyubov

Kudelina, an economics graduate with over 20 years’ experience in

the Finance Ministry, as a Deputy Defense Minister with special

responsibility for budgets and finance, is clearly meant to underline

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2The Moscow city government has, for example, funded major overhaul work on Russian

naval vessels.

the new order. It is, however, too early to say how effective in practice will be the intended tighter financial management.

DEFENSE SPENDING OUTSIDE THE OFFICIAL DEFENSE BUDGET

Russian tallies of final defense spending, though of more value

than the figures contained in planned budgets, still present an inadequate picture of the true level of outlays. This is because the

government in Moscow operates on a very different definition of

what constitutes defense spending than the one adopted by NATO

countries. Expenditure on many of Russia’s military personnel is

not found, as it would be in the west, in the defense allocation but

rather in other parts of the state budget. Examples include internal

security troops, the federal border guard, the presidential guard,

the federal security service, those forces formally designated for the

protection of the Russian federation and, until this year, railway

troops. In total these organizations contain well over 500,000 people and deploy significant numbers of aircraft, helicopters, armored

combat vehicles, artillery pieces and patrol craft.

Other elements of defense spending are also located in supposedly civilian component of the state budget. These include: research and development work of specific military interest funded

through the basic science and research vote; subsidies for defense

enterprises and defense related construction as well as support for

many defense related so-called presidential programs, met through

the industry, energy and construction budget; money for conventional arms control and non-proliferation, including for the destruction of chemical weapons, treated separately in the state budget;

subsidies to defense industries paid through the allocation to closed

territories; national defense costs defrayed through provision made

to the federations; military courts paid for out of the justice budget;

and, as already mentioned, military pensions.

There are also a number of off-budget sources of defense spending. Oblasts and cities have on occasions provided direct financial

assistance for local defense enterprises and military units 2 while

the factories themselves sometimes subsidize weapons production

and repair out of the proceeds of their civilian activities, often, it

should be said, from ignorance of true costs. Some money earned

from the export of military equipment is also plowed back into defense, in particular spending on research and development of new

technologies. In December 2000 Leonid Safronov, Deputy Minister

of Industry, Science, and Technology, announced that the government planned to impose a duty of 6.5 percent on military exports.

The money thus obtained would then be divided up among new

promising projects. The MOD earns significant sums of money by

hiring out soldiers to local authorities and civilian enterprises, by

leasing property and by selling second hand equipment, including

weapons. These funds are then used to supplement the central government’s budget allocation. Again, both the MOD and defense factories engage in barter deals, many of whose details are probably

not even reported to the center, and borrow funds at extremely soft

interest rates. And, finally, the MOD saves much money by delayVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00192 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.009 CRS1 PsN: CRS1
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ing payments as long as possible, thus ensuring, at a minimum,

that intervening inflation will reduce the real value of the debt

while hoping that the central government will ultimately assume

responsibility for meeting the obligations. The latter ploy has

proved highly successful. In late 2000 the government agreed to

take over from the MOD responsibility for debts it had incurred to

the defense industries.

The total value of off-budget defense spending is very difficult to

estimate and clearly varies widely between years, dependent partly

on the seriousness of the MOD’s financial plight and the condition

of the overall economy. Defense outlays drawn from allegedly civilian parts of the state budget are easier to identify although some

uncertainty obviously remains. Nonetheless, it seems likely that in

2000 not far short of half of budget funded defense spending came

from outside the official defense budget. In 1999 the proportion had

been even higher.

TRENDS IN DEFENSE SPENDING

A major problem with all Russian defense budget figures is that

they are given only in the prices of the year under consideration.

Measuring the real change in spending over time requires an allowance to be made for inflation. Moscow does not publish—and

probably does not calculate—an inflation rate specifically for the

defense sector. Inflation data for consumer goods and, indeed, for

products offered wholesale is provided and some commentators

have used particularly the first of these in an attempt to measure

real changes in planned outlays. However, prices in individual sectors of an economy often change at very different paces, particularly in countries (like Russia) where general inflation is high and

market mechanisms are inadequately developed, and there is no

warrant for assuming that the price of Russian weapons has, over

either the short or the long term, increased in line with that of consumer goods. Calculations of the real change in official defense

spending made on this basis are thus of uncertain validity. Add in

the problem of trying to determine the inflation adjusted level of

defense spending outside the published defense budget when even

its nominal level is not entirely clear and it is obvious that, at the

very least, some method for cross checking the results is needed.

This is provided by the building block approach, initially developed in the United States during the 1950s. In concept it is very

simple: identify every item that falls within what NATO would call

defense expenditure, determine the outlays on each of them and

then add everything together to produce a figure for total defense

spending. Thus, for example, spending on weapons procurement is

calculated by identifying every system that has been purchased

and how many of each has been obtained and then multiplying that

by the unit price. Similarly, military pay is determined according

to how many servicemen there are in each rank and the salary, including the various allowances, given to those ranks. Constant

prices of a selected year are normally used to overcome the problems of inflation. The method ought to be foolproof. The problem

is, of course, getting hold of all of the inputs. Even in post coldwar Russia, much of the information is highly classified and some

may not be collated at all. How, for instance, can even the most

168

dedicated Western analyst hope to identify and price every piece of

new construction or repair at every military facility or know in detail the cost of work in each field of defense research? In many

areas, there is no alternative but to aggregate and estimate. Nobody should pretend that the final results are perfect. They are,

however, even for determining aggregate levels of spending, usually

an improvement over anything that can be obtained by accepting

or, indeed, manipulating Russian Government figures.

Figure 1 shows the real value of total Russian defense spending

over recent years according to building block calculations carried

out by the author. It reveals a stark fall in outlays through 1998,

at which point they were worth only about one-third of those some

6 years earlier. Such a steep rate of decline would appear to be unparalleled among major states that have not suffered defeat in war.

There has been some recovery over the past 2 years but in 2000

total defense expenditure was still in real terms worth well under

40 percent of that in 1992 and 15 percent of that of the Soviet

Union at its 1988 peak.

FIGURE 1.—TOTAL DEFENSE SPENDING ON NATO DEFINITIONS, 1992–2000

[Billions of rubles at constant 2000 prices]

The dramatic decline in defense outlays during the early and

mid-1990s was primarily the result of severe economic difficulties.

Russian GDP fell by over 40 percent between 1992 and 1998, inflation ballooned out of control for a time and remained high throughout the period, unemployment increased to around 12 percent of

the workforce, living standards for most people plummeted and the

government found it very difficult to raise the revenue needed to

meet its obligations. Beyond this, however, defense was accorded a

much lower priority by President Yeltsin and most of his senior advisers than it had been by their Soviet predecessors. The cold war

was over, the West was sympathetic to the regime and, in any case,


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3For the purposes of this figure the SSBN fleet is considered part of the strategic forces rather

than the navy.

the military still possessed huge amounts of modern, serviceable

equipment.

During 1999 and 2000 Russian defense spending rose in total by

an estimated 16 percent after inflation. The beginnings of genuine

economic recovery—GDP grew by about 14 percent over the same

period—meant that, for the first time in years, it was possible to

find extra resources for defense without hitting significantly either

standards of living or the rest of the economy. Beyond that, however, the military put forward an increasingly powerful case for

more resources. The international scene appeared to be darkening.

NATO’s actions in Yugoslavia were presented as evidence that the

West, despite fine words, remained fundamentally hostile to Russian interests and was willing to pursue its goals with vigor unless

constrained by the existence of strong Russian forces. Islamic militancy in Chechnya and Central Asia not only brought home the reality of the threat to national unity and to Russian influence in the

near abroad but also underlined the weakness of the Russian

forces. No longer was it possible to claim that weaponry and skills

inherited from the days of the Soviet Union were adequate. Finally,

the replacement as Russian President of Yeltsin by Putin brought

to the fore a man with both more sympathy for security concerns

and a greater belief in the need to keep the military onside.

THE ALLOCATION OF RUSSIAN DEFENSE SPENDING

One advantage of the building block methodology is that, with

defense spending computed item by item, it is possible to recompile

it according to different definitions. The two most useful are by

branch of service and by function.

ALLOCATION BY BRANCH OF SERVICE

Figure 2 shows our estimate of the percentage distribution of

outlays by service in 2000.3

The calculations indicate that in 2000 nearly two-thirds of total

defense outlays went to the regular forces, with the remainder split

between the various paramilitary organizations (border guards, internal security troops and the like), MOD civilians and certain centralized MOD functions which cannot sensibly be allocated to a

particular service. Within the money devoted to the regular forces,

the largest share went to the ground forces followed by the air and

air defense forces and the strategic forces. Such distributions usually change only slowly over time but in Russia during the 1990s

there was a significant enhancement in the proportion of funding

allocated to the strategic forces. The reasons for this are not discussed by the Russians in public but to a western observer they are

clear. Strategic weapons provide far more ‘‘bangs for the buck’’ than conventional systems and make better sense while the major

threat is thought to come from a technically superior, nuclear

armed, NATO. In the 1970s and 1980s Moscow’s understanding of

a war with NATO was, in crude terms, one in which its heavily superior conventional forces drove through Germany, placing on

Western leaders the unpalatable choice between surrender or reVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00195 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.009 CRS1 PsN: CRS1
170

4 In spring 2001 Kvashnin was still continuing his campaign, reportedly telling the Academy

of Military Sciences that ‘‘the Russian army is a man with one arm pumped up (that’s the Strasort to nuclear weapons. In the 1990s, with the break-up of the

Warsaw Pact, this was no longer practicable. Weapons of mass destruction were now seen as increasingly essential to offset conventional weaknesses which, through lack of money and other resources, could not be addressed.

FIGURE 2.—DEFENSE SPENDING BY BRANCH OF SERVICE IN 2000

Over the last 2 years there have been some signs that this emphasis is beginning to be questioned. Many in the MOD have come

to accept that the military problems Russia faces—and is likely to

continue facing over the next decade—cannot be met by strategic

forces. Intercontinental and submarine launched ballistic missiles

are of little use in the conflicts in Chechnya or the near abroad.

The challenge there is from bands of Islamic militants and the requirement in military terms is for better trained and better

equipped ground and air forces. The reduction in the relative financial priority for these branches of service has, it is thought, run

counter to Russia’s true needs.

Not all, however, yet share the new thinking. One reason for the

very public spat that occurred over summer and autumn 2000 between the then Defense Minister Sergeyev and the Chief of the

General Staff Kvashnin was the very different perspectives they

held on the relative importance of strategic and conventional

forces. After much hesitation President Putin appeared to back

Kvashnin, agreeing that more money needed to be put into conventional systems and that—partly to save money—the Strategic Missile Forces should by 2006 lose their independence and be absorbed

into the air force. The latest information suggests, however, that

the battle is far from over.4


76171.002
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tegic Missile Troops) while the other is short and dried-up (that’s the general purpose forces).

That’s not a normal man; it’s some kind of mutant. I can’t allow that. It won’t work! We’ll dry

up together!!’’

ALLOCATION BY FUNCTION

In the Soviet era over two-thirds of all defense spending was

typically allocated to the research, development, procurement and

maintenance of military equipment and supporting infrastructure.

This left a smaller proportion for personnel related expenditure

(pay, allowances, pensions, food, clothing, accommodation, etc.)

than in the United States or United Kingdom despite the very

large numbers that the Soviet Union had under arms. The explanation, of course, was that most servicemen were conscripts who

could be forced to endure dreadful living standards, receiving in return just pocket money. The change in the distribution of Russian

spending over the last decade has been dramatic, as our estimates

for 2000—given in Figure 3—demonstrate.

FIGURE 3.—DEFENSE SPENDING BY FUNCTION IN 2000 1

1 These figures, being based on NATO definitions of what constitutes defense spending and how it should

be allocated by category, inevitably differ from the partial data given by the Russians for the functional

breakdown of the defense budget.

Personnel related spending now accounts for approaching threefifths of all defense outlays, a significantly higher proportion than

in the West. Despite this, however, the MOD has still not been able

to meet all its obligations. Officer salaries, once the envy of most

employees in the civilian economy, have fallen dramatically in real

terms as infrequent pay rises have failed by a long way to keep

pace with inflation. Table 5 shows typical earnings for spring 2001.


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172

TABLE 5.—SALARIES OF MILITARY OFFICERS IN SPRING 2001

[Rubles per month]

Basic

salary

Additional

payments

Total

Lieutenant in charge of platoon ........................................ R1,627 R743 R2,370

Captain in charge of company .......................................... 2,080 NA NA

Lieutenant Colonel in charge of battalion ........................ 2,562 953 3,515

Colonel in charge of regiment ........................................... 4,041 NA NA

Major General in charge of division .................................. 1 5,028 1,301 6,329

1 A different source gives this figure as 4,786 rubles.

NA—Not available.

Although precise calculations are difficult, it seems likely on

these figures that a pay increase of more than one-third would be

needed to provide most Russian officers with the same income relative to their civilian counterparts as would be normal in a western

society. Moreover, although the large pay arrears that built up during the Yeltsin era have now largely been cleared, neither the recently growing economy nor supposed government sympathy for the

military’s plight has changed the fundamental position of the military officer. Published data suggests that over the past 2 years the

only servicemen to secure pay rises much above inflation have been

those sent to hot spots such as Chechnya.

Although a large number of officers have been forced to take second jobs (thus provoking media sarcasm over ‘‘part-time soldiers’’),

Russian statistics suggest that at the beginning of 2001 almost half

of service families were living below subsistence levels and some

170,000 personnel were still on housing waiting lists. Morale

among officers is unsurprisingly very low while recruitment is increasingly difficult. The average age of pilots in the air force has

reached 37 compared to 30 in 1992. Frustrated by financial hardship, many officers, both senior and junior, have turned to corruption. In December 2000 Colonel General Oleynik, head of the Directorate of Budget and Finance, was dismissed (perhaps a little

harshly) for involvement in the alleged laundering of $450 million

of defense budget funds through a Ukrainian company. As of late

spring 2001, a further 13 generals were also said to be under investigation for corruption by the military prosecutor. In a report to the

state Duma in May 2001 the Russian Audit Chamber stated that

last year the Defense Ministry lost some 1.5 billion rubles through

embezzlement and other illegal activities

The situation for conscripts is, of course, even worse than that

for officers. As in the Soviet era, pay consists of no more than pocket money while the quality of benefits-in-kind (food, clothing, accommodation, etc.) has declined. Diet is at best monotonous and

there have been occasions on which units have run out of basic

foodstuffs. Worn out uniforms are not replaced and there has usually been no money to repair and maintain barracks. Sanitary conditions are often appalling. Inevitably, although discipline has generally been maintained, there are many reports of suicides, deserVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00198 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.009 CRS1 PsN: CRS1
173

tions, nervous breakdowns and physical ill health. On a per capita

basis outlays on medical services in the forces were last year just

one-fifth of those in Russia as a whole—and the latter were, by either Western or even past Soviet standards, grossly inadequate.

However insufficient, the money made available to support servicemen has been generous compared to that directed toward equipment research, development, procurement and maintenance. These

now account for less than two-fifths of total defense funding. Although much basic research has continued, particularly in areas

where the cost is not excessive, there have been problems maintaining momentum through the prototype construction, testing and

evaluation phases. Program timings have been stretched and in

some cases projects survive in little more than name. Russia’s

weapons research and development network, though still extensive

and, by West European standards, achieving impressive results in

some areas, is but a shadow of its former self.

As both total defense outlays and the proportion of those remaining allocated to equipment procurement have fallen, orders for new

weapons dried up. By the late 1990s the value of overall weapons

production had declined to less than one-tenth of what it was at

the start of the decade. As Table 6 shows, many key sectors were

hit even harder than that.

TABLE 6.—WEAPONS PRODUCTION 1990–2000

1990 1992 1994 1996 1998 2000

Tanks ........................................... 1,600 500 40 5 10 30

Light AFVs .................................... 3,400 700 400 300 250 50

Fighters ........................................ 400 150 50 20 30 40

Bombers/ASW/SMAC ..................... 40 202100

ICBMs/SLBMs ............................... 120 70 25 20 15 5

Major warships ............................ 220101

Submarines .................................. 1264311

Official figures showing a significant percentage growth in state

spending on defense equipment procurement over the past 2 years

must, if true, reflect the acquisition of smaller systems and spares

which attract little publicity. Certainly, there is little to justify

them in terms of major weapons production. Despite its relative

funding priority, the output of ICBMs has fallen to such an extent

that around 60 percent of the missiles currently deployed are now

past the service life originally planned for them. Tank manufacture

has virtually ceased at one of the two plants still working in the

field and only continued at the other in a desultory manner. Of the

two major fighter production firms, one—MiG—apparently has

very few orders while the principal bomber facility may also have

little to do. Last year it was reported that only 1 percent of Russian

military aircraft had been built since 1995 and almost half of the

fleet dated to before 1985. The shipyards have a similar shortage

of orders. Moreover, with conventional systems, a large share of the

manufacturing that has taken place is aimed at the export market,

particularly China and India, leaving virtually nothing for Russia’s

174

own forces. All of the new submarines constructed in recent years

have, for instance, been destined for overseas.

The MOD did not just have to give up its hopes of new weapons

systems. Funding has been so tight that it has also continually

postponed necessary maintenance contracts. As a result, by late

1999, only 30 percent of the ground forces’ helicopters and 60 percent of its tanks were reported as being in satisfactory condition.

The air force claimed around the same time that some 500 of its

fixed wing aircraft and helicopters were in need of major renovation while the navy said that three-fourths of the vessels still in

service needed refitting or repairs. These figures, though obviously

open to definitional questions, give an accurate flavor of the deterioration in capability.

Moreover, even when systems were operational, there was often

insufficient funding to train servicemen fully in their use. Average

flying time for air crews, low by Western standards even in Soviet

times, fell sharply. With just one-fifth of the fuel supplies the air

force judged necessary, bomber pilots managed on average only 20

hours of airborne training last year while fighter pilots did even

worse, securing just 10 hours. Around 400 of the 1500 pilots graduating from military schools since 1995 have apparently yet to get

airborne. The air force has publicly blamed limited flight training

for the 50 percent increase in accidents that took place last year.

The navy has had similar problems. In 2000 warships were reportedly at sea on average for just 6.4 days while the naval air force

spent 11 percent less time in the air than in 1999, itself a poor

year even by previous Russian standards. Ground troops have reported insufficient fuel to run vehicles and have had to restrict activity.

Infrastructure has also suffered. Excluding military housing, it

currently receives only an estimated 6 percent of overall defense

outlays. Keynote projects have been few in number and more basic

improvements limited. By last year two-thirds of military airfields

were said to be in need of major overhaul and modernization while

only one-fifth of the money which experts said was needed to tackle

the problem was made available. One report concluded gloomily

that, if the situation did not change, practically all military runways could be out of service by 2005. Ship repair facilities were

also still ignored; the navy claimed that only 4 percent of the necessary funding was supplied in 2000. Although in 1997 Russia

pledged to eliminate its chemical weapons stocks within 10 years

only meager progress has been made, largely because of lack of

money. In 2000 the budget allocated little more than one-sixth of

the sum specialists said was required if Russia was to meet its obligations. Substantially more resources have, however, been promised for this year.

FINANCIAL ASPECTS OF WEAPONS PRODUCTION

The MOD’s financial problems have inevitably had a knock-on effect on its suppliers, particularly defense industries. Not only has

much less been ordered but, even when contracts have been agreed,

payments have often been delayed for months. Without funds the

plants cannot pay their own workers or suppliers and have fallen

deeply into debt. Many, perhaps most, are by any normal measure

175

bankrupt and would in a market economy have been closed. In

Russia they have been left to stagger on as several restructuring

and rationalization plans have first been heralded and then abandoned once the social and financial costs have become apparent.

Staff are rarely sacked. Instead they are moved to a shorter working week, often doing little productive even when in the factory. According to specialist Russian journals, one-fourth of employees have

been forced to take unpaid leave lasting, on average, 40 days. In

the West individuals placed in such a situation would have left in

large numbers. In Russia, however, workers have remained tied to

the company both by the lack of alternative employment and by social considerations. For instance, the factory, even when it cannot

pay employees’ wages, still owns their flat which has to be vacated

if a job is taken elsewhere. Unsurprisingly, there is vast overmanning. The aviation and aerospace industry in Russia employs

around eight times as many people as that of the whole of Western

Europe but has an output that is dramatically smaller. The average age of workers across defense industry is now well over 50.

The Russian Government has in recent months been preparing

new plans to tackle the crisis in the defense industries. Firstly, it

has said that, with the state budget now in surplus, decisive action

will be taken to settle state debts to defense industry enterprises.

The exact size of these remains a matter of disagreement between

the administration and the factories but the former fixes them 32.5

billion rubles and has promised that, by January 1, 2003, half of

this will have been paid in money and the rest covered by bonds.

Potentially even more important for the long term, Deputy Prime

Minister Ilya Klebanov has announced that, in order to reduce

overlap and eliminate waste, a new and major restructuring program is in preparation for the sector. It is to involve mergers and

closures and be spread over a decade. Full details are as yet unavailable but some reports suggest that, within the first 3 or 4

years, one-third of the enterprises could disappear. Funding of 2 to

3 billion rubles a year is said to be needed to support the program.

Past experience suggests that all schemes should be treated with

caution. Promises of debt repayment could easily evaporate if the

government’s financial position were to weaken and any radical defense industrial restructuring is in our view likely to be much more

expensive than forecast and to face considerable opposition.

Changes will probably be on a much smaller scale than economists

would like or is needed to bring capacity into line with orders.

Moreover, whatever organizational changes are made, an elderly

workforce and obsolescent production machinery will remain a poor

basis on which to build any rapid and sustained recovery in production levels.

THE DEFENSE BURDEN

Russian statisticians calculate the financial burden defense

places on the economy by measuring official budget outlays as a

proportion of GDP (see Table 7). For 2000 the result was 2.7 percent, a little below that in the United States and broadly in line

with the figures for France and the United Kingdom. The impression given is thus one of moderation. However, a more accurate

comparison, taking into account military spending funded outside

176

5 China admits to a defense burden of only 1.4 percent of GDP but, like Russia, conceals much

of its military spending in supposedly civilian parts of the state budget and in non-budgetary

accounts.

the official defense budget, suggests that the true burden in Russia

last year was well over 5 percent. As such it was twice the NATO

average and also probably twice that in China.5 On a more positive

note it should, however, be recognized that the burden has fallen

significantly over the past decade: in 1992 it was on our estimates

approaching 10 percent, one of the largest in the world.

TABLE 7.—THE DEFENSE BURDEN ON OFFICIAL RUSSIAN

STATISTICS, 1992–2000

[Final defense outlays as a percentage of GDP]

Year Percentage

1992 .......................................................... 4.7

1993 .......................................................... 4.4

1994 .......................................................... 4.6

1995 .......................................................... 3.1

1996 .......................................................... 3.0

1997 .......................................................... 3.1

1998 .......................................................... 2.4

1999 .......................................................... 2.6

2000 .......................................................... 2.7

The implications for Russian defense reform of this substantial

and ongoing understatement of the burden are not entirely clear.

However, it seems likely that, with both the government and the

military apparently laboring under the impression that the defense

sector is much less of a charge on society than is really the case,

the pressure for radical change has been weakened. Indeed, in recent years one of the most persistent refrains in the armed forces’

repeated demands for more funding rather than large scale restructuring has been the claim that, financially, they are treated badly

compared to their counterparts in many other countries. That argument may eventually be undermined. Deputy Defense Minister

Lyubov Kudelina has recently called not only for much greater

transparency in spending but also a full analysis of non-defense

budget funding. If conducted properly, this will, of course, show the

Russian forces still absorb what is, by current international standards, a high proportion of national resources.

DEFENSE SPENDING IN DOLLARS

Few Western readers are likely to be wholly satisfied with expenditure data in rubles, seeking instead numbers in a currency

they believe they can understand. But how can one convert rubles

into, for example, dollars? The methodology normally adopted is

straightforward: a market exchange rate, quoted in the quality financial press and elsewhere, is applied via simple division to the

published defense budget and a result thereby obtained. Unfortunately, however, while the ruble is not freely convertible and while

177

6 It does not, however, measure Russian military capability which reflects resource flows over

many years, the efficiency with which those resources are deployed and a wide range of intangibles. Some commentators, failing to recognize this and, above all, to differentiate properly between inputs and outputs, have drawn conclusions on relative capabilities which—whether valid

or otherwise—cannot be justified simply from defense spending data.

trade constitutes a relatively small proportion of Russian GDP,

there is no reason to believe that market exchange rates even approximately reflect the military purchasing power of the currency.

The discrepancy can be enormous. In 2000, for example, the initial

budget allocation for defense was on this approach worth only

about $5 billion, not dramatically more than that of Singapore.

Even taking into account the additional money poured into the defense budget during the year, outlays were still valued at under $7

billion, significantly less than those of Canada. The Russian armed

forces (including paramilitaries) are, however, in terms of manpower nearly 15 times the size of their Canadian counterparts and

they have, in addition to a major strategic missile capability, 7

times as many large naval vessels, 14 times as many combat aircraft and approaching 200 times as many tanks.

Statistics derived from market exchange rate conversions are

thus quite obviously seriously flawed—though that does not prevent them either from being quoted in otherwise serious publications or for wholly erroneous deductions on the nature of Russian

policy or its industrial efficiency being drawn therefrom. We prefer

to make our own estimates from scratch, with the goal of measuring the financial cost of replicating the Russian military effort in

the United States.6 As before, we adopt the building block methodology and cover all items that NATO countries would consider

part of their defense spending. Some simplification of procedures is

necessary because of lack of information but in principle equipment

unit prices are determined according to how much it would cost a

U.S. factory to produce, repair and maintain systems with the technical characteristics and quality of manufacture that exists in Russia. Fuel costs are similarly based on U.S. prices and Russian

usage rates. Russian military and MOD civilian personnel are assigned a dollar valuation dependent on factors such as their rank,

educational standard, training, assessed morale and (where relevant) leadership skills. The dollar cost of food, clothing and accommodation takes account of the low standards normal in Russia.

The calculations are complex and subject to uncertainty but the

bottom line is that, on our estimates, the United States could last

year have procured the full Russian military effort for around $50

billion. This puts Russia in third place globally, far behind the

United States itself and—on our calculations—some way adrift also

of China. The latter is thought to have overtaken Russia in terms

of defense resource allocation around the mid-1990s and now, despite the recent upsurge in Russian outlays, to devote around 25

percent more a year to the military. The leading European defense

powers, the United Kingdom and France, together with Japan, still

in 2000 lagged behind Russia.

PROSPECTS

At the time of writing (July 2001) the Russian Government has

just approved the basic outlines of the 2002 federal budget. These

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7 As so often with Russian statements, the language is imprecise but it seems likely that, by

maintenance, Ivanov meant nearly everything outside the defense order. 8Some sources have said that the reduction will be larger, perhaps 53,000 posts (26 percent).

show a defense allocation of 262.9 billion rubles, an increase of 20.5

percent over planned spending this year. Were inflation in the defense sector to equal that expected for the overall economy (an admittedly uncertain thesis), the new budget would involve a real rise

in outlays of over 8 percent, more than twice likely GDP growth.

The proposals are, however, subject as always to scrutiny by the

Duma and are likely to be revised before passing into law. There

are few details on how any additional money is to be distributed

but 9.3 billion rubles will be set aside to provide servicemen with

an above-inflation pay award. Unconfirmed reports suggest that as

a result the monthly salary (including bonuses) of a platoon commander will rise from 2,370 rubles to 4,012 rubles while that of a

battalion commander will be increased from 3,515 rubles to 6,199

rubles President Putin has also recently submitted legislation to

the Duma which will bring military salaries into line with that of

Russian civil servants by January 2004. According to preliminary

data, this is likely to require a further rise in military pay over and

above anything given to civil servants. The deputies are expected

to vote on the proposed law in the autumn.

Despite the commitment to increasing pay, Defense Minister

Ivanov has said that he wishes to cut the proportion of the defense

budget going on the maintenance rather than development of the

armed forces from 70 percent in 2000 to 60 percent in 2005 and

50 percent by 2010.7 The only way of achieving this is, as he and

other ministers have admitted, by a substantial reduction in force

numbers. Despite inevitable qualms from some senior military officers, details of these cuts have been announced. The posts of some

365,000 Defense Ministry servicemen, 105,000 servicemen from

other power ministries and 130,000 civilians are to be axed by

2005. Figures published separately for the downsizing in individual

services do not add up exactly to these numbers (perhaps suggesting some ongoing debate) but provide an indication of priorities.

Within the MOD, 180,000 military slots (52 percent) will be lost by

the ground forces, 60,000 (40 percent) by the strategic rocket forces,

50,000 (29 percent) by the navy and 50,000 (27 percent) by the air

and air defense forces. Among the other departments with military

employees, the Ministry of the Interior will probably have to surrender 37,000 posts (18 percent),8 while the number of border

guards will be reduced by 30,000, railway troops by 10,000 and

‘‘Emergency Situations’’ forces by 4,500. Further cuts, post-2005,

have also not been ruled out though at the moment they are judged

unlikely.

The Russian authorities have claimed that this reduction in posts

will enable Defense Ministry spending per serviceman to double by

2005 and triple by 2010. Assuming—as seems likely—that the

starting point for the calculation was the official figure of almost

1.2 million men serving in the MOD’s forces in 2000, this means

that real levels of defense spending are planned to rise by almost

7 percent a year through 2005. Without any further reductions in

posts after 2005, attainment of the 2010 target would involve a furVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00204 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.009 CRS1 PsN: CRS1
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9The Russian Government will, of course, at the moment be seeing—and making judgments

based on—different and more benign forecasts of the defense burden. According to German Gref,

the Minister of Economic Development and Trade, the authorities in Moscow are forecasting annual average economic growth of 5 percent a year through 2010 rather than the 3 to 4 percent

we posit. Moreover, they will equate defense spending with the defense budget, thus omitting

all outlays on military activities funded through other parts of the state budget or by nonbudgetary means. The Putin government may well believe that, even with the massive hikes

planned for defense outlays, the latter will, in 2010, still account for just 3.5 percent of GDP.

This level has long been seen as reasonable and, indeed, during the Yeltsin era, became something of a totem target for those seeking increased spending.

ther hike in outlays over the second 5 year period of about 8.5 percent per annum after inflation.

These goals are clearly extremely ambitious and we doubt whether, without a substantial deterioration in the international political

climate, they will be realized. The 8.3 percent growth in GDP

achieved last year was in large measure the result of increased energy and other raw material prices and the continuing impact of

the undervaluation of the ruble on international markets. The

boost provided by these factors is already starting to subside and

although, barring a major international recession, the days of negative growth seem to be over, it is probable that over the next decade GDP will rise by on average no more than 3 to 4 percent per

annum. If total defense spending were to expand at the same pace

as the Russians appear to be planning for the MOD budget and

economic growth were 3 to 4 percent a year then the defense burden would swell from just over 5 percent of GDP last year to more

than 6 percent in 2005 and approaching 8 percent by 2010.9 At

these levels it would increasingly impinge on the resources available either to invest in the civilian economy or improve standards

of living.

Moreover, even if the planned rises in defense spending were to

be obtained, it is doubtful whether the sought after re-orientation

of outlays away from personnel and toward equipment could be

fully achieved. Despite official claims that there are 1.2 million

military personnel in the MOD, we believe that actual numbers are

significantly smaller. Some of the projected cutbacks may thus involve little more than the scrapping of vacant posts. In these cases

the financial savings will be minimal. Furthermore, where regular

servicemen are retired, they will be entitled by law to substantial

housing and severance benefits. Independent Russian analysts

have calculated the additional financial cost of cutting personnel by

the planned amount at 21 billion rubles over 5 years, a figure we

believe to be a little too high but which is nonetheless indicative

of the heavy charge on the defense budget. Former Defense Minister Sergeyev is alleged to have written last year to Prime Minister Kasyanov arguing that it was impossible to reduce military

personnel numbers by even 50,000 because they could not be provided with their housing entitlements.

There is also a concern that, in determining the rank mix needed

to yield their planned savings, the authorities are storing up problems for the future. They have, indeed, said that almost two-thirds

of the eliminated MOD military slots will need to be those of officers, including a very large number of senior staff. Insofar as the

current force structure is top heavy, this emphasis makes sense.

However, from around 2005 onward, Russia faces a severe and unavoidable demographic crunch, with the number of 18-year-old

180

males available for conscription falling within 5 years by over 40

percent. Since at least the mid-1990s there have been many complaints from the forces that, even with the existing demographic

pool, it has been difficult to secure sufficient numbers of healthy,

well educated recruits. Unless the number of conscripts is cut more

sharply than is at present envisaged, this problem will become

much more acute toward the end of the decade. If, however, the

government decides to reduce the number of conscripts in line with

availability, the only way of preserving its planned force size will

be to retain more regulars than envisaged. This will inevitably be

costly.

Moreover, there has long been a recognition among Russian specialists of the benefits of eliminating conscription and converting

the forces to an all-professional basis. Indeed, at one point, President Yeltsin declared that 2000 would see the final compulsory inductions into the armed forces. This deadline has now obviously

been shelved but even a gradual shift over the next decade to increase the proportion of regulars in the services will add significantly to the wage bill.

Were the Russian Government to achieve its goals of tripling defense budget spending per soldier by 2010 and re-orienting outlays

so that by the same date half of outlays were directed toward ‘‘developing’’ rather than ‘‘maintaining’’ the forces, then in real terms

the MOD ‘‘development’’ budget (largely weapons research, development and procurement together probably with additional infrastructure) would rise by around 230 percent over the period. This

seems implausibly high and we have therefore made our own projections. These cover all defense spending rather than just that

funded through the defense budget. They are based on the assumptions that for the remainder of the decade total defense outlays will

rise in real terms by 3.5 percent a year on average, in line with

GDP, and that the share of those outlays allocated to development

will increase by much less than Moscow currently envisages. As a

result, development spending is forecast to grow by about threefourths, much less than that implicit in the Russian data but still

a very impressive figure.

There are, of course, an almost infinite number of ways in which

this additional money could be allocated. Nonetheless, it is clear

that there will be no immediate, large scale, boom in weapons procurement. Neither the government nor the armed forces perceive

any great benefit from increased acquisition of most of the weapons

systems currently in the inventory, these usually having been developed in the 1980s or earlier and now considered less and less

a match for their Western counterparts. Rather there is a belief

that the emphasis needs to be placed on creating, almost across the

board, a new generation of equipment which contains the latest

technology. In financial terms, therefore, a high priority will probably be given to weapons research institutes. They are likely to receive substantial amounts of extra money for better machine tools

and other equipment while their staff, hitherto very poorly paid,

should see their status enhanced. This will, of course, be accompanied by an expectation of better results but it is unlikely that

many major new weapons systems, including even those that have

181

10 According to Yuriy Koptiev, general director of the Rosaviakosmos state agency, the new

fifth generation fighter, the PAK FA, is unlikely to be ready for delivery to the armed forces

before 2011–2012 even if sufficient money is found for its development. The Russian Government has, indeed, said that between now and 2015 the armed forces will probably buy only 7

to 10 percent of Russian aircraft industry output, with a further 13 to 15 percent being purchased by domestic airlines and the rest exported. 11The production of large ASW vessels apparently requires the cooperation of 2,000 subcontractors!

been in development status for some years, will be ready for quantitatively significant levels of production much before 2007–2008.10

Manufacturing facilities will in any case need several years to

prepare for the arrival of new systems. If the government presses

ahead with its much needed reorganization and restructuring

plans, heavy demands will inevitably be placed on defense industry

management. There will be new chains of command and of supply

to forge,11 existing equipment and manpower to relocate or jettison

and a more commercially oriented ethos to instill. Moreover, with

many of the promised weapons systems technically much more advanced than their predecessors, increasingly sophisticated manufacturing equipment will have to be bought and staff will have to

undergo training in its use.

The cost of developing better weapons systems and modernizing

manufacturing plants to produce them in quantity will be enormous and, if done properly, could easily absorb all of the additional

development funding contained in our forecast. In practice, however, significant sums are likely to be diverted for the better maintenance and repair of the existing weapons inventory. In part this

is because, given the unavoidable delays in bringing new weaponry

into service, the operational life of existing systems will need to be

extended, often well past original expectations. Beyond that, however, the forces have, since the most recent Chechen conflict, became increasingly aware that the reliability of many of their older

weapons systems (including associated vehicles) is uncertain and

thus likely to undermine operations and put soldiers’ lives at risk.

They will press for a better adherence to recommended servicing

schedules than has been typical over the past decade.

Nonetheless, despite life extensions programs and better maintenance, many Russian weapons systems are so elderly that the

forces will in practice have little option but to scrap them in the

coming few years. As a result the total inventory is likely to decline

significantly. Exact figures are difficult to predict but our best forecast for holdings in the major weapons category is shown in Table

8.

TABLE 8.—WEAPONS INVENTORY IN 2000 AND 2010

Year

Modern

tanks and

armored

vehicles

Artillery

Combat

aircraft

and attack

helicopters

Major surface combatants

and submarines

2000 ......................................................... 45,000 33,000 2,800 95

2010 ......................................................... 35,000 20,000 1,900 60

182

It is thus evident that, through 2010, there is unlikely to be any

significant improvement in the overall capability of Russian forces.

Post that date, however, as new weapons systems begin to enter

the inventory in quantity, the picture should gradually improve.

There will be fewer men than at present but they should be better

trained and probably better motivated. The move away from

conscripts toward an all-professional force could well be completed

in this timeframe. Ultimately, although there is no possibility of

Russia’s conventional forces being rebuilt to the point where their

strength relative to that of their Western counterparts is comparable to that enjoyed by the Soviet military throughout the cold

war, they should, with sufficient funding, re-emerge as a modern

and powerful presence on the world stage.

(183)

RUSSIAN FINANCIAL TRANSITION: THE DEVELOPMENT OF INSTITUTIONS AND MARKETS

FOR GROWTH

By David M. Kemme 1

CONTENTS

Page

Summary .................................................................................................................. 183

Introduction .............................................................................................................. 183

Development of Financial Institutions and Competitive Financial Markets ...... 185

Why focus on the banking sector? ................................................................... 186

Demonetization and non-payments ................................................................. 188

Financial repression and liberalization .......................................................... 190

The State of the Banking System: Crisis, Recovery and Crisis? ......................... 198

System characteristics and policy framework ................................................ 198

Recovery of banking activity ............................................................................ 200

Concerns and Issues ................................................................................................ 203

References ................................................................................................................ 208

1David M. Kemme is the William N. Morris Chair of Excellence in International Economics,

University of Memphis. The author would like to thank Josef Brada, Martin Gilman, Kim

Iskyan, Lucjan Orlowski and an anonymous reviewer for helpful comments on an earlier draft.

SUMMARY

A well-developed financial intermediation industry increases domestic savings, efficiently allocates investment resources to the

most productive uses in the economy and increases the rate of economic growth. In the Soviet economy the banking system served as

a means of collecting household savings and a means of distributing centrally determined capital grants to enterprises. Banks then

audited enterprise financial activities to ensure compliance to the

financial plan. After a decade the transition from the Soviet banking system to a market oriented banking system is incomplete and

fraught with uncertainty. While the number of financial institutions has increased dramatically, the state sector still dominates financial sector activity, the legal and regulatory framework is incomplete, information necessary for risk management is of poor

quality and policymakers and regulators have been slow to act to

improve intermediation services. While significant progress has

been made, the commonly recognized characteristics of a sound financial system are not yet met.

INTRODUCTION

The Russian financial crisis of 1998 not only destroyed the credibility of financial policymakers and the confidence of investors, but

also delayed significant institutional reforms necessary for longVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00209 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.010 CRS1 PsN: CRS1
184

2Gosudarstvennye kaznacheiskie obiazatelstva (GKOs), are short-term treasury bills. Foreign

investors owned about 30 percent of GKOs. Granville (2000), p. 201 reports that in early 1998

there were some $365 billion (more than 3,000 percent of the banking system assets) of outstanding foreign exchange forward contracts, mainly the result of foreign counter parties hedging their GKO investments. Devaluation would, and ultimately did, render many banks insolvent. 3See Granville (2000), pp. 196–203 for a description of the GKO market collapse, resulting

devaluation and debt default. 4During the early 1990s there were expressions of concern about the stability of the banking

system and in 1995 there was a liquidity crisis on the inter-bank lending market. However,

some analysts were dismissive about the possibility of a banking system crisis: ‘‘This talk about

crisis in the midst of one of history’s largest banking booms has an air of unreality to it.’’ Warner (1998), p. 335. It was true that banks had extraordinary opportunities for profits because

of the low cost of funds, but conditions can and did change rapidly. Less than a year later in

the same journal, but after the crisis, Buchs (1999), p. 700 notes ‘‘. . . it is less the crisis itself

but the timing of the crisis which was a surprise in Russia.’’ 5For a review of economic performance during the 1990s see IMF (1999), OECD (1997) and

OECD (2000). Selected economic data may be found in Tables 7 to 9. OECD (1997) Annex V

also provides a detailed chronology of economic events and policy measures. On August 17, 1998

Russian authorities devalued the Ruble, imposed a unilateral restructuring of GKO debt and

declared a 90-day moratorium on private debt repayments. Estimates of losses to investors

range from $20 billion to $90 billion. IMF (1999), p. 39. For a detailed description of the 1998

crisis see Buchs (1999) and ‘‘What Went Wrong,’’ Russian Economic Trends, September 1998.

And for a description of the results see Westin (1999). 6The level of financial development is usually described by measures of ‘‘depth,’’ for example,

the ratio of banking assets to gross domestic product (GDP), or market capitalization to GDP,

etc. Berthelemy and Varoudakis (1996) and Pagano (1993) provide a brief review of the connection between financial development and growth. Levine (1997) also provides a survey of issues

of financial development and growth, Levine and Zervos (1998) examines potential links between both stock markets and commercial banks and growth, while Beck, Levine and Loayza

(2000) and Levine, Loayza and Beck (2000) provide more recent empirical evidence linking financial development to economic growth.

term economic progress. While the favorable external environment

of the mid-1990s provided support for domestic reforms and adjustment, events in global financial markets alone are not sufficient to

explain the domestic financial collapse. Russian financial authorities were not only determined to prevent exogenous external shocks

from spilling over into domestic financial markets, but also determined to defend the exchange rate peg as the domestic GKO market collapsed.2 The failure to deepen the reform of institutions and

appropriately manage financial risk at both the macro-economic

and micro-economic level set the stage for crisis. The deterioration

in the terms of trade and the government’s inability to maintain

federal revenue flows worsened fiscal imbalance and overall macroeconomic internal balance. Huge interest rate swings and the devaluation of the ruble destroyed the balance sheets of major

banks.3 The Russian economy moved from a somewhat optimistic

macro-economic environment in 1997 and the first quarter of 1998,

to financial collapse by the end of 1998.4 By mid-1999 the economy

had stabilized and policymakers were taking measures to bolster

the fiscal system.5 Does the positive economic news represent real

progress in domestic structural reform and solid economic performance? Or, have the increases in the world price of oil and stabilization of global financial markets provided the supportive external

environment that allows the fragile Russian economy to grow even

without significant domestic reforms?

This paper focuses on development of the domestic banking industry not only as an essential element of transition to a market

economy, but also as a necessary factor for long-term economic

growth. There is an extensive theoretical and empirical literature

indicating a significant causal influence of the level of financial development upon long run economic growth.6 Financial development

improves the allocation of savings to investment opportunities. The

185

7The literature discuses two approaches to financial development. ‘‘Demand following’’ financial development follows widening of markets and product differentiation, which then requires

more efficient risk diversification and control of transaction costs. This type of financial development is viewed as passive or it plays at most a permissive role in the growth process. ‘‘Supply

leading’’ financial development precedes the demand for financial services and proponents argue

it has a clear autonomous positive effect on growth due to the enhanced ability to mobilize resources, moving them from traditional to modern, high growth sectors. Supply leading financial

development may dominate the early stages of development or transition, making possible the

financing and increasing the effectiveness of sectors, institutions and activities neglected under

central planning, until demand following financial development takes over (a la Gerschenkron,

1962). 8The three primary functions of the Soviet monobank were financial control of enterprises,

dispersement of funds allocated by the central plan and mobilization of domestic savings to finance domestic debt of the state sector.

possibility of choosing more productive investments, which in turn

generate higher rates of aggregate economic growth, requires improved management of liquidity risks, more efficient diversification

of investor’s portfolios and higher quality of information about various projects and investor’s abilities. As the demand for these services arises, specialized institutions develop. But, the literature indicates that aggregate income and savings must reach certain levels,

or thresholds, before institutions and markets develop spontaneously. In transition economies economic policymakers may intervene, providing an environment for institutional development that

may supercede spontaneous market developments.7

If one takes a more activist, ‘‘supply leading’’ financial development approach to transition and development, policymakers first

must ask: (1) Among financial institutions what areas should be

developed/supported first? (2) What are the most appropriate mechanisms to enhance the efficiency of the financial institutions identified? (3) What is the impact of competition and what is the optimal

level of competition (in banking)? And, then, more specifically, (4)

at what stage of financial development is the Russian economy and

what policies should be implemented to enhance long term economic growth?

In the next section I briefly address questions one and two based

upon a brief review of the financial development literature. This

provides a framework for analysis of policy and institutional developments. The following section is a review of the banking sector’s

recovery from the 1998 crisis. Here I also discuss policy and institutional issues which must be resolved to ensure stable, long-term

economic growth. The last section concludes with concerns and

issues to be resolved.

DEVELOPMENT OF FINANCIAL INSTITUTIONS AND COMPETITIVE

FINANCIAL MARKETS

The Soviet centrally planned economy had little need for a developed financial sector. The payments system was simple and sound:

cash was used for household transactions and enterprise deposit

transfers were made within the monobank for inter-enterprise

transactions. Capital and investment funds were available via direct grants from the state budget according to the central plan. The

banking system functioned simply as a payments system and state

auditor to monitor plan fulfillment.8 Monetary policy was accommodating, ensuring that cash supplies met demand and enterprise deposit creation from the state budget corresponded to plan, both according to micro-objectives as well as balancing in the aggregate to

186

9For the classic description of the Soviet system of money and banking see Garvey (1977).

For a more recent discussion of both Soviet banking and transition in the early 1990s see

Tompson (1997).

prevent inflation. Barter transactions in both the household and

enterprise sectors and unplanned transactions within the enterprise sector were tolerated to smooth the operation of the plan. The

financial plan governed the allocation of society’s savings among

potential investment opportunities typically based upon political

objectives rather than financial criteria.9 While the banking system

in a market economy is a critical element of the payments system,

it also plays an active role in the allocation of investment resources.

WHY FOCUS ON THE BANKING SECTOR?

In the Soviet system the banking system did not provide financial intermediation services. Developed market economies, though,

have both stock and bond markets and developed financial intermediaries such as banks. There is considerable discussion about

which is more important. There is also a debate about the effectiveness of universal banking vis-a`-vis specialized banking coupled

with stock markets. Despite the nuances and the different routes

taken, developed market economies have tended to converge toward

a similar model of corporate finance. In developed economies, retained earnings or internally generated funds account for roughly

60 to 90 percent of investment financing, bank loans account for

roughly 15 to 30 percent and bond and equity offerings just a few

percent. In developing economies both bank loans, accounting for

25 to 35 percent, and equity markets, accounting for as much as

25 percent, play a slightly more important role in investment financing than in developed economies. While this varies over time

and across countries, retained earnings remain the dominant

source of funds, with bank lending next, and equities markets relatively unimportant in terms of providing finance for investment

projects. In fact, Stiglitz (1993) argues that stock markets are primarily a means of sharing risk, not raising investment funds.

When there are production risks, information asymmetries and

costly monitoring, debt contracts with fixed repayment dates will

always be preferred (by investors) to the purchase of shares with

periodic reimbursement by payments of dividends that are subject

to productivity shocks. Thus, bank intermediation is likely to play

a significantly larger role in investment financing regardless of

stage of development.

Monitoring costs are minimized with debt contracts because such

costs are incurred only in the case of insolvency, while financing

via shares requires continuous, ongoing monitoring. Banks and

lending intermediaries have an advantage over stock and bond

markets because they can be more efficient in terms of information

gathering and monitoring. It is not efficient for an individual investor to undertake these costs, but banks can spread them out over

many investors (depositors). Because some of the information collected on the performance of a firm becomes public, there is also

a free rider problem that makes capturing payment for monitoring

costs problematic. With large diversified portfolios banks can guarVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00212 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.010 CRS1 PsN: CRS1
187

10 Note that in very early stages of economic development the economy is increasingly

monetised as transactions become more complicated and sophisticated, thus there is a secular

downward trend in money velocity. However, after some threshold level of development, pressure to reduce the opportunity cost of holding money leads to the replacement of money with

credit instruments and an increase in the velocity of narrow money aggregates. The strong empirical link between GDP and degree of monetisation is demonstrated by Goldsmith (1969).

antee a yield on deposits and make a credible commitment to monitoring investment projects. Thus, the informational advantage of

banks as a source of external financing of investment is a strong

argument in favor of emphasizing the development of the banking

system as a means of enhancing capital accumulation. In fact,

Wright, Buck and Filatotchev (1998) provide evidence that banks

in Russia are beginning to develop oversight and monitoring relationships with loan recipients, albeit at a relatively slow pace.

Banks may not be superior to stock markets at all stages of development, however. Both provide diversification and management of

liquidity risk, provide a monitoring mechanism, which improves

the management of resources, and provide means of evaluating the

returns on investment activities, all of which contribute to the efficient allocation of resources. Competition among banks and between banking intermediaries and stock markets leads to lower

intermediation costs and contributes to economic growth. But competition also leads to increased probability of insolvency, credit rationing and related adverse effects on growth. The optimal level of

competition is a policy issue of importance in both market economies and transition economies.

The performance of intermediation services takes a well-functioning payments system for granted. In any economy a well-functioning payments system, a reliable and flexible means of exchange

and payment, is necessary for growth. While the Soviet economy

payments system was reliable, it was not flexible and does not satisfy the needs of participants in a market economy. Without direct

capital grants from the central budget, enterprise projects must

compete for funds, either internally, from retained earnings, or externally, from bank loans or securities offerings. Outside-thepayments-system transactions such as barter are also possible, but

are costly. These costs often eliminate potential productivity gains

due to increases in the division of labor and thus reduce the profitability of potential projects. In a market economy a financial system with low transaction costs develops in order to reduce the opportunity cost of holding money. As a result the payments system

in a market economy evolves toward a credit system managed by

banking intermediaries. Technological advances continuously reduce the information costs of utilizing credit while financial assets

and credit instruments gradually replace traditional monetary assets. This is reflected by increases in the weight of financial activities in gross domestic product (GDP) as economic development

takes place. Thus, the velocity of narrow monetary aggregates increases after a certain stage of development and the increase in

this measure of velocity is paralleled by the development of intermediation technologies.10

188

11 Buchs (1999) reports dollarization of 10 percent of GDP. 12Tightening of monetary policy and higher real interest rates led to liquidity problems and

banks in turn borrowed heavily on the inter-bank loan market for liquidity. Both volume and

rates increased leading many banks to withdraw from the market. On August 23–24 overnight

rates spiked, lending was rationed and the market collapsed. The Central Bank was only partially accommodating and several hundred banks failed. See OECD (1997), p. 82 for additional

details. 13OECD (1997), Annex II discusses the development of various money surrogates. Veksels

may be promissory notes or, if tradable, bills of exchange. They perform a much broader role,

however, serving as the equivalent of debt instruments like certificates of deposit, commercial

paper, simple IOUs and bonds. 14While OECD (1997), Chapter 2 describes the introduction of new securities and means of

payment as important innovations and monetary and institutional changes at this time in a

positive tone, the chapter concludes with a section titled ‘‘Commercial banking in the Russian

Federation: the first signs of stability or impending crisis?’’ Conditions deteriorated rapidly from

the time of printing and within a year the financial system collapsed. 15 Barter and offset prices tended to be higher than veksel prices that in turn were higher

than cash prices for the same commodities. See OECD (2000) pp. 91, 92. 16See Gaddy and Ickes (2001), Woodruff (1999) and Commander and Mumssen (1998) for further analysis of non-monetary transactions and the impact upon decisionmaking in the Russian

economy. 17For additional details on demonetisation see OECD (2000), Chapter 2.

DEMONETIZATION AND NON-PAYMENTS

In a transition economy changes in the velocity of narrow money

aggregates must be interpreted with caution, however. Measurement problems are severe. In Russia the method for calculating

GDP is being refined, defining and measuring monetary aggregates

is difficult, and the amount of dollars in cash in circulation is large

and difficult to measure.11 Further, significant changes in the behavior of economic agents have occurred and creation of new monetary and credit instruments is rapid and unpredictable.

Demonetisation in the Russian economy may increase or decrease

velocity for reasons completely independent of financial development. For example, in 1994 the Central Bank of the Russian Federation (Central Bank of Russia or CBR) began to implement more

stringent prudential regulations at the same time monetary policy

was tightened. A crisis in the inter-bank lending market in 1995

led financial intermediaries to innovate, creating new types of securities to facilitate payments.12 There was a rapid increase in the

use of cash surrogates including barter, sometimes complicated offset arrangements (zachety), bills of exchange (veksels), and various

federal, regional and local securities.13 There was also a rapid increase in payments arrears. While some of these activities may be

considered a first step toward financial deepening, employing

primitive payments and intermediation technologies with high

transactions costs, such as barter and illiquid offset arrangements,

is clearly a step backward.14 Only if orderly secondary markets for

zachety and veksels are developed may it be interpreted as a step

forward. Matters were complicated at this time as the practice of

issuing credit denominated in bills of exchange allowed banks to facilitate tax evasion, disguise bad loans by converting them to

veksel credits and avoid provision requirements. Lack of transparency in accounting complicated matters further as prices varied

depending upon the means of payment, confounding efforts to improve corporate governance, restructure enterprises and enforce tax

and other regulations.15 Corruption and illegal activities also flourished.16 By 1997–1998 money surrogates accounted for over half of

industrial transactions and consolidated budget revenues. In many

regions of the country this share reached 70 percent.17

189

18 Note that Pinto, et al. (2000), p. 1, defines non-payments as (1) arrears and (2) all forms

of non-cash settlements including barter, veksels or promissory notes and tax offsets whereby

government spending arrears and overdue tax payments are mutually cancelled. I focus on noncash payments or cash surrogates since these actually are a means of conducting payments, either at a discount or premium, which may compete with payments within the banking system. 19For example, treasury tax offsets were employed in 1994–1996 then replaced by direct monetary offsets in 1996, 1997, which were replaced by reverse monetary offsets in 1997, 1998,

which in turn were replaced by targeted financing. See Pinto, Drebentsov and Morozov (2000). 20 It is also important to note that a large portion of the increase in arrears was due to the

accumulation of penalties and fines on enterprises for late payment of taxes and payments to

the government. Government-organization to government-organization payments arrears do not

accrue fines and penalties and thus the proportion of enterprise arrears to government as a proportion of total arrears increased. Penalties and fines amounted to 65 percent of all debt to the

Federal budget by the end of 1997. While the initial payment arrear is viewed by some as an

increase in ‘‘soft credit’’ to the enterprise sector, the accumulation of fines and penalties probably should not be. See Mumssen (1998) and OECD (2000). 21Gossnab, the State Committee on Material and Technical Supply, was one of the most important state committees instrumental in developing, coordinating and enforcing the central

plan during the Soviet era.

While Pinto, Drebentsov and Morozov (2000) argue for a complete dismantling of the non-payments system, there were some

positive aspects.18 It in fact represented an evolutionary step in the

financial development process. In response to very contractionary

macro-economic policy and the elimination of direct enterprise subsidies, in a system with soft budget constraints, cash short enterprises resorted to non-cash surrogates for payments both with each

other and with the Treasury. Fiscal authorities permitted and enhanced the development of non-cash instruments for fiscal purposes

as a means of supporting inefficient enterprises, which could no

longer be subsidized directly. As international financial institutions

objected to the use of a particular instrument it was eliminated,

but quickly replaced by another nearly equivalent instrument.19

The share of non-cash transactions varied by industrial branch,

but clearly increased through the 1990s, as indicated in Figure 1

and Table 1. The increase in offset arrangements in 1996–1998 also

paralleled the increase of enterprise payments arrears, as they became the dominant form of non-cash payments. While it may be argued that offset arrangements prevented a further contraction in

the economy and to some extent provided liquidity (some offsets

were tradable) they also were very inefficient as a means of payment since transactions costs were extremely high and they facilitated the continuing distortion of relative prices.20 With the development of alternative credit instruments barter should decrease

over time.

There are three causes noted for the Russian demonetisation: (1)

barter occurred between enterprises that had Soviet era links and

was facilitated by trade institutions that act much like Gossnab 21

did, (2) macro-economic policy, the elimination of directed credits

and high interest rates, increased the opportunity cost of money,

encouraging financial innovation and the creation of non-money

means of payments, and (3) barter and varying prices for differing

means of payment facilitated tax avoidance. Clearly all three reasons contributed to the demonetisation, but by 1999 world oil prices

and export earnings increased, and interest rates came down, all

providing greater liquidity to the economy overall, and the need for

monetary surrogates declined. The banking system stabilized and

transaction levels within the payments system returned to more

normal levels. While stable, the system is still far from liberalized.

190

FIGURE 1.—SHARE OF NON-CASH RECEIPTS FOR INDUSTRIAL FIRMS

Source: OECD (2000) p. 85. Original Source: Russian Economic Barometer.

TABLE 1.—TYPES OF PAYMENTS BY LARGE FIRMS AND NATURAL MONOPOLIES BY

INDUSTRIAL BRANCH, DECEMBER 1998

[As a percentage of total payments]

Cash Offsets Securities Barter Other Total

All firms ....................................... 43.4 29.5 11.5 7.5 8.1 100

Electricity ..................................... 19.5 45.2 16.7 4.1 14.5 100

Fuels ............................................ 39.4 36.5 15.2 4.7 4.2 100

Machine-building and metalwork 14.1 37.4 31.3 13.5 3.7 100

Construction and construction

materials ................................. 26.0 44.6 7.8 18.5 3.1 100

Transportation .............................. 37.4 45.8 11.0 0.3 5.5 100

Light industry and food ............... 69.8 12.7 4.0 7.6 5.9 100

Agriculture ................................... 65.1 3.3 0.5 28.6 2.5 100

Trade and public catering ........... 84.4 11.6 3.2 0.3 0.5 100

Source: OECD (2000), p. 87. Original source Goskomstat.

FINANCIAL REPRESSION AND LIBERALIZATION

McKinnon (1973) defines financial repression as any policy or

regulation that prevents financial intermediaries from operating at

a level in accordance with their technological potential. Typical repressive policies of the banking system in a market-type economy

are forms of implicit or indirect taxation of financial intermediaries

or transactions. The most common are bank reserve requirements

with low or zero yield, ceilings or controls on lending and deposit

rates, and the inflation tax on monetary assets in general. The

costs include the loss in efficiency due to the distortions in interest

rates, credit rationing and overall discouraged savings due to low


76171.028
191

22The costs can be significant. In a study of twenty-six developing countries the inflation tax

was estimated at 2.8 percent of GDP and ceilings on interest rates generated a tax equivalent

to 1.8 percent of GDP. See Berthelemy and Varoudakis (1996). 23Stiglitz (1994) notes seven types of market failure: (1) monitoring as a public good, (2)

externalities of monitoring, selection and lending, (3) externalities of financial disruption, (4)

missing and incomplete markets, (5) imperfect competition, (6) Pareto inefficiency of competitive

markets, and (7) uninformed investors. He then provides a taxonomy of government interventions which may be appropriate. Levine (1996) provides a framework for policy analysis and government intervention. Harwood and Smith (1997) provides an extensive look at financial development strategies for developing countries. 24For example, Jaramillo-Vallejo (1994) takes issue with Stiglitz’s arguments for government

intervention. 25Tompson (1997) argues that at least through the mid-1990s Russian banks really did not

bank. They did little to collect deposits and did little lending except to the state. A large share

of their liabilities were free and a large share of their assets were idle. Banks maintained a

high level of excess reserves even during highly inflationary periods. This activity is not necessarily financial repression via government policies, but by poor management. Iskyan and

Besedin (2000) call Russian banks ‘‘bank-like institutions’’ and Schoor (2001) maintains most

banks are simply treasury operations of their enterprise owners. 26 It is difficult to ascertain what level of repression is optimal. E.g., mild financial repression

may include deposit rate ceilings, which enhance franchise values. However, if ceilings and other

regulations diminish competition and hinder the efficient allocation of resources diminishing

growth then liberalization is in order.

deposit rates.22 In addition, the market structure itself must be

considered as a potential limiting factor on the development of the

financial system. Stiglitz (1994) emphasizes market failure and the

need for government intervention of various sorts to improve efficiency in the financial system.23 There is considerable debate in the

literature on both the optimal level of competition and the need for

and type of government intervention, however.24

With virtually no lending activity, strict controls on deposit accounts and rate ceilings and complete monopolization of the banking system during the centrally planned era, the Russian banking

system has evolved from what may be considered an extreme in

terms of financial repression. To complicate matters Russian bank

management was not prepared to operate the newly created commercial banks as profit maximizing banks in a market economy.25

Russian banks were not able to identify potentially profitable investments, due to the lack of business reputations and reliable

credit histories, predominance of insider control (politically supported) in enterprises, weak contract enforcement and an underdeveloped legal system. Although bank managers are slowly developing the skills to engage in effective project appraisal and monitoring, they have weak incentives to develop these skills as long

as there are alternative, cheaper sources of high profits, like government securities.

The benefits of liberalization seem obvious, but the pace and timing of liberalization are critical. Many argue that the fiscal deficit

must be under control prior to liberalization because significant increases in interest rates to dampen growth or control inflation may

lead to adverse selection in bank lending activity, thereby threatening the soundness of the banking system. In addition, many argue

that a perfectly competitive banking industry will underprovide financial services because of the public good nature of the information on profitability of entering the deposit market by individual

banks and the high cost of entering the market. Thus, Hellman, et

al. (1997) argue that ‘‘mild’’ financial repression may be beneficial

because it creates rent opportunities that enhance incentives for financial deepening and deposit mobilization.26 And Van Wijnbergen

(1983) argues that informal financing that developed early in many

192

27 Bekaert and Harvey (2001), p. 11. 28 Actually, income and substitution effects make the a priori outcome on growth indeterminate. 29The August 1998 crisis led Sberbank to lose half of its net assets when the government defaulted on GKOs. The government bailed out Sberbank, whereas depositors at other failing institutions (Menatep, Most, SBS-Agro, Inkombank, Mosbusiness Bank, and Promstroibank) were required to transfer deposits to Sberbank at unfavorable terms. See Buchs (1999) p. 693 and

Schoers (2001). 30The Antimonopoly Ministry, however, has initiated three proceedings against Sberbank and

the CBR since the beginning of this year. However, all decisions taken concerning the promotion

of competition in the banking sector must be submitted to the CBR, which ‘‘seems to deliberately

hinder any attempts to achieve this task.’’ Russian Economic Trends, (April 2001), p. 6. It

should also be emphasized that Sberbank’s advantages in the deposit market also contribute to

an inefficient allocation of capital at the macro-level since its assets are held predominately in

government securities or loans to large state-owned enterprises, replicating investment patterns

of the Soviet era.

developing economies may actually be more efficient than intermediated financing in a liberalized system. But this is true only if

the informal sector has higher quality information on risk and

lending opportunities. While all three caveats may apply to the

Russian economy to a limited extent, recent research indicates that

the effects of financial liberalization on economic growth are ‘‘not

subsumed by other economic reforms or proxies for the development of capital markets and financial intermediation.’’ 27 Therefore

liberalization, per se, should proceed as quickly as possible.

A liberalized financial system contributes to overall economic

growth by increasing savings. Financial markets and banking

intermediaries improve the mobilization of savings, providing higher than expected yields and greater diversification of risk. This in

turn encourages financial savings rather than the purchase of consumer durables (or real assets with a low rate of return). Such a

reorientation of savings reinforces the deepening of the financial

system.28 This pattern may not be observed in the transition economy as pent up consumer demand is released in the initial period.

The financial crisis in Russia (as well as other transition economies) then introduced skepticism on the part of savers and weakened the credibility of the financial system overall. The fact that

there is no universal deposit insurance system for Russian savers

also discourages savings. Because Sberbank is the only institution

with state support perceived to be equivalent to deposit guarantees,

households transferred deposits from independent, private commercial banks to Sberbank.29 The share of total household deposits

held by Sberbank increased from just over 50 percent in mid-1994

to over 85 percent by January 1999, then declined slowly to just

over 75 percent in April 2001. One reason that other commercial

banks, private and state-owned, cannot compete in the deposit

market is because they lack the deposit guarantees that Sberbank

offers implicitly. Thus, to increase savings government policy

should reduce the risks to depositors associated with saving via

bank deposits by developing a system of deposit insurance and by

eliminating the household deposit monopoly Sberbank enjoys.

There has been tremendous resistance to this, however, as evidenced by the continuing discussion of the proposed federal laws on

deposit insurance.30

A liberalized system also improves the allocation of resources, increasing capital productivity and economic growth. The inherent

difficulties of resource allocation, with productivity risks, insufficient and imperfect information on the return on investment and

193

31To reduce the risk of disruption in the demand for products produced with highly specialized technologies (technology risk) firms often invest in less specialized and therefore less productive, flexible technologies. Therefore, diversification via activities of financial intermediaries,

allows more investment in highly specialized, more productive technologies. 32The law of large numbers reduces the probability that all depositors/investors withdraw at

the same time.

entrepreneurs’ skills, provide opportunities for creation of financial

intermediation services. Financial institutions provide diversification of risks associated with productivity and demand shocks, manage liquidity risks and evaluate potential projects and entrepreneurs. These activities increase the rate of economic growth by

increasing the resources invested in productive activities, increasing technological specialization,31 reducing the premature liquidation of capital 32 and increasing productive efficiency. Evaluating

projects and entrepreneurs, essentially assessment and monitoring,

has very large fixed costs which financial intermediaries can

spread over many investors, no one of which would be willing to

pay the initial fixed costs. The intermediary can evaluate more

projects, collect more information and provide it in a standardized

form to large numbers of investors who then choose among varying

levels of risk depending upon their risk preference. As a result of

better assessment of risk and better information, more resources

can be directed toward the most productive or profitable projects.

Monitoring and diversifying systemic shocks also allows an increase in resources invested in productive, but riskier projects,

therefore increasing the overall productivity of the economy’s capital stock.

The working of financial intermediaries described above stands

in stark contrast to the allocation of capital in the Soviet system

in which crude indicators of effectiveness, imperfect information

and political forces guided central planners’ investment decisions.

The Russian banking system is painfully evolving from one which

served as the agent of central planners toward a system of market

driven, profit oriented financial intermediaries. But it is far from

that goal. First, the financial services industry is far from competitive. Although the number of commercial banks is large, just over

1,300, activity is highly concentrated. As of April 2001, Sberbank

accounted for over 75 percent of household savings deposits.

Sberbank accounts for about 20 percent of lending and Vneshtorg

Bank accounts for about 5 percent. These banks have very little

lending experience and will likely favor large enterprises in priority

sectors not unlike the Soviet pattern of investments. As Table 2 indicates total domestic credit as a share of GDP is about 60 percent

of the comparable market economy and private sector credit relative to GDP is less than 50 percent of the market economy benchmark. Second, while the number of privately-owned banks is decreasing, the state also continues to found new banks, Rosiiski

Bank Razvitiya (the Russian Development Bank) in 1999 and

Rosselkhozbank (the Russian Agricultural Bank) in 2000, which

are likely to have different investment objectives, enjoy the implicit

guarantees of the state, and therefore will likely provide directed,

soft credits to industry and agriculture. Given that private sector

lending activity is lagging dramatically (as indicated in Table 2) a

more appropriate policy may be the creation of institutions subject

to market discipline, but designed to meet the financing needs of

194

33See Schoors (2001) 34 Iskayan and Besedin (2000), p. 5 reports that ‘‘a CBR audit of financial statements submitted to it found that roughly half of a representative group of banks systematically falsified reports.’’ In addition, even if information reported is correct, Russian accounting standards make

it difficult to understand an enterprise’s condition and inter-enterprise payments problems, and

non-payments, make it difficult for managers to assess their own enterprise’s performance,

much less to convince potential lenders/investors. 35Thomson (1997), p. 1176. Note the level of lending was low and very short term, typically

30 to 60 days. No doubt the high and variable inflation of the time was a significant deterrent

to lending. Although inflation has been reduced banks still tend to lend short term to finance

transactions (e.g., imports) or acquisitions rather than longer term investment projects.

small and medium enterprises in the private sector. On the positive

side, smaller, regional banks, which were less affected by the 1998

crisis, are in a position to expand their activities.33

TABLE 2.—TOTAL DOMESTIC CREDIT AND PRIVATE SECTOR CREDIT AS PERCENT OF

GDP AND MARKET ECONOMY BENCHMARK

1994 1999

Total domestic credit, percent of GDP ............................................... 31.7 32.7

Market economy benchmark, percent ................................................. 52.0 51.3

Proportion of benchmark level ........................................................... 61.0 63.7

Private sector credit, percent of GDP ................................................ 12.1 11.5

Market economy benchmark, percent ................................................. 44.2 43.3

Proportion of benchmark level ........................................................... 27.4 26.6

Source: Derived from Tables 1 and 2 of Fries and Taci (2001). Benchmarks are based upon regression

estimates of each ratio as a function of GNP per capita for a sample of 127 market economies. See

Fries and Tacci (2001) for details.

Third, information on enterprise performance, potential investment returns and entrepreneurial talents is very limited and of

poor quality regardless of whether intermediaries or individual investors collect the information. In fact, even official, legally required information is often incorrect.34 Fourth, most banks are acting primarily as treasury operations of their owners or acting implicitly as an agent of the government in lending activities, in effect

continuing the history of centrally directed capital grants, but now

with a weak expectation of repayment. As indicated in Tables 3

and 4 loans (claims on the private sector) account for roughly onethird of the banking sector’s assets. Tompson (1997) notes in 1995

that only 49.5 percent of assets were nominally income earning,

probably much less if non-performing loans were excluded.35

The distribution of assets indicates moral hazard issues remain

a serious problem. It was suggested above that the introduction of

deposit insurance would enhance competition, increase aggregate

savings and improve the allocation of liabilities within the banking

system. A second, perhaps more important reason to introduce a

system of risk-based deposit insurance, is that an explicit system

of guarantees is a more efficient means of reducing moral hazard

and improving resource allocation than the current system of implicit guarantees. Since the financial institution itself determines

the size of the implied guarantee, the institution can expand the

implicit subsidy by doing more and riskier lending. Explicit riskbased guarantees can be limited, however. By pricing the deposit

insurance in accordance with the institution’s risk profile, moral

TABLE 3.

—CONSOLIDATED ACCOUNTS OF CREDIT INSTITUTIONS

[In million rubles, December 31] 1

1995 1996 1997 1998 1999 

Reserves 2 ............................................................................................................... R36,712.3 R47,123.4 R72,974.5 R67,762.9 R160,017.3 R

Foreign assets ........................................................................................................ 46,149.4 72,874.8 72,717.3 219,593.0 370,651.3 Claims on general government .............................................................................. 62,638.5 150,721.3 194,689.0 259,401.6 437,675.2 

of which, claims on governments of constituent territories of RF and

local self-government bodies ................................................................... 721.7 2,790.4 18,691.8 24,445.6 19,870.5 

Claims on non-financial state enterprises ............................................................ 62,460.4 69,371.4 33,217.4 33,078.8 46,901.2 Claims on non-financial private enterprises and households .............................. 133,786.8 157,337.2 236,438.4 345,962.6 521,644.8 Claims on other financial institutions ................................................................... 525.0 242.0 8,075.9 7,270.7 13,060.2 

Total assets .......................................................................................... 342,272.4 497,670.1 618,112.5 933,069.6 1,549,950.0 2

Demand deposits .................................................................................................... 69,331.9 87,303.0 162,532.1 149,470.7 249,673.7 Time, saving and foreign currency deposits ......................................................... 124,496.6 164,898.7 158,714.8 283,996.1 456,527.8 

of which, deposits in foreign currency ......................................................... 55,255.7 69,447.7 80,454.7 190,872.7 290,212.9 

Deposits, access

—temporarily restricted 3 ............................................................ ................ ................ 6,270.5 22,595.1 10,223.6 

Money market instruments ..................................................................................... 11,858.5 30,372.2 42,435.9 43,311.9 107,817.2 

Foreign liabilities .................................................................................................... 29,969.8 58,892.5 104,197.4 203,136.8 222,626.6 General government deposits ................................................................................. 9,741.1 11,557.2 18,236.1 20,676.5 28,671.8 

of which, deposits of governments of constituent territories of RF and

local self-government bodies ................................................................... 4,251.9 4,210.6 9,139.9 10,148.2 15,626.8 

Obligations to monetary authorities ...................................................................... 8,005.1 6,798.8 8,779.8 71,893.6 200,121.4 Capital accounts .................................................................................................... 66,687.8 123,817.5 143,909.4 157,594.7 293,199.4 Sundry (balance) .................................................................................................... 22,181.5 14,030.3

¥26,963.5

¥19,605.7

¥18,911.6

1 From the consolidated balance sheets of credit institutions, Sberbank Savings Bank, and Vneshekonom Bank.2 Reserves of credit institutions comprise cash reserves in vaults and their funds in accounts with the CBR.3 Deposits with temporarily limited access comprise funds in accounts with credit institutions which cannot be used by their holders within a certain time limit in acco

a contract or transaction terms or current conditions of a credit institution’s activity.

Source: The Bulletin of Banking Statistics, various issues, CBR.

196

TABLE 4.—SELECTED ASSETS AND LIABILITIES OF COMMERCIAL BANKS, INCLUDING

SBERBANK

[In billion rubles]

Total assets

Claims on

the general government

Claims on

the private

sector

Bank savings by

Russian

citizens

(ruble

household

deposits)

Foreign

currency

deposits

Foreign liabilities

1995 ..................... R342.3 R62.6 R133.8 R70.6 R55.3 R30.0

1996 ..................... 497.7 150.7 157.3 118.4 69.4 58.9

1997 ..................... 622.7 191.5 225.9 148.2 80.5 104.2

1998 ..................... 933.1 259.4 346.0 149.5 190.9 203.1

1999 ..................... 1,549.7 437.7 521.6 211.1 290.2 222.5

2000 ..................... 2,259.4 526.0 867.1 304.2 420.1 249.0

2001 (April) ......... 2,472.0 561.3 989.2 342.5 477.1 256.4

Source: Russian Economic Trends, June 2001, Original Source: Goskomstat, CBR.

hazard can be limited and discrepancies between depositors’, insurers’ and lenders’ risk tolerances are narrowed. Thus, a system of

risk-based deposit insurance benefits not only individual depositors, but also reduces system risk by reducing moral hazard. A prerequisite for an effective system of risk-based deposit insurance is

the ability to measure risk, i.e., accurate financial information and

uniform accounting standards providing greater transparency of

bank activity. Legal reforms in the Russian banking system are

gradually providing the foundations for these prerequisites, but

currently, accurately measuring risk exposure of individual banks

is difficult if not impossible.

The financial system is not passive in a market economy, but accelerates growth in the real sector. The organization of financial

intermediation networks is expensive, however. The level of financial sector development and economic activity is inter-related. Because the bulk of costs in establishing an intermediation network

are the initial fixed costs, threshold effects are typical. An economy

develops a specific type of intermediation system corresponding to

the overall level of economic activity, which may be proxied by the

level of per capita income. Then as per capita income increases, at

some point the benefits of expanding or innovating within the

intermediation system are perceived and capturable, the next stage

of financial development begins. The benefits of deepening the financial system have a positive effect on overall economic growth

and create the possibility of a circular relationship between financial development and growth. In this case a ‘‘virtuous circle’’ in

which high income levels support development of the financial system and development of the financial system makes possible higher

rates of growth. On the other hand, an underdevelopment trap or

low-level equilibria may result. In an underdeveloped economy with

few growth prospects, low-income levels make the development of

the financial system impossible, which in turn hinders the allocaVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00222 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.010 CRS1 PsN: CRS1
197

36See Greenwood and Jovanovic (1990), Levine (1992b), Townsend (1983). 37See Saint-Paul (1992).

tion of resources to investment and further weakens growth.36

When financial institutions are inadequately developed selecting

more flexible, less specialized, and therefore less productive technologies mitigates production risk. But reduction in risk by technological flexibility in production weakens the incentives to develop

financial markets and banking intermediaries that involve substantial fixed costs. This results in a low level equilibrium with an

underdeveloped financial system.37 A more developed financial system enables selection of more specialized, more risky but more productive production technologies. And, the resulting increase in risk

is more easily diversified and mitigated by the existence of a developed financial system.

Before turning to a description of the Russian banking system it

is important to realize that the banking industry in a market economy is typically not a perfectly competitive industry, but characterized by varying degrees of imperfect competition. Thus, in a transition economy policies should encourage competition, recognizing

that the optimal level of competition is unclear. Natural imperfections in the banking system in a market economy arise due to the

information intensive functions of the system. The activity of gathering and processing information on investments involves large

fixed costs, which leads to imperfect competition and market segmentation. Because lenders (savers) and investors (borrowers) are

generally not the same individuals there are information

asymmetries since investors have better access to information

about the quality and likely success of investment projects than

lenders do. Therefore the functioning of financial markets is characterized by adverse selection and adverse incentives. Although

banking is often monopolistically competitive Stiglitz (1994) argues

greater competition is a two edged sword. Compression of intermediation margins via greater competition erodes profits and

makes the system more vulnerable to productivity shocks as it increases the possibility of insolvency. Unlike other sectors insolvency in the banking sector can have wide spread negative repercussions on the rest of the economy as the volume of lending and

activity in the real sector decline. Also, when a bank goes bankrupt

the information it has collected on its particular clients or sector

of lending activity may simply disappear. If so this leads to borrower rationing, which has a negative impact upon growth—the opposite effect that we would expect from compressing intermediation

margins. The optimal level of competition, or the optimal intermediation margin, is not that of a perfectly competitive market.

Reaching that optimal level is difficult in a well-functioning market

environment and particularly difficult in a transition environment

like that of Russia today.

198

38Great Britain and Japan are extremes with bank system assets as a percent of GDP at 270

percent and 159 percent in 1990 and 1993 respectively. Warner (1998), Table 2. 39 Note though that GDP has fluctuated greatly and published data are sometime suspect.

Therefore these ratios should be interpreted with caution. See Iskyan and Besedin (2000) p. 21. 40 Russian Federation (1997), p. 88. 41 Russian Federation (1997), p. 88.

THE STATE OF THE BANKING SYSTEM: CRISIS, RECOVERY AND

CRISIS?

SYSTEM CHARACTERISTICS AND POLICY FRAMEWORK

While the overall level of financial development in a transition

economy is difficult to measure, traditional indicators of financial

development indicate the Russian financial sector is underdeveloped vis-a`-vis market economies even after the crisis and stabilization of the system. As Table 5 indicates banking system assets as a percentage of GDP has increased from 22.2 percent in

1995 to 32.0 percent in 2000. This ratio for a market economy is

typically in the 50 to 60 percent range.38 Loans to GDP has increased from 8.7 percent to 12.3 percent. Banking system capital

as a percentage of GDP has fluctuated, but averaged about 5.5 percent, in the range of a market economy, typically 5 to 6 percent.39

While these aggregate measures seem to be improving it should be

noted again that total domestic credit relative to GDP is about 60

percent of the comparable market economy and private sector credit relative to GDP is well less than half that of the comparable

market economy (see Table 2). Further, these proportions have not

changed during the last 5 years. Importantly the aggregate measures conceal the fact that the Russian banking industry is highly

concentrated. At the end of 1997, just prior to the 1998 crisis, the

top 5 banks accounted for 36 percent of total assets, and the top

50 accounted for 71 percent.40 Also, as mentioned above, Sberbank

holds roughly 75 percent of household deposits. Including enterprise deposits the top 5 banks accounted for 58 percent of ruble deposits and the top 50 banks accounted for 65 percent at the end

of 1997.41

TABLE 5.—BANKING SYSTEM CHARACTERISTICS (END OF PERIOD)

[In percent]

1995 1996 1997 1998 1999 2000

Assets/GDP ....................... 22.2 23.2 25.1 34.0 32.6 32.0

H.H. deposits/GDP ............ 4.6 5.5 6.0 5.5 4.4 4.3

Loans/assets .................... 39.0 31.6 36.3 37.1 33.7 38.4

Loans/GDP ........................ 8.7 7.3 9.1 12.6 11.0 12.3

Source: Calculated from Tables 2 and 7.

Since 1998 bank restructuring has taken place, albeit at a pace

that some see as too slow. The crisis led to a dramatic decline in

bank capital and a deposit run on the large Moscow banks leaving

the majority of them insolvent. The CBR adopted emergency measures forcing six large commercial banks to transfer the bulk of

household deposits to Sberbank, with any remaining deposits froVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00224 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.010 CRS1 PsN: CRS1
199

42These banks were Inkombank, SBS-Agro, Moct Bank, Rosiiskii Kredit, Menatep and

Promstroibank. Also see OECD (1997) Annex I for a discussion of the largest 23 banks prior

to the crisis. 43For example, the CBR’s initial attempt to revoke the license of Inkombank was contested

in court and it was not until June 2000 that the revocation of the license was allowed to stand

and a Moscow arbitration court named external managers to liquidate the bank. See Iskyan and

Besedin (2000) for a chronology of this case and a primer on asset stripping. Also see Schoors

(1999). Another notable case is that of Promstroibank. In July 1999 the CBR withdrew

Promstroibank’s license and it was declared bankrupt. Various government officials declared

their support of Promstroibank, the bankruptcy procedures were halted and the license suspension declared illegal, even though the bank was insolvent. In November 2000 an arbitration

court ruled the CBR’s actions were legal and proceedings were to continue. See Russian Economic Trends (November, 2000), p. 17. 44 It lacked funding and authority. Its first board meeting was held in March 1999. See Russian Economic Trends, March 1999, p. 3. 45Russian Economic Trends, December, 1998, p. 3 46While there are tangible results of ARCO’s efforts critics maintain they are negligible since

these banks are very small compared to the overall banking system and these bailouts may be

seen as benefiting incompetent managers and therefore increasing moral hazard. The overall

benefit to the banking system remains an open question. 47See Russian Economic Trends, various issues, (2000), (2001). 48 Note that Uneximbank may be the only bank to be successfully restructured without assistance from ARCO or any other state agency. Russian Economic Trends, October 2000, p. 13.

zen.42 This prevented further withdrawals by the population and

stabilized the payments system. However, the CBR was unable to

move quickly to close large insolvent banks, which were at the

heart of the influential Financial Industrial Groups, or to extend

rehabilitation credits in a timely manner. Although the bank had

the power to revoke licenses and take over the management of insolvent banks, the attempts to do so immediately after the crisis

were unsuccessful.43 Legal delays and political maneuvering allowed assets to be transferred from the failing institutions to newly

created shell banks and balance sheets were unilaterally restructured. Although the Agency for Restructuring Credit Organizations

(ARCO) was established rather quickly, in November 1998, its effectiveness also was limited in the early period after the crisis.44

It was capitalized with 10 billion rubles, the state holding 51 percent of its shares and the CBR 49 percent, an amount estimated

at about 10 percent of that necessary for a complete recapitalization of the banking system.45

By mid-2000 the results of ARCO’s modest efforts were becoming

visible.46 Temporary administration was imposed upon Most Bank

in May and Vneshtorg Bank purchased it in October 2000. SBSAgro and Mezhkombank were bankrupted. Bankruptcy proceedings

continue with Promstroibank and Menatep, Mosbusiness Bank and

Imperial Bank remain in receivership, or are battling for survival.47 The first bank to emerge from ARCO management, in

2001, is Chelyabkomzembank, purchased by Rosselkhozbank the

wholly state-owned bank created in April 2000. A restructuring

plan for Uneximbank was approved and shareholders approved its

merger with Rosbank (the bridge bank of Rosiiski Kredit).48 In addition, the Central Bank is expected to divest itself of ownership

in all banks. It sold its interest in five Russian-owned foreign-based

banks (rosagranbanks) to Vneshtorg Bank this year and will sell

its ownership in Vneshtorg Bank by 2002 and in Sberbank by 2004.

The foundation of the Russian banking system is provided by two

fundamental laws, the Law on Central Bank of the Russian Federation and the Law on Banks and Banking Activity and by various parts of the civil code, in particular bankruptcy provisions and

the tax code. The CBR carries the responsibility for not only moneVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00225 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.010 CRS1 PsN: CRS1
200

49For additional details see OECD (1997), pp. 83, 84. 50 IMF (1999). 51See Iskyan and Besedin (2001), Appendix B for a summary of the Gref program and the

corresponding legislation. 52Russian Economic Trends, June 2001, p. 8. 53Russian Economic Trends, June, 2001, p. 7. 54Russian Economic Trends, May 2001, p. 6.

tary policy, but also bank licensing and prudential and regulatory

oversight. Although the banking laws originated from the Soviet

era, they have been amended many times. The 1995 amendments

gave the Central Bank greater independence and made it the lender of last resort.49

In 1999 Russian authorities provided a stronger foundation for

bankruptcy and bank rehabilitation, and the framework to accelerate the process of bank restructuring by passing two new laws. The

Law on Insolvency of Credit Organizations strengthened the CBR’s

intervention powers and the Law on Restructuring of Credit Organizations (June 1999) gave sole responsibility for restructuring

banks to ARCO, provided for an equitable and transparent mechanism for shareholder write downs, and empowered ARCO to invalidate transactions made with the intent to defraud depositors and

creditors of insolvent banks.50 In spring 2001 the Duma passed

three bills (incorporating most of the Putin government’s proposal

referred to as the Gref program or the ‘‘IMF package’’) which gave

the CBR additional supervisory powers, introduced the legal concepts of a banking group and holding, streamlined the procedures

for bankruptcy of credit organizations and revised the responsibilities of bank founders, shareholders and managers.51 Inter alia,

specific legal criteria were introduced to facilitate the CBR’s actions

to withdraw banking licenses and initiate bankruptcy procedures

which are expected to eliminate the legal wrangling typical of most

recent actions initiated by the CBR. Given the new legislation it

appears that a second phase in bank restructuring may now be undertaken.52

RECOVERY OF BANKING ACTIVITY

Only recently has macro-economic performance allowed banks to

rebuild reserves and slowly increase the level of confidence of depositors and investors. Growth in the banking sector has been driven by the overall positive developments in the real sector and increasing demand for banking services. Bank loans increased 66

percent in 2000 and nine out of ten banks were reporting profits.

By the first quarter of 2001 assets of commercial banks reached 93

percent of the pre-crisis level in real terms, and hard currency assets were 43 percent of total assets.53 As personal incomes recovered, household deposits in the banking sector have increased and

the share held by Sberbank has stabilized at just over 75 percent

in June 2001. (Also see Figure 2.) By spring 2001 lending had increased to about 40 percent of assets in the Russian banking sector. This is improved, but still very low compared with the 80 to

90 percent typical of a bank in a developed market economy. Further, Sberbank and Vneshtorg Bank, the two largest state-owned

banks, accounted for most of the lending to the real economy.54

201

55See OECD (1997), pp. 85–86. 56Of course the consequences of such pressures are problematic to the extent that relatedparty lending some of which may not be market driven intermediation, and lending to state institutions distorts the allocation of financial capital. Related-party lending and its consequences

is very difficult to measure, however. See Iskyan and Besedin (2001) p. 15. 57This is for the banking system. Of the approximately 1,300 banks, the 1,115 smallest have

capital ranging from $0.1 million to $5 million (Iskyan and Besedin (2001), p. 14). Many of these

Continued

FIGURE 2.—HOUSEHOLD DEPOSITS IN SBERBANK AND OTHER COMMERCIAL BANKS

[In billion rubles]

Source: Russian Economic Trends, June 1999, p. 4. Original Source: Goskomstat.

Although lending has increased, Russian commercial banks still

hold unusually large amounts of non-income producing excess reserves, illustrated in Figure 3. Due to the high risk of lending to

the productive sphere of the economy loans amount to less than 45

percent of assets. Nearly 15 percent of assets are held in noninterest bearing accounts at the CBR. Given the high inflation environment this obviously impacts bank profitability. The lack of

lending to enterprises, investment into the real economy, also limits economic growth. This is not a new phenomenon, however.

Throughout the 1990s banks held very low levels of income earning

assets.55 This is attributable to the inability of bank managers to

find, evaluate and monitor viable investment projects, and extreme

caution with respect to the possibility of bank deposit runs and

risks associated with inter-bank lending. The government has pressured banks to increase lending and, as mentioned above, created

two new banks, Rosiiski Bank Razvitiya (the Russian Development

Bank) and Rosselkhozbank (the Russian Agricultural Bank), to expand lending in critical areas.56

Increased lending is a double-edged sword, however. The rapid

increase in bank lending requires increased diligence upon the part

of bank regulators. Although bank capital increased 43 percent in

2000, undercapitalization is still a serious problem.57 Total equity


76171.038
202

institutions simply conduct treasury functions of their enterprise owner or operate as foreign

exchange offices rather as banks 58Russsian Economic Trends, July 2000, p. 14.

capital is no more than 6 percent of GDP. Further, under relatively

weak supervision many banks violate existing accounting rules,

supplying the CBR with false financial statements. Regional offices

are alleged to ignore the exaggerated statements of financial performance. According to the CBR 60 percent of banks overstated

their profits and equity in official reports. At the same time CBR

regional offices classified 9 percent of these banks as stable and

with no faults. In addition, according to the CBR at least 20 percent of the banks classified as stable may be in difficulty.58 To improve financial reporting, in October 2000 the CBR launched the

introduction of international accounting standards (IAS) for six

banks. For these banks IAS-based reports will be provided in 2001.

Other banks are expected to adopt IAS reporting, but over a process of many years. While adopting IAS is highly beneficial, CBR

authorities at all levels must also be diligent and determined in enforcing prudential regulations. While significant legislative

progress has been made, CBR regulatory efforts are still insufficient.

FIGURE 3.—SHARE OF COMMERCIAL BANKS’ CLAIMS ON THE PRIVATE SECTOR AND

SHARE OF EXCESS RESERVES IN TOTAL ASSETS

[In percent]

Source: Ivanova and Schoors (2000), p. 5.


76171.037
203

CONCERNS AND ISSUES

It is clear that Russian policymakers have made much progress

in reconstructing the banking system in the aftermath of the 1998

crisis. Recent legislation has increased the authority of the Central

Bank to expedite bankruptcy and restructuring programs for individual banks and the economic recovery has provided an environment for improving bank profitability. The banking system in the

aggregate, however, is still far from a vibrant, sound banking system. Koch (1998) provides a framework for analysis of the banking

system presented in Table 6. In each of the six categories there is

substantial work to be done.

TABLE 6.—INDICATORS OF A ROBUST FINANCIAL SYSTEM

1. Legal and juridical framework

Well-defined property rights and contract law

Market contracts easily enforceable in practice

Ability to pledge and seize collateral

Well-developed bankruptcy code

2. Accounting, disclosure and transparency

Loan valuation, asset classification and provisioning practices reflecting sound

assessment of counterparties

Effective and regular auditing mechanisms

Information on the creditworthiness of financial institutions made publicly

available on a regular, frequent basis

Timely publication of relevant aggregate financial data (macro-economic indicators, reserves, banking sector statistics, etc.)

Availability of impartial credit rating or credit information facilities

3. Stakeholder oversight and institutional governance

Capital adequacy requirements commensurate with risk

Replacement of management for poor performance

Enforceable legal liability of managers

Pervasive use of effective systems of risk management and internal control

4. Market structure

Financial sector open to qualified new entrants, including those from abroad

Share of foreign participants in total assets

Financial sector concentration ratios

Liquid inter-bank money and capital markets

Regulations permitting a full range of financial instruments

Sound and effective payment and settlement systems

5. Supervisory/regulatory authority

Independent from political interference in the daily conduct of supervision and

appropriate accountability for achieving clearly defined objectives

Power to force disclosure, impose penalties, etc.

Adequate resources for staffing, training, compensation

Conducts supervision on a consolidated basis

Shares information with other supervisors

Verification of information on risk management and internal control systems

and on asset quality by regular examinations or external audits

Adherence to norms established by international consultative bodies (Basle

Committee, etc.), in principle and in practice

Measures to address particular types of risk:

Evaluation of risk management systems

204

59Russian Economic Trends, April 2000, p. 6. While banks may be lending to more risky ventures there is also a serious problem in matching the term structure of assets and liabilities.

Approximately 25 percent of loans are for terms of 1 year or more whereas about 14 percent

of liabilities are for 1 year or more. Without a highly liquid, capital market with sufficient depth

a liquidity crisis may easily develop.

TABLE 6.—INDICATORS OF A ROBUST FINANCIAL SYSTEM—Continued

Connected lending

Risk exposure and loan concentration

Special attention to foreign currency and interest rate risk management

and exposures

Heightened scrutiny of asset quality and capital adequacy in the face of

sharp asset price movements

Strategy for addressing financial insolvency:

Procedures for prompt corrective action or the equivalent

Appropriate exit policy

6. Design of the safety net

Explicit rather than implicit deposit insurance, paid for by banks and targeted

especially toward protecting small depositors

Appropriate allocation of losses among stakeholders

Stringent conditionality for the use of public money

Source: Koch (1998). Original source: Group of Ten (1997).

As mentioned above new legislation improved the legal juridical

framework, but much of the legislation is untested in practice. The

bankruptcy code is improved, but it is too early to tell if legal challenges and political pressures have been eliminated from the process. Accounting, disclosure and transparency is improving and the

CBR’s recent project on IAS is a tremendous step. However, even

when bank reporting reveals problems authorities have been reluctant to take appropriate actions. For example, in the spring of this

year the CBR reported ‘‘the risk exposure of Russian banks exceeds

all reasonable limits.’’ 59 But the CBR does not appear to be taking

any action to ameliorate excessive risk exposure. Will the CBR be

able and willing to take a more active approach in system risk

management?

The 1998 crisis revealed that stakeholder oversight and institutional governance was a serious problem. New legislation was required to better define the legal liabilities of managers and enable

management to be replaced during the restructuring process. Internal controls were notoriously weak and creditor rights were not

clearly delineated and forcefully represented by authorities during

the early phase of restructuring. Managers were able to strip the

assets of banks and effectively rob depositors and creditors. ARCO

still holds ownership stakes in over a dozen banks in the process

of restructuring and new legislation will likely enable the process

to work more smoothly in the future. However, political pressure

and legal challenges will not likely disappear.

Market structure issues, ranging from the concentration of the

industry, efficiency of financial products markets, relative lack of

lending to the private sector, ease of entry and development of new

financial institutions are a serious concern. Certain markets remain nearly monopolized. Sberbank’s domination of the household

deposit market gives it enormous power in the enterprise lending

205

60For example, in May 2001 Infobank, a creditworthy institution with many large retail customers, nearly went bankrupt defaulting on payments on the inter-bank credit market. This

could have precipitated a liquidity crisis similar to that of 1995. Russian Economic Trends, June

2001.

market. Further, many argue there remains too much state ownership to effect competitive market-oriented behavior on the part of

financial institutions. Sberbank and Vneshtorg Bank are more than

50 percent owned by the Central Bank, ARCO has a dominant

share of over a dozen institutions, and the Russian Federal Property Fund owns a majority of Roseksim Bank. The creation of the

Russian Development Bank and the Russian Agriculture Bank

seem to move the industry toward greater participation by the

state rather than less, and greater lending to state-owned enterprises rather than to the private sector. In addition, state organizations account for very large shares of deposits and assets for many

banks. All of which provides tremendous opportunity for political

pressures to influence bank behavior. One positive factor is that

the Duma has required the Central Bank to divest itself of ownership of commercial banks by 2005. Exactly how this is done is of

critical importance. To date the Central Bank has sold its stake in

five rosagranbanks to Vneshtorg Bank—ownership remained in the

state sector. While this does remove one conflict of interest and enables the Central Bank to take a slightly greater arms length view

of these banks, the state still has ownership of them and political

pressures are only one small step further away.

In addition, money and capital markets lack depth and breadth,

which in turn may allow an individual, apparently healthy, participant to precipitate a market wrenching liquidity crunch.60 In 1995

the Central Bank was slow to provide additional liquidity and

nearly 200 banks failed. Can the Central Bank identify participants with excessive risk exposure and limit their participation to

dampen system risk? Tough supervisory and prudential regulation

is required. Given the admissions of rather lax enforcement of existing regulations, not so stringent enforcement of loan classification and provisioning requirements and the propensity for individual banks to distort information in the reporting process, serious

questions remain.

Finally, the safety net for depositors, an explicit, universal deposit insurance program, paid for by the banks, but targeting

household depositors is critical. It is the foundation for creating

greater confidence in the banking system and increasing the

amount of savings mobilized and available for investment. It also

allows smaller banks to compete with Sberbank for deposits, promotes competition, reduces moral hazard and diversifies system

risk. Yet the Duma, after much debate and many readings has

failed to act.

In summary, tremendous change has taken place in the Russian

banking system through the 1990s and since the 1998 crisis. The

overall economic environment has improved and supported the recovery of the financial system (see Tables 7 to 9). It is an open

question however, whether or not the systemic changes and the attitudes of regulators and policymakers have changed sufficiently to

prevent a banking crisis comparable to that of 1998.

TABLE 7.

—SELECTED ECONOMIC ACTIVITY

Nominal GDP (In

billion rubles)

Real GDP, (seasonally adjusted)

(1997 = 100)

Nominal consumption of

goods and services (In billion

rubles) 1

Real consumption of goods

and services 2

(1995 = 100)

Nominal expenditures on newconstruction and

equipment (In

billion rubles)

Rea

ture

const

equip

= 

1995 ......................................................................... R1,540.5 102.6 R664.8 100.0 R267.0 1996 ......................................................................... 2,145.7 99.1 950.1 97.9 376.0 1997 ......................................................................... 2,478.6 100.0 1,124.0 100.9 408.8 1998 ......................................................................... 2,741.1 95.1 1,339.9 95.5 407.1 1999 ......................................................................... 4,757.2 100.2 2,191.7 82.7 670.4 2000 ......................................................................... 7,063.4 108.6 2,911.4 91.0 1,165.2 2001 (April) ............................................................. ...................... ...................... 1,114.3 93.0 331.0 

1 Series on consumption and investment differs slightly from SNA concept.2 Nominal consumption deflated by CPI.

Source: Russian Economic Trends, February 2001. Original Source: CBR.

207

TABLE 8.—MONETARY AGGREGATES (END OF PERIOD)

Monetary

base (In

billion

rubles)

Net

international

reserves 1

(In billion dollars)

Net domestic

assets 2

(In billion rubles)

M0—

currency

in circulation

(In billion rubles)

M2 3 (In

billion

rubles)

Outstanding

stock of

GKOs

and OFZs

nominal

(In billion rubles)

1995 ................................. R103.8 $7.7 R68.1 R80.8 R220.8 R73.7

1996 ................................. 130.9 1.7 123.0 103.8 288.3 237.1

1997 ................................. 164.5 4.0 142.1 130.4 374.1 384.9

1998 ................................. 210.4 ¥8.4 249.3 187.8 448.3 NA

1999 ................................. 324.3 ¥3.2 0.0 266.5 704.7 NA

2000 ................................. 519.6 16.0 88.6 419.3 1,144.3 184.2

2001, April ....................... 531.1 20.4 NA 435.4 1,210.0 189.5

1 Since June 2000 net international reserves and net domestic assets are estimated by RET.

2 Net domestic assets of the monetary authorities equal monetary base minus net international reserves. Net domestic assets are calculated using exchange rates of 27 rubles per dollar for 2000, 24.18

rubles per dollar for 1999, 6.0 rubles per dollar for 1998, 5,560 rubles per dollar for 1997, 4,640 rubles

per dollar for 1996, and 3,550 rubles per dollar for 1995. In 1999 there were some changes in methodology for net domestic assets and net international reserves data. 3M2 includes currency in circulation, demand deposits, and time deposits (there is a break in the series from December 1996, from then it includes only deposits at banks with active licenses).

NA—Not available.

Source: Russian Economic Trends, June 2001, original source: CBR.

TABLE 9.—INTEREST RATES (AVERAGE ANNUAL RATES) 1

CBR refinance

rate 1

(percent)

Lending

rate 2

(percent)

Deposit

rate 2

(percent)

Overnight

interbank

rate

(percent)

GKO

average

secondary

market

yield,

all maturities

(percent)

RTS index,

monthly

average

(01.09.95

= 100)

1995 ......................................... 185 320.3 102.0 190.4 161.8 80.9

1996 ......................................... 110 146.8 55.1 47.6 85.8 160.3

1997 ......................................... 32 32.0 16.8 21.0 26.0 427.9

1998 ......................................... 60 41.5 17.1 50.6 NA 277.6

1999 ......................................... 57 40.1 13.7 14.8 NA 106.9

2000 ......................................... 32 24.2 6.5 7.1 12.7 199.5

2001, April ............................... 25 17.4 3.5 .......... .......... 166.0

1 Unweighted monthly average.

2 Data prior to January 1997 are not compatible with current methodology. From 1998 data on lending

rate are for commercial banks excluding Sberbank.

NA—Not available.

Source: Russian Economic Trends, June 2001, original source: CBR.

208

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(213)

Breakup of Monopolies: Energy, Transportation

and Agriculture

THE RUSSIAN ENERGY SECTOR: CURRENT

CONDITIONS AND LONG-TERM OUTLOOK

By Matthew J. Sagers 1

CONTENTS

Page

Summary .................................................................................................................. 213

Introduction .............................................................................................................. 217

Oil Sector .................................................................................................................. 219

Crude oil production ......................................................................................... 219

Oil exports ......................................................................................................... 223

Refinery operations and oil consumption ....................................................... 226

Gas Sector ................................................................................................................ 231

Gas production .................................................................................................. 231

Gas exports ....................................................................................................... 233

Gas consumption .............................................................................................. 234

Coal Sector ............................................................................................................... 236

Electric Power Sector .............................................................................................. 239

Electricity production ....................................................................................... 239

Electricity consumption .................................................................................... 239

Organizational structure .................................................................................. 242

The Russian Federation’s Primary Energy Balance in Long-Term Perspective 244

References ................................................................................................................ 252

1Matthew J. Sagers was Director of Energy Services at PlanEcon, Inc. until October 2001

when he shifted positions to Director, Energy Economics for Eurasia and Eastern Europe at

Cambridge Energy Research Associates. He holds a Ph.D. in Geography from The Ohio State

University.

SUMMARY

Energy production holds a central place in the economic and political life of the Russian Federation, as the country is a leading

energy-producing country, ranking first in the world in gas production, third in oil production, fifth in hydro and nuclear generation,

and sixth in coal production. The reform and re-emergence of this

key part of the economy are integrally linked to the country’s overall economic transformation and recovery, due not only to the energy sector’s direct impact on gross domestic product (GDP) and

overall value-added in the economy, but also to its importance in

foreign exchange earnings and Russia’s fiscal stability. Similar to

the overall economy, however, Russia’s energy sector initially experienced a sizable decline coincident with the launch of Russia’s

transition from a centrally planned to a market-type economy, although after bottoming out in 1997, it has since been rising. 2000

was a very good year for Russian energy production, with aggreVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00239 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.011 CRS1 PsN: CRS1
214

2Government of the Russian Federation, 2000.

3The energy data presented in this report are given in the metric units commonly used in

Russia rather than standard U.S. measures. An exception is Russian aggregate energy balances,

which are reported here in the usual international standard of million metric tons of oil equivalent (mtoe); Russian aggregate balances are presented in terms of million metric tons of coal

equivalent (standard fuel or mtce) while U.S. aggregate balances are often presented in quadrillion British thermal units (btu) (or quads). The conversion coefficient to mtoe from mtce is 0.7.

Similarly, oil production is reported in million metric tons (mmt) per year instead of million barrels of oil per day (mbd), for which the conversion coefficient is 0.02 (i.e., 7.3 barrels per metric

ton of oil). Natural gas production is reported in billion cubic meters (bcm) per year (at 20°C

and a pressure 760 mm of mercury) instead of the U.S. measure (billions of cubic feet [bcf] measured at 15°C and 760 mm of mercury); the conversion coefficient from bcm to bcf is 35.315. 4Sagers and Movit, 2001.

gate primary energy output rising by 2.1 percent; oil production

climbing by 6.0 percent; coal production up by 3.5 percent; and

electricity generation increasing by 3.8 percent; however, natural

gas production declined, falling by 1.1 percent.

Broadly speaking, energy sector reforms over the past decade

have typically lagged behind those in the economy at large. But increasingly, the outcome of general economic reforms will depend to

a large extent upon the success of those in the energy sector. If

properly managed, Russia’s energy resources can help accelerate

the economic reform process; if poorly managed, it can easily

hinder that process.

Russia’s principal energy policy document is the Energy Strategy

of Russia to 2020, which was officially approved by the government

in November 2000.2 The Energy Strategy states Russia’s priorities

for its long-term energy policy and the mechanisms for its implementation. The Strategy is set within the context of a resumption

of economic growth in Russia, and there is a broad concern that,

given the poor state of the Russian energy sector, it may not be

able to provide for both increasing energy demand within Russia

as well as generate the energy exports needed to sustain economic

growth. Thus, the Strategy continues to emphasize improvements

in energy efficiency and reform of energy pricing structures.

The Energy Strategy’s projections for energy supply to 2020 are

based on a major change in energy policy outlook. It expresses

major concern over the energy security risk from what is deemed

to be too high a dependence on natural gas. The Strategy envisages

a change in the fuel mix such that the share of natural gas in total

primary energy consumption decreases from about 50 percent in

the late 1990s to 42 to 45 percent in 2020. In its place, the share

of coal is planned to increase from 17 to 18 percent in the late

1990s to 22 percent in 2010 and to 21 to 23 percent in 2020. Nuclear energy is also slated to increase, expanding to 6 percent in

2020 from current levels of 5 percent, while oil’s share in primary

energy consumption will remain practically unchanged. The Strategy projects primary energy production in Russia in 2020 in a

range of 1,525 to 1,740 million metric tons of coal-equivalent (mtce)

(1,068 to 1,218 million metric tons of oil equivalent [mtoe]).3

However, PlanEcon’s most recent energy forecast for Russia4

takes an entirely different tack. It does not view the large dependence on gas as a particular cause for concern; instead, this is

viewed as a natural consequence of Russia’s massive reserves of

natural gas. The PlanEcon forecast projects total output of primary

energy in 2020 in Russia at a much higher level than in the Strategy (1.446.3 mtoe, 46.7 percent higher than the 2000 figure), comVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00240 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.011 CRS1 PsN: CRS1
215

bined with less energy consumption, and therefore higher energy

exports. In particular, coal production is expected to resume its

long-term secular decline; oil output is expected to continue to recover (albeit slowly); and gas production is anticipated to turn

around shortly, due both to improvements in the domestic investment climate (reflecting higher prices and toughening payment

conditions) and to more buoyant demand from expanding economic

activity in the region. Thus, natural gas is expected to garner a

steadily rising share of Russia’s energy production over the next

two decades, reaching 58.3 percent by 2020. Over the entire 2000– 2020 period, aggregate primary energy output in Russia is projected to increase at an annual average rate of about 1.9 percent

in the PlanEcon forecast.

For the most part, this forecast presumes the implementation of

the bulk of the measures outlined in the proposed Putin-Gref reform program. This program includes general reliance on market

forces and mobilizing private investment, strong elements of commercialization and marketization in the reform of the ‘‘natural monopolies’’ in the gas and electric power sector, particularly in terms

of price reform, and the prospects of fairly strong economic recovery.

In PlanEcon’s energy forecast, Russian oil production is projected

to grow at an average rate of 1.4 percent per year over the entire

20 year period to 2020, to reach 392.7 million metric tons (mmt)

in 2010, and then 423.2 mmt by 2020. The official Russian Energy

Strategy to 2020 envisions oil output at 335 mmt in 2010 and 360

mmt in 2020, an average annual rate of growth over the 20 year

period of only 0.5 percent. The Strategy’s overall oil production forecast seems far too conservative given what was achieved in 2000

(e.g., higher investment, expanded drilling, more new fields) and

the changes in the investment climate that are likely to be realized

over the next few years.

Despite Gazprom’s current worries over its ability to produce gas

in the future (a key feature of the Strategy’s outlook), in PlanEcon’s

view, the decline in Russia’s gas output is largely an organizational/institutional issue related to the lack of incentives to invest

rather than a question of reserves or even the capacity to mobilize

investment. Thus, with the current direction of reforms in the gas

sector (albeit quite modest), production is likely to be able to turn

around relatively quickly to support rising gas demand. PlanEcon

projects Russian gas output in 2005 at 642.6 billion cubic meters

(bcm), expanding to 797.0 bcm in 2010 and 1,030 bcm in 2020; gas

output growth is forecast to average 2.9 percent per annum over

the 20 year period.

In contrast, the Russian Energy Strategy, because of its goal of

diminishing the domestic economy’s reliance on gas, projects gas

output at only 655 bcm in 2010 and a mere 700 bcm in 2020. Furthermore, the expanded production is largely geared toward higher

exports, while domestic consumption is envisioned as remaining

relatively flat over the next two decades.

The Energy Strategy takes the view that energy consumption in

Russia has become too unbalanced in favor of gas. In particular,

the Strategy calls for greater use of coal and nuclear power to meet

the increased demand for electricity. The Strategy projects a decline

216

in the share of gas in Russian primary energy consumption to

about 40 percent by 2020, led by a decline in the share of gas in

fuels use by the electric power sector from the current 62 percent

to 51 percent by 2020. Concomitantly, according to the Strategy,

the share of coal in primary energy consumption will rise slightly

over the 20 year period, to about 22.5 percent by 2020.

PlanEcon’s view is that coal and nuclear are not only intrinsically much more expensive than gas, but also come with enormous

environmental liabilities. Therefore with huge reserves of relatively

economic and clean natural gas, we forecast that Russia’s reliance

on coal for power generation and process heat is likely to wane further. The declining relative importance of metallurgy in the country’s aggregate economic output should also serve to reduce the

share of coal in primary energy consumption as well. Thus, by

2010, PlanEcon projects that the share of gas will be up to 57.1

percent, and that it will rise further, to 60.6 percent, by the end

of the forecast horizon in 2020.

Russian coal production, in energy equivalent terms, is projected

to slowly decline over the forecast horizon in the PlanEcon forecast

(¥0.5 percent per year on average). In contrast, the Energy Strategy envisions coal production rising to 320 mmt in 2010 and over

400 mmt in 2020. In the Strategy, major technological breakthroughs are postulated in coal production, processing and transportation that result in declining costs, and therefore end-user

prices, of coal. In PlanEcon’s view, such a prognosis seems highly

unlikely, particularly the geographic locus of both production (increasingly concentrated in Siberia) and energy consumption (in European Russia).

The projected level of primary electricity production in the current PlanEcon forecast envisions the completion of only six new

(1,000 MW) nuclear units during the forecast period, including four

before 2005. The recently approved Energy Strategy calls for the

completion of five new units (which were already well advanced in

construction during the Soviet period) before 2005, identifying

these as the cheapest generating capacity (in costs per MW or per

kWh) that Russia could bring on stream. PlanEcon concurs in this

assessment mainly because of the sizable investment that has already been sunk into these units. However, PlanEcon does not consider the Strategy’s longer term plans for further nuclear expansion

beyond these initial units to be realistic.

On the demand side, PlanEcon projects that the growth in primary energy consumption will lag well behind the trend in aggregate economic activity. Primary energy consumption is projected to

rise at an average rate of only 1.7 percent per year over the 20 year

period.

The projection of primary energy production and consumption

provides a forecast for their difference, or net energy exports for

Russia. Russian net energy exports reached a trough in 1993 at

302.8 mtoe, a decline relative to 1990 of 24.4 percent. Net energy

exports are projected to rise to 565.3 mtoe in 2020, an increase of

55.5 percent above the level of 2000. This is projected to be comprised mainly of oil and gas, with gas surpassing oil in importance

in the export mix by 2015.

217

5Sagers, Kyukov, and Shmat, 1995.

INTRODUCTION

This report provides an overview of Russia’s energy sector, particularly its current situation, and provides an assessment of its

long-term outlook. The Russian Federation is a leading energyproducing country, ranking first in the world in gas production,

third in oil production, fifth in hydro and nuclear generation, and

sixth in coal production. In 2000, the Russian Federation produced

in aggregate 997.8 mtoe of primary energy (i.e., energy not resulting from the transformation of other sources).

Energy production holds a central place in the economic and political life of the country. In the Soviet period, the energy sector

was developed to provide resources for heavy industry and the

defense-related sectors, as well as to earn foreign exchange for financing vital imports. Under present conditions, the emphasis has

been shifted to the creation of an efficient market economy, which

in the long run will be able to provide a higher level of well-being

for the country’s population.

The reform and re-emergence of this key part of the economy are

integrally linked to the country’s overall economic transformation

and recovery, due not only to the energy sector’s direct impact on

GDP and overall value-added in the economy, but also to its importance in foreign exchange earnings and Russia’s fiscal stability.5 In

2000, the energy sector accounted for perhaps 16 percent of valueadded in the economy (GDP) and about 45 to 48 percent of Federal

budget revenues as well as 54.0 percent of foreign exchange earnings and 29.0 percent of the gross value of industrial output in the

country. In the current situation, raw materials extraction, particularly of fuels, figures as a key engine of economic growth, generating vital foreign-exchange earnings and attracting foreign investment.

Similar to the overall economy, however, Russia’s energy sector

initially experienced a sizable decline coincident with the launch of

Russia’s transition from a centrally planned to a market-type economy. By 1997, Russia’s primary energy production had plunged to

a low point of 956.5 mtoe, a level only 71.6 percent of the peak output achieved in 1988 (of 1,393.5 mtoe).

However, Russia’s aggregate primary energy production has

risen for the third consecutive year in 2000 (+2.1 percent), representing a significant recovery after declining by 26.8 percent in

the period 1990–1997 during the initial period of Russia’s difficult

transition from a planned economy. The sizable increase registered

in oil and coal production last year was tempered by a slight downturn in gas production.

Broadly speaking, energy sector reforms over the past decade

have typically lagged behind those in the economy at large. But increasingly, the outcome of general economic reforms will depend to

a large extent upon the success of those in the energy sector. If

properly managed, Russia’s energy resources can become a major

contributor to the general welfare and help accelerate the economic

reform process; if poorly managed, it can easily hinder that process.

Russia’s principal energy policy document is the Energy Strategy

of Russia to 2020, which was officially approved by the government

218

6Government of the Russian Federation, 2000.

in November 2000.6 The Energy Strategy states Russia’s priorities

for its long-term energy policy and the mechanisms for its implementation. This is the most recent in a series of energy policy documents laying out a strategy for the energy sector under the transition to a market economy, including its immediate predecessor, the

Basic Guidelines for the Energy Policy of the Russian Federation to

2010 (approved in October 1995). The new Energy Strategy specifies the main trends, tasks, and objectives of energy policy to 2020.

It states that the highest priority is the most efficient use of the

country’s fuel and energy resources so that the fuel and energy sector can be harnessed to improve the living standards of the population.

Similar to President Putin’s overall economic strategy, Russia’s

Energy Strategy is based on the assumption that to continue social

and economic reforms, to overcome the economic crisis, and to initiate stable development, Russia needs a strong state power. The

document states that a strong state power in Russia means a

democratic, law-based and active Federal state, and that the state’s

role is to become an efficient coordinator of the economic and social

reforms, determine optimal purposes and parameters of national

development, and create conditions and mechanisms for their implementation.

The social and economic part of the Energy Strategy has been developed to address the following tasks: (1) to create acceptable living standards for all categories of the population; (2) to create a

strong state and ensure human sovereignty; (3) to create an efficient and competitive economy; and (4) to ensure an honorable

place for Russia in the world community. The document posits that

this will not be possible unless long-term economic growth is ensured (minimum of 5 to 6 percent per year). To ensure such growth

rates, the following should be implemented: (1) strengthening the

economic functions of the state; (2) normalization of monetary and

credit systems and restoration of budget equilibrium; (3) full-scale

capital renewal and rational structural policy; (4) development and

implementation of publicly acceptable and socially responsible economic policies to ensure priority growth of the real income of the

population; and (5) stimulation of the purchasing power of enterprises and population for products, goods, and services, especially

those locally made.

The development of the fuel-energy complex should meet the

above stated parameters of the economic development of Russia.

Thus, the Energy Strategy determines the demand of the country

in fuel and energy required for economic growth, taking into account the expected structural, technological and territorial changes,

and develops a forecast for the development of the fuel-energy complex and its main industries.

Price and tax policy remains the linchpin of the mechanisms

driving the Energy Strategy forward. The goal is to skillfully conduct price and tax policy in combination with anti-monopoly measures to keep the fuel and energy sector a major source of budget

revenues and to alter the wasteful character of energy-intensive

branches of the Russian economy.

219

7Sagers, 1996.

8The energy production data cited in this paper for Russia as a whole or regional totals are

usually taken from reports issued by the Russian State Statistics Committee (Goskomstat

Rossii), while production data for individual companies or enterprises are taken from published

statistical reports issued by the Ministry of Energy (i.e., the monthly bulletins Statistika,

Dokumenty, Fakty or Itogi raboty Mintopenergo).

OIL SECTOR

CRUDE OIL PRODUCTION

The Russian Federation (Russia) remains one of the world’s

major petroleum-producing countries, currently ranking third in

the world behind Saudi Arabia and the United States. Since Russia

also has accounted for about 90 percent (more or less) of the former

Soviet oil output for several decades, when the former U.S.S.R. led

the world in oil production between 1974 (when it surpassed the

United States) and 1991, so did Russia. Russia is also one of the

leading oil exporters in the world and ranks among the world leaders in oil reserves, with an even greater oil potential.7

Russia’s oil sector was particularly negatively affected by the

launch of Russia’s economic reforms and initially experienced a severe depression. By 1996, Russian crude oil production had plunged

to only 301.2 mmt, a level barely half (52.9 percent) of the peak

output achieved in 1987 (of 569.5 mmt).8 In 1997, production actually turned around slightly, rising by 1.5 percent. Although the improving trend reversed in 1998 (a year of financial crisis in Russia),

as output experienced a slight dip, it then recovered again in 1999

and surged in 2000. Perhaps not so surprisingly, annual trends in

Russia’s GDP show a similar pattern.

The current upward swing in Russian crude oil production began

in early 1999, and continued to gain momentum throughout 2000.

Overall for the year as a whole, Russian oil production was up by

6.0 percent, to 323.2 mmt.

A number of elements were involved in producing the turnaround

in Russian output, but given that the upturn began in the second

quarter of 1999, clearly the major underlying driver for this recovery was the sharp rebound in international oil prices that occurred

after March 1999, when the Organization of Petroleum Exporting

Countries (OPEC) (in collaboration with some major non-OPEC

producers such as Russia, Mexico, and Norway) agreed to reduce

their oil output and exports to international markets. The resulting

rise in world oil prices led to a substantial increase in revenues for

the Russian producers, and allowed them to increase capital spending on upstream development. At the same time, production costs

(in dollar-equivalent) for the Russian producers were reduced substantially in the wake of the sizable devaluation of the ruble associated with Russia’s financial crisis of 1998, greatly increasing the

sector’s profit margins.

Another dimension of the turnaround reflects a number of positive changes in the investment climate in the Russian oil industry

that enabled this supply/investment response by the producers to

take place. The combination of Vladimir Putin’s accession to President in March 2000 together with the parliamentary elections of

1999 (substantially altering the composition of the state Duma,

Russia’s lower house of Parliament) have had a role in this. The

220

9The exchange rate does not reflect the true purchasing power of ruble expenditures in the

upstream oil sector vis-a`-vis the dollar. Real investment activity is much higher than indicated

by the conversion of ruble outlays into dollars at the average exchange rate. 10Similarly, a total of 36 new fields produced their first oil in 1999. This included 18 new

fields by the Russian oil majors, 15 by independent Russian companies, and 3 by foreign producers. In 1998, a total of 20 new small fields were brought on stream. 11Gazprom’s contribution to Russian petroleum output amounted to some 10.2 mmt in 1992

and by 2000 had almost returned to this level (10.0 mmt); i.e., Gazprom has produced 2.6 to

3.2 percent of the Russian total during the last decade. Much of this would be gas condensate,

although Gazprom does produce some oil as well. Total output of gas condensate (at least that

proportion of gas liquids output included in the crude petroleum production statistics; i.e.,

‘‘lease’’ condensate as opposed to ‘‘plant’’ condensate) in Russia was 9.7 mmt in 1999 and 10.4

mmt in 2000, or about 3.2 percent of Russia’s total annual petroleum (crude oil plus condensate)

output.

policy directions taken by the Putin government toward the oil sector build on some important achievements that actually preceded

Putin’s accession to power, such as the beginning of tax reform (introduction of part 1 of the new Tax Code) and passage of the

Amending and Enabling Laws to the Law on Production-Sharing

(in early 1999).

The strong surge in Russian oil output has been largely driven

by high international oil prices that boosted the revenues of the

Russian producers, which they plowed back into capital spending.

Capital investment in the upstream oil sector in 2000 more than

doubled from the 1999 level in real terms (+102.4 percent according

to the Ministry of Energy), at 110.6 billion rubles ($3.9 billion at

the average exchange rate for the year).9 Of this, 34.5 billion rubles

(31.2 percent of the total) was spent on drilling activity. Development drilling in the sector increased by a whopping 80.3 percent

in 2000, to 8,286,000 meters, and the number of new wells completed increased by 56.3 percent, to 3,405.

The largest contribution to the higher production level in 2000

continued to come from well work-overs, which reduced the number

of idle wells to 31,940 by the end of the year (i.e., to only 22.5 percent of the total well stock compared to 24.2 percent at the end of

1999). This combination of new wells and restarted old wells added

over 19 mmt to annual production capacity in 2000. ‘‘New oil,’’ however, is also becoming noticeable again after virtually disappearing in the mid-1990s. A total of 43 new fields were

brought on stream during 2000, the largest annual number in almost two decades. These new fields contributed relatively little to

aggregate production during the year (a mere 546,000 tons), but

the contribution of all so-called ‘‘new fields’’ (those that have been

in production less than 5 years) 10 was a more substantial 16.1

mmt in 2000, or 5.0 percent of national production last year.

In 2000, a total of 132 enterprises (companies) were producing oil

in Russia according to Goskomstat; however, the bulk of these

(110) are small, producing less than 1 mmt annually, and only 12

companies produce more than 10 mmt per year. Although the proportion is declining over time, the bulk of Russia’s oil production

is still produced by the large oil enterprises that previously were

part of the former U.S.S.R. Ministry of Oil (95.5 percent in 1992

and 91.6 percent in 2000).

Gazprom remains the largest single producer outside these oil

enterprises,11 but as production by joint ventures (JV) with ‘‘foreign’’ companies has surged, these have now become the largest

component of production outside the traditional oil enterprises. At

221

12The Russian oil industry was reorganized in the 1990s into a few large VICs which combine

geological exploration, crude production, oil refining, and distribution and retailing of refined

products in one integrated structure. These companies have also been largely privatized, although the share of federal government ownership in some of them remains quite sizable, and

republic-level administrations also own sizable stakes in some of the ‘‘regional’’ VICs. Current

plans call for the eventual sale of most of the remaining shares still held at the Federal level

to raise funds for the budget. The interest in establishing a state-owned ‘‘national’’ oil company,

championed periodically since 1995, has largely waned since the election of President Vladimir

Putin in March 2000. Currently, the Russian oil sector includes 11 large VICs, which collectively

accounted for 88.2 percent of national crude production and 78.9 percent of total refinery

throughput in 2000. The oil pipeline systems are not part of this ‘‘privatized’’ structure, but so

far remain largely state-owned (some shares have been distributed to employees and some plans

for further privatization have been mooted); they function as service-for-fee carriers, serving all

the various companies. The pipelines are administered by two entities. One, Transneft, operates

the crude pipeline network, while the other, Transnefteprodukt, operates the product pipeline

network. 13The TNK figure includes the takeover of Sidanko’s Kondpetroleum and Chernogorneft (now

TNK Nyagan and TNK Nizhnevartovsk, respectively). 14The level of foreign involvement in JVs must be viewed with some caution. Many allegedly ‘‘foreign’’ partners are in fact Russian-owned (although foreign-registered) companies, as they

are not clearly identifiable international oil companies. The real role of Russian companies is

likely to grow further, as some of them are buying out the original foreign JV partners.

the same time, there has been a proliferation of other new types

of oil producers, including Russian ‘‘independent’’ (or private) companies and geological exploration enterprises.

Among the various groups of producers, aggregate production

rose substantially (+8.1 percent) for the largest and more important

producing group, the large Russian vertically integrated companies

(VICs); 12 their combined aggregate output amounted to 296.3 mmt

in 2000 (or 91.7 percent of total national output). Among the leaders in expanding production in 2000 were: Rosneft (+6.3 percent);

Surgutneftegaz (+14.2 percent); Yukos (+11.4 percent); and Tyumen

Oil Company (TNK), whose output was up by 23.4 percent.13 Russia’s largest oil producer was Lukoil, at 62.2 mmt, with its acquisition of Komi-TEK. The second-largest Russian producer is Yukos,

at 49.5 mmt (following the consolidation of the Eastern Oil Company [VNK] into Yukos).

The output of the smaller, ‘‘independent’’ producers, which until

2000 had generally been far more dynamic than the large VICs, included 10.826 mmt produced by small Russian companies (+22.2

percent compared to last year), as well as 19.105 mmt officially

credited to the foreign joint ventures (+4.6 percent versus last

year), and 2.188 mmt produced by the Khar’yaga and Sakhalin-2

PSAs (production-sharing agreements). Thus, ‘‘foreign’’ companies

(the JVs and PSAs together) accounted for 21.3 mmt in 2000, or

6.6 percent of Russia’s total oil production last year.14

Although the immediate situation appears quite positive, many

of the underlying fundamentals in the oil sector remain quite poor;

the transition to a market-type economy has proven to be very difficult. Many of the economic and fiscal policies implemented tended

to be highly unfavorable for the energy sector, particularly in the

initial phases of the reform process, although policy has tended to

become more rational over time. The fiscal burden on upstream operations was by and large based on revenues and not on net profit—and thus penalized exploration and production in high-cost environments (particularly applicable in the period previous to 1998

with the strong ruble). Also, domestic energy prices initially remained controlled while those for most other goods were liberalized

(causing the oil sector’s production costs to skyrocket with the high

rate of inflation), taxes have remained oriented to budget (as opVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00247 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.011 CRS1 PsN: CRS1
222

15 ‘‘Osnovniye,’’ 2000. 16West Siberia first faced a ‘‘production crisis’’ in 1983–1985. The downward trend then was

reversed (albeit for only a couple of years) through a massive injection of financial and material

resources. But after reaching an all-time peak of 418.6 mmt in 1988, West Siberian production

then plunged to less than half this level by 1996. 17Sagers, 1996. 18TNK signed an exclusive deal with U.S. Halliburton to provide sophisticated oilfield services

for its fields in 1999, while Yukos has a similar arrangement with France’s Schlumberger dating

from 1998. According to McKinsey Report: Russian Oil (February 2001), the actual total factor

productivity (the combined measure of labor and capital productivity) of the Russian oil industry

is only about 30 percent of international levels. The main reasons for the productivity gap at

the operational level are lower oil recovery (due mostly to less hydro-fracturing and poor resposed to investor) needs, the regulatory regimes need to be streamlined and clarified, and access to export markets continues to be restricted.

At the same time, Russia’s oil industry has undergone the most

liberalization and commercialization within the entire energy sector. The breakdown of the old central command structures and demonopolization under privatization, coupled with the proliferation

of new producing entities, the formation of a quasi-market for oil

domestically, the liberalization of prices, and the (partial) liberalization of exports, point to the tremendous changes that have occurred within this sector since 1991. The Russian Government has

made considerable progress in clarifying the sector’s administrative

structure, establishing the level of competence of different levels of

authority (Federal, regional, and local), and putting the sector on

a firmer legal foundation. Nonetheless, all of these issues remain

unsettled and much more still needs to be done. In fact, there was

noticeable back-sliding on reform in the period after 1998, particularly in the area of exports, with administrative limitations again

being imposed on crude and product exports.

While the fundamental problem in the oil industry is an economic one, partly caused by the ongoing economic transition, objective technical factors are also important.15 Russia’s prolific West

Siberian oil province is very mature,16 although its depletion can

be attenuated by proper reservoir management and development of

small and difficult fields; at the same time, a new oil basin with

reserves similar in size to West Siberia’s is not on the horizon.

Thus, the key factor determining Russia’s level of oil production in

the future essentially hinges on just how long West Siberia’s current plateau of 200 to 220 mmt per year can be maintained, while

new reserves are put into production in less mature provinces such

as Timan-Pechora and Sakhalin.17 Longer term, new provinces

such as East Siberia, the Pechora Sea, or the Russian sector of the

Caspian, are likely to make sizeable contributions to the country’s

overall production profile.

Production costs and international oil prices are crucial considerations in the prospects for maintaining West Siberia’s current production plateau. But it should be technically possible to attenuate

West Siberia’s maturation with the help of modern reservoir management and modern tertiary recovery techniques to maximize reservoir drainage, and formation and well treatment in less permeable reservoirs. Several alliances have been formed to this effect

between Russian companies and Western service companies like

Halliburton and Schlumberger, and these are beginning to show

some positive results.18

223

ervoir management techniques), and inefficient drilling because of low quality drill bits, cleaning

muds, and cement being used. 19This has been due to a combination of factors, including a decline in demand associated

with the large contraction in economic activity, the financial difficulties of the refining sector

in these republics, and the breakdown in inter-republican trade and payments mechanisms. In

particular, Russia rapidly increased the prices being charged in inter-republican trade toward

those prevailing on the world market after 1992, causing the importer-republics built up large

payments arrears, and as a result, led Russia to withhold supplies and divert them to hard currency markets. Because of this leverage, non-payments by the importing republics for oil have

remained relatively modest in comparison with natural gas or electricity. 20 In aggregate, Russia’s crude exports in 2000 generated $25.319 billion according to

Goskomstat, or 178.8 percent more than in 1999. The average export price rose from $105.3 per

ton in 1999 to $175.2 per ton in 2000. Exports to the non-Commonwealth of Independent States

(CIS) generated $23.0 billion (an average of $179.9 per ton), while CIS exports generated $2.4

billion (an average of $139.7 per ton).

Water-flooding, which has been employed in West Siberia since

the very beginning to quickly boost output to maximum levels, has

resulted in an increasingly large water cut. By 1990, the water cut

was 76 percent for Russia as a whole, and 72 percent for the West

Siberian fields; the average had been only 50 percent as recently

as 1976. Currently, water encroachment in Russia is 70 to 90 percent at nearly all of the large fields. Injection of (associated) gas

(which also has the advantage of reducing gas flaring) has been

slow to be introduced, still accounting for only 1.9 percent of Russian oil production in 1999. Conversely, the share of oil produced

from free-flowing wells dropped from 51.8 percent in 1970 to only

12.0 percent by 1990, and by 1999 was down to 8.4 percent.

OIL EXPORTS

Russia is one of the largest oil exporters in the world, currently

ranking second behind Saudi Arabia. In the peak year of 1988,

Russia exported 256.5 mmt of crude beyond its borders, of which

132.1 mmt (51.5 percent) went to the other former Soviet republics.

However, the amount of crude oil Russia has shipped to the rest

of the former Soviet Union has declined dramatically since the

break-up of the U.S.S.R. in 1991: in 2000, Russia’s crude oil exports

to all countries amounted to 144.5 mmt, but only 21.2 mmt (14.7

percent) was exported to the former Soviet republics (Table 1).19 In

contrast, Russia’s crude exports to countries outside the former Soviet Union were up by 11.6 percent in 2000, to 125.3 mmt, actually

surpassing the previous peak of 124.4 mmt achieved in 1988.20

Russia’s international exports of crude oil had contracted sharply

between 1988 and 1991 under the old Soviet Government, falling

by 45.4 percent, from 124.4 mmt to only 56.5 mmt in 1991. The Soviet Government had forced virtually the entire drop in domestic

crude oil production into a reduction in exports. Since 1992, Russia’s international exports have continued to rise with the

marketization of the sector despite a host of administrative impediments and limits on exports.

The East European countries (then including Eastern Germany)

were traditionally the largest destination for Russian crude. The

region as currently defined (i.e., without Eastern Germany) saw its

Russian crude imports contract to as little as 12.9 mmt in 1994,

representing 14.5 percent of Russian international exports. This

amount has since tripled, reaching 36.3 mmt in 2000 (29.0 percent

of Russia’s non-former Soviet Union exports).

TABLE 1.

—OIL BALANCE FOR THE RUSSIAN FEDERATION

[In million metric tons]

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Crude oil production ........................ 516.2 462.3 399.3 353.9 317.8 306.8 301.2 305.6 303.3 305.2 Refinery throughput ......................... 295.5 286.5 257.2 220.1 180.6 179.0 173.8 176.3 162.9 170.1 Direct use of crude/residual 1 .......... 10.5 20.0 11.1 16.7 15.0 12.4 6.3 8.6 9.7 6.1 

Refined products consumption 2 ...... 250.6 228.7 216.5 176.6 138.7 137.9 121.2 121.6 113.3 120.3 

Oil exports

Crude oil ................................. 219.9 173.9 141.7 127.6 126.8 122.3 125.6 126.8 137.1 134.5 

Foreign ........................... 99.3 56.5 66.2 79.8 89.0 91.3 103.0 105.6 111.9 112.3 Other republics .............. 120.6 117.4 75.5 47.8 37.8 31.0 22.6 21.3 25.2 22.2 

Refined products ..................... 50.7 63.6 43.0 44.8 43.4 45.4 56.6 60.6 53.8 50.8 

Foreign ........................... 37.9 41.6 25.3 34.3 38.0 42.1 55.0 58.4 51.2 47.8 Other republics .............. 12.8 22.0 17.6 10.5 5.4 3.3 1.6 2.2 2.6 3.0 

Oil imports

Crude oil ................................. 18.8 18.1 10.7 10.5 4.6 6.9 4.5 6.1 6.4 5.6 

Foreign ........................... ——————————Other republics .............. 18.8 18.1 10.7 10.5 4.6 6.9 4.5 6.1 6.4 5.6 

Refined products ..................... 5.8 5.8 2.3 1.3 1.5 4.3 4.0 5.9 4.1 0.9 

Foreign ........................... 0.2 0.7 0.9 0.2 0.4 1.4 1.8 3.5 2.4 0.4 Other republics .............. 5.6 5.1 1.4 1.1 1.1 2.9 2.3 2.3 1.8 0.5 

1 Balancing item.2 Apparent consumption (production minus exports plus imports).

225

Earlier, Eastern Europe’s oil demand was declining, and they

also sought to diversify their imports. More recently, oil demand

has recovered, and these countries have found Russia to be an economical source of imports due to existing delivery infrastructure.

The bulk of this oil arrives via the Druzhba Pipeline, which delivers crude to the Czech Republic, Slovakia, Hungary, Poland, and

Eastern Germany, and occasionally, the former Yugoslav republics.

The other major destination for Russia’s crude is Western Europe. These countries took 54.3 mmt of crude from Russia in 2000.

The amount of Russian oil going to Western Europe has declined

since peaking at 70.5 mmt (79.2 percent of Russia’s total international exports) in 1994. Like Mexico and the North Sea, Russia/

former Soviet Union represents a major source of non-OPEC oil.

The presence of Russian/former Soviet Union oil has been a welcome addition to the West European market, helping to diversify

sources from too heavy a reliance on the Gulf region and OPEC.

Most of the West European countries purchase oil from the Russia,

although typically it represents less than 10 percent of total oil

supplies for any individual country.

Russia’s non-former Soviet Union crude exports in 2000 included

112.4 mmt shipped out through the main Russian pipeline system

operated by Transneft, plus another 12.9 mmt (10.3 percent of the

total) exported via other routes, including railroad shipments and

through other minor ports. The share of exports carried by these

minor routes continues to ratchet upward, probably because the

main means used by the Russian Government to limit exports is

control over Transneft’s pumping schedule. In 1999, Russia’s exports outside the Transneft system amounted to 8.6 mmt (7.7 percent of the total).

According to the Ministry of Energy, in 2000, Transneft moved

a total of 314.8 mmt of crude in its pipeline system (5.1 percent

more than in 1999). It delivered 312.5 mmt, of which 160.9 mmt

was to Russian refineries, and 124.4 mmt of crude was shipped to

export destinations outside the territory of the former Soviet Union

(39.8 percent of the total shipped). In turn, this included 112.4

mmt of Russian crude and 11.7 mmt of transit crude (from

Kazakhstan, Turkmenistan, and Azerbaijan), and another 0.35

mmt from Belarus that joined the pipeline system there on its way

to Poland.

Despite the fact that total flows in the Russian oil pipeline system are now much less than before because of the precipitous decline in Russia’s crude oil production (Russian pipeline shipments

declined by 43.3 percent between 1990 and 2000, from 497.9 mmt

to 294.6 mmt according to Goskomstat figures), constraints in Russia’s crude oil pipelines have been a bottleneck since mid-1993.

The key constraints are at the export ports and the pipelines

supplying them, particularly at Novorossiysk, Russia’s major oil export port on the Black Sea. The reason for the emerging export constraints is that previously a large portion of the total crude flow

was dispersed to refineries across the former Soviet Union, and a

substantial amount was delivered to Eastern Europe via the

Druzhba Pipeline. But with the dramatic decline in oil demand in

the former Soviet Union (and to a lesser extent in Eastern Europe),

a much larger proportion of the total flow has become focused upon

226

the small number of export ports that dispatch crude to other international markets. The former Soviet Union pipeline system was designed mainly to move crude to internal consuming centers, while

international exports were of much less importance. As a result,

much of the core system in the interior of Russia now has huge redundant capacity.

Of Russia’s own export shipments handled by Transneft in 2000,

53.2 percent (59.8 mmt) moved out via marine ports and 46.8 percent (52.6 mmt) moved out via the Druzhba Pipeline to Eastern

Europe. Russia has made more of the marine terminal space, especially at Novorossiysk and Odessa, available for Caspian transit

crude. The major marine terminals handled a total of 70.5 mmt in

2000, representing 56.7 percent of the overall total, while 53.9 mmt

(43.3 percent) went out via the Druzhba Pipeline (Table 2). Compared to 1999, Druzhba shipments increased by only 1.6 percent

while marine shipments increased by 13.6 percent. The large

growth in marine shipments was mainly due to the new Butinge

terminal in Lithuania, although all the other major terminals also

handled more crude in 2000.

The addition of the new Butinge terminal in Lithuania in mid1999 added another 8 mmt of annual marine export capacity to the

former Soviet Union pipeline system. Even so, collectively the overall capacity utilization at the major marine terminals was still almost 90 percent in 2000 (Table 2). There is some remaining spare

capacity at Ventspils and Butinge. But substantial new capacity is

expected to be available shortly, with both the Primorsk (Baltic

Pipeline) and the Yuzhnaya Ozereyka (Caspian Pipeline Consortium) terminals slated for completion in 2001.

The Druzhba Pipeline’s aggregate capacity utilization is also

quite high, increasing to 90 percent in 2000 (Table 2). However, the

southern branch of the Druzhba (to the Czech Republic, Hungary,

and Slovakia) remains underutilized, while the northern branch (to

Poland and Germany) is now full. The increased flow in 2000 was

concentrated entirely in the northern branch of the Druzhba that

serves Poland and Eastern Germany.

REFINERY OPERATIONS AND OIL CONSUMPTION

The Russian Federation has a large refining sector, comprising

28 plants considered ‘‘full fledged’’ refineries. In addition to these

petroleum refineries, Russia also has about a dozen other oil processing plants, including lube plants, oilfield topping plants, and

specialized gas condensate processing facilities.

The 28 main refineries had a total primary distillation capacity

that the Ministry of Energy reported as 296 mmt at the beginning

of 1999. Collectively, these facilities therefore operated at a capacity of only 58 percent in 1999 compared with 87.5 percent as recently as 1990, even though almost 45 mmt of distillation capacity

has been officially liquidated since 1990. Utilization varies considerably from refinery to refinery. Clearly, with so much excess capacity and the likelihood that refinery runs are going to fall even

lower and remain there for some time, a massive rationalization of

refining capacity is in store. Much of the redundant refining capacity is concentrated in the Volga and Urals regions.

TABLE 2.

—FORMER SOVIET UNION CRUDE OIL EXPORTS BY EXPORT POINT (TRANSNEFT SYSTEM)

[In thousand tons]

Export point 1994 1995 1996 1997 1998 1999 2000 

Total (sum) ................................................................................................. 94,343 95,805 104,836 105,807 115,018 115,099 124,386Ports (sum) ................................................................................................. 53,451 54,084 60,851 60,633 63,580 62,058 70,473Capacity utilization (in percent) ................................................................. 73.2 74.1 81.1 80.8 84.8 78.6 89.2 

Russian oil (reported) ...................................................................... 50,474 51,439 57,056 58,281 58,762 53,735 59,822(Difference) ....................................................................................... 2,977 2,645 3,794 2,352 4,819 8,323 10,651Novorossiysk ..................................................................................... 30,003 29,018 31,706 31,090 32,870 33,066 37,363Capacity utilization (in percent) ........................................................ 88.2 85.3 93.3 91.4 96.7 97.3 95.8 

Russian crude ......................................................................... 28,903 28,111 29,989 30,258 29,893 30,021 34,906Kazakh crude ........................................................................... 1,100 906 1717 712 199 436 1,699Azerbaijan crude ...................................................................... ——— 120 2,778 1,877 561Turkmen crude ......................................................................... ————— 731 198

Ventspils ........................................................................................... 11,609 12,103 14,355 14,579 14,549 13,029 13,620Capacity utilization (in percent) ........................................................ 64.5 67.2 79.8 81.0 80.8 72.4 75.7 

Russian crude ......................................................................... 10,952 11,520 14,258 14,574 14,549 13,029 13,620Kazakh crude ........................................................................... 657 583 97 4 0 0 0

Tuapse .............................................................................................. 4,407 4,431 4,652 4,778 6,107 5,149 5,699Capacity utilization (in percent) ........................................................ 88.1 88.6 93.0 95.6 122.1 103.0 114.0 

Russian crude ......................................................................... 4,407 4,431 4,642 4,758 6,107 5,149 5,699Kazakh crude ........................................................................... 0 0 10 20 0 0 0

Odessa .............................................................................................. 7,432 8,532 10,138 10,186 10,054 10,265 10,724Capacity utilization (in percent) ........................................................ 92.9 106.7 101.4 101.9 100.5 102.7 107.2 

Russian crude ......................................................................... 6,232 7,377 8,167 8,691 8,212 5,536 2,530Kazakh crude ........................................................................... 1,200 1156 1971 1496 1,842 4,729 8,194

Butinge ............................................................................................. ————— 550 3,067

Capacity utilization (in percent) ........................................................ ————— 13.8 38.3 

Russian crude ......................................................................... ————— 550 3,067

Druzhba Pipeline (sum) .............................................................................. 40,892 41,722 43,985 45,174 51,438 53,040 53,913

Capacity utilization (in percent) ........................................................ 68.2 69.5 73.3 75.3 85.7 88.4 89.9 Russian oil (reported) ...................................................................... 38,808 39,706 41,381 42,879 49,117 49,927 52,573

TABLE 2.

—FORMER SOVIET UNION CRUDE OIL EXPORTS BY EXPORT POINT (TRANSNEFT SYSTEM)

—Continued

[In thousand tons]

Export point 1994 1995 1996 1997 1998 1999 2000 

(Difference) ....................................................................................... 2,084 2,016 2,604 2,295 2,320 3,113 1,341

Druzhba Northern Route: Capacity utilization (in percent) ........................ 68.9 68.5 78.6 79.7 95.9 104.5 110.3 

Germany ............................................................................................ 17,276 15,873 17,670 16,766 18,898 20,024 20,403

Russian crude ......................................................................... 16,276 14,957 16,126 15,664 18,457 19,052 19,533

To refineries .................................................................... .............. .............. 12,837 12,938 18,457 19,052 19,533To Rostock (export) ......................................................... .............. .............. 3,288 2,726 0 0 0

Kazakh crude ........................................................................... 1,000 917 1544 1103 441 972 871

Poland ............................................................................................... 6,850 8,108 9,857 11,115 14,658 16,558 18,195

Russian crude (shipments) ..................................................... 6,066 7,339 9,171 10,225 13,551 14,416 17,845Kazakh crude ........................................................................... 500 519 385 490 725 1,791 0Belarussian crude ................................................................... 284 250 300 400 382 350 350

To refineries .................................................................... .............. .............. .............. 9,921 13,273 14,408 16,217To Gdansk (export) ......................................................... .............. .............. .............. 1,194 1,385 2,150 1,978

Druzhba Southern Route: Capacity utilization (in percent) ....................... 67.1 71.0 65.8 69.2 71.5 65.8 61.3 

Czech Republic ................................................................................. 6,506 7,117 5,942 5,785 5,594 4,822 3,714

Russian crude ......................................................................... 6,306 6,928 5,692 5,785 5,265 4,822 3,714Kazakh crude ........................................................................... 200 189 250 0 329 0 0

Slovakia ............................................................................................ 4,971 5,058 5,303 5,335 5,711 5,555 5,506

Russian crude ......................................................................... 4,871 4,967 5,203 5,151 5,267 5,555 5,386Kazakh crude ........................................................................... 100 92 100 184 444 0 120

Hungary ............................................................................................ 5,289 5,565 5,213 6,172 6,577 6,081 6,095

Russian crude ......................................................................... 5,289 5,515 5,188 6,055 6,577 6,081 6,095Kazakh crude ........................................................................... 0 50 25 118 0 0 0

Total Kazakh shipments ......................................... 4,100 3,828 6,001 4,122 3,980 7,928 10,883Total Kazakh shipments (reported) ........................ 4,070 3,813 6,001 4,142 3,980 8,072 11,610

Note: Kazakh amounts by individual exit point are only approximate.

229

Russia’s refineries are not very sophisticated, with limited secondary processing capacity. Petroleum products are obtained mainly via straight-run distillation processes (primary refining), the

method with the simplest technology and lowest costs; there is relatively little use of cracking or other secondary refining processes.

Reflecting the lack of sophistication of the sector, the depth of refining is quite low. This indicator, defined as the share of premium

products (essentially light products and lubes) in the output mix,

was a mere 64.3 percent in 1998 for Russian refining overall compared with over 85 percent in advanced Western countries. Furthermore, this indicator deteriorated during the 1990s, falling from

65.0 percent in 1991, although there has been some improvement

since 1994 (when it dropped to 61.3 percent).

The Energy Strategy to 2020 envisages substantial development

of the oil refining industry through the construction and modernization of capacity, particularly the deepening of the refining

process. Such reconstruction should also improve environmental

conditions by reducing emissions as well as reducing the energy

and material costs of production. The modernization is also aimed

at improving the refining industry so that the quality of its products can be brought up to world standards. Thus, the Energy Strategy calls for the depth of refining to be increased to 75 percent by

2010 and 85 percent by 2020. This is to be accomplished by a broad

program of refinery modernization and the installation of additional secondary processing capacity, particularly new cracking facilities.

The last decade saw a sharp plunge in refinery operations associated with the ongoing economic transition. Although Russia’s refinery runs had been declining since 1980 (peak throughput in Russia

was in 1980 at 325.2 mmt), during the 1980s throughput only slowly drifted down. But beginning in 1992, with the launch of economic reforms, crude runs by Russian refineries began to contract

sharply. The decline lessened somewhat in 1995–1997, due partly

to stabilization in internal refined product consumption, but mostly

was due to a deliberate policy of fostering refined product exports.

In 1998, a year of economic crisis, throughput dropped rather

sharply again, to 162.9 mmt; at that point, throughput was down

to only 54.7 percent of what it was in 1990.

The government had tried repeatedly during the 1990s to hold

refinery throughput at much higher levels (in an effort to ‘‘fix’’ consumption of refined products at existing levels and ‘‘stabilize’’ the

economy), but to little avail; it also was usually counterproductive.

This was due to reasons largely having to due with the refineries’

inability to pay much higher prices for crude and the financial insolvency of their customers. But this policy was more ‘‘successful’’

in 1999–2000 as the government reined in crude exports and forced

higher deliveries to the refineries. This was through a mechanism

that required specified deliveries to domestic consumers to be met

before producing companies were allowed access to Transneft’s

pipeline system for exports. As a result, refinery throughput rose

in 1999–2000, reaching 170.1 mmt in 1999 and 174.1 mmt in 2000.

Longer term, the Energy Strategy envisages growth in refinery

throughput to 220 to 225 mmt by 2015–2020. This volume is projected as providing 130 mmt of light products (gasoline, diesel, and

230

kerosene) with the greater depth of refining anticipated. At the

same time, production of mazut is anticipated to drop from 53 mmt

currently to 30 mmt.

While Russian refinery runs would normally be expected to rebound with the turnaround in product consumption as the overall

economy re-expands, throughput of 220 to 225 mmt is probably economically unwarranted. First, aggregate product demand is currently less than 120 mmt, and is likely to grow fairly slowly over

the coming two decades. Second, increased depth of refining should

limit the need for higher throughput to provide sufficient light

products. Third, the level of refined product exports, now running

at 50 to 60 mmt annually, is likely to contract substantially as

higher domestic crude acquisition prices and higher railroad transport tariffs erode profit margins on product exports. This is likely

to result in throughput levels somewhat lower than now even by

2020.

The Russian Federation is a large consumer of refined products.

Aggregate apparent products consumption (throughput minus product exports plus product imports) peaked in 1987, at 257.0 mmt.

Following the launch of Russia’s economic reform program in January 1992, bringing with it large declines in overall economic activity (GDP, industrial production, and transportation) combined with

increases in (relative) fuel prices, consumption of refined products

in Russia fell sharply. Overall consumption of refined products had

contracted by 55.2 percent by 1998, reaching 113.3 mmt. In 1999,

however, buoyed by a stabilizing economy and administrative limits on product exports, apparent consumption of refined products

increased by 6.7 percent, to 120.9 mmt. In 2000, despite both continued limits on product exports and brisk economic growth, aggregate consumption of refined products dropped again, by 6.5 percent

to 112.5 mmt. Russian statistics (from Goskomstat) report that gasoline consumption (sales/deliveries to the domestic market) in 2000

dropped by 4.8 percent, to 23.2 mmt; diesel fuel consumption increased by 5.1 percent, to 49.2 mmt; and residual fuel oil (mazut)

consumption fell by 3.8 percent, to 41.9 mmt.

With the transition to a market economy, oil ‘‘demand’’ is undergoing structural changes, both by sector and by product. The composition of aggregate economic output is shifting away from heavy

industry toward services. An emerging middle class is leading to

sharp increases in private car ownership and use. Thus, the importance of traditional consumers, such as industry and electric power,

in overall oil consumption is declining, while the relatively limited

development of trucking and private automobiles is being redressed. As a result, changes in demand clearly favor lighter products at the expense of residual fuel oil (mazut).

Transportation is obviously the key sectoral component of the increased demand for light products. By 1999, the share of transportation had increased to about 50 percent of Russia’s aggregate (civilian) petroleum product consumption, compared to 39 percent in

1990. The share of electric power (powerplants and boilers) had

dropped to about 20 percent, compared to 31 percent in 1990. Similarly, industry’s share had dropped as well, to about 18 percent,

and agriculture’s share had contracted to under 6 percent, about

the same as the domestic sector (households and municipal use).

231

21Sagers, 1999.

GAS SECTOR

GAS PRODUCTION

Russia is the world’s leading gas producer. Russian production

increased by nearly 8 times between 1970 and 1991, growing from

83.3 bcm to a peak of 642.9 bcm. During the 1990s, Russian gas

production declined as the economy went into a tailspin, but the

decline was surprisingly small given broader trends in the Russian

economy. While Russian GDP declined by about 43 percent between 1990 and 1998 and aggregate industrial output plunged by

about 56 percent, Russian gas output contracted by a mere 7.7 percent. Russian natural gas production has been able to virtually

‘‘defy gravity’’ and remain relatively stable because it was buoyed

by surprisingly strong domestic consumption, which has been, in

turn, a function of low prices and unusually easy payment terms.21

Another element that also supported the level of output was a large

build-up in underground storage.

Russian gas production fell from a peak of 642.9 bcm in 1991 to

a low of 571.1 bcm in 1997, before recovering to 591.0 bcm the following year. In 1999–2000, Russian production has declined slightly; in 2000, gas production declined by 1.1 percent, to 584.2 bcm.

The decline in output in 2000 occurred despite rising demand for

gas, both within Russia and the former Soviet Union as well as in

Europe (see below).

The Russian gas industry is dominated by the Gazprom, the

world’s largest gas production, transmission, and exporting company. Gazprom, the successor of the old U.S.S.R. Ministry of the

Gas Industry, is a privatized company, although still retaining a

substantial Russian Government shareholding. In 2000 Gazprom

produced 89.5 percent of total Russian gas production; controlled

virtually all the gas transported through Russia’s high-pressure

pipelines; controlled all gas exports outside the former Soviet

Union; and provided about 20 percent of Federal budget revenues

and around 16 percent of Russia’s total export revenues.

Although the bulk of natural gas production within Russia is by

enterprises of Gazprom, production outside Gazprom is becoming

relatively more important. Traditionally, this was mainly comprised of associated gas recovered by oil producers. But an important trend in the last few years has been the appearance of new

so-called ‘‘independent’’ gas producers that collectively now produce

almost as much gas as the oil companies do.

Also, Gazprom’s production has fallen significantly in the last

year or two—in 2000, by more than 20 bcm to 523.1 bcm—giving

rise to considerable speculation that a substantial and irreversible

production decline is imminent for Russian gas.

Gazprom produced 523.2 bcm in 2000 (89.6 percent of the Russian total), as its production declined by 4.1 percent compared to

1999. Gazprom cited the ‘‘exhaustion of its main fields’’ as the principal reason for the decline, combined with the lack of cash to invest in new fields. However, gas production by other entities increased in Russia; non-Gazprom output increased from 45.1 bcm in

1999 to 61.0 bcm (+35.3 percent) in 2000. The major oil companies

232

22Gazprom reported that its investment outlays on various projects (not just in Russia)

amounted to 101.2 billion rubles in 2000 ($3.6 billion) compared with 79.1 billion rubles ($3.2

billion) in 1999.

delivered marginally higher volumes of gas in 2000 (+4.5 percent,

to 31.0 bcm), but the major increase (+232 percent, from 10.5 to

24.4 bcm) came from new, so-called ‘‘independent’’ gas producers,

most noticeably the Itera group. Output by Itera’s subsidiaries

alone amounted to 18.0 bcm in 2000. Itera plans to increase output

to 30 bcm in 2001.

Over the next few years and well into the future, the Energy

Ministry expects that Gazprom’s share of Russian production will

continue to contract. Thus, a key problem for Russia is establishing

a workable regulatory framework to allow such ‘‘independents’’ easier access to Gazprom’s pipeline network. This remains a major

focus of the government’s ongoing reforms of the so-called ‘‘natural

monopolies.’’ Gazprom complains that its ability to fund investment remains

very limited because of low domestic prices and high non-payments

by domestic and Commonwealth of Independent States (CIS) customers. Gazprom’s plan is to hold its production in 2001 at 523

bcm, and claims to have sufficient investment funds to ‘‘support’’ production at a level of about 530 bcm per annum after that. If correct, this would mean that any increases in production would have

to come from non-Gazprom production; i.e., ‘‘independent’’ producers and joint ventures. Moreover given Gazprom’s forecast decline

for its fields currently in production (see below), it would also mean

that a great deal of new capacity has to be brought on stream over

the next two decades.

Aggregate investment in the gas sector amounted to 90.5 billion rubles in 2000 ($3.2 billion at the average exchange rate), a decline

of 11.6 percent in real terms according to the Ministry of Energy.

But it appears that investment spending picked up strongly in the

second half of the year, a rather belated response to a substantial

improvement in revenues and cash receipts for the sector in 2000.

It appears that Gazprom was far more reticent to plow back its

higher revenues into upstream investment than the oil companies

were.22

Gazprom’s claims of insufficient cash to fund investment is becoming less and less credible as Gazprom’s cashflow has been bolstered not only by rising international gas prices, but also by improved payments and higher prices domestically. Gazprom reported

a profit of 60.7 billion rubles ($2.1 billion) in 2000 as the company’s

total revenues jumped 63 percent, to 498.1 billion rubles ($17.2 billion), with export revenues almost doubling to 294.3 billion rubles

($10.2 billion) and domestic sales increasing by about 20 percent,

to 118.7 billion rubles ($4.1 billion).

In particular, the share of payments for gas by Russian consumers improved dramatically in 2000, from only about 63 percent in

1999 to about 71 percent in 2000, and the share of cash in total

payments improved from 53 percent in 1999 to 71 percent. Combined with the domestic price increase that went into effect in May

2000 (of 20 percent), the sector’s real cash receipts (sales volume

× average price × average percent payment × average percent payment in cash) in 2000 from domestic sales would be about double

233

23The only ‘‘Russian’’ gas that Ukraine expects to receive in 2001 is the in-kind payment (by

Gazprom) for transit services; the remainder of its supplies are slated to come from

Turkmenistan (although Itera remains the intermediary). But Ukraine’s national oil and gas

company Naftohaz Ukrainy expects to transit less gas in 2001 than it did in 2000, and to thereContinued

what they were in 1999. The outstanding arrears owed by Russian

consumers for gas actually dropped in 2000, from 108.3 billion rubles at the beginning of the year to 81.4 billion rubles ($2.8 billion)

at the end of the year, a decline of 24.8 percent, or $931 million.

However, the debts owed by CIS countries increased by 14.8 percent in 2000, to a reported 58.0 billion rubles ($2.0 billion).

GAS EXPORTS

Russia is the largest gas exporter in the world, shipping over 200

bcm beyond its borders since 1998 (217.1 bcm in 2000, or 37.2 percent of production), including 129.0 bcm to countries beyond the

borders of the former U.S.S.R. and 88.1 bcm to the former Soviet

republics (Table 3).

Between 1990 and 1996 (when they bottomed out), Russia’s gas

exports to the other former Soviet republics plunged by 52.3 percent (Table 3). This sizable decline, from 153.2 bcm to 73.0 bcm,

was caused by two primary factors. First, demand for natural gas

declined due to a substantial decrease in general economic (especially industrial) activity in these countries. Second, most of the importing republics amassed enormous debts for natural gas, making

Russian suppliers anxious about delivering any more gas without

payments being made. As of the end of 2000, Russia was owed 58

billion rubles ($2.0 billion at the average exchange rate for the

year) by the other republics for natural gas (according to Russian

statistics): Ukraine owed 39.7 billion rubles ($1.4 billion); Belarus

owed 6.0 billion rubles ($208 million); and Moldova owed 12.3 billion rubles ($426 million).

Russia exported 129.0 bcm in 2000 to destinations outside the

former Soviet Union, including 38.6 bcm to Eastern Europe, 80.1

bcm to Western Europe, and 10.3 bcm to Turkey. These non-former

Soviet Union exports increased by only 1.7 percent in volume terms

in 2000 (Table 3); the bulk of this increment was actually realized

to just one country, Turkey, as exports to both Eastern Europe and

West Europe remained almost flat. Gazprom expects to export

135.0 bcm to countries outside the former Soviet Union in 2001,

however, an increase of 4.7 percent.

With ‘‘Russian’’ gas exports to the former Soviet Union countries

amounting to 88.1 bcm in 2000, this represented a sizable 13.3 percent increase compared to 1999 (Table 3). In turn, this was comprised of 4.8 bcm to the Baltic states and 83.3 bcm to the CIS countries. Although some 23.3 bcm of this is evidently ‘‘re-directed’’ gas

from other countries (or re-exported gas), this can be considered to

be ‘‘Russian’’ gas because of the role of Itera as the consignee, both

on the import and export contracts. In 2001, ‘‘Russian’’ exports to

the former Soviet Union should be much lower because of the

switch in the structure of Ukraine’s gas supplies. Gazprom reported that it expects to ship only 53.3 bcm of Russian gas to the

CIS and Baltic states in 2001 (including both its own and ‘‘independent’’ exports), of which about 30 bcm will be to Ukraine.23

234

fore receive a smaller payment than expected. In 2000, it moved 123.5 bcm, of which 112.3 bcm

was to Europe (outside the former Soviet Union), and 11.3 bcm to CIS countries. Although its

contract with Gazprom calls for transit of 124.6 bcm in 2001, Gazprom is making increasing

use of the new pipeline through Belarus and Poland, and actual shipments through Ukraine

are declining. Naftohaz Ukrainy projects that it may transit less than 110 bcm to Europe in

2001, and total transit may be less than 120 bcm.

Ukraine remains the largest customer for Russian gas in the

former Soviet Union. Russian customs statistics report that Russia

exported only 39.7 bcm to Ukraine in 2000, while Ukraine itself

claims that its gas imports amounted to 60.7 bcm, comprised of

27.9 bcm from Gazprom and 32.8 bcm from Itera. The 27.9 bcm

was what Gazprom paid for Ukraine’s transit services, and the

Itera imports would represent a combination of Turkmen imports

arranged through Itera (1.9 bcm) as well as Itera’s ‘‘own’’ gas (from

Russian or Turkmen sources).

GAS CONSUMPTION

Despite the attention given Russia’s international gas exports,

natural gas is produced mostly for internal Russian consumption

(representing 68.4 percent of production in 2000). Over the past 20

years, natural gas has made significant progress in replacing the

previously most important sources of primary energy, coal and oil,

in Russia’s primary energy balance. In 1990, natural gas accounted

for 43.1 percent of Russia’s primary energy consumption, and by

2000, the share of gas had edged up to over half of total consumption at 52.2 percent (Table 6).

During the 1980s when the gas industry was growing so rapidly,

the massive increments in gas supply were absorbed by directing

most of it to a few very large industrial consumers, especially electric power stations, but also including iron and steel plants and nitrogenous fertilizer centers. This minimized the need for the construction of an extensive network of distribution lines to serve

more dispersed consumers such as the housing and municipal sector (including households).

Gas consumption (end-of-pipe deliveries) in Russia peaked at

409.0 bcm in 1991. Apparent gas consumption (including pipeline

use) in Russia also peaked in 1991, at 468.7 bcm (Table 3). By

1997, with the declines in economic activity and some energy efficiency gains, apparent consumption of natural gas in Russia bottomed out at 377.5 bcm, down 19.5 percent compared to 1991, and

actual deliveries to consumers dropped by 19.3 percent between

1991 and 1997, bottoming out at 330.0 bcm; since then, apparent

consumption has climbed back to 404.4 bcm by 2000, and actual deliveries to 347.1 bcm.

Since the second half of the 1980s, electric power has accounted

for the largest share of natural gas consumption in Russia. In

1990, out of 404.0 bcm of natural gas in total deliveries, electric

power stations used 179.0 bcm, or 44.3 percent. In 2000, electric

power took 136.4 bcm, or 39.2 percent of all sales to domestic consumers.

TABLE 3.

—GAS BALANCE FOR THE RUSSIAN FEDERATION

[In billion cubic meters]

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Gas production ................................. 640.6 642.9 640.4 617.6 606.8 595.4 601.5 571.1 591.0 590.7 Gas consumption (total apparent) .. 460.7 468.7 454.7 453.2 424.4 408.4 409.5 377.5 390.8 389.8 

Deliveries ................................. 404.0 409.0 395.3 382.1 348.0 339.0 336.8 330.0 331.6 339.9 Pipeline use/changes in storage 1 ................................... 56.7 59.7 59.4 71.1 76.4 69.4 72.7 47.5 59.2 49.9 

Pipeline use and losses

(reported) ................... 63.6 63.5 59.6 57.1 56.3 54.2 56.3 47.7 53.0 53.0 

Change in storage (residual) .......................

¥6.9

¥3.8

¥0.2 14.0 20.1 15.2 16.4

¥0.2 6.2

¥3.1 

Gas exports ...................................... 249.7 173.0 195.3 171.0 184.4 190.6 196.5 198.4 202.5 204.5 

Foreign .................................... 96.5 90.0 88.9 92.7 105.8 117.4 123.5 116.7 120.5 126.8 Other republics ....................... 153.2 83.0 106.4 78.3 78.6 73.2 73.0 81.7 82.0 77.7 

Gas imports ..................................... 70.1 13.8 7.0 6.6 2.0 3.6 4.5 4.9 2.3 3.6 

Foreign .................................... ——————————Other republics ....................... 70.1 13.8 7.0 6.6 2.0 3.6 4.5 4.9 2.3 3.6 

Kazakhstan ..................... ............ ............ 3.9 3.5 1.6 3.2 2.0 2.7 2.3 3.6 Turkmenistan ................. ............ ............ 3.1 3.1 0.3 0.3 1.9 1.9 — — Latvia ............................. ............ ............ ———— 0.7 0.3 ............ ............ 

Uzbekistan ...................... ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ 

1 Balancing item.

236

Industry remains the second largest consumer of natural gas in

Russia. In 1990, Russian industry used 165.7 bcm of natural gas

(41.0 percent of the total), primarily in chemicals, machine-building

and metalworking, ferrous metallurgy, and the oil and gas extraction sector. These four sectors accounted for over 71 percent of all

industrial consumption in Russia in 1990, or almost 29 percent of

total gas deliveries at that time. But as industrial activity contracted with the transition, the share of industry in Russian gas

consumption also declined, at least through 1998, bottoming out

that year at 94.0 bcm, representing 28.4 percent of total consumption.

In 1990, the volume of gas used in the municipal sector and

housing reached 42.3 bcm, or 10.5 percent of total Russian gas deliveries. Since 1990, the relative importance of the municipal sector

has climbed as industrial consumption has declined, as the amount

used by the housing and municipal sector has slowly increased. Its

share had climbed to 27 to 28 percent by 1999–2000, actually rivaling that of industry.

COAL SECTOR

Russian (gross) coal production declined by 41.3 percent between

1990 and 1998, from 395.3 mmt to 232.2 mmt, largely reflecting

the contraction in consumption with the transition-related economic decline. However, production did turn around in 1999 and

2000, reaching 257.9 mmt in 2000. In 2000, this was comprised of

171.7 mmt (66.6 percent of the total) of ‘‘hard’’ coal (i.e., of bituminous or anthracite rank) and 86.2 mmt (33.4 percent) of lowerrank lignite.

The bulk of Russian coal (over 80 percent) is produced in Siberia,

far from the main energy-consuming centers of the country in European Russia. The principal producing basins include: the

Kuznetsk Basin (in West Siberia), with an output of 114.0 mmt in

2000; the Kansk-Achinsk Basin (in East Siberia), with an output

39.9 mmt in 2000; the Pechora Basin (in northern European Russia), with an output of 18.4 mmt in 2000; and South Yakutia (Far

East), with an output of 10.1 mmt in 2000.

Not surprisingly, the principal areas of increase in 2000 were the

Kuznetsk Basin in West Siberia (+4.6 percent) and the KanskAchinsk Basin in East Siberia (+9.8 percent); the older producing

areas in European Russia did not do quite as well. These two large

Siberian basins now account for 61.2 percent of national coal production. Although underground-mined coal expanded in 2000 (by

1.6 percent), coal mined in open-pits expanded by 4.2 percent, raising the share of open-pit-mined coal to 64.6 percent.

The expansion in coal output in 2000 was heavily driven by rising export demand, although internal (apparent) consumption was

up slightly as well. Russia’s exports of coal to international markets (beyond the territory of the former Soviet Union) grew quite

rapidly in 2000, jumping by 69.8 percent, to 37.3 mmt (Table 4).

Russia’s coal exports to the former Soviet Union countries were up

as well, although more moderately (+6.6 percent), to 6.1 mmt.

TABLE 4.

—COAL BALANCE FOR THE RUSSIAN FEDERATION

[In million metric tons]

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Coal production ................................ 395.3 353.3 337.3 305.0 270.9 262.2 255.0 244.4 232.2 249.1 Coal consumption (apparent) .......... 398.4 361.1 337.5 305.0 274.9 251.2 249.5 237.3 223.7 237.4 

Coal deliveries to consumers

(reported) ............................ ND ND ND ND 272.6 259.0 205.6 197.8 196.4 210.0 

Coal exports ..................................... 49.2 37.4 40.5 28.7 23.3 29.6 25.6 22.9 23.5 27.7 

Foreign .................................... 20.0 17.5 18.1 20.2 17.6 21.0 18.5 18.1 18.3 22.0 Other republics ....................... 29.2 19.9 22.4 8.5 5.7 8.5 7.1 4.8 5.2 5.7 

Coal imports .................................... 52.3 45.2 40.7 28.7 27.3 18.5 20.1 15.8 14.9 16.1 

Foreign .................................... ————— 1.0 0.7 1.1 0.3 0.1 Other republics ....................... 52.3 45.2 40.7 28.7 27.3 17.5 19.3 14.7 14.7 16.0 

ND

—No data.

238

24During most of the 1990s (until December 1997), operational responsibility for the Russian

coal-mining sector rested with a central body known as the Russian Coal Company or Rosugol.

Rosugol was disbanded in connection with the agreement on the distribution of loans and credits

from the World Bank for coal sector restructuring.

This strong export performance reflects not only the effect of

higher prices (the average export price for Russian coal in December 2000 was $28.3 per ton [$26.9 per ton for non-CIS and $38.8

per ton for CIS sales] compared with $15.4 per ton in December

1999), but also the benefit from the sizable reduction in costs

achieved with the devaluation of the ruble in 1998. These have

made Russian coal exports much more profitable for the producers

and highly competitive in export markets.

Reflecting rising demand from the strong economic rebound in

2000, Russia’s coal imports surged as well, increasing by 58.5 percent, to 25.4 mmt (Table 4). Most of this coal is imported from

Kazakhstan. Thus, apparent coal consumption in Russia also grew,

reflecting the expansion in economic activity and expanded thermal

electricity generation. Apparent consumption in Russia amounted

to 239.9 mmt in 2000, up 1.0 percent compared to 1999. However,

reported deliveries to consumers actually declined, dropping by 2.0

percent, to 205.8 mmt. Consumption mainly increased in electric

power stations (+8.8 percent, to 135.2 mmt), coking/metallurgy

(+3.6 percent, to 42.1 mmt), and the municipal sector (+9.6 percent,

to 13.0 mmt).

Despite the turnaround in output in 1999–2000, Russian coal

production in PlanEcon’s energy forecast is projected to slowly decline over the next two decades (see below). In contrast, the Russian Energy Strategy envisions coal production rising to 320 mmt

in 2010 and over 400 mmt in 2020. In the Strategy, major technological breakthroughs are postulated in production, processing and

transportation that result in declining costs, and therefore end-user

prices, of coal. This is viewed as making coal a cost-effective energy

choice for consumers in European Russia.

The Russian coal-mining sector has been only slowly transformed

in the last 5 years or so as the government has pressed forward

on a difficult restructuring program under the impetus of the

World Bank. In 2000, the sector included about 65 coal producers,

including 60 already corporatized as coal-mining companies (not including subsidiaries), as well as 5 producers still organized as state

enterprises; these companies worked 106 open-pit mines and 114

underground mines.24 Three of the more prospective companies

were privatized in 2000, reducing the number of companies in

which the federal government still holds a majority of shares to 24.

As a result of the ongoing restructuring program for the sector,

over the 1994–2000 period, a total of 134,200 workers have been

shed, of which 23,500 were let go in 2000, and about 170 of the

worst mines have already been closed. Because of this, productivity

has been rising (in 2000, this improved to 108 tons per worker per

month), and with higher domestic and international coal prices in

2000, has substantially reduced the need for direct government

subsidies. But the government still provided ‘‘selective assistance’’

to 70 mines in 2000. The Ministry of Energy’s program for 2001

calls for subsidies of 8 billion rubles ($270 million), of which it

would like to direct 3.1 billion rubles (38.5 percent) to investment

239

projects rather than the closures and social payments that have

dominated up to now. What has also improved the finances of the

sector is the improved situation for payments by consumers. Over

the first 11 months of 2000, consumers actually paid for 86.2 percent of the coal they received, of which 46 percent was in cash. In

January 2000, this had been only 54 percent and 38 percent, respectively.

ELECTRIC POWER SECTOR

ELECTRICITY PRODUCTION

Electricity generation in Russia closely follows consumption

trends; only a relatively small proportion of electricity production

is exported. As the economy slowed in the late Soviet period, generation increases started to slow dramatically in the latter half of

the 1980s, and began to decline in 1991. Then with the transitionrelated difficulties of the 1990s, electricity production fell sharply.

By 1998, when aggregate production bottomed out at 827.2 billion

kilowatt-hours (kWh), output had declined by 23.6 percent from the

1990 peak of 1,082.2 billion kWh. Since then, output has risen

slightly with economic re-expansion, reaching 878.1 billion kWh in

2000 (Table 5). Production in 2000 was comprised of 66.3 percent

from thermal stations, 18.8 percent from hydro-stations, and 14.9

percent from nuclear stations.

Thermal generation in Russia increased by 3.2 percent in 2000,

to 582.3 billion kWh. At the same time, primary electricity generation grew substantially, as nuclear generation increased by 8.8 percent, to 130.5 billion kWh, and hydro-electric generation increased

by 2.7 percent, to 165.3 billion kWh.

The increased requirement for thermal generation put Unified

Energy Systems of Russia (UES), the electricity utility which runs

most of the Russia’s thermal plants (see below), in a tough situation because Gazprom periodically threatened to reduce gas supplies last year, citing non-payments. However, UES actually ended

up consuming more gas in 2000 than in 1999 (136.4 bcm vs. 134.1

bcm) as well as consuming more coal (132.5 mmt vs. 121.8 mmt).

UES’ fuel mix for thermal generation in 2000 shifted only slightly

away from gas: to 66 percent gas, 28.6 percent coal, and 5.4 percent

oil (residual fuel oil); this compares with 67.5 percent gas, 26.0 percent coal, and 6.5 percent oil in 1999.

ELECTRICITY CONSUMPTION

Electricity consumption in Russia started to fall in 1991 as the

economy began the transition. The drop in (gross) electricity consumption (measured as production minus net exports) continued

through 1998, when it bottomed out at 809.1 billion kWh, 24.7 percent less than the peak of 1,073.9 billion kWh achieved in 1990.

Following the recent economic turnaround, consumption increased

in both 1999 and 2000.

TABLE 5.

—ELECTRICITY BALANCE FOR THE RUSSIAN FEDERATION

[In billion kilowatt-hours]

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Total production ............................... 1,082.2 1,068.2 1,008.5 956.6 875.9 862.1 847.2 834.1 827.2 846.2 

Thermal stations ..................... 797.1 780.1 716.3 662.6 601.1 586.4 583.6 568.3 566.3 563.3 Hydro-stations ......................... 166.8 168.1 172.6 175.0 177.0 176.4 154.8 157.5 158.7 160.9 Nuclear stations ...................... 118.3 120.0 119.6 119.0 97.8 99.3 108.8 108.3 102.2 122.0 

Exports (

¥) ..................................... 43.3 47.2 44.0 43.4 41.7 38.0 31.8 26.8 26.4 22.5 

Imports (+) ...................................... 35.0 35.1 27.7 24.7 22.2 18.4 12.3 7.1 8.3 8.4 Apparent consumption ..................... 1,073.9 1,056.1 992.2 937.9 856.4 842.5 827.7 814.4 809.1 832.1 Losses and self-use ......................... 154.6 153.4 149.7 142.0 160.6 167.0 164.1 161.6 160.2 163.9 

Transmission losses ................ 84.2 83.9 84.1 79.8 73.0 71.9 70.6 69.6 69.0 70.6 Power station use and losses 70.4 69.5 65.6 62.2 87.5 95.1 93.5 92.0 91.3 93.4 

Domestic deliveries .......................... 919.3 902.7 842.5 795.9 695.8 675.5 663.6 652.8 648.9 668.2 

Industry and construction ....... 574.3 552.5 505.3 450.4 359.5 345.1 331.4 329.4 320.7 336.9 Agriculture ............................... 96.4 103.4 102.9 103.8 97.7 88.6 85.9 78.1 75.0 72.0 Transportation ......................... 103.8 96.7 86.8 76.7 68.4 65.2 64.9 63.5 60.0 60.6 Housing/municipal sector

(urban) ................................ 144.8 150.1 147.5 165.0 170.3 176.6 181.4 181.8 193.1 198.6 

Industry (including power stations) .................................. 644.7 622.0 570.9 512.6 447.0 440.2 424.9 421.4 412.0 430.3 

ND

—No data.

241

25 Net exports of electricity from Russia can thus be calculated as the difference between reported production and consumption in 2000 at 13.2 billion kWh, down from 14.1 billion kWh

in 1999. Russia’s exports of electricity (invoiced) in 2000 were reported as 14.849 billion kWh

by Goskomstat, a decline of 38.5 percent from 15.346 billion kWh in 1999 (although total exports

in 1999 amounted to 22.5 billion kWh). Thus, imports in 2000 would be 1.6 billion kWh.

The decline in electricity consumption during the period was

much less than the overall decline in economic activity. This reflects a combination of several factors, including the relatively slow

reform and commercialization of the sector (manifestations of

which are low end-user prices and high levels of non-payments) as

well as a high proportion of ‘‘overhead’’ or ‘‘fixed’’ consumption; i.e.,

consumption that occurs irrespective of direct production or economic activity. For example, a factory must be lighted and the assembly line turned on regardless of whether it produces only one

item or a hundred.

According to the Ministry of Energy, (gross) electricity consumption rose in 2000, although only by 3.7 percent, to 864.9 billion

kWh.25 This indicates that the electricity intensity of the aggregate

economy (kWh consumed per unit of GDP) is improving somewhat

as the economy re-expands; i.e., the inverse situation of what occurred earlier in the decade as GDP declined.

The growth in Russian electricity consumption in 2000 occurred

despite a much tougher payment policy by UES. Driven by the

need to come up with sufficient cash to pay for its fuel deliveries

(especially of gas), UES was willing to cut off non-payers, even if

they were entire regions or major enterprises or even key defense

facilities. With the tougher approach, UES had lifted the share of

payments by Russian consumers to 100 percent by the end of the

year, with the share of cash in these payments increasing to 74.2

percent.

Final electricity consumption (actual deliveries to consumers) declined by 29.4 percent between 1990 and 1998, from 919.3 billion

kWh to a low point of 648.9 billion kWh. In 1999, final consumption increased to 668.2 billion kWh (Table 5). Final consumption

fell slightly more than apparent electricity consumption because of

a slower rate in the fall of electricity use at power plants and

transmission losses.

Electricity consumption in Russia has been dominated by the industrial sector (particularly heavy industry), with a correspondingly small share by the residential and commercial sector. Whereas electricity consumption patterns shifted away from industry to

the commercial and residential sectors in other countries over the

course of their development, the Soviet development experience remained fixated upon industrialization, with the result that there

was relatively little shift in this regard in Russia through the

1980s. In 1990, the industrial sector still consumed 60.4 percent of

total final electricity consumption, while the residential sector accounted for a mere 8.4 percent; combined, residential-commercial

users (the domestic sector) still accounted for only 18.9 percent of

total final electricity consumption in 1990.

But such a shift is evident during the ongoing re-orientation of

economic activity under the transition to a market-type economy.

During the 1990s the sectors experiencing the greatest decline in

electricity use have been industry and transport. Industrial elecVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00267 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.011 CRS1 PsN: CRS1
242

tricity consumption (including the construction sector) fell by 41.3

percent between 1990 and 1999, dropping its share of final consumption to 50.4 percent in 1999. Industrial electricity consumption finally turned around in 1999 with the industrial recovery. In

contrast, electricity consumption in the household and commercialmunicipal sector generally has been rising throughout the transition period. The combined share of the domestic sector (householdscommercial users) in final consumption in 1999 was 29.7 percent.

ORGANIZATIONAL STRUCTURE

The Russian electricity sector is now administered and run by

three key entities: the large joint-stock company known as RAO

UES (Russian Joint-Stock Company of the Unified Energy Systems

of Russia); the 72 regional distribution companies (the energos);

and the nuclear power operator, Rosenergoatom, which has exclusive responsibility for the nuclear stations (except for the Leningrad nuclear station which operates separately).

The government’s organizational plan for the electric power sector laid out in 1992–1993 intended for each of the distribution companies to operate in the context of a Russian electricity ‘‘market,’’ both generating electricity themselves from their own smaller stations as well as buying power from the large stations (independent

producers) to supply their customers if needed or selling power into

the grid if they generated a surplus. One of RAO UES’ major tasks

was to arrange a ‘‘Federal wholesale electricity market’’ (FOREM)

through its operation of the transmission system. As dispatcher

and operator of the high-voltage grid, it plays a crucial role in

maintaining system stability and wheeling electricity to deficit

power networks from those with a surplus. The Central Dispatch

Office, which coordinates the seven regional power pools of the

RAO UES network, was corporatized, with 100 percent of its statutory capital owned by RAO UES. The various regional dispatch offices (for each regional power pool) are subsidiaries of RAO UES

as well.

RAO UES was organized and officially registered as a joint-stock

company on December 31, 1992. It essentially absorbed many of

the enterprises and activities of the former Rosenergo ‘‘concern,’’ the successor of the old U.S.S.R. Ministry of Electric Power. At that

time, the Russian Government planned to hold onto 51 percent of

the new holding company’s shares (although up to 30 percent was

planned to eventually be transferred to local administrations, and

currently the regional administrations vote 30 percent of the government shares in the energos), 21 percent was sold to employees

of the enterprises that comprise the company both for privatization

checks and for cash, and 15.1 percent was distributed to the population through check auctions (in February and June 1994), while

another 7.1 percent was reserved for cash sale or auction. By early

2000, the government’s stake in RAO UES had been reduced to

52.7 percent, with about 22 percent purchased by foreign institutional investors, about 6 percent in preferred (non-voting) shares in

the hands of employees, and the remainder held by Russian institutional investors and individuals.

The local distribution companies, or energo, were incorporated

into the RAO UES holding as ‘‘daughter’’ subsidiaries; RAO UES

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26The scheme establishing RAO UES intended to strip the largest thermal stations (over

1,000 MW) and hydro-electric stations (over 300 MW) out of the energos where they previously

had been administered, and put them in RAO UES’ hands, which together with RAO UES’ control of the high-voltage transmission grid, would lead to the formation of a wholesale electricity

market among the regions. With the loss of the large stations, few of the energos would be selfsufficient in electricity.

was intended to hold a 49 percent stake in each energo (on behalf

of the state). Thus, RAO UES was given broad control over the sector and was intended to represent the government’s interests in the

power sector. However, due to several structural factors, RAO UES

has been unable to effectively exert its control and manage these

widespread assets successfully. This largely reflects the fact that

RAO UES bears the ministerial administrative legacy from its Soviet predecessor plus the conflict between its role as a commercial

company and that of a state-owned managerial body for the sector;

an additional factor is that with the changes in the operating environment since 1990, it is simply too difficult for RAO UES to effectively manage the entire sector.

Many energos, supported by local government administrations,

have taken a more independent line, with particularly strong opposition coming from the surplus power regions that objected to having valuable generating assets taken from them. As a result, various compromises have been reached. Still, for most of the energos,

RAO UES did receive a 46 to 51 percent stake (giving it a majority

of votes depending upon the particular composition of preferred

versus common shares for each energo), and it has a 100 percent

stake in 8 others, while in only two it holds no shares.

In turn, the energos include within their structure the smaller

electric power stations (of less than 1,000 MW for thermal stations

or less than 300 MW for hydro-stations), comprising about 480 stations. The energos own 118 GW of capacity, but operationally retain roughly 135 GW (about 63 percent of the Russian total), including about 65 GW of heat-and-power stations (TETs) and 30 GW

of smaller thermal and hydro plants. Each of the smaller stations

is, in turn, a ‘‘daughter’’ company of the local distribution company;

i.e., it is itself a joint-stock company with 49 percent of its shares

owned by the larger distribution company.

While a large component of RAO UES’ holdings is comprised of

the regional distribution companies (almost 60 percent of its charter capital lies in its holdings of the energos), this is not the only

component. RAO UES also holds the large (independent) stations 26

as well as the bulk of the high-voltage transmission grid system

(over 330 kV) and some auxiliary operations, such as research institutes, design bureaus, and construction enterprises. Thus, RAO

UES has been described as the world’s largest holding structure.

Russia’s 51 larger stations (hydro-electric stations [GES] of more

than 300 MW and thermal stations of more than 1000 MW) were

supposed to be separated from the energos and were initially intended to become ‘‘daughter’’ companies within the RAO UES holding. These 51 stations (comprising a total of 96 GW or 45 percent

of Russian total installed capacity), despite being incorporated into

RAO UES, are described as being ‘‘independent’’ power producers.

Similar to what happened among the energos, however, not all

the stations followed the national scheme. Only 23 of these stations

are wholly under RAO UES (comprising 41 GW), while 9 stations

244

27Government of the Russian Federation, 2000.

(comprising 16 GW) are ‘‘leased’’ back to the local energos and 17

either remained with the energo, became an energo ‘‘daughter’’ company like the smaller stations, or were privatized under regional programs. Of these 17, 4 were privatized by the (autonomous) republics; 4 were ‘‘incorporated’’ by local authorities; and 5

were ‘‘incorporated’’ under different decrees or rules. In other cases,

special purchase rules for the output of these stations has been

agreed, further limiting the benefits to RAO UES from ownership.

Thus, in a variety of ways, control over many of these larger stations has not remained with RAO UES as intended, but has often

slipped back to the energos.

The nuclear stations also supply electricity to the network independently (their output is purchased both by RAO UES as well as

by some of the energos directly). They are under the administration

of the Russian Ministry of Nuclear Power, Minatom, or more properly, the government holding company under that ministry known

as Rosenergoatom (except for the Leningrad station, which operates independently).

The Russian electric sector remains in a state of flux, and since

the existing organizational structure creates a number of problems

for the system in terms of operation and management, it is slated

to undergo additional changes. A general restructuring plan for the

sector was recently approved by the government, more or less along

the lines of an earlier proposal mooted by Anatoly Chubais, the

chief executive of RAO UES. The key elements of the plan envision

the central government holding (RAO UES) divesting itself of generation and distribution assets, and refocusing its activities on the

‘‘natural monopoly’’ element of transmission. Change will be difficult, however, both because of the effective decentralization that

has occurred and because the power sector has become extremely

politicized at both the national and regional levels.

THE RUSSIAN FEDERATION’S PRIMARY ENERGY BALANCE IN LONG- TERM PERSPECTIVE

The main trends, tasks, and objectives of energy policy to 2020

are embodied in Russia’s recently approved Energy Strategy of Russia to 2020.27 This is the most recent in a series of energy policy

documents laying out a strategy for the energy sector and mechanisms for its implementation under the transition to a market

economy. Its immediate predecessor was the Basic Guidelines for

the Energy Policy of the Russian Federation to 2010 (approved in

October 1995).

A major difference between the 1995 and 2000 documents is their

macro-economic contexts. In 1995, Russia’s economy was still contracting, and the reduction in primary energy requirements concomitant with that was largely viewed as a factor facilitating the

task of supplying the country with energy and allowing foreign exchange to be generated by exporting the surplus. In contrast, the

2000 Strategy is set against a background of a resurgent economic

growth, and its focus is mainly upon meeting the growing energy

needs of a re-expanding economy. There is an overarching concern

that, given the poor state of the Russian energy sector, it may not

245

28Sagers and Movit, 2001. 29Sagers and Movit, 2001.

be able to meet the increasing energy demand nor provide the vital

exports needed to sustain the economic transformation. Thus, even

more so than in the past, the 2000 Energy Strategy emphasizes improvements in energy efficiency and reform of energy pricing structures as principal mechanisms.

The new Energy Strategy’s projections for energy supply to 2020

are based on a major change in energy policy outlook given the concern of an energy security risk from a deemed too high dependence

on natural gas. The Strategy envisages a change in the fuel mix

such that the share of natural gas in total primary energy consumption will decrease from levels of about 50 percent in the late

1990s to 42 to 45 percent in 2020. In its place, the share of coal

is planned to increase from 11 to 12 percent in 1998 to 22 percent

in 2010 and 21 to 23 percent in 2020. Nuclear energy is also slated

to increase, expanding to 6 percent in 2020 from current levels of

5 percent, while oil’s share in primary energy consumption will remain practically unchanged.

The Strategy projects primary energy production in Russia in

2020 at 1,525 to 1,740 million tons of coal-equivalent (1,068 to

1,218 mtoe), primary energy consumption in 2020 at 2,090 to 2,325

million tons of coal-equivalent (1,464 to 1,628 mtoe), and net energy exports at 565 to 585 million tons of coal-equivalent (396 to

410 mtoe).

In contrast, PlanEcon’s current energy forecast for Russia28

projects a substantially different picture for 2020, with a higher

level of aggregate energy production, a lower level of consumption,

and a higher level of exports. By 2020, PlanEcon’s current energy

forecast29 projects total output of primary energy in Russia at

1.446.3 mtoe, 10.7 percent above the 1990 level, and 46.7 percent

higher than the 2000 figure (Table 6).

In the PlanEcon forecast, coal production is expected to eventually resume its long-term secular decline; oil output is expected to

continue to recover (albeit slowly); and gas production should be

able to turn around shortly, due both to improvements in the domestic investment climate (reflecting higher prices and toughening

payment conditions) and to more buoyant demand from expanding

economic activity in the region. Thus, natural gas is expected to remain the largest component of Russia’s energy production. The

share of natural gas in primary energy output rose to 47.9 percent

in 2000, and is projected to reach 58.3 percent by 2020.

Over the entire 2000–2020 period, aggregate primary energy output in Russia is projected to increase at an annual average rate of

about 1.9 percent. While output of crude oil and natural gas is projected to rise considerably over the next 20 years, primary electricity production is anticipated to remain more or less stagnant

(due mainly to high capital costs), and coal output (in energy equivalent terms) is expected to resume its long-term slide as rising extraction costs and prohibitive transport charges erode its markets.

TABLE 6.

—PLANECON’S FORECAST OF THE PRIMARY ENERGY BALANCE OF THE RUSSIAN FEDERATION TO 2020

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2005 2010 2015 

Production (mtoe) ...................... 1,306.1 1,233.4 1,157.8 1,071.7 1,011.8 991.2 982.8 956.5 961.4 977.4 997.8 1,081.4 1,229.8 1,364.Shares (in percent):

Coal .................................. 14.5 13.5 13.8 13.5 12.8 12.8 12.5 12.3 11.5 12.3 12.5 11.3 9.6 8.Oil ..................................... 39.5 37.4 34.2 32.1 31.2 31.0 30.6 32.0 31.5 31.2 32.4 33.7 31.9 30.Natural gas ...................... 40.1 42.6 45.3 47.2 49.1 49.1 50.1 48.8 50.3 49.4 47.9 48.6 53.0 56.Primary electricity ............ 4.8 5.3 5.7 6.2 6.2 6.4 6.1 6.3 6.2 6.6 6.8 6.0 5.2 4.Other ................................. 1.1 1.2 1.0 1.0 0.7 0.7 0.6 0.6 0.5 0.5 0.5 0.3 0.2 0.

Consumption (mtoe) .................. 905.9 905.0 814.8 768.9 692.9 667.9 640.2 609.9 606.9 622.0 634.2 679.0 745.7 829.Shares (in percent):

Coal .................................. 20.5 18.4 19.0 18.5 18.7 18.1 18.2 18.3 17.2 18.0 17.6 19.1 16.9 15.Oil ..................................... 29.5 29.4 26.5 23.4 21.8 22.1 19.8 21.2 20.1 20.2 19.3 18.4 17.5 15.Natural gas ...................... 41.6 43.7 45.4 48.6 50.1 50.0 52.3 50.3 52.7 51.3 52.2 52.8 57.1 43.Primary electricity ............ 6.8 7.0 7.6 8.1 8.4 8.8 8.7 9.2 9.3 9.8 10.2 9.1 8.1 7.Other ................................. 1.6 1.6 1.5 1.4 1.1 1.1 1.0 0.9 0.7 0.8 0.7 0.6 0.4 0.

Net exports (mtoe) .................... 400.2 328.4 343.0 302.8 318.9 323.3 342.5 346.7 354.4 355.4 363.6 402.5 484.1 534.

Coal .................................. 3.4

¥0.0 4.4 2.9 0.4 6.3 6.7 5.7 6.4 8.3 13.0

¥7.5

¥8.0

¥8.

Oil ..................................... 249.2 195.4 180.0 164.2 164.8 159.3 174.4 176.3 181.1 179.5 200.5 239.4 262.0 267.Natural gas ...................... 146.9 130.3 154.0 131.4 149.3 153.2 157.0 160.2 163.8 164.4 147.1 167.0 226.1 271.Primary electricity ............ 0.6 2.8 4.6 4.3 4.5 4.5 4.5 4.5 3.1 3.2 3.0 3.5 4.0 4.

Note: Historical figures through 2000.

247

Nonetheless, oil is projected to see a slight decline in its share

of primary energy production, despite steadily rising output. This

is because longer term, it is uncertain if the investment needed by

the sector to sustain and expand oil output will continue to be

forthcoming. The single most important determinant of oil investment is the tax regime, so the longer term prospects for Russian

oil production are largely dependent upon tax reform. In its present

form, the Russian oil taxation system has several major defects.

The main problem is that it depends excessively on revenue- or

volume-based rather than profit-based taxes. Until the circumstances of extraordinary high international prices and low production costs in 1999–2000, the existing Russian tax system resulted in unacceptable returns on virtually all categories of investment.

Yet, maintaining the recovery in the oil sector depends heavily

on investment to replace the declining volumes of ‘‘flowing oil.’’ The

Duma is slated to act on tax reforms for the oil sector in 2001, and

the remaining normative acts needed to complete Russia’s regime

for production-sharing agreements for oil and gas production, are

also slated to be completed as well. These measures should allow

investment in the oil sector to continue to rise. Combined with improved effectiveness in the sector’s application of investment resources, this should assure a steadily rising volume of ‘‘new oil’’ sufficient to more than offset the decline of ‘‘flowing oil.’’ Thus, Russian oil production is projected to continue to rise over

the forecast period by PlanEcon, although growth is expected to

slow over time. During the next decade, oil output is projected to

expand steadily at about 1.5 percent per year before slowing to

about 0.5 percent per year in the period 2016–2020. Russian oil

production is projected to grow at an average rate of 1.4 percent

per year over the entire 20 year period to 2020, to reach 392.7 mmt

in 2010, and then 423.2 mmt by 2020.

The official Russian Energy Strategy to 2020 envisions oil output

at 335 mmt in 2010 and 360 mmt in 2020, an average annual rate

of growth over the 20 year period of only 0.5 percent. The Strategy

estimates that to reach these production targets, investments of

$42 billion (expressed in constant ruble equivalent compared to

1999) will need to be mobilized over the next decade, and another

$80 billion will be needed in the following decade. This is an average of $6 billion per year over the 20 year period compared with

the 1999 investment level valued at $2.0 billion (see above).

In general, these Russian estimates of investment requirements

seem reasonable with the Strategy’s oil production forecast. However, the overall oil production forecast seems far too conservative

given what was achieved in 2000 (e.g., higher investment, expanded drilling, more new fields) and the changes in the investment climate that are likely to be realized over the next few years.

In contrast, natural gas production in Russia is largely dependent upon developments in consumption. Despite Gazprom’s current

worries over its ability to produce gas in the near term, in

PlanEcon’s view, the decline in Russia’s gas output is largely an organizational/institutional issue related to the lack of incentives to

invest rather than a question of reserves or even the capacity to

mobilize investment. Thus, with the current direction of reforms in

248

the gas sector (albeit quite modest), production is likely to be able

to turn around relatively quickly to support rising gas demand, although growth will still remain fairly moderate. It will be driven

upward by a combination of internal consumption needs and export

demand in the former Soviet Union countries and non-former Soviet Union. PlanEcon projects Russian gas output in 2005 at 642.6

bcm, expanding to 797.0 bcm in 2010 and 1,030 bcm in 2020; gas

output growth is forecast to average 2.9 percent per annum over

the 20 year period.

In contrast, the Russian Energy Strategy, because of its goal of

diminishing the domestic economy’s reliance on gas, projects gas

output at only 655 bcm in 2010 and a mere 700 bcm in 2020. The

average annual growth rate envisioned in the Strategy for gas production is thus a mere 0.9 percent over the 20 year period. The expanded production is largely geared toward higher exports, while

domestic consumption is envisioned as remaining relatively flat

over the next two decades.

Clearly, such limited expansion would be favorable for Gazprom,

as the organization is not really challenged in achieving this output. Such a situation that is essentially non-threatening to

Gazprom’s current dominance in the Russian gas sector.

In fact, the Strategy reflects Gazprom’s current sensibilities, and

projects output from Gazprom’s three main producing fields

(Urengoy, Yamburg, and Medvezh’ye) to decline from the current

level of output (400 bcm) to a mere 87 bcm by 2020, necessitating

a relatively high level of investment in replacement production capacity. Such a high rate of decline for the main fields (¥7.2 percent

per annum on average) seems excessive given the past experience

with the large fields exploiting West Siberia’s Cenomanian reservoirs. PlanEcon’s forecast for Russian gas production envisions a

much lower rate of decline in Gazprom’s main existing fields (3.1

percent per annum on average), but nonetheless requires a substantial expansion of ‘‘new gas’’ (775 bcm by 2020). To achieve this,

organizational/institutional changes will be needed in the Russian

gas sector to support the development of more gas outside Gazprom

(by so-called ‘‘independents’’).

Russian coal production, in energy equivalent terms, is projected

by PlanEcon to slowly decline over the forecast horizon (¥0.5 percent per year on average). In contrast, the Energy Strategy envisions coal production rising to 320 mmt in 2010 and over 400 mmt

in 2020. In the Strategy, major technological breakthroughs are

postulated in production, processing and transportation that result

in declining costs, and therefore end-user prices, of coal. Such a

view seems quite unrealistic, however.

The projected level of primary electricity production in the current PlanEcon forecast envisions the completion of six new (1,000

MW) nuclear units during the forecast period, including four before

2005. The recently approved Energy Strategy calls for the completion of five new units (which were already well advanced in construction during the Soviet period) before 2005, identifying these as

the cheapest generating capacity (in costs per MW or per kWh)

that Russia could bring on stream. PlanEcon concurs in this assessment mainly because of the sizable investment that has already

been sunk into these units, particularly recently; the first of these

249

units (Rostov No. 1, a VVER–1000) was started up in February

2001. Commercial generation of power at the new unit is expected

to occur in October 2001.

However, PlanEcon does not consider the Strategy’s longer term

plans for further nuclear expansion beyond these initial units to be

realistic. The Strategy calls for 12 GW of new nuclear capacity (12

units) to be installed by 2010, pushing installed capacity to 33.2

GW and nuclear generation in the country up to 220 billion kWh,

to be followed by further expansion and modernization of older

units that would boost installed capacity to 48.4 GW in 2020, producing 320 billion kWh (19.8 percent of the Strategy’s projected

total for electricity generation). In comparison, Russia’s nuclear

stations produced 130.5 billion kWh in 2000, or 14.9 percent of

total production. PlanEcon’s forecast projects nuclear generation of

only 106 billion kWh in 2020 (8.2 percent of total generation),

largely because of the retirement of 13.2 GW of nuclear capacity

over the 20 year period, which is only partially offset by the installation of the 6.0 GW of new nuclear capacity.

In thinking about the long-term outlook for the Russian Federation’s primary energy balance, one of the most important factors in

a functioning marketized economy (which Russia hopes to become)

is energy demand. In turn, one of the most important demand drivers is the path of aggregate economic activity (GDP).

PlanEcon projects that Russia’s economic re-expansion will continue in the future, although at a much slower rate than in 2000

(at least initially)—GDP growth is projected to average 3.8 percent

per year in 2001–2005 and 4.6 percent in 2006–2010, before accelerating to 5.5 percent in 2011–2015. But in the subsequent 5 year

period (2016–2020), economic growth is projected to slow to 3.5 percent per annum on average. Average GDP growth over the 20 year

period is projected at 4.4 percent.

Two factors that will slow growth in the near term is rising domestic prices for energy and transportation and tougher payment

conditions (particularly for electricity and gas). These developments, overdue since the 1998 devaluation that depressed these

regulated prices in real terms, will reduce the profitability of many

traditional, Soviet-style activities (particularly in industry). These

were resuscitated and given a second lease on life by the tumultuous events of 1998. Nonetheless, economic growth is anticipated

to remain fairly strong throughout the forecast period, although

there remains a high degree of uncertainty in the pace of economic

reform and the underlying economic policies that will be pursued

by the Russian Government under President Vladimir Putin. Not

surprisingly, the official Russian Energy Strategy envisions even

more rapid growth than this, with average annual growth rates in

the range of 5.5 to 6.2 percent.

But because a fairly rapid pace of structural change in the Russian economy would be commensurate with such high rates of economic growth (together with other adjustments), PlanEcon projects

that the growth in primary energy consumption will lag well behind the trend in aggregate economic activity. Primary energy consumption is projected to rise at an average rate of only 1.7 percent

per year over the 20 year period. While the energy intensity of the

Russian economy in 2000 was considerably higher than in the SoVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00275 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.011 CRS1 PsN: CRS1
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viet period, improvements in the energy efficiency of the economy

have occurred in the last few years, and this pattern is expected

to continue by PlanEcon, perhaps even at a more rapid rate. The

improvement in energy efficiency in the economy is projected in the

range of 2.0 to 3.3 percent per year over the 20 year period by

PlanEcon, averaging about 2.7 percent per annum. In the final period of the forecast (2015–2020), the aggregate energy elasticity

(the rate of change in energy consumption per the rate of change

in GDP) is projected to decline to a value closer to recent Western

historical experience (i.e., to 0.3 to 0.4). Thus, by 2020, aggregate

energy intensity is projected to decline to 64.4 percent of the 1990

level.

The official Energy Strategy is even more aggressive in projecting

energy savings potential in the economy. Despite postulating much

higher underlying economic expansion (see above), it projects that

primary energy consumption will grow an average of only 1.3 percent per year between 2000 and 2020.

The shares of individual fuels in meeting aggregate primary energy needs in Russia changed significantly over the course of the

1990s, and PlanEcon believes that they will continue to change in

similar directions over the next two decades. The share of natural

gas has risen from 41.6 percent in 1990 to 52.2 percent in 2000.

By 2010, we project the share of gas will be up to 57.1 percent, and

that it will rise further, to 60.6 percent, by the end of the forecast

horizon in 2020. Most of the gain in the share of gas takes place

at the expense of coal. From a share of 20.5 percent in 1990, coal

had already experienced a decline in importance to a low point of

17.2 percent of total primary energy consumption by 1998, before

rebounding to 18.0 percent in 1999 and 17.6 percent in 2000.

PlanEcon forecasts that coal’s share of the total will rise again in

2001, to 19.9 percent, before heading back down to 19.1 percent in

2005, with a further drop by the end of the forecast, to only 13.8

percent by 2020.

The Energy Strategy envisions a very different picture. The Ministry of Energy, the Strategy’s principal author, thinks that energy

consumption has become too unbalanced in favor of gas. In particular, the Strategy calls for greater use of coal and nuclear power to

meet the increased demand for electricity. The Strategy projects a

decline in the share of gas in Russian primary energy consumption

to about 40 percent by 2020, led by a decline in the share of gas

in fuels use by the electric power sector from the current 62 percent to 51 percent by 2020. Concomitantly, according to the Strategy, the share of coal in primary energy consumption will rise

slightly over the 20 year period, to about 22.5 percent by 2020.

PlanEcon’s view is that coal and nuclear are not only intrinsically much more expensive than gas, but also come with enormous

environmental liabilities. Therefore with huge reserves of relatively

economic and clean natural gas, PlanEcon forecasts that Russia’s

reliance on coal for power generation and process heat is likely to

wane further. The declining relative importance of metallurgy in

the country’s aggregate economic output should also serve to reduce the share of coal in primary energy consumption as well.

PlanEcon anticipates that the share of oil/petroleum products in

meeting primary energy consumption will decline further before reVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00276 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.011 CRS1 PsN: CRS1
251

bounding slightly by 2020. Although demand for motor fuels will

increase as the Russian economy is increasingly motorized and the

fleet of cars and trucks continues to grow, this will be partially offset by the retirement of the sizable fleet of less fuel-efficient

gasoline-powered trucks and the improvement in the fuel efficiency

of vehicles more generally. Additionally, restructuring away from

heavy industry will further depress demand for residual fuel oil

(mazut) under industrial boilers, while mazut as well as coal will

face heavy competition from less expensive natural gas. The share

of petroleum products has fallen from 29.5 percent in 1990 to only

19.3 percent by 2000. Over the forecast period the share of petroleum products is projected to decline to 17.5 percent in 2010 and

15.1 percent in 2015 before rising to 18.5 percent in 2020.

The projection of primary energy production and consumption

also provides a forecast for their difference, or net energy exports

for Russia. Russian net energy exports reached a trough in 1993

at 302.8 mtoe, a decline relative to 1990 of 24.4 percent. The greatest share of the decline took place in net exports of oil, as the lack

of investment resources and the impact of the general economic decline fell heavily on the oil extraction sector. Net oil exports in

1993 were at only 65.9 percent of the 1990 level, and were even

further below the peak reached in the late 1980s.

Net oil exports are now expected to surpass the 1990 level (of

249.2 mtoe) already in 2008, and reach a peak of 267.4 mtoe in

2015 before dropping slightly over the ensuing 5 years to 260.4

mtoe in 2020. The expansion of Russian oil output is anticipated

to decline over time, causing a decline in net exports at the end of

the forecast because of higher growth in demand projected at that

time (i.e., 2.3 percent per year in 2016–2020) when restructuring

of mazut and low-octane gasoline consumption is of less consequence.

Net exports of natural gas have remained constrained during

most of the 1990s by the lack of absorption capacity by customers

in international markets (primarily Europe) and elsewhere in the

CIS. Partly because of limited demand growth in the importing

countries (as well as institutional barriers to mobilizing investment

to expand production in Russia), net exports of gas remained stagnant at around 150 to 160 mtoe (180 to 200 bcm) in the late 1990s.

But with continued inroads by gas in displacing coal and mazut in

the CIS and Eastern Europe and modest expansion of West European and Turkish demand for Russian gas, net exports of gas are

projected to rise rather steadily in the later periods. Some new

markets are also likely to be pioneered in Asia as well for Russian

gas from Sakhalin and perhaps East Siberia as well. Net gas exports are forecast to reach 308.5 mtoe (377.1 bcm) by 2020, 2.2

times the level that characterized the low point of 1991.

PlanEcon anticipates that Russia will not retain its position as

a small net exporter of both coal and electricity. The net surplus

for coal is expected to become a slight net deficit already in 2001,

and the gap will steadily expand over the next two decades. Russia’s own exports of coal to the non-former Soviet Union are expected to be more than offset by rising imports of coal from

Kazakhstan. But a small net trade surplus in electricity is projected to remain over the 2000–2020 period.

252

REFERENCES

Goskomstat Rossii (Gosudarstvennyy komitet Rossiyskoy Federatsii

po statistike), Sotsial’no-ekonomicheskoye polozheniya Rossii

2000 god, Moscow: 2001.

Goskomstat Rossii, Sotsial’no-ekonomicheskoye polozheniye Rossii

1999 god, Moscow, 2000.

Goskomstat Rossii, Rossiyskiy statisticheskiy ezhegodnik,

statisticheskiy sbornik, Moscow: 2000.

Goskomstat Rossii, Rossiyskiy statisticheskiy ezhegodnik,

statisticheskiy sbornik, Moscow: 1999.

Goskomstat Rossii, Promyshlennost Rossii, statisticheskiy sbornik,

Moscow, 1995.

Government of the Russian Federation, Energy Strategy of Russia

for the Period to 2020: Main Provisions, Moscow, November

2000.

GVTs Energetiki, Itogi raboty Mintopenergo Rossii 1999 god, Moscow: 2000.

GVTs Energetiki, Itogi raboty Mintopenergo Rossii 1998 god, Moscow: 1999.

McKinsey Report: Russian Oil, February 2001.

Mintopenergo (Ministerstvo Topliva i Energetiki Rossiyskoy

Federatsii) and IPROEnergo (Assotsiatsiya institut pravovykh

osnov energoeffektivnosti), Toplivo i energetika Rossii, Moscow:

1999.

Mintopenergo (Ministerstvo Topliva i Energetiki Rossiyskoy

Federatsii) and IPROEnergo (Assotsiatsiya institut pravovykh

osnov energoeffektivnosti), Toplivo i energetika Rossii, Moscow:

1998.

‘‘Osnovniye kontseptual’niye polozheniya i razvitiya neftegazovogo

kompleksa Rossii’’ (Basic Concepts for the Progress and Development of the Oil and Gas Complex of Russia), Neftegazovaya

Vertikal’, 1: January 2000 (Web address: ww.ngv.orc.ru).

Sagers, Matthew J., and Charles Movit, ‘‘Projected Developments

in the Primary Energy Balances of the Former Soviet Republics to the Year 2020, ‘‘ in PlanEcon Energy Outlook. Washington, DC: PlanEcon, Inc., July 2001.

Sagers, Matthew J., Valeriy A. Kryukov, and Vladimir V. Shmat,

‘‘Resource Rent from the Oil and Gas Sector and the Russian

Economy,’’ Post-Soviet Geography, 36, 7: 389–425, September

1995.

Sagers, Matthew J., ‘‘The Russian Gas Industry in 1998 and Prospects for the Future,’’ in PlanEcon Energy Outlook. Washington, DC: PlanEcon, Inc., April 1999, 147–217.

Sagers, Matthew J., ‘‘Russian Crude Oil Production in 1996: Conditions and Prospects,’’ Post-Soviet Geography and Economics,

37, 9: 523–587, November 1996.

(253)

AGRICULTURAL REFORM: MAJOR COMMODITY

RESTRUCTURING BUT LITTLE INSTITUTIONAL

CHANGE

By William Liefert 1

CONTENTS

Page

Summary .................................................................................................................. 253

Introduction .............................................................................................................. 254

Main Elements of Agricultural Reform .................................................................. 255

How Reform Has Changed Agricultural Production, Consumption, and Trade . 257

The pre-reform Soviet agriculture and food economy .................................... 258

Price liberalization ........................................................................................... 260

Trade liberalization .......................................................................................... 262

Fall in output was inevitable part of market reform .................................... 263

Current support and trade policies ................................................................. 264

Effects on U.S. agricultural trade ................................................................... 265

Consumption and food security concerns ....................................................... 266

Farm Restructuring and Institutional Market Infrastructure ............................ 268

Private farms .................................................................................................... 268

Household plots ................................................................................................ 271

Former state and collective farms ................................................................... 272

New agricultural operators and a new spirit of enterprise? ......................... 274

Could Reform Turn Russia into a Major Grain Exporter? ................................... 276

Conclusion ................................................................................................................ 278

References ................................................................................................................ 280

1William Liefert is a Senior Economist with the Economic Research Service (ERS), U.S. Department of Agriculture (USDA). The author thanks Stefan Osborne, Bryan Lohmar, Zvi

Lerman, and Mary Anne Normile for helpful comments, though he bears full responsibility for

any remaining shortcomings. The opinions expressed in this paper are the author’s alone and

do not in any way represent official USDA views or policies.

SUMMARY

Economic reform in Russia has substantially changed the volume

and commodity mix of agricultural production, consumption, and

trade. The main development has been the large drop in output,

with the livestock sector being particularly hard hit. During the

1990s livestock output and animal inventories both fell by about

half. However, the production decline has been an inevitable part

of market reform, as the hefty Soviet-era subsidies to agriculture

dropped severely. The contraction of the livestock sector has ended

the large imports of grain and soybeans needed during the Soviet

period as animal feed. On the other hand, imports of meat and

other high value products have increased. These changes have affected U.S. agriculture, as Russia has become the top foreign market for U.S. poultry, in some years taking nearly half of all poultry

exports.

254

2The paper draws heavily on a forthcoming ERS study (Liefert and Swinnen) that examines

how reform has changed agricultural production, consumption, and trade in the transition

economies of the former Soviet bloc. Another forthcoming ERS study (Cochrane et al.) focuses

on how reform in the transition economies has specifically restructured the livestock sector.

Sources on Russian agricultural developments during transition include ERS (annual to 1996,

1997, and 1998), OECD (annual), and OECD (1998). Much of the data presented in the paper

are from ERS and Organization for Economic Cooperation and Development (OECD) databases.

Institutional change, which involves farm restructuring and creation of the commercial and public infrastructure that a marketoriented agricultural economy needs, has been disappointingly

slow. Private farms account for only 2 to 3 percent of agricultural

output, while the former state and collective farms continue to

dominate the organizational structure of agriculture. Although officially reorganized, with many becoming ‘‘joint stock companies,’’ these farms have not substantially changed their systems of management and internal incentives inherited from the Soviet period.

No federal legislation exists that allows genuine private ownership

of agricultural land, which precludes development of a land market. In the absence of major institutional reform in agriculture,

productivity growth in the sector during the transition period has

been negligible at best.

INTRODUCTION

This paper surveys developments within the Russian agricultural

economy since reform began in the early 1990s.2 The paper focuses

on two main questions: how has reform changed the commodity

volumes and structure of Russian agriculture (production, consumption, and trade), and how has the institutional reform of Russian agriculture progressed? Institutional reform involves such

matters as farm level restructuring and creation of the commercial

and public infrastructure that a market-oriented agricultural economy needs.

The major commodity-related development during transition has

been the large fall in production, especially in the livestock sector.

Total agricultural output has declined by 40 percent compared to

the pre-reform period, and production of livestock goods about 50

percent. The drop in output is important for U.S. policymakers and

agricultural interests, for three main reasons. The first is that it

has strongly affected U.S. agricultural exports. During the Soviet

period, the U.S.S.R. was a major importer of U.S. grain, soybeans,

and soybean meal, used primarily as animal feed for the country’s

growing livestock herds. The severe downsizing of the livestock sector in Russia (as well as in the rest of the former U.S.S.R.) during

transition has largely terminated these imports. Russia is now importing substantial amounts of meat and other livestock products,

especially poultry. Consequently, Russia has become the largest

foreign market for U.S. poultry, in some years taking nearly half

of all poultry exports.

Another reason commodity developments are important for the

United States concerns policy advising and technical assistance.

The Russian agricultural establishment argues that the contraction

of agriculture, especially that of the livestock sector, is a catastrophe for the country, and that state policy toward agriculture

should focus on returning output to pre-reform levels. To accomplish this goal, agricultural interests lobby for a substantial inVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00280 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.012 CRS1 PsN: CRS1
255

crease in subsidies and trade protection for the sector, as well as

other policy interventions into agricultural markets that would be

to the sector’s advantage, such as raising prices for agricultural

output relative to input prices. The United States, as well as the

European Union (EU) and international organizations such as the

World Bank and European Bank for Reconstruction and Development (EBRD), have been heavily involved in policy advising and

technical assistance with Russian agriculture. Therefore, it is important that the Russian agricultural establishment and advising

Western bodies generally agree on the explanations as to why the

main reform-related developments within the sector have occurred,

the drop in output being at the top of the list.

The third reason the United States should be concerned about

Russian agricultural commodity developments is that the drop in

production and consumption during transition has raised questions

about Russia’s food security. Both the United States and EU have

responded by providing Russia with food aid (most recently in

1999–2000).

The paper is organized as follows. The first section examines the

main elements of Russian agricultural reform. The next section examines how reform has changed Russian agricultural production,

consumption, and trade, highlighting the role that price and trade

liberalization played in commodity restructuring. Subsections discuss how the restructuring has affected U.S. agricultural trade, the

current status of Russian support and trade protection for agriculture, and the consequences of commodity restructuring for food

consumption and food security.

The next section examines institutional developments, in particular farm restructuring and creation of market infrastructure for agriculture during transition. The focus concerning farm restructuring is on the three major types of agricultural producers—private

farms, household plots, and the former state and collective farms.

The section concludes by looking at new types of agricultural producers—large vertically integrated agri-food enterprises—which

some Russian agricultural specialists believe could be a progressive

force in Russian agriculture, perhaps raising productivity and injecting a stronger entrepreneurial spirit into the sector. The paper’s

last section examines the possibility that effective reform could

turn Russia into a major exporter of grain, as some Western specialists forecasted at the beginning of transition.

MAIN ELEMENTS OF AGRICULTURAL REFORM

Agricultural reform in Russia has involved four main elements:

(1) market liberalization; (2) farm restructuring; (3) reform of upstream and downstream operations; and (4) creation of supporting

market infrastructure. Market liberalization involves removing government controls over the allocation of resources and output, thereby allowing the market to become the main means of allocation. It

includes the key reform policies of liberalizing prices and trade and

eliminating subsidies to agricultural producers and consumers. By

changing prices, incomes, and other key monetary values that influence the market decisions of producers and consumers, market

liberalization has resulted in major changes in the commodity volume and mix of countries’ agricultural production, consumption,

256

3 Another way of explaining how market liberalization and farm restructuring differently affect the economy is with the concepts of (1) allocative efficiency and (2) technical efficiency and

technological change. By changing the mix and distribution of output in a way that better satisfies consumers’ desires, market liberalization increases allocative efficiency. The gains to consumers occur without any necessary improvement in the economy’s overall (or any sectoral) production function. Conceptually, market liberalization results in movement along the economy’s existing production possibilities frontier. By allowing more output to be produced from a given

amount of input, farm restructuring increases technical efficiency. The move by underachieving

farms to the best domestically available production practices results in movement from within

an economy’s production possibilities frontier to the frontier. If the improvement occurs because

farms move to a new superior system or technology of production, the farm restructuring

spawns technological change. This shifts the production possibilities frontier out.

and trade. Liberalization and its effects thereby mainly address the

question of what goods are produced and consumed in the agricultural economy. Market liberalization also links the macro-economy

to agriculture. Macro-developments such as inflation and movement in the exchange rate affect the key variables (prices, consumer income) that drive agricultural markets.

Farm restructuring changes the nature or system of production

at the level of the actual producer. It involves how farms are

owned, organized, and managed, that is, how goods are produced.

Key policies are privatization and land reform, which directly affect

incentives for using labor and other resource inputs.

Market liberalization and farm restructuring affect output and

consumption in different ways. Market liberalization changes the

mix of goods produced and consumed in a way that better satisfies

consumers’ desires for goods, but without any necessary improvement in the system or technology of production. Farm restructuring

entails changes by producers in the nature of production that could

increase productivity. This would allow more output to be produced

from a given amount of input, which would increase the total quantity of goods available for consumption.3

Market liberalization and farm restructuring are nonetheless

interrelated. The main way is that market liberalization can help

motivate farm restructuring. The desire to increase profit, or the

fight just to stay in business, can spur producers to reduce costs

by changing their system of production. The pressures from market

competition are the key to the relationship. However, market liberalization by itself will not inevitably lead to farm restructuring— producers must still make the actual changes in how they produce.

The third element of agricultural reform is transforming upstream and downstream operations. Upstream activities concern

the supplying of agricultural inputs, while downstream activities

cover storage, transportation, processing, and distribution. The

transformation of these previously state-run operations that were

well-integrated into the planned economy into privatized, marketoriented, and competitive enterprises not only would improve their

productivity and performance, but also help farms improve theirs.

The fourth element of agricultural reform is the creation of supporting market infrastructure. This involves establishing the institutions and services, whether commercially or publicly provided,

that a well-functioning market-oriented agricultural economy

needs. These include systems of agricultural banking and finance,

market information, and commercial law that can clarify and protect property, enforce contracts, and resolve disputes. Development

of market infrastructure and the transformation of upstream and

downstream operations are closely related, and in some respects

257

4For data on Russian agricultural production and trade, as well as analysis of issues involving

Russian agriculture, see the briefing rooms on Russia at the ERS Web site www.ers.usda.gov.

ERS briefing rooms also exist for agriculture in the other transition economies of Ukraine, Hungary, and Poland.

might be hard to separate from each other. For example, in many

isolated regions within Russia, the collapse of the planned economy

has deprived farms (especially small ones) of any channels for obtaining inputs, or for selling, storing, or processing their output. In

other words, upstream and downstream linkages, as well as the

market infrastructure (such as market information) that could

allow farms to find new linkages, are completely lacking.

The four elements of agricultural reform identified in this paper

are roughly comparable to the taxonomy of reform elements developed by the World Bank (Csaki and Nash, 2000) for agriculture in

all transition economies of the former Soviet bloc. The World Bank

reform elements are (1) price and market liberalization; (2) land reform and privatization; (3) privatization and reform of agroprocessing and input supply enterprises; (4) rural finance; and (5)

institutional reforms (largely involving public services). Market liberalization corresponds to World Bank element No. 1, farm level restructuring to World Bank element No. 2, reform of upstream and

downstream operations to World Bank element No. 3, and market

infrastructure to World Bank elements Nos. 4 and 5.

HOW REFORM HAS CHANGED AGRICULTURAL PRODUCTION, CONSUMPTION, AND TRADE

Since reform began in the early 1990s, Russian agriculture has

experienced major commodity restructuring—that is, major

changes in the commodity volume and mix of agricultural production, consumption, and trade. The main feature of the restructuring

has been a substantial drop in agricultural production, especially

in the livestock sector (Table 1).4 During the 1990s meat production, as well as livestock inventories, fell by about half.

The data in the table are based on countries’ official production

numbers, which exaggerate the decline in output. In the pre-reform

period farms had an incentive to overstate their production in order

to look better with respect to output performance, while in the

transition period farms have an incentive to understate production,

in order to avoid taxes and buttress their argument that they need

more state support. Also, the difficulty of measuring output by private and household producers adds to the undercounting of transition production. Yet, even if not wholly accurate, the official numbers clearly show a large decline in output. The downsizing of the

sector has also coincided with a major drop in consumption of livestock products (Table 2).

Table 1 shows that the drop in agricultural production has been

part of an economywide decline in output. Given that Soviet planners favored production of capital goods over consumer products,

one should not be surprised that the elimination of central planning strongly hit industrial production (especially heavy industry

such as metallurgy and chemicals). However, since foodstuffs are

the most fundamental of consumer purchases, a major decline in

agricultural production might seem counterintuitive. Yet, the main

reason agricultural output has fallen in Russia during the transiVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00283 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.012 CRS1 PsN: CRS1
258

tion period is the same as why industrial output and gross domestic product (GDP) have declined—consumers’ desires for goods have

replaced planners’ preferences as the dominant force in determining what goods are produced, consumed, and traded. As with heavy

industry, the contraction and commodity restructuring of agriculture in Russia has been an inevitable part of market reform.

TABLE 1.—CHANGES IN PRODUCTION

Commodity Production

index

Aggregate:

Total agriculture ............................................................................... 60

Total crops ................................................................................. 69

Total livestock products ............................................................ 52

Total industry ..................................................................................... 50

Gross domestic product (GDP) ........................................................... 61

Crops:

Grain ................................................................................................... 61

Sunflowerseed ..................................................................................... 106

Sugar beets ........................................................................................ 40

Potatoes .............................................................................................. 93

Vegetables .......................................................................................... 101

Livestock products:

Meat .................................................................................................... 48

Milk ..................................................................................................... 61

Eggs .................................................................................................... 68

Livestock inventories:

Cattle .................................................................................................. 53

Pigs ..................................................................................................... 45

Poultry ................................................................................................. 56

Note: The production index gives average annual production (or inventories) over 1997–1999 relative to

average annual production (or inventories) over 1986–1990, with 1986–1990 = 100.

Source: USDA.

Agricultural production has dropped severely in almost all the

transition economies of the former Soviet bloc, though particularly

in the countries of the former U.S.S.R. In most transition economies, total agricultural output fell during the 1990s by 25 to 50

percent. The ensuing explanation for the sector’s downsizing applies to a fair degree to all these countries. To examine the

downsizing of Russian agriculture, one must first explore certain

features of the pre-reform Soviet agricultural economy.

THE PRE-REFORM SOVIET AGRICULTURE AND FOOD ECONOMY

In the late 1960s the leadership of the Soviet Union decided to

increase production of livestock goods, a policy the East European

countries of the Soviet bloc generally followed. Consequently, from

1970 to 1990 livestock herds and output in these countries grew by

40 to 60 percent. For example, in the former U.S.S.R., Poland, and

Hungary, meat production in 1990 was higher than in 1970 by 63,

43, and 57 percent (Economic Research Service (ERS) databases).

The rise in feed requirements caused by the growing herds stimuVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00284 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.012 CRS1 PsN: CRS1
259

lated the crop sector. In the late 1980s the average annual output

of feed grain in the former U.S.S.R. was up by about half compared

to the late 1960s. The feed requirements of the former U.S.S.R.

were so great that the country also became a substantial importer

of grain, soybeans, and soybean meal, much from the United States

(Table 3).

TABLE 2.—PER CAPITA CONSUMPTION OF FOODSTUFFS BY COUNTRY

[In kilograms]

Foodstuff Poland

HungaryRomania Russia Ukraine U.S.A. Germany

Great

BritainJapan

1990:

Meat ................

Milk (excluding

butter).

Cereals ............

Potatoes ...........

73

230

145

144

101

178

148

58

74

99

173

59

75

1 184

1 164

106

68

1 184

1 164

131

113

256

109

55

96

224

94

81

72

227

93

105

38

65

133

25

1997:

Meat ................

Milk (excluding

butter).

Cereals ............

Potatoes ...........

66

204

157

136

84

156

113

66

50

179

205

82

48

145

156

125

32

156

160

126

117

254

116

62

83

236

83

79

73

234

95

113

42

68

118

26

1 Figure for entire U.S.S.R.

Source: United Nations Food and Agriculture Organization.

TABLE 3.—AGRICULTURAL IMPORTS BY THE FORMER U.S.S.R. AND RUSSIA

[In thousands of tons]

Commodity

Former U.S.S.R. Russia

1986–1990 1995–1998 1995–1998

Total imports:

Grain ....................................................... 35,720 2,150 2,860

Soybeans and soybean meal 1 ................ 4,500 850 190

Meat ........................................................ 810 1,970 1,670

Imports from the United States:

Grain ....................................................... 13,700 660 190

Soybeans and soybean meal 1 ................ 1,720 160 20

Meat ........................................................ 2 1,200 990

1 In soybean equivalent.

Note: Figures give average annual values over the period. Imports by the former U.S.S.R. in 1995–1998

are from beyond the region, while imports by Russia for 1995–1998 are from both beyond and within the

former U.S.S.R.

Source: USDA.

260

By 1990 per capita consumption of livestock products and foodstuffs in general in the pre-reform transition economies compared

favorably to levels in many Organization for Economic Cooperation

and Development (OECD) nations (Table 2). Since per capita GDP

in the U.S.S.R. and Eastern Europe was at most only half the

OECD average, these countries were producing and consuming

high-cost livestock products at a much higher volume than one

would expect based on the countries’ real income. This ‘‘achievement’’ came at a price, as large state subsidies, to both producers

and consumers, were necessary to maintain the high levels of production and consumption. For example, by 1990 direct budget subsidies to the agriculture and food economy in the U.S.S.R. equaled

about 10 percent of GDP, with the bulk going to the livestock sector. The subsidies created price gaps, whereby the prices paid to

producers exceeded those charged to consumers. In the late 1980s

agricultural producer prices in the aggregate exceeded consumer

prices by about 75 percent (Liefert and Swinnen).

A major feature of the pre-reform Soviet food economy was that

consumer prices for foodstuffs were set so low that output could not

satisfy all the demand generated by the prices. In the pre-reform

period long lines of shoppers and bought-out food stores were commonly interpreted in both the Soviet Union and the West as signs

of major food shortages. However, low state-set consumer prices

that overly stimulated demand were the main cause of these ‘‘market shortages,’’ rather than inadequate supplies of foodstuffs in volume terms (as the inter-country comparison of consumption in

Table 2 shows).

PRICE LIBERALIZATION

The lead policy of economic reform in Russia was price liberalization. This involved the corollary policy of reducing or eliminating

state budget subsidies needed to maintain the gaps between prices

paid to producers and prices charged to consumers. The result was

that the market became the dominant force in determining prices

and the quantities of goods produced and sold. The fall in producer

prices from ending the price gap lowered production.

Price liberalization had two other more indirect but nonetheless

significant effects on markets for agricultural products. These came

from the drop in consumer income and the deterioration in the

terms of trade for agriculture that accompanied the liberalizing of

prices. The freeing of prices led to high economywide inflation, in

the early reform years in the hundreds of percent annually. The

massive inflation substantially reduced consumers’ real income,

and correspondingly purchasing power, as prices economywide rose

by a greater percent than wages and salaries. By the late 1990s

real per capita income in Russia was only about half the level of

1990 (PlanEcon). The income decline reflects not only the drop in

pay for workers who kept their jobs, but also the rise in unemployment during the transition period.

The degree to which changes in real income affect the market for

a specific foodstuff depends on how sensitive demand is to income

variations (income elasticity of demand). Among foodstuffs, demand

for livestock products is relatively sensitive to changes in income

(income elastic). This means that declining income particularly hurt

261

the livestock sector. The fall in demand cut production further. The

downsizing of the livestock sector also lowered demand for animal

feed (feed grains and oilseeds), and thereby upset those markets.

Since the bulk of grain output in Russia is used as animal feed (as

in most countries), the contraction of the livestock sector largely

drove the decrease in grain production, rather than a decline in

human demand for grain products.

In fact, for certain foods, such as bread and potatoes, demand

can rise rather than fall when income decreases (inferior goods).

Table 2 shows that during the transition, consumption of cereals in

Russia has remained generally steady while potato consumption

has increased, suggesting that in Russia potatoes might be inferior

goods.

The second way price liberalization affected agricultural markets

was on the supply side, by raising the real prices for agricultural

inputs. In the inflation following price liberalization, prices for agricultural inputs rose by a much greater percentage than prices for

agricultural output. This increased the real prices producers had to

pay for inputs, or in other words, worsened producers’ terms of

trade. In Russia, agriculture’s terms of trade declined during the

1990s by about 75 percent. For example, in Russia in 1992, wheat

producers on average had to sell 0.3 tons of output to purchase one

ton of nitrogen fertilizer. In 1997 they had to sell 1.4 tons of wheat

(Russian Federation, 1998). Higher input prices decreased the

amount of inputs used in production, which reduced output further.

For example, in Russia from 1990 to 1997, fertilizer use per hectare

fell 80 percent, from 88 to 16 kilograms (Russian Federation, 2000).

Price liberalization could result in input prices rising relative to

output prices for two reasons. The first is that in the pre-reform

period prices for inputs were set lower relative to their production

cost than were prices for output. When prices were then freed,

prices for inputs had to rise more than prices for output to reach

the value of the real cost of production. Such price-setting behavior

means that in the pre-reform period producers were subsidized not

only through direct budget subsidies, but also indirectly through

the price system.

The second possible reason input prices could rise relative to output prices involves not just market liberalization but also the market structure for suppliers of agricultural inputs. In the pre-reform

period farms were typically dependent for the supply of any particular input on just a few, and perhaps only one, large state distributor(s). During the early reform years, markets were liberalized

and the input distributors privatized without the latter being broken up into smaller competing units. During the transition period

farms have accused the large suppliers of using their monopolytype market power inherited from the Soviet period to charge higher prices than would be possible if a number of smaller competitive

suppliers existed, prices that exceed the input producers’ costs of

production.

Although this problem has probably existed to some degree,

gauging the degree of the problem is difficult. In Russia, local authorities continue to help the large former state and collective

farms obtain inputs, often at below market prices, in return for the

farms’ willingness to sell them a certain amount of output at

262

5This point takes issue with the criticism commonly made of the Soviet Union that it could

not even feed itself. Rather than allaying food shortages, the imports of animal feed were used

to maintain artificially high levels of livestock production and consumption. 6The reason the data in Table 3 stop at 1998 is that in 1999 and 2000 the United States

and EU gave Russia substantial food aid. The official Russian foreign trade data do not distinguish between commercial imports and food aid, and separating out the two categories of inflows

would be overly difficult.

agreed-upon prices. Since the prices of both inputs and output exchanged in these deals often deviate from existing market prices,

it is difficult to determine whether farms are on net gaining or losing from the arrangement. Given that Russian regional governments have been paternalistic toward their local agriculture, fearing that defunct farms would create unemployment and food security problems, they have probably not used this relationship much

to farms’ disadvantage.

TRADE LIBERALIZATION

The second major reform policy that affected commodity restructuring in agriculture was trade liberalization. When Russia liberalized trade, domestic producer prices for most agricultural goods lay

above world market prices (OECD, 1998). This was yet another

way that the pre-reform system subsidized Russian agriculture— setting domestic producer prices above world prices. The fall in

prices to world levels during the transition period further reduced

agricultural production.

The Soviet Union was a major agricultural importer of products

from outside the Soviet bloc (with most of the imports going to Russia). The main imports included feed grain, soybeans, and soybean

meal, needed to feed the growing livestock herds. The reformdriven contraction of the livestock sector has severely reduced

these imports (Table 3).5 Instead of importing feed to maintain

their expensive livestock herds, Russia and the other countries of

the former U.S.S.R. are now importing meat and other livestock

products directly. From the second half of the 1980s to the period

1995–1998, average annual meat imports by the countries of the

former U.S.S.R. rose by about 125 percent (Table 3), with Russia

taking the bulk.6

The switch by Russia during transition from being a major importer of animal feed to a major importer of meat and other livestock products suggests that the country has a comparative disadvantage in the production of livestock products relative to animal

feed; that is, it produces meat and other livestock products at a

higher cost than it produces animal feed, relative to world market

prices. Liefert (1994) supports this conclusion. He finds that at the

end of the Soviet period, the U.S.S.R. had a general comparative

disadvantage in agricultural goods vis-a`-vis industry, and within

agriculture a comparative disadvantage in meat production compared to grain. That agricultural trade during the Soviet period appears to have been inconsistent with comparative advantage shows

the extent to which trade was driven by policy rather than economic rationality. Liefert (forthcoming) finds that in the late 1990s,

despite the major production and trade adjustments that had occurred during almost a decade of transition, Russia continued to

have a comparative disadvantage in meat production vis-a`-vis

grain.

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In addition to meat, Russia’s main agriculture and food imports

include other high-value products such as fruit, processed foods,

beverages, and confectionary products, as well as the bulk crop

sugar (mainly from Ukraine). A negligible agricultural exporter,

Russia has maintained a large trade deficit in agriculture (Table 4).

TABLE 4.—AGRICULTURAL TRADE BALANCE

[In billions of U.S. dollars]

1992 1993 1994 1995 1996 1997 1998

Total trade

Imports ......... $9.62 $5.95 $10.7 $13.18 $11.56 $13.36 $10.27

Exports ......... 1.65 1.67 2.78 2.67 3.2 2.48 2.2

Net imports .. 7.97 4.28 7.92 10.51 8.36 10.88 8.07

Trade with the

United States

Imports ......... 1.13 1.22 0.65 1.03 1.33 2 0.83

Exports ......... 0.02 0.02 0.02 0.02 0.04 0.03 0.03

Net imports .. 1.11 1.2 0.63 1.01 1.29 1.97 0.8

Source: USDA and OECD.

FALL IN OUTPUT WAS INEVITABLE PART OF MARKET REFORM

The analysis shows that commodity restructuring in Russia has

been an inherent part of market liberalizing reforms. Price and

trade liberalization substantially changed prices and incomes—the

two main factors on which producers and consumers base their decisions to produce, buy, and sell goods. Changes in these variables

in turn induced major changes in agricultural production, consumption, and trade. The decline in output, particularly in the livestock

sector, was inevitable. Price liberalization caused output for a typical good to fall for three reasons—elimination of the gap between

producer and consumer prices, the drop in consumer income, and

the rise in inputs’ real prices, with the last two effects occurring

from economywide price liberalization. Trade liberalization added a

fourth reason production could drop, since world prices lay below

domestic producer prices for most agricultural goods.

A parallel way of explaining why reform has reduced output is

by identifying how the pre-reform system directly and indirectly

subsidized agriculture, and how price and trade liberalization

caused production to drop by eliminating these subsidies. The three

main types of subsidies were direct budget subsidies from the government (which maintained the gap between producer and consumer prices), the domestic price system which kept prices for agricultural inputs low relative to producer output prices and the real

costs of production, and the price and trade system which kept domestic producer prices above world trade prices.

That the decline in agricultural output has been a necessary consequence of market liberalization means that the change in output

is an unsuitable indicator of the success of agricultural reform. The

degree to which output has fallen in individual countries is largely

a measure of the extent to which agriculture in the pre-reform peVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00289 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.012 CRS1 PsN: CRS1
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7 Although examining why industrial output has also fallen during the transition period is beyond the scope of this report, the general reasons are the same as those given for agriculture.

Planners’ desires for goods dominated over those of consumers, industrial production was subsidized (especially in heavy industry), and production and trade were not driven by countries’

comparative advantage vis-a`-vis the world market. Thus, industry also was an overexpanded

sector of the economy. 8For detailed discussion and data concerning support to Russian agriculture during the transition period, see OECD 1998.

riod was subsidized, planners’ preferences for goods deviated from

consumers’ preferences, and the structure of countries’ production

and foreign trade differed from that based on comparative advantage.7

CURRENT SUPPORT AND TRADE POLICIES

Although the various types of direct and indirect subsidies to

Russian agriculture steadily diminished during the 1990s, state

support to agriculture has not been wholly eliminated. Relative to

agriculture’s share in GDP of 7 percent, budget subsidies by the

federal government are low, comprising less than 2 percent of the

federal budget, and just a fraction of 1 percent of GDP. However,

as federal subsidies to agriculture diminished during the decade,

subsidies by regional and local governments increased, such that in

the aggregate they currently exceed total federal budget support.

Regional governments are concerned about both the local food security and employment consequences of falling output and unprofitable farms within their jurisdictions. With their growing support to

agriculture, local governments have gained influence over farms.

As mentioned earlier, they typically help their farms obtain inputs,

often at low or subsidized prices, in return for the farms’ willingness to sell them output at agreed-upon prices.

Farms are also subsidized indirectly by the recurring policy of

writing off of debt. Farms habitually receive ‘‘soft credits,’’ either

from state or quasi-state lenders, which are usually written off.

During the 1990s most Russian former state and collective farms

were unprofitable (currently about 50 percent are), and yet virtually none have gone bankrupt and closed down. That unprofitable farms can keep functioning means that their creditors (both

input suppliers and lenders) indirectly subsidize them by either not

calling in debt or eventually abolishing it.

Foreign trade policy in agriculture currently is not overly protectionist. Import quotas do not exist, with the exception of sugar (directed mainly at Ukraine). Import tariffs for most agricultural

goods range between 10 and 20 percent, with 30 percent being the

maximum. Some exports are also restricted, in particular

sunflowerseed. Sunflowerseed exports are taxed, mainly to keep domestic output within the country to help national processors

(crushers) suffering from excess capacity.

The dismantling of the state monopoly over foreign trade, and

the array of prices and trade controls that were part of the monopoly, has substantially narrowed the gap between world and domestic producer prices for agricultural goods. As a result, the indirect

subsidy to Russian agricultural producers during the Soviet period

from receiving prices above world trade prices has declined significantly.8

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9For further discussion of Russia’s WTO accession involving agriculture, see Liefert (1997).

However, agricultural trade restrictions have been stronger at

the regional rather than federal level. Regional and local governments commonly restrict outflows of agricultural output from their

jurisdiction. This hinders not only export beyond the borders of

Russia, but also agricultural trade within the country. The most

benign-possible reason for the flow restrictions is that regional authorities wish to protect their own consumers by ensuring that

local supplies are adequate. The most malign-possible reason is corruption, as officials might exploit the regional price differences created by these restrictions to earn easy profits. Such controls work

to segment regional markets from each other, as well as cut regional markets off from the world market. Without these restrictions Russian agricultural exports probably would not be much

higher, but imports would be lower. The controls prevent regional

output from reaching the large cities, such as Moscow and St. Petersburg, where domestic output competes with imports.

Russia began its negotiations for accession to the World Trade

Organization (WTO) in 1994, and could finally gain admission

within the next few years. The two main areas of negotiation concern market access (involving import restrictions such as tariffs

and quotas) and domestic support. Compared to most other countries (whether in the WTO or not), the levels of Russia’s current

tariffs and domestic support to agriculture are neither particularly

high nor low. Although Russia’s negotiated terms of entry could reduce these amounts a bit, the effect on import volumes might not

be substantial, at least in the near term. However, WTO accession

would bind the country to maximum allowable levels of tariffs and

domestic support, which would prevent Russia from raising the levels in the future.

Accession would also facilitate the development of a transparent,

rules-based, and predictable trading system, the lack of which is

probably the biggest current impediment to trade. For example,

Russia has used arguments concerning health and safety to restrict

imports of poultry from the United States. By binding Russia to the

WTO’s Agreement on the Application of Sanitary and Phytosanitary Measures, accession would require that any Russian complaints raised on this issue comply with WTO rules and procedures.

A potential problem concerning WTO rules’ enforcement for Russia,

though, is the proliferation of support and controls by regional and

local governments (such as the bans on outflows). Although these

measures might conflict with WTO rules and commitments (just as

they often violate Russian federal law), enforcing WTO disciplines

at such decentralized levels of government could be difficult.9

EFFECTS ON U.S. AGRICULTURAL TRADE

The Soviet Union was a major market for U.S. grain, soybeans,

and soybean meal (Table 3). The reform-driven changes in agricultural production and trade in Russia and the other countries of the

former U.S.S.R. have strongly affected U.S. agricultural trade. U.S.

exports of the above commodities to the region have fallen substantially (Table 3). However, the United States has moved from exporting almost no meat to the region in the pre-reform period to

266

being a major meat exporter. The bulk of the exports are poultry,

with most going to Russia. Since the changes in Russian agricultural trade are being driven by the economic fundamentals of comparative advantage, rather than any short-run ‘‘disruptions of transition,’’ the changes in the volume and structure of U.S. agricultural exports to Russia and the rest of the former U.S.S.R. region

are not likely to be reversed in the foreseeable future.

During the second half of the 1990s, Russia took nearly half of

all U.S. poultry exports. Poultry accounted for about three-fourths

of all U.S. agriculture and food exports to Russia in value terms,

and imported poultry (mainly from the United States) provided

over half of all poultry consumed in Russia. Other U.S. agricultural

exports include red meat and processed foods. As the United States

imports virtually no agricultural products from Russia, during the

1990s it ran an agricultural trade surplus with the country annually averaging about $1 billion (Table 4).

Russia’s financial crisis that hit in August 1998 severely cut the

country’s agricultural imports, seriously hurting U.S. exports. One

of the main consequences of the crisis was depreciation of the ruble

vis-a`-vis the U.S. dollar and other major Western currencies by

about 75 percent, as the exchange rate quickly fell from about 6 rubles to the dollar to 25 rubles. In the fourth quarter of 1998, total

Russian agricultural imports were down by about 80 percent compared to the previous year, and by 2000 had recovered to only half

the pre-crisis level. U.S. agricultural exports (again especially poultry) to Russia crashed in late 1998, though have since steadily rebounded. By early 2001 U.S. poultry sales to Russia were close to

pre-crisis levels (230,000 metric tons in the first quarter of 2001).

In 2001 and 2002 U.S. meat exports to Russia might also benefit

from the outbreak of both mad cow disease (Bovine Spongiform

Encephalopathy, or BSE) and foot-and-mouth disease in the EU.

The EU has been Russia’s main source of imported beef and pork.

In early 2001 Russia, along with other countries such as the

United States and Canada, banned the import of all EU meat

(though poultry was later allowed). In 1999 and 2001 Russia also

forbade imports of pork from China, because of foot-and-mouth disease outbreaks there. Although it is unclear how long the meat import embargoes imposed by Russia will last, the bans, as well as

lingering Russian suspicion concerning imported meat from the EU

and China, could provide U.S. beef and pork producers with at

least a short- to medium-term opportunity to expand exports.

CONSUMPTION AND FOOD SECURITY CONCERNS

The drop in agricultural production during reform has coincided

with a fall in consumption of livestock products (Table 2). In discussing food security in Russia, the Western media commonly give

the decline in agricultural output and consumption as evidence

that transition has seriously worsened food security. Although

transition has created a food security problem, the cause of the

problem is not the drop in agricultural output, nor is it more generally insufficient food supplies. As mentioned earlier, before reform, Russia had high per capita levels of consumption of most

foodstuffs, including meat and other high-value livestock products,

compared with even rich OECD nations. The best evidence of the

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10One of the motivating factors in the large aid to Russia was worry about the effects on food

availability of Russia’s economic crisis of 1998. As discussed earlier in the report, the crisis substantially depreciated the Russian ruble vis-a`-vis Western currencies. By raising the price of imported foodstuffs, the depreciation cut food imports in half. It has been a commonly held belief

during the transition that Russia imports over half of its food. If true, the large drop in imports

following ruble depreciation could by itself threaten food security. However, the Economic Research Service of USDA has calculated that even before Russia’s crisis, imports accounted for

only about a fifth of the country’s total food consumption. Poultry (mainly from the United

States) was the only major foodstuff for which imports have been providing over half of domestic

consumption. Imports do account, though, for over half of the food consumed in major cities such

as Moscow and St. Petersburg. Extrapolating the experience of the big cities to the entire country might explain how the misconception developed concerning the importance of imports to

total national food supplies (see Liefert and Liefert, 1999).

adequate availability of foodstuffs during transition is that, even

with food supplies and consumption being relatively high in the

pre-reform period, consumption of staple foods such as cereals and

potatoes has remained steady or even risen (Table 2). Consumption

of high-value livestock products has fallen during transition. As

mentioned before, however, per capita GDP in Russia and the rest

of the U.S.S.R. before reform was at most only half the OECD average. Consumption of ‘‘luxury’’ livestock products has therefore declined during transition to levels more consistent with the country’s

real income.

Reform has threatened food security in Russia not because of inadequate overall supplies of foodstuffs, but because of problems involving access to food for segments of the population and certain regions within the country. The inflation and rising unemployment of

the transition period increased poverty, such that food became less

affordable to a growing share of the population. The groups most

vulnerable to poverty are those dependent on the state welfare system for their income (such as pensioners), which has declined in

real terms because of inflation, and workers who have lost their

jobs or suffered a decline in their real wages, largely because they

are (were) employed by industries producing goods for which demand has dropped during reform. Reports suggest that as much as

30 percent of the Russian population might be living below the poverty level.

In addition, as discussed earlier, agricultural surplus-producing

regions commonly restrict the outflow of foodstuffs. Whether the

authorities’ motive is to protect their consumers by strengthening

local supplies or to benefit corruptly from the price arbitrage opportunities created by the restrictions, the controls can prevent fooddeficit regions from obtaining needed supplies.

In 1999–2000, Russia received substantial food aid from the

United States and EU. U.S. aid for the 2 years totaled over 3 million metric tons (mmt) of commodities worth about $1.1 billion,

while the EU gave 1.8 mmt, worth almost $0.5 billion. Most of the

U.S. and EU aid was targeted to food deficit regions, while some

of the U.S. aid was distributed by private voluntary organizations

to the poor and elderly.10

These distribution policies reflect the wisdom of targeting food

aid to needy social groups and regions. Such distribution will not

only have the strongest possible humanitarian effect, but also limit

any potential harm to agricultural producers. Funneling food aid to

the poor who have reduced purchasing power and to food deficit regions where food prices are high will minimize the injury that food

aid can cause agricultural producers by depressing prices.

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The reform-driven drop in agricultural production and consumption in Russia is part of the economywide reallocation of resources

away from producing and consuming goods favored by planners

and the political elite to goods favored by consumers. It might seem

surprising to describe foodstuffs as goods more favored by planners

than consumers. Yet, as previously discussed, the high levels of agricultural production and consumption of foodstuffs during the prereform period required large direct and indirect subsidies to both

producers and consumers. Once market liberalization and the decline in subsidies resulted in foodstuffs reflecting the full cost of

their production, consumers switched from buying high value livestock products to other goods and services. Reform has in fact created entirely new goods, and in particular services, which consumers were starved of under the old regime and to which demand has

turned during reform. Some of the worry in both Russia and the

West about declining food production and consumption during reform has been based on the misconception that by their very nature, foodstuffs must be more favored by consumers than planners,

such that the general public must on net inevitably suffer if reform

reduces consumption.

FARM RESTRUCTURING AND INSTITUTIONAL MARKET

INFRASTRUCTURE

This paper argued earlier that because the contraction of agricultural output has been an inherent part of market reform, output

is a misleading indicator of reform progress within the sector. A

more appropriate indicator is growth in productivity, that is, farms’

ability to produce more output from a given amount of inputs. Productivity growth would increase farm output and profitability, improve the cost-price competitiveness of Russian production vis-a`-vis

the world market (which in the Russian context mainly means

competing better against imported foodstuffs in the country’s large

urban markets), and save resources that could move out of agriculture to produce goods in other sectors of the economy.

The changes in Russian agriculture that could raise productivity

must come in the major areas of agricultural reform (other than

market liberalization) identified at the start of the paper—farm restructuring, changes in upstream and downstream operations, and

development of institutional infrastructure. However, progress in

these areas to date has been disappointing, from the point of view

of both the actual changes made and improved productivity performance. Developments will be examined from the point of view

of the three main types of agricultural producers during the transition period: private farms, household plots, and the former state

and collective farms.

PRIVATE FARMS

At the start of reform many Russian agricultural reformers

hoped that private farms would be the vanguard of successful market-driven reform of agriculture. By 1995 about 280,000 private

farms existed in Russia, comprising 5 percent of all farmland, and

producing 2 percent of total agricultural output (Table 5). The average size of the farms in 1995 was 43 hectares (106 acres).

TABLE 5.

—SHARE IN AGRICULTURAL OUTPUT OF DIFFERENT PRODUCERS

[In percent]

Commodity

Private farms Household plots 1 Former state and collective f

1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 1995 1996 1997 199

Total output ............................... 1.9 1.9 2.4 2.1 2.5 47.9 49.1 51.1 59.2 57.2 50.2 49.0 46.5 38.Grain .......................................... 4.7 4.6 6.2 6.8 7.1 0.9 0.8 0.8 0.9 0.9 94.4 94.6 93.0 92.Sunflowerseed ........................... 12.3 11.4 10.8 10.9 12.6 1.4 1.6 1.4 1.5 1.3 86.3 87.0 87.8 87.Sugar beets ............................... 3.5 3.3 3.5 4.0 5.4 0.6 0.7 0.8 0.8 0.8 95.9 96.0 95.7 95.Potatoes ..................................... 0.9 0.9 1.0 1.0 1.0 89.9 90.2 91.3 91.2 92.0 9.2 8.9 7.7 7.Vegetables ................................. 1.3 1.1 1.5 1.8 2.1 73.4 76.8 76.3 79.6 77.0 25.3 22.1 22.2 18.Meat 2 ........................................ 1.5 1.7 1.6 1.6 1.7 48.6 51.6 55.9 56.9 59.4 49.9 46.7 42.5 41.

Milk ............................................ 1.5 1.5 1.5 1.6 1.7 41.4 45.4 47.2 48.3 49.7 57.1 53.1 51.3 50.Eggs .......................................... 0.4 0.4 0.4 0.4 0.4 30.2 31.2 30.4 30.1 29.4 69.4 68.4 69.2 69.

1 Includes garden plots.2 Liveweight (before slaughter).

Source: Russian State Committee for Statistics.

270

Since 1995 private farming has not grown by much, in terms of

either number of farms or the farms’ share in total output (though

average farm size has increased to 58 hectares). A number of serious impediments exist to their growth and prosperity. Although

these obstacles hurt all types of agricultural producers to some degree, they are the most vexing for private farms. One impediment

is the absence of full private ownership rights in agricultural land.

A 1993 Presidential Decree sanctioned private property in farmland. This has allowed individual farmers to obtain and use farmland for private gain, as well as de facto pass the land on to their

heirs. Most private farmers acquired their land in two ways. The

first was the reorganization of former state and collective farms in

1993, whereby farm members were given shares of land which they

could choose to farm individually. The second way was purchasing

land from the state land reserve, which was created at the beginning of reform from land taken from former collective farms.

However, private farmers do not fully own their land, and can

only sell it back to the state land reserve. Also, foreigners cannot

purchase farmland. What is most lacking is federal legislation

passed by the Duma which gives individuals full legal title to farmland, which they could sell to others. The Yeltsin Administration

pushed for legislation that would allow full private property in

farmland, and it appears that some in the Putin Administration

also support such a position. However, the Duma, in which conservative agrarian interests have been strong throughout the transition period, has consistently opposed such legislation. In June

2001 a law in the Duma passed its first reading (three ‘‘readings’’ are necessary to become law) that would allow private ownership

of land. However, the law sidesteps the issue of ownership of agricultural land, by stating that agricultural land will be handled in

future legislation. If no federal legislation is passed in the near to

medium term that specifically addresses the question of farmland,

regional (oblast) legislation would probably determine the specific

conditions of its ownership and use. Although some regions have

passed liberal legislation concerning agricultural land, others have

enacted very conservative laws that deny private ownership.

The mass of conflicting federal and regional laws and rules concerning farmland has had the collective effect of preventing the development of an agricultural land market. One negative consequence of the absence of private ownership of farmland and a

land market is that farmers cannot use their land as collateral for

debt. Current law in fact prohibits farms from mortgaging their

land. This makes it virtually impossible for them to obtain commercial loans. A second negative effect is that without the security of

full ownership, farmers have reduced incentive to invest in developing their land.

Other major impediments to the development of private farming

concern the third and fourth major elements of Russian agricultural reform identified at the start of the paper—upstream and

downstream linkages and supporting market infrastructure. Upstream and downstream linkages and market infrastructure have

all been weak during the transition period. During the Soviet era

farms received inputs directly from the state and also gave their

output directly to the state distribution system. Private farmers,

271

however, must secure inputs for themselves and also market their

output. The commercial channels for doing so were non-existent at

the start of reform, and grew only slowly during the 1990s.

Private farmers not only need to establish these key linkages,

but they also need supporting commercial and public institutions

and infrastructure that a market-oriented agricultural economy requires. They in particular need a financial system that allows fast,

affordable access to capital, a system for quick and inexpensive dissemination of market information (where can one buy and sell, and

at what price?), and a strong system of commercial law that protects property and enforces contracts. Infrastructure and services

in all these areas are weak. Virtually no system of private commercial finance exists for agriculture. A recent publication on Russia’s

agro-food economy (Wehrheim et al., 2000) argues that undeveloped

institutions and infrastructure are the main problem facing the

sector. The absence of this infrastructure increases the risks and

transaction costs of doing business.

Another endemic problem in Russia that raises transaction costs

is extortion and bribery, a consequence largely of the dysfunctional

legal system. The problem is particularly serious for sellers of agricultural products. The easily identifiable and perishable nature of

their output makes them vulnerable to vandalism by extortionists

or corrupt officials who want to punish those who thwart them. In

addition to poor institutional infrastructure, private farmers (like

the entire sector) are plagued by deficient physical infrastructure.

Although storage is inadequate, the main weakness is transportation, particularly the poor road system.

Yet another major impediment to the development of private

farming is resistance by the farmers’ parent farms. The managers

of the former state and collective farms do not support, and often

actively oppose, having their workers spin off private farms. Weak

institutional infrastructure and upstream and downstream linkages increase private farmers’ vulnerability vis-a`-vis their parent

farms, for it makes them dependent on the farms for obtaining inputs and marketing their output.

HOUSEHOLD PLOTS

As during the Soviet period, households on the former state and

collective farms have small plots that they can independently cultivate. The plots average no more than half a hectare in size (about

one acre). Yet, as during the Soviet period, they produce a disproportionate share of the country’s agricultural output. The share

has steadily risen during the transition period (mainly because output by the former state and collective farms has dropped), such

that they now account for more than half of all production (Table

5). The plots produce mainly livestock products, potatoes, and vegetables, and virtually no bulk crops, such as grain and oilseeds. The

households typically consume part of their output themselves and

sell the rest, usually directly to consumers at local farmers’ markets. During the reform period there has also been growth in output by garden plots tended by the general population.

The household plots’ disproportionate share in output raises the

question of whether they could serve as the foundation for developing a market-oriented agricultural system based on privately

272

11 Because the former state and collective farms produce most of the country’s bulk crops,

their output volumes are sensitive to the weather. A major reason these farms’ share in total

agricultural output slips in 1998–1999 to only about 40 percent is because poor weather caused

low harvests, especially of grain. The statement that these farms currently account for about

40 to 45 percent of total output assumes average weather conditions.

owned household farms. The plots’ achievement, however, is deceiving. A major reason for their ‘‘success’’ is their strongly symbiotic

(parasitic?) relationship with their parent farms, through which the

plotholders obtain inputs (such as animal feed) inexpensively or for

free. Despite the official statistics which identify the share of these

plots in total farmland as only 3 percent, the plotholders also use

some of their parent farms’ land for their own purposes. The

amount of land they actually utilize could be as high as 10 to 15

percent of the total (OECD, 2001). If the plots were wholly

privatized, they would face the same challenges as the struggling

private farms described earlier, in particular the problem of obtaining inputs through commercial means.

The plotholders would face these hurdles with the additional

handicap of being much smaller than existing private farms. Even

if the plots increased in area tenfold, they would still be very small.

Russia could end up with a situation similar to Poland, the only

country of the Soviet bloc that had small peasant-run farms, where

farms currently average about 8 hectares in size (20 acres). The

unproductivity of such a scenario is shown by the fact that agriculture in Poland accounts for only 5 percent of the country’s GDP,

but has 25 percent of the labor force. Small plots in Russia would

in particular suffer from diseconomies of scale in producing bulk

crops, which require heavy machinery for planting and harvesting.

Although the productivity of Russia’s household plots demonstrates

the beneficial effect on incentives from giving farmers the freedom

to farm for their own gain, such a system of small non-capitalized

plots would be technologically and organizationally pre-modern in

nature.

FORMER STATE AND COLLECTIVE FARMS

The dominant agricultural producers in Russia (if not in terms

of total output, then in institutional structure and influence) continue to be the former state and collective farms. They hold about

85 percent of all farmland and produce about 40 to 45 percent of

total agricultural output (Table 5).11 They account for most bulk

crop production. In 1993 the state and collective farms of the Soviet

era were forced officially to reorganize. Many became ‘‘joint stock

companies,’’ while others became some sort of cooperative or collective association. As joint stock companies, the farms issued vouchers to all workers and managers, which gave them a claim to a

share in the farms’ land and other assets. Individuals could use

these vouchers to obtain land to work as private farmers.

With the collapse of central planning, farm managers were given

the freedom and responsibility to make their own production decisions, obtain inputs, and market their output. As a result, their position within the farms strengthened considerably. Farm management has been conservative during the reform period, such that little real change has occurred concerning farm organization, administration, and the system of internal work incentives. Farm producVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00298 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.012 CRS1 PsN: CRS1
273

tivity has increased only negligibly, if at all. Lerman et al. (2001)

calculate that during 1992–1997, total factor productivity in Russian agriculture rose only 7 percent (in total over the period, not

annually). Voigt and Uvarovsky (2001) compute that during 1993– 1998, total factor productivity on the former state and collective

farms fell 15 percent (in total). Both Sedik et al. (1999) and Voigt

and Uvarovsky (2001) find that technical efficiency on the former

state and collective farms, which measures the productivity performance of farms relative to the most productive farms in the country, has fallen during the transition period. This means that farms

in general have moved further away from, rather than closer to,

the best possible production practices within the country.

Because of the unlikelihood that private farming as previously

described will flourish in the near to medium term, the ‘‘reorganized’’ former state and collective farms will probably continue to

dominate agriculture in the foreseeable future (say the next 10

years). What are the chances that these farms will evolve into more

dynamic and productive enterprises?

The farms face some major handicaps inherited from the Soviet

period in changing their nature and behavior. One is that during

the Soviet era farms did not specialize in production. Although very

large (state farms averaged about 38,000 acres and collective farms

15,000 acres), they usually produced dozens of commodities. If a

farm had the capability to produce a certain agricultural good, it

usually did. Such non-specialization contrasted sharply with industrial policy during the Soviet period, whereby a huge enterprise

might be the country’s sole producer of a major product. The growing influence of local government over farms during the reform period has reinforced the tendency to diversify rather than specialize

in production, as local governments worry about food security.

Greater specialization would reduce farms’ production costs by allowing them to capture economies of scale.

Another handicap is the farms’ tradition of providing social welfare services for their workers, which includes health, education,

housing, and entertainment. Although the quality of these services

has declined during the reform period, the general obligation remains. According to a farm survey, these services increase farms’

total costs by 10 to 30 percent (Uzun, 2001). Yet another handicap

is the relationship household plotholders have vis-a`-vis their parent

farms, by which the former obtain inputs at the latter’s expense.

According to the same farm survey, this relationship raises farms’

costs by another 20 percent (Uzun, 2001). Non-specialization in

production, provision of welfare benefits, and service as a conduit

for free inputs to plotholders all impede farms’ ability to become

market-oriented profit-maximizing and cost-minimizing producers.

In addition to reducing the burdens just identified, there are two

general ways farms could become more efficient and productive.

The first would simply be to shed existing unproductive inputs, especially labor. The relative unproductivity of agricultural labor is

shown by the fact that agriculture currently accounts for about 7

percent of GDP, but has 14 percent of the country’s total labor

force. (In comparison, agriculture’s share in the labor force in the

United States is only about 2 percent—which is also primary agriculture’s share in U.S. GDP—and in the EU 5 percent.) Poor labor

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12More generally, Lerman (1999, 2000) finds a correlation between GDP growth in transition

economies and growth in agricultural output. GDP growth not only increases the quantity of

agricultural inputs available to farms, but also helps develop the agricultural services and commercial infrastructure that farms need to function and reduce operational and transaction costs.

productivity in Russia keeps production costs high and farm wages

and income low.

An advantage of raising productivity by shedding labor is that it

does not require a change in the existing system or technology of

agricultural production. The drawback is that it requires economic

developments outside of agriculture. The rest of the economy must

grow in order to generate new jobs for agricultural workers.12 Local

governments resist attempts by farms to pressure workers to leave,

out of fear it will add to unemployment. The collapse of the national social welfare system during the transition period also discourages workers from leaving the farm. Workers are understandably reluctant to face the prospects of both unemployment and a

social welfare system inferior to that they currently enjoy.

The second way farms could increase productivity would be from

genuine farm restructuring—that is, a major improvement in how

farms are managed and internally motivated, which would increase

the incentives to use resources more productively. Throughout the

transition period, farm management has opposed such major

changes, while the agricultural establishment in general has defended the existing system.

Rather than advocating major systemic reform of agriculture,

managers and agricultural policymakers argue that improvement

should come in two different ways. The first way is by restoring the

various types of support that existed during the Soviet period, such

as direct government subsidies to agriculture and high output

prices relative to input prices. The main complaint of agriculture

during the reform period is that the deterioration in its terms of

trade has made inputs unaffordable. The second way is by acquiring superior Western technology. Yet, unless major improvements

are made in the systemic nature of agriculture (effective farm level

restructuring supported by the necessary institutional infrastructure), Russian agriculture might not effectively use the superior

material technology and therefore fail to raise productivity.

The reason the Russian agricultural establishment has resisted

major reform is probably some combination of a genuine belief that

the main problems in agriculture are not systemic in nature, and

that major systemic changes would threaten their power and privileges. This writer is in fact sympathetic to the argument that Russian agriculture lacks the mentality necessary to implement major

reform. The Russian agricultural establishment appears to be

stunned by the huge contraction of the sector, particularly the

halving of livestock operations. Adding to the shock is the mindset

inherited from the Soviet period whereby the main goal and performance indicator of economic activity was rising output (rather

than growing productivity or consumer satisfaction).

NEW AGRICULTURAL OPERATORS AND A NEW SPIRIT OF ENTERPRISE?

There is evidence that some new forms of farm organization and ‘‘agricultural operators’’ are emerging in the country (Rylko, 2001).

A feature of these new producers is that they are very large

275

(around 36,000 hectares, or 85,000 acres, on average), and often are

vertically integrated enterprises, combining primary production,

processing, and distribution. Most of these new operations have not

evolved from the former state and collective farms, but rather have

been created by entities outside of primary agriculture, such as

banks, input suppliers, agro-processors, or industrial enterprises.

The apparent motive for the move into primary agriculture is that

they think it will profitably complement their existing business

(such as input supply or processing). Uzun (2001) finds that the

most successful of the former state and collective farms are also

very large, the hypothesis (backed by some evidence) being that

they have lower per unit costs of production from economies of

scale. Uzun argues that one reason these farms are successful is

that they specialize in production much more than most former

state and collective farms.

Nonetheless, the evidence is too new and slight to argue that

these new operators and large former state and collective farms are

the wave of the future. Yet, it is telling that the most dynamic new

types of farm organization in Russia involve large and integrated

enterprises, rather than smaller family-type farms.

Is there any recent evidence that Russian agricultural performance in the aggregate is improving, perhaps because of the benign

influence of these new types of producers? The economic crisis of

1998 provided a good test of Russian agriculture’s ability to respond to opportunities to expand output. The extreme depreciation

of the ruble following the crisis severely cut imports and raised agricultural producer prices expressed in domestic currency. A large

Russian production response would show that market incentives

and mechanisms were working reasonably well.

However, it appears that agricultural output has responded to

this opportunity only mildly. Although total agricultural output increased in 1999 and 2000 by 3 and 5 percent, this was mainly because weather improved in those years over the terrible weather

year of 1998 (which produced Russia’s lowest grain harvest in decades). In 2000 total agricultural production was still 4 percent

lower than in 1997 (admittedly a very good weather year).

The change in production of livestock products is a better indicator of response than the change in crops, given that Russia is a

larger importer of livestock products compared to crops and that

livestock output is not so vulnerable to the weather. In 1999 livestock production declined 4 percent, while aggregate output in 2000

was roughly unchanged. The 2000 performance in fact represents

some progress, since it was the first year since reform began that

livestock output did not fall. Other positive indicators in 2000 were

that farm profitability improved (the number of unprofitable farms

fell from 54 percent to 48 percent), and output of agricultural inputs rose (Serova, 2001).

All this evidence supports the conclusion that the isolated effect

of major ruble depreciation on agricultural output has been positive, though not robust. Some Russian agricultural specialists believe more generally that in the last couple years an improvement

has occurred in the attitude and behavior of agricultural enterprises (farms and processors). Enterprises better understand and

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13This information is based mainly on the author’s recent conversations with agricultural specialists in Russia. 14The forecast by Liefert et al. was for the former U.S.S.R. in the aggregate, though it would

be unlikely that the region could become a major grain exporter if Russia were not exporting.

driven economy, and thereby are becoming more concerned about

productivity, cost minimization, marketing, and the need to be selffinancing.13 Such opinion provides some basis for optimism, though

it is unclear how prevalent and deep the changed behavior is. In

its most recent review of Russian agriculture, the OECD (2001) argues that any current upturn in the sector might be a response

more to short-run and reversible favorable developments, such as

good weather and ruble depreciation, rather than to any major improvement in business mentality or behavior.

This writer believes that it is still too early to conclude that a

definite improvement has taken place in the attitude and performance of Russian agricultural producers. Although productivity

growth is needed to make Russian agriculture profitable and competitive, the motivation within the sector to make the necessary

systemic changes to raise productivity still appears rather weak.

Motivation could be imposed on the sector from outside by the state

enforcing a genuine ‘‘hard budget constraint.’’ This would involve

ending soft credits and requiring farms punctually to pay all debts,

that is, to become genuinely self-financing. However, the agricultural establishment and local governments resist this, and no other

force pushes for it. As a result, although most farms have been unprofitable during the 1990s, hardly any have gone bankrupt, as

they muddle on with de facto subsidies from soft credits. Almost all

farms continue to function despite a huge sectorwide drop in production, and with agriculture still employing almost as much labor

as in the pre-reform period.

COULD REFORM TURN RUSSIA INTO A MAJOR GRAIN EXPORTER?

When Russia began economic reform in the early 1990s, U.S. agricultural interests worried that reform might not only eliminate

the large U.S. exports of grain and soybeans to the country, but

also turn Russia into a major grain exporter. Using forecasting

models, Liefert et al. (1993) and Tyers (1994) predicted that if reform succeeded in significantly raising agricultural productivity in

Russia, the country would become a major grain exporter, perhaps

up to 20 million tons a year.14 Johnson (1993) argued that by simply reducing waste and thereby raising utilizable output of grain,

which is one form of productivity growth, Russia could have exportable surpluses.

The reason Russia has not become a grain exporter is that the

farm level restructuring and creation of supporting infrastructure

that would raise productivity have not occurred. This means that

the forecasters were not necessarily wrong in their predictions,

since their forecasts were based on the general premise (fleshed out

with specific assumptions) that ambitious and effective reform

would be pursued.

However, even if reform succeeded in raising productivity in

grain production, this might be insufficient to move Russia toward

grain exports. The forecasting studies just identified examined the

effect of reform within the agricultural economy alone. The studies

277

15 Conceptually, productivity growth would shift the domestic supply curve for grain to the

right, thereby increasing output. However, by lowering the production cost of all goods by a uniform percentage, the productivity rise should appreciate the country’s currency (under standard

assumptions by an amount equal to the productivity growth). The appreciation would lower the

good’s world price expressed in domestic currency. The drop in price would increase domestic

consumption and reduce domestic production. Thus, the country’s trade deficit in the good might

change little. Liefert (1994) examines the relationship between productivity growth and comparative advantage, particularly as applied to transition economies.

correctly forecast that the isolated effect of productivity growth in

grain would be to improve the trade balance in the product. Productivity growth would stimulate exports by reducing per unit costs

of production, thereby making domestic output more price competitive vis-a`-vis imports and the world market—in other words, the

productivity growth would improve Russia’s comparative advantage

in the product.

Assume, though, that reform raises productivity uniformly

throughout the economy (for all inputs used to produce all goods),

say by 50 percent. Because of the inverse relationship between productivity growth and costs of production, production costs for all

goods would fall also by a uniform percentage. (Under standard assumptions, the per unit costs would drop by one-third.) Since comparative advantage depends on relative costs and prices, Russia’s

structure of comparative advantage would not change. If Russia

were a relatively high cost producer of grain before the uniform

productivity increase, it would remain a relatively high cost producer, because per unit costs for all goods would change by the

same percentage. This means that if Russia were a net importer

of grain or any other good before the productivity growth, it would

be economically profitable for the country to continue importing the

good.15

An example of this general point is that ever since Great Britain

repealed the Corn Laws in the middle of the 19th century which

opened the country up to free trade, it has been a major importer

of agricultural goods. Over the past 150 years Britain has had significant productivity growth in agriculture in absolute terms. However, because productivity growth has occurred throughout the

economy, Britain remains a high cost producer of agricultural

goods relative to other goods it produces, and thereby has continued as a large agricultural importer.

If Russia currently does not have a comparative advantage in

grain, as appears to be the case, it can develop a comparative advantage and thereby become a major exporter only if productivity

growth in grain production exceeds that in most other areas of the

economy. The southern half of the European part of the former

U.S.S.R. has highly favorable natural conditions for agriculture,

particularly grain production—excellent soil and climate and generally adequate (though inconsistent) precipitation. Once that region, which covers Ukraine and southern European Russia, adopts

world-standard production technology, creates reasonably efficient

systems of farm organization and management, and builds institutional infrastructure to service agriculture properly, it will most

likely have a comparative advantage in production of grain and

various other crops, such that it should be a major exporter. This

would be consistent with the region’s history of being a large grain

exporter. However, during the transition period, agriculture has

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16 Using a forecasting model for Russian agriculture, the Economic Research Service of the

USDA predicts that during the next 10 years Russia remains a net grain importer (though of

only a couple million tons a year). The forecasts are based on assumptions that productivity

growth in the grain sector, as well as throughout agriculture, is slight (ERS, 2001).

been one of the most conservative and anti-reform sectors in Russia

(as well as Ukraine), and there is no firm evidence that it will become significantly more progressive during the next 10 to 15 years

(the new farm operators notwithstanding). Thus, during at least

this time frame, the likelihood that agriculture will outperform the

rest of the economy in productivity growth to become a major exporting sector appears dim.16

CONCLUSION

During the transition period, Russian agricultural output has

fallen in volume terms by 40 percent. The livestock sector has been

hit the hardest, with production and animal inventories both down

by about half. The decline in agricultural production, however, has

been an inevitable consequence of market reform. The main reason

for the output drop is that consumers’ desires for goods have replaced those of planners and the political leadership as the dominant force in determining what goods are produced and consumed.

The policies that engineered the switch from planners’ to consumers’ preferences as the driving force of production and consumption

were price and trade liberalization. These policies reduced or eliminated the array of Soviet-era subsidies to agriculture that maintained artificially high levels of production and consumption. Agriculture was subsidized three general ways: (1) through direct budget subsidies from the government; (2) through the domestic price

system whereby the prices farms had to pay for inputs were set low

relative to output prices and to the real costs of production; and (3)

through a price support system whereby the prices agricultural

producers received for their output were kept above world trade

prices.

The restructuring of agricultural production and consumption

has strongly affected U.S. agricultural exports. The Soviet Union

was a large importer of grain, soybeans, and soybean meal, needed

to feed growing livestock herds, with the United States being a

major supplier. The contraction of the livestock sector has pretty

much ended these imports. In their place, Russia has been importing substantial amounts of meat. These changes have strongly affected U.S. agriculture, as Russia has become the largest foreign

market for U.S. poultry. Research at the Economic Research Service of the U.S. Department of Agriculture (USDA) shows that the

switch from importing animal feed to maintain a large livestock

sector to importing meat and other livestock products is consistent

with Russia’s comparative advantage in agriculture—that is, the

country produces livestock goods at a relatively higher cost than it

produces animal feed.

The production decline has been accompanied by a fall in consumption of many foodstuffs, particularly livestock products such

as meat and milk. This has raised concerns about food security. Although transition has created a food security problem for Russia,

the cause of the problem is not the drop in agricultural output, nor

is it more generally insufficient food supplies. Before reform Russia

279

had high per capita levels of consumption of most foodstuffs, compared even to rich OECD countries. Although consumption of expensive livestock products has dropped, consumption of staple foods

such as bread and potatoes has remained steady or even increased.

Reform has threatened food security because of problems involving access to food. Reform has increased the number of poor who

lack the purchasing power to sustain adequate diets. Also, impediments to the flow of foodstuffs within the country have prevented

food-deficit regions from obtaining supplies from surplus-producing

areas.

That the fall in agricultural production has been a necessary part

of market reform shows that output is an inappropriate indicator

of reform progress. Better performance indicators for Russian agriculture are productivity growth (getting more output from a given

amount of inputs) and cost reduction. In addition to increasing output, productivity growth would make domestic production more

price competitive vis-a`-vis the world market, and free up resources

that could be used to produce goods in other sectors of the economy

(such as the fast-growing service sector).

Productivity growth and cost reduction could be achieved two

main ways. The first is through effective farm restructuring, which

involves changing farms’ internal systems of organization, management, and incentives for workers. The second is by reducing transaction costs for farms and enterprises by creating the institutional

infrastructure that a market-oriented agricultural system needs.

Necessary institutional infrastructure includes systems of rural

banking and finance, market information, and commercial law that

can clarify and protect property, enforce contracts, and resolve disputes. This infrastructure would also strengthen the upstream and

downstream linkages that connect agricultural producers to their

input suppliers and output processors and distributors.

To date, progress in farm restructuring and growth of institutional infrastructure has been disappointingly slow. Private farming has not taken off, and currently accounts for only 2 percent of

agricultural output. A major reason is that the mass of conflicting

laws concerning the use of agricultural land does not allow for full

private ownership of land, which prevents development of an agricultural land market. This hurts private farmers’ incentives to invest in their land, as well as their ability to get loans, since they

cannot use land as collateral. Russian agricultural producers in

general, but in particular private farmers, have also suffered from

the fact that commercial and public institutional infrastructure for

agriculture remains very undeveloped.

The household plots maintained by workers on the former state

and collective farms now produce over half of the country’s total agricultural output (mainly livestock goods, potatoes, and vegetables).

A major reason for the plots’ ‘‘success,’’ however, is their symbiotic

relationship with their parent farms, which allows plotholders to

obtain inputs inexpensively or for free. Without this crutch, the

plots would face all the challenges of private farms, with the added

handicap of being only a fraction of their size.

The former state and collective farms continue to dominate the

organizational structure of Russian agriculture. Although forced in

1993 officially to reorganize, with many becoming ‘‘joint stock comVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00305 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.012 CRS1 PsN: CRS1
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panies’’ owned by their workers, the farms have done little to

change how they internally operate. Farm managers and the agricultural establishment generally oppose systemic changes in agriculture, probably from some combination of a genuine belief that

the main problems in Russian agriculture are not systemic in nature, and fear that major changes would threaten their power and

privileges. Most farms have been unprofitable throughout the transition period, and get by largely from continued soft loans from either state or quasi-state lenders that are eventually written off.

Some new types of producers are appearing in Russian agriculture, in particular large vertically-integrated enterprises, often

created by input suppliers or processors. Some Russian agricultural

specialists argue that farms and processors in general are becoming more reconciled to the challenges and opportunities of producing for a market economy, and thereby are growing more concerned

about productivity, cost reduction, and marketing. However, the

evidence is still too slight to conclude that these new producers,

and attitudes, represent the future of Russian agriculture, and that

they will lead to a substantial improvement in agricultural performance. If such improvement is not forthcoming, the main consequence for U.S. agriculture is that Russia will not become a

major agricultural exporter, and will likely continue as a big meat

importer.

REFERENCES

Cochrane, Nancy J., coordinator. Livestock Production in Transition. Economic Research Service, USDA, Agriculture Economic

Report (forthcoming).

Economic Research Service (ERS), USDA. Former USSR, International Agriculture and Trade Reports, annual 1992–1996.

Economic Research Service, USDA. Newly Independent States and

the Baltics, International Agriculture and Trade Reports, May

1997.

Economic Research Service, USDA. Transition Economies, International Agriculture and Trade Reports, May 1998.

Economic Research Service, USDA. USDA Agricultural Baseline

Projections to 2010. Staff Report WAOB–2001–1, Feb. 2001.

Johnson, D. Gale. ‘‘Trade Effects of Dismantling the Socialized Agriculture of the Former Soviet Union.’’ Comparative Economic

Studies 35, 4:21–31, Winter 1993.

Lerman, Zvi. ‘‘Land Reform and Farm Restructuring: What Has

Been Accomplished to Date.’’ American Economic Review 89,

2:271–275, May 1999.

Lerman, Zvi. ‘‘From Common Heritage to Divergence: Why the

Transition Economies are Drifting Apart by Measures of Agricultural Performance.’’ American Journal of Agricultural Economics 82, 5:1140–1148, Nov. 2000.

Lerman, Zvi, Yoav Kislev, Alon Kriss, and David Biton. ‘‘Agricultural Output and Productivity in the Former Soviet Republics.’’ Presented at Meeting of the American Agricultural Economics

Association, Chicago, ILL, August 2001.

Liefert, William M. ‘‘Economic Reform and Comparative Advantage

in Agriculture in the Newly Independent States. American

Journal of Agricultural Economics 76, 3:636–640, August 1994.

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Liefert, William M. ‘‘NIS and Baltic Countries Look to Join the

WTO.’’ Agricultural Outlook, Economic Research Service,

USDA, Nov. 1997, pp. 26–30.

Liefert, William M. ‘‘Comparative (Dis?)Advantage in Russian Agriculture.’’ American Journal of Agricultural Economics (forthcoming).

Liefert, William M., Robert B. Koopman, and Edward C. Cook.’’ Agricultural Reform in the Former USSR.’’ Comparative Economic Studies 35, 4:49–68, Winter 1993.

Liefert,William M., and Olga Liefert. ‘‘Russia’s Economic Crisis: Effects on Agriculture.’’ Agricultural Outlook, ERS, USDA, June

1999, pp. 15–18.

Liefert, William M., and Johan F.N. Swinnen. Changes in Agricultural Markets in Transition Economies. Economic Research

Service, USDA, Agriculture Economic Report (forthcoming).

OECD. Agricultural Policies in Transition Economies: Monitoring

and Evaluation, annual 1993–1997 (with slight variation in

yearly titles).

OECD. Agricultural Policies in Emerging and Transition Economies, annual 1998–2001.

OECD. Review of Agricultural Policies: Russian Federation, 1998.

PlanEcon. Review and Outlook for the Former Soviet Republics, Washington, DC, annual.

Rylko, Dmitri N. ‘‘New Agricultural Operators, Input Markets, and

Vertical Sector Coordination.’’ Presented at Workshop on Russian Agricultural Input Markets, Golitsino, Russia, July 2001.

Russian Federation, State Committee for Statistics. Rossiiskii

Statisticheskii Ezhegodnik (Russian Statistical Yearbook), Moscow, annual.

Sedik, David J., Christian S. Foster, and William M. Liefert. ‘‘Economic Reforms and Agriculture in the Russian Federation,

1992–1995.’’ Communist Economies and Economic Transformation 8, 2:133–148, 1996.

Sedik, David J., Michael Trueblood, and Carlos Arnade. ‘‘Corporate

Farm Performance in Russia, 1991–1995: An Efficiency Analysis.’’ Journal of Comparative Economics 27, 3:514–533, Sept.

1999.

Serova, Eugenia. ‘‘Russia: Agri-Food Sector in 2000.’’ Presented at

OECD Global Forum on Agriculture, Paris, April 2001.

Tyers, Rod. Economic Reform in Europe and the Former Soviet

Union: Implications for International Food Markets. Washington, DC: International Food Policy Research Institute, Research Report 99, 1994.

Uzun, V.Y. ‘‘Organizational Types of Agricultural Production in

Russia.’’ Presented at Workshop on Russian Agricultural Input

Markets, Golitsino, Russia, July 2001.

Voigt, Peter, and Vladimir Uvarovsky. ‘‘Developments in Productivity and Efficiency in Russia’s Agriculture: The Transition Period.’’ Quarterly Journal of International Agriculture 40, 1:45–

66, 2001.

Wehrheim, Peter, Klaus Frohberg, Eugenia Serova, and Joachim

von Braun, editors. Russia’s Agro-food Sector: Towards Truly

Functioning Markets. Dordrecht, Netherlands: Kluwer Academic Publishers, 2000.

(283)

Human Capital and the Social Contract

RUSSIA’S DEMOGRAPHIC AND HEALTH

MELTDOWN

By Murray Feshbach 1

CONTENTS

Page

Summary .................................................................................................................. 283

Introduction .............................................................................................................. 284

Demographic Markers ............................................................................................. 285

Fertility ..................................................................................................................... 288

Migration .................................................................................................................. 289

Mortality ................................................................................................................... 290

HIV/AIDS ................................................................................................................. 290

Other Health Status Issues .................................................................................... 297

Some Positive Signs ................................................................................................. 299

Selected Environmental Health Issues .................................................................. 301

Foreign Assistance and Unmet Needs ................................................................... 304

1Dr. Murray Feshbach is currently a Senior Scholar at the Woodrow Wilson International

Center for Scholars of the Smithsonian Institution. He began work in October 2000 on policy

implications of the population, health and environmental problems in Russia. He retired as Research Professor Emeritus from Georgetown University in July 2000. During this period he

spent much of 1986–1987 as Sovietologist-in-Residence at NATO headquarters in Brussels, Belgium, working directly for Lord Carrington, Secretary-General. Prior to Georgetown University,

he was Chief of the U.S.S.R. Population, Employment and Research and Development Branch,

Foreign Demographic Analysis Division, U.S. Bureau of Census, until his retirement in 1981

from this organization. He joined the Census Bureau in 1957 after several years working on

the Soviet Economy Project at the National Bureau of Economic Research, in New York, during

1955 to 1956.

This paper is a revised, enlarged and edited version of ‘‘Russian Population Meltdown,’’ Wilson

Quarterly, volume XXV, no. 1, Winter 2001, pp. 15–21. Also see, Murray Feshbach and Alfred

Friendly, Jr., Ecocide in the U.S.S.R., Health and Nature Under Siege, New York, Basic Books,

1992 and Murray Feshbach, Ecological Disaster, Cleaning up the Hidden Legacy of the Soviet

Regime, New York, Twentieth Century Books, 1995.

SUMMARY

The demographic and health meltdown in Russia during the first

half of the 21st century is based on trends already evident or

emerging. The overall population and health decline starts with

children born to women with poor reproductive health, and proceeds to high premature mortality of Russian males.

Human immunodeficiency virus (HIV)/acquired immunodeficiency syndrome (AIDS) and its co-infection with tuberculosis

are now in early but virulent stages. If present trends continue,

these infections will have an increasingly negative effect on life expectancy and overall health of the Russian population. Mental retardation of the young adds another severely negative factor to future Russian health. Accumulative consequences of this demographic and health meltdown will be deterrence of an economic reVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00309 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.013 CRS1 PsN: CRS1
284

vival, reduction of military capabilities and dampening of morale of

the populace. Migration into Russia is not likely to fully offset the

effects of this demographic and health decline. Only large-scale

Chinese in migration would stem the decline of the Russian population.

INTRODUCTION

In his first annual presidential address to the Russian people on

July 8, 2000, President Vladimir Putin listed the 16 ‘‘most acute

problems facing our country.’’ Number one on the list, topping even

the country’s economic condition and the diminishing effectiveness

of its political institutions, was the declining size of Russia’s population. Putin put the matter bluntly. The Russian population is

shrinking by 750,000 every year, and thanks to a large excess of

deaths over births, and insufficient migration to compensate for the

mortality/birth ratio, it looks likely to continue dropping for years

to come. If the trend is not altered, he warned, ‘‘the very survival

of the nation will be endangered.’’ Unfortunately, even Putin’s grim reckoning of the numbers,

based on official projections made by the State Statistical Agency,

may understate the dimensions of the calamity confronting his

country. Its birthrate has reached extraordinarily low levels, while

the death rate is high and rising. The incidence of HIV/AIDS,

syphilis, tuberculosis, hepatitis C, and other infectious diseases is

soaring, even as the Russian health care system is vastly underfunded and insufficient for the need. Perhaps 40 percent of the nation’s hospitals and clinics do not have hot water or sewage. Seventy-five percent or more of pregnant women suffer a serious pathology during their pregnancy, such as sepsis, toxemia, or anemia.

Only about 25 percent of Russian children are born healthy. At

the same time, the infant mortality rate had significantly declined,

at least according to official statistics in the last 5 years, but increased again in 2000. The leading Russian pediatrician Aleksandr

Baranov estimates that only 5 to 10 percent of all Russian children

are healthy, a much lower proportion than the official figure.

As if these challenges were not enough, Russia bears the burden

of decades of environmentally destructive practices that have a direct, harmful impact on public health. Their legacy includes not

just conventional pollution of the air and water but serious contamination around many nuclear and chemical sites throughout the

country. In Dzerzhinsk and Chapayevsk, 2 of the 160 ‘‘military

chemical cities’’ that produce chemicals for the military-industrial

complex, the rate of spontaneous abortions or miscarriages is 15 to

34 percent of conceptions—a strong indication of chromosomal aberrations induced by the local environment. Yet a weakened Russia

lacks the means to contain ongoing pollution or to begin the monumental task of environmental cleanup. The decline in the size of

the Russian population, and in Russians’ general health, vastly increases the difficulty of creating the economic wealth upon which

such a cleanup—and so much else—depends.

It is not only compassion that should arouse the concern of the

West. While some may cheer the weakening of this sometimes lessthan-friendly power, still armed with large numbers of nuclear, biological, and chemical weapons, Russia’s decline raises the twin

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2 Issued by the National Intelligence Council, as: Global Infectious Disease Threats to the

United States, Washington, DC, 2000, 60 pp. 3Goskomstat, online Web site: www.gks.ru, February 2001, under the rubric ‘‘Sotsial’no- ekonomicheskoye polozheniye v Rossii.’’ Also see footnote 4.

prospects of political disintegration and subsequent consolidation

under an authoritarian leader overtly hostile to Western interests.

The nation’s problems, in any event, can no longer be thought of

as somehow only its own. An unclassified U.S. national intelligence

estimate warned that the global rise of new and re-emergent infectious diseases will not only contribute to social and political instability in other countries but ‘‘endanger U.S. citizens at home and

abroad.’’ 2 All new cases of infectious diseases (including HIV/AIDS

at about 42,000 per year) in the United States have nearly doubled,

to some 170,000 annually, since 1980. In Russia, the numbers of

major diseases have increased many multiples. For example, new

incidence of HIV/AIDS, officially recorded as 1,000 new cases in

1995, was over 56,000 by the end of 2000; all epidemiologists and

commentators in Russia and at UNAIDS believe this number is actually 5 to 10 times higher. And radioactive contamination from

Russia’s deteriorating weapons stockpiles, its decommissioned (but

not unloaded) nuclear rods and reactor compartments from submarines, and from sunken ships and submarines such as the Lenin

nuclear icebreaker and the Kursk nuclear submarine, poses a

threat of unknown dimensions, particularly to the nearby Scandinavian countries.

DEMOGRAPHIC MARKERS

The broad outlines of Russia’s looming demographic decline can

be sketched in stark terms. Russians are dying at a significantly

faster rate than they are being born. Even in Germany and Italy,

which also record more deaths than births, the difference is only

about 10 percent. In Russia deaths have exceeded births by a multiple of 1.8 to 2.0 since the early 1990s (Figure 1). In 2000, the

number of births in Russia was 1,259,400, while the number of

deaths was 2,217,100—both increasing compared to 1999. The net

natural increase declined more than the previous year because

deaths increased even more than births.3 From the regional point

of view, births increased in 70 regions, while deaths increased in

78 of the 89 administrative-territorial units. Nonetheless, deaths

still exceeded births by 1.8 times in 2000, the same disparity as in

1999. In the first 4 months of 2001, the population shrank, by

308,800 persons, to 144,500,000 (including net migration), according to Interfax News Agency, on June 22, 2001. If this were to continue throughout the year, the net decline in the population of Russia, would be over 900,000 persons, a number 150,000 greater than

the one Putin cited in his speech only 1 year earlier. By age group,

the decline during the period 2000 to 2016 of persons younger than

16 will be over 8 million, from 29,044,400 to 19,871,600, or by 32

percent; Goskomstat’s projection for the working age population

(16- to 59-year-old males and 16- to 54-year-old females, inclusive)

will drop by 6.4 million persons over the first 15 years of the period, from 86,359,400 to 79,967,900 at the beginning of 2016, or by

7 percent.

286

4Predpolozhitel’naya chislennost naseleniya Rossiyskoy Federatsii do 2016 goda

(Statisticheskiy byulleten), Moscow, 1999, pp. 113 and 144. All projections from this source use

the medium variant. This variant incorporates an assumption that total fertility rates in Russia

will approximate those of western countries over a period of time (i.e., be lower than currently),

that mortality will decrease in the first year of life, and that migration will be small from

‘‘Russian-speaking diaspora’’ in Belorussia, Ukraine, Baltic States and Moldavia, and only a

slow ‘‘repatriation’’ from the remaining CIS countries. Ibid., p. 5.

FIGURE 1.—HOW RUSSIA COMPARES, 1980–1999

As negative as Putin’s declaration was, it was based on the relatively optimistic projections of the State Statistical Agency,

Goskomstat. This scenario assumes a small decrease in the total

fertility rate beginning in 2000, a small increase in the mortality

rate, and a large decrease in net in-migration. But only the latter

projection is remotely plausible. However, if one expects large numbers of Chinese and/or illegal migrants from Afghanistan, China,

Kurdistan, Southeast Asia and others to contribute to the economy,

and settle in as residents, this could change markedly. As noted

later, one leading migration specialist expects a significant number

of legal Chinese migrants to settle into the east of the country; the

political and social implications may be very serious; the economic

consequences could be very positive.4

By 2050, I believe, Russia’s population will shrink by one-third.

In other words, it will drop from 144.7 million at the beginning of

2001 to about 100 million, a blow that even a stable, prosperous

country would have difficulty sustaining. The draft version of the

United Nations’ World Population Prospects. The 2000 Revision.

Highlights, (ESA/P/Wp.165, 28 February 2001, table 15), projects a

drop of 41,233,000 for Russia between 2000 and 2050, the largest

in absolute terms for any country included in the report. Based on

the medium variant projection this would yield a figure of

104,258,000. The next largest decline, in absolute terms, occurs in

Ukraine (¥19,609,000), and then Japan (¥17,876,000). Italy and

Germany are expected to witness declines of 14.5 million and 11.2

million, respectively, over the same half century. However, in relative terms only four countries exceed the relative decline (of 28.3

percent) in the Russian Federation—Estonia (46.1 percent), Bulgaria (43.0 percent), Ukraine (39.6 percent), and Georgia (38.8 perVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00312 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.013 CRS1 PsN: CRS1

76171.027
287

5 UN Population Projections, Revision 2000, table 15. 6 Anatoliy Vishnevskiy and Yevgeniy Andreyev, Voprosy ekonomiki, January 2000, p. 33.

cent) and Guyana (33.7 percent)—all except one, in the eastern European region.5 Many western European countries also are projected to experience population declines, but not nearly as severe

as that in Russia. While I believe that the assumption of relatively

stable or improving mortality, and of an improvement in total fertility rate, as assumed in the United Nations (UN) projection are

not likely I understand that any projection of 5 decades is at hazard to begin with. But the evidence presented below would seem

to indicate that a lower variant projection would be more realistic

in Russia than even the decline projected by the medium variant.

My projections, growing from a model developed for West Germany by the Population Reference Bureau, are less apocalyptic

than those of various Russian officials, Duma members, and demographers. A new study produced under the auspices of the Institute of Social and Political Research of the Russian Academy of

Sciences, for example, predicts that the Russian population will decline to between 70 and 90 million by 2045. If one takes the annual

750,000 decrease noted by Putin and multiplies it by 50 years, the

result is a drop in population of 37.5 million persons, to a net total

of 108 million—not far from my estimate of 100 million.

A model used by Dr. Yuri Komarov, former head of the Medical

and Socio-Economic Information Institute of the Russian Ministry

of Health, developed a projection of 94 million population in 2050.

Dr. Nataliya Rimashevskaya, Director of the Institute of SocioEconomic Problems of the Population of the Russian Academy of

Science, projected a population of 55 million in 2050 (this probably

should have been indicated as the projected population in the year

2075 as other individual Russian demographers have projected).

Anatoliy Vishnevskiy and Yevgeniy Andreyev (head of the Demographic and Human Ecology Center of the Institute of Scientific

Forecasting and Laboratory Chief at the Center, respectively), published another set of projections in the January 2001 issue of

Voprosy ekonomiki. In the worst case scenario, that is, a continued

drop in births and increases in deaths, with zero net in-migration,

the result is 86.5 million population in 2050. The better case scenario, with a rise in the total fertility rate to two children per

woman (which is very unlikely, as they also indicate) and no

change in mortality rates (also very unlikely, as noted below) yields

only 94.5 million.6 The United Nations Revision 2000, cited above,

projects a high of 113 million in 2050, 104 million as the medium

projection, and 96 million as the low variant. (Personal communication from a staff member of the UN Population Division.) Thus, a

decline of some 45 to 50 million over the first half of the century

is not out of line with many other projections.

The U.S. population, meanwhile, is projected by the U.S. Bureau

of the Census to grow from today’s 285 million to 396 million in

2050, a level almost four times the UN-projected Russian population.

288

7These and other official demographic projections are from Goskomstat RF,

Predpolozhitel’naya chislennost naseleniya Rossiyskoy Federatsii do 2016 goda (Statisticheskiy

byulleten), Moscow, 1999, 132 pp.

TABLE 1.—NUMBER OF FEMALES, AGES 20–24, 25–29, AND 20–29

Year 20–24 25–29 Total

2000 (As of September 1) ........................................... 5,415 5,118 10,533

2003 ............................................................................. 5,728 5,311 11,040

2006 ............................................................................. 5,988 5,539 11,527

2010 ............................................................................. 5,827 5,923 11,750

2013 ............................................................................. 4,681 6,069 10,751

2016 ............................................................................. 3,721 5,527 9,247

2019 ............................................................................. 3,539 4,258 7,797

2022 ............................................................................. 3,592 3,589 7,181

2025 ............................................................................. 3,742 3,536 7,279

2029 ............................................................................. 3,914 3,681 7,595

2032 ............................................................................. 3,886 3,839 7,725

2035 ............................................................................. 3,721 3,917 7,638

In broad demographic terms, one can say that Russia’s population is being attacked by two pincers. On one side is the fertility

rate, which has been falling since the early 1980s. Russian women

now bear little more than half the number of children needed to

sustain the population at current levels. In absolute terms, the

number of annual births has dropped by half, to 1.2 million in

2000, since reaching a high of 2.5 million in 1983. Due to Russia’s

rising mortality rates, fertility would need to reach 2.15 births per

woman just to reach the simple population replacement level. As

of 1999, however, the total fertility rate stood at 1.17 births per

woman (the total fertility rate for 2000 has not yet been published

(early July 2001), but is likely no higher than 1.20, or may even

be as low as 1.10). That is to say, Russian women bear an average

of 1.17 children over their entire fertile life, ages 15 to 49. Fertility

would need to rise by some two-thirds to reach the replacement

level of 2.1 to 2.15, at current mortality levels; that is, over 750,000

additional births per year.

FERTILITY

Some Russian demographers take comfort from the fact that

their country is not entirely alone, since deaths exceed births in a

number of European countries. But in countries such as Germany

and Italy, the net ratio is close to 1.1 deaths to every birth. In Russia, deaths exceeded births by 929,600 in 1999, a ratio of 1.8 to 1.

If health trends and environmental conditions are not dramatically

changed for the better, Russia could see two or more deaths for

every birth in the not-too-distant future.

Goskomstat’s projection points to an increase in fertility from

1.184 in 1999 up to 1.205 in the year 2000, then a continual decline

to 1.160 by 2015.7 In the UN Revision 2000 projection, the anticipated total fertility rate is slightly higher than Goskomstat’s, and

will be 1.18 in the period 2010–2015. It rises to 1.36 in 2020–2025,

and only in 2045–2050, does it reach to 1.75 children per woman

289

8The time period over which the decrease took place is not cited in the original source. S.

Bazal’chuk, ‘‘Opros. Pir vo vremya chumy,’’ Moskovskaya Pravda, 29 June 2001, p. 2, from Eastview Press Web site.: http://udb.eastview.com. According to an ITAR-TASS News Agency report

of March 10, 2001, ‘‘every third married couple suffers from [one] form [or another] of sterility.

Report by Anna Bazhenova. ‘‘Only Every Fifth Newborn in Russia is Practically Healthy.’’ The

latter source is somewhat more negative than the other reports.

(let alone to 2.1 or 2.15). Goskomstat’s projection likely is based on

a hopeful extrapolation of trends at the end of the 1990s, but neither it nor the UN projection takes fully into account the serious

deterioration of Russians’ reproductive and general health. Also

working against the hoped-for mitigation of the population decline

is the harsh reality that the number of women in the prime childbearing ages of 20 to 29 is declining and will continue to fall sharply, while the rates of sexually transmitted diseases among men and

women (which affect fertility) and gynecological illnesses are both

rising. Between the year 2000 and 2037, the number of 20- to 29-

year-old females (the age group in which two-thirds of births take

place in Russia) will decline from 10,530,000 to 7,431,000. A short

interval of increase, to a peak of some 11,840,000 from 2000 to

2009, will be dramatically reversed during most of the rest of the

first quarter of the century. This reflects the precipitous decline in

births after 1987. These are persons already born. However, the

likely outcome is a fall in the total fertility rate due to qualitative

and quantitative reasons, as explained below.

The ranks of eligible parents, especially fathers, are being

thinned not just by deaths but by illnesses such as tuberculosis,

HIV/AIDS, alcoholism, drug abuse, and other causes, including infertility. Even as disease and mortality take more and more young

people out of the pool of potential parents, attitudes toward childbearing have changed for the worse. An estimated two-thirds of all

pregnancies now end in abortions (excluding spontaneous abortions).

Moreover, the recorded number of abortions excludes those performed in private clinics or illegal facilities, which if known would

raise the ratio of artificially induced abortions to births even higher. Equally important is the frequent negative consequences of

multiple abortions on the fertility of these women; up to 30 percent

are reported to become ill or infertile.

According to a study published in late June 2001 under the auspices of the Agency for Social Security of Russia, 30 percent of

young females do not wish to have children because of the economic

hardships they confront. This source also cites the declining health

of 33 percent of 17-year-old females which has led to a decrease in

the ability to have children.8 Fifteen to 20 percent of all Russian

families experience infertility, with 10 to 15 percent of females infertile, and some 5 to 10 percent of males. It is hard to see how

the hoped-for fertility gains will occur. Yet without a doubling or

even tripling in the total fertility rate of Russian women, and a

sharp decline in mortality, a steep decline in Russia’s population

seems unavoidable.

MIGRATION

Legal migration should fall far short of the numbers needed to

ensure an overall increase in the population. Goskomstat now

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9Predpolozhitel’naya chislennost naseleniya Rossiyskoy Federatsii do 2016 goda

(Statisticheskiy byulleten), Moscow, 1999, 144 pp. 10 V. Yemelyanenko, ‘‘Chinese Happiness’’ Izvestiya, 23 June 2001, online version. A fascinating new approach toward making this migration more viable is the announcement that a marketing network of made-in-China commodities will be established beginning in August 2001. The

network will be set up in 22 Russian cities, with headquarters in Vladivostok. Asian Pulse, July

2, 2001 cited in Lexis-Nexis. And how many will accompany and/or be permanent staff members

for this activity? How will the Russian national-patriots react to this putative ‘‘yellow peril’’

about which they have always been paranoid? 11 Ibid. The German Government also is rethinking its attitude toward restrictions on immigration of workers due to impending demographic decline in their population.

projects a decline in net immigration from 132,000 in 1999 to less

than half that number in 2015 (at 60,600).9 Only massive immigration of Chinese could suffice to compensate for the trend, and this

one would think would be unacceptable to the Russian authorities.

Nonetheless, while it is likely not to occur, one of the leading migration specialists in Russia, Zhanna Zayonchkovskaya is cited in

an article published in June 2001, that she expects that ‘‘the Chinese in Russia may become the second largest ethnic group after

Russians and an inalienable component of the Russian labor

force.’’ 10 If this bold assertion comes to fruition, it will change

many social and economic parameters very significantly; but then

Russia may not be Russia as we have known it until now.

She continues:

‘‘. . . the effectiveness of the labor market and the country’s

social stability will depend in the future directly on how

well the authorities manage to organize the coexistence

with immigrant groups . . . [especially if] 10 to 20 million

Chinese will live in the Russian Federation. Only a growth

in immigration of this magnitude will compensate sufficiently for the decline in births and the rise in mortality.’’ 11

MORTALITY

Mortality rates are also assumed to rise in the official

Goskomstat calculation, but much less markedly than I anticipate.

The Goskomstat projection through 2015, shows a crude death rate

of 14.3 deaths per 1000 population in 2000 (exceeded in reality in

both 1999 and 2000, with reported rates of 14.7 and 15.3 deaths

per 1,000 population, respectively) and a projection of increases up

to ‘‘only’’ 15.0 deaths per 1000 population in 2015, barely above the

reported rate in 1999, let alone the ‘‘excess’’ in 2000 as reported.

Some further perspective on the Russian situation is provided by

a comparison with the United States, which projects an average life

expectancy at birth and survival rates for specific age groups that

are far from the best in the world—especially among American 15-

to 19-year-old males, who kill themselves with drugs, alcohol, and

motorcycles. But in the United States, a boy who lives to age 16

has an 88 to 90 percent chance of living to age 60. His Russian

counterpart has only a 58 to 60 percent chance. And those chances

are shrinking.

HIV/AIDS

Tuberculosis, like HIV/AIDS, also is one of the maladies whose

surging incidence is not reflected in current Goskomstat projecVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00316 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.013 CRS1 PsN: CRS1
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12Ministerstvo zdravookhraneniya Rossiyskoy Federatsii, Zdorov’ye naseleniya Rossii i

deyatel’nost uchrezhdeniy zdravookhraneniya v 1999 godu, statisticheskiye materialy, Moscow,

2000, p. 51. See also, http://www.minzdrav-rf.ru/cgi-bin/show.pl?rubr=19&doc=551. 13 It is not clear whether these deaths occur among those whose illness has shifted from HIV

to AIDS, or all persons starting from HIV. Moskovskiy komsomolets, 16 August 1999, p. 4, cited

in http://aidsrussia.org/English/news/99Oct28/99oct28.html.

tions. The disease flourishes among people weakened by HIV/AIDS,

alcoholism, and poverty. Findings by the research institute of the

Russian Federal Security Service during the 1990s projected enormous numbers of deaths from tuberculosis. According to the Russian Ministry of Health, the number of tuberculosis deaths increased by 12 percent in the 1998–1999 period. The 1999 death toll

from tuberculosis of 29,000 was about 15 times the number in the

United States, or nearly 30 times greater when measured as deaths

per 100,000 population in both countries. The number of new cases

increased from 50,640 in 1990 to 124,044 in 1999. Correspondingly,

the number of deaths increased slightly more proportionately from

11,571 to 29,078 (or a case/fatality ratio of 22.8 deaths per 100 new

cases in 1990 up to 23.4 in 1999).12

The Russian Ministry of Health Web site reports that after a

major shortfall in funding in 1998 (that is, only 58.3 million rubles,

equivalent to $2.1 million at a rate of 28 rubles per dollar) of the

460.0 million rubles approved in the 1998 Federal Budget actually

was funded; in 1999, however, the full amount of 485.8 million rubles was fully allocated. In addition, a larger sum was provided for

capital investment and reconstruction work of anti-tuberculosis facilities. Perhaps they feel that this pattern creates sufficient expectations of full funding internally to reject the proposed loan of the

World Bank, for some $100 million for tuberculosis needs ($50 million for AIDS).

Many Russian authorities also underestimate the future impact

of HIV/AIDS, spread chiefly by intravenous drug use and sexual

contact. Dr. Vadim Pokrovskiy of the Federal Center for AIDS Prevention and Treatment, Russia’s leading HIV/AIDS epidemiologist

and the most aggressive messenger of the future AIDS-related difficulties facing the Russian Government and population, estimates

there will be 5 to 10 million deaths in the years after 2015 (deaths

that, again, I believe from the logic of the numbers and discussions

in Moscow, are not reflected in the population projections). Most of

the victims will be 20 to 29 years old, and most will be males—

further diminishing the pool of potential fathers. According to information cited on the online Web site of the Canadian AIDS Research Project in 1999, it was reported in the Russian press that

‘‘most Russian HIV/AIDS patients die within 3 to 5 years after infection.’’ 13 Several other key pieces of information, and/or projections add to the burden of this disease on the Russian population

now and in the future. The Russian AIDS Center projects that

within 5 years, there will be up to 5 million HIV positive individual

patients. (How many will not be patients, and therefore not recorded in this number is unknown, but would undoubtedly add significantly to this number.)

292

14 Anastasiya Kuzina, ‘‘Russia Will be Bankrupted Not by Bureaucrats but by AIDS. Each HIV-Infected Person Already Costs the Treasury $10,000 per Year,’’ Moskovskiy komsomolets, 16 May 2001, p. 2. And if the Federal Budget for 2001 allocates 42.96 million rubles (which

when divided by 28 rubles per dollar equals about $1.5 million for 300,000, 700,000 or 1 million

HIV/AIDS patients, is sufficient for 150 patients! 15 Cited in Emily Charnock, ‘‘Health Official Says HIV is Soaring; Cases Double in Five

Months,’’ The Washington Times, 17 June 2001, p. A8. 16Kuzina, loc. cit. 17K.I. Volkova, A.N. Kokosov, and N.A. Brazhenko, ‘‘Tuberkulez v period epidemii vich/spida

i narkomanii,’’ Problemy tuberkuleza, no. 2, February 2001, p. 62. 18 In contrast, a figure of 1,011 in all (prevalence) was reported for September 1, 2000. Cf.

Anna Bazhenova, ‘‘Russia to Have Over 1 Million HIV-Infected by Year End,’’ ITAR–TASS News

Agency, 3 April 2001 and V.V. Pokrovskiy et al., ‘‘Razvitiye epidemii VICh-infektsii v Rossii,’’

Epidemiologiya i infektsionnaya bolezn, no. 1, January–February 2001, p. 14, and ‘‘Chislo VIChinfitsirovannykh rastet,’’ SPV Vedomosti, 3 May 2001, p. 1. It would appear that the figure of

300,000 and these numbers are irreconcilable, even with any reasonable multiplier. However,

a dissenting view on the numbers of HIV-positive persons is expressed by Dr. Nikolay Fedorov,

head of the Department for Gene Testing of Blood and its Components, of the Central Scientific

Research Institute of Transfusional Medicine and Medical Equipment, of the Russian Academy

of Medical and Technical Sciences and of the Ministry of Health. He advocates the use of gene

testing and not just testing for antibodies, which he indicates give many false positives. He

blames, in part, poor quality reagents and careless laboratory personnel. Thus, it is not the testing per se, but the mechanics of the test process. See, Andrey Vaganov, ‘‘VICh-infektsiya:

prigovor ne okonchatel’nyy,’’ Nezavisimaya gazeta, July 6, 2001, p. 2. The rate of false-positives

in the United States perhaps is 3 percent, but most are verified or rejected by additional antibody testing and the Fedorov proposition apparently is exaggerated. Is this also a form of denial

of the serious extent of the problem in the Russian Federation?

As a consequence, the first 4 months of 2001 found 27,500 new

cases of HIV14 and by the end of the 5th month, according to a

staff member of the Ministry of Health, Dr. Irina Kochkarova, the

number of new cases was 63,000 (apparently more than doubling

from the end of the previous month).15 Thus, the prediction that

‘‘in 5 years’ time, every 30th inhabitant of Russia will be

infected . . . Bearing in mind that HIV primarily affects

young people (90 percent of cases are persons aged 15 to

29), every tenth person under the age of 30 will be a carrier of the virus.’’ 16

The Moskovskiy komsomolets report adds that if one looks at the

increase in sexual transmission (heterosexual and homosexual) almost doubling from 6.0 percent of the total number of new cases

of HIV in 2000, to 10.3 percent in the first quarter of 2001, is extremely worrisome. Dr. Kochkarova is cited as also asserting that

the actual number of HIV-positive people is five to seven times

higher than the official figures. And, the article continues, if the

sexual transmission rate reaches 30 to 40 percent of the new incidence ‘‘and this will be a cinch for us,’’ the virus will have gone far

beyond just the infectious drug use (IDU) community.

The most direct comparison between a reported and asserted

number is revealed in an article about the etiology, co-factor, and

prevalence of tuberculosis, injection drug use, and HIV/AIDS in St.

Petersburg. Problemy tuberkuleza provides remarkable details and

information about these interconnections. To the point at hand,

specifically, it contains a figure of 300,000 HIV-positive individuals

who are drug abusers.17 Simultaneously, the latest officially registered number (prevalence) of cases of HIV/AIDS in St. Petersburg

is 7,582 cases at the end of 2000. In addition, more than half of

this total (4,712) was recorded during the first 4 months of 2001.18

If the 300,000 figure is to be believed, and the trends continue,

mortality will be even higher than projected by Goskomstat and

the UN, unless and until a vaccine is found, distributed, and propVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00318 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.013 CRS1 PsN: CRS1
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19Described in ‘‘Politika i ekonomika. VICh-polozhitel’naya armiya,’’ Moskovskiy komsomolets, 1 March 2001, p. 2. 20 Ibid. Also see Yelena Stroiteleya and Aleksandr Chuykov, ‘‘Strel’ba na porazheniye. Nasha

armiya prodolzhayet voyevat protiv sebya, Izvestiya, July 10, 2001, p. 1.

erly administered in time to mitigate this impending demographic

disaster.

Moscow reported a rate of only 2.5 new cases of HIV nationally

per 100,000 population in 1998. However, if we apply the reported

number of new cases of HIV in 2000 (56,471) to the total population, the rate increases to 38.8 per 100,000 population (derived by

dividing 56,471 by 1,455—the population in 100,000 units, midyear 2000 estimate). The U.S. HIV incidence rate was 16.7 new

cases per 100,000 population in 1998. There are major regional differentials in the rates of infection. The Baltic port city of

Kaliningrad and its surrounding oblast held the unhappy distinction of recording the highest official rate of HIV increase, at 76.9

new cases per 100,000 in that year. Moscow city and Moscow Oblast, as well as Irkutsk Oblast, and several others, however, are

currently overtaking it.

The burden of this disease will not fall only on the general population or the economy ensuing from treatment costs, but also on the

armed forces of Russia. According to correspondent Anastasiya

Kuzina, an internal use only document obtained by Moskovskiy

Komsomolets, points to the growing incidence of HIV/AIDS within

the military and rising concern among the leadership over this phenomenon.19 AIDS (read HIV, even though the original cites the

later aspect of the illness) penetration into the military was classified as secret for 13 years, until 2000. The report was signed by

Dr. P. Mel’nichenko, Chief Public Health (Sanitarnaya) Physician

of the Ministry of Defense, and entitled, ‘‘Internal [Sluzhebnoye]

Letter on HIV-Infection Morbidity in the World, in the Country and

in the Armed Forces of the Russian Federation.’’ The upsurge in

Injection Drug Use in the general population has been reflected in

the draftees into the military forces. Some of the infected military

draftees reportedly have been sentenced under Article 228—the

Drug Addiction Article. Still others may have joined to avoid their

own medical care debt and to be cured by the military medical

services. ‘‘As in civilian life, the number of infected soldiers in our

power structures [that is, not just the armed forces, per se, but also

the KGB/FSB, the internal security troops, etc.] began to double

annually [except for 1998 and 2000], and half were registered as

being ill in the last 2 years alone.’’ 20 The numbers of those officially diagnosed with HIV/AIDS in the military are: 1991—4;

1992—2; 1993—2; 1994—7; 1995—2; 1996—29; 1997—72; 1998— 46; 1999—117; and 2000—110. The total is 391. Apparently, however, these numbers apply only to soldiers and sailors, not officers

and warrant officers. The same source gives a total of ‘‘about 550

soldiers and officers.’’ Through 1996, only 13 officers and warrant

officers were afflicted with HIV, but the number implied here for

this category is about 150. In July 2001, Izvestiya was reporting

that the Armed forces daily found up to 2 HIV-positive

conscriptees, and in recent years over 800 persons were infected

with the disease. Compounding the illness problem for the military

are reports of illiterate conscripts coming even from the Moscow

294

21 ‘‘Russian army received 46 illiterate conscripts from the Moscow region [oblast],’’ Ekho

Moskvy Radio (in Russian), 1100 GMT, 4 July 2001 (from FBIS CEP20010704000162) and ‘‘Over

500 Drug Addicts exempted from military service in Samara Region [Oblast],’’ from http://

www.militarynewsru/fcl—l/enews.asp?id=64646 (from FBIS, CEP20010705000076). Another example of the prevalence of the lack of formal education among young males is the report about

the situation in Kurgan Oblast, Western Siberia, is reported on Russian Public TV (ORT), 0500

gmt, 16 April 2001, as cited by BBC Monitoring, April 16, 2001, that ‘‘Every sixth conscript has

only an elementary education of four grades. Almost half of those recognized as physically fit

for service left school after the 7th or 8th year of studies.’’

Oblast (46 in all) and the rejection of over 500 drug addicts in one

region (Samara Oblast) for military service. The former figure implies a possible serious increase in illiteracy among 18-year-old

males. In 1999, only 22 such illiterate persons were drafted from

all of Russia, not from 1 of the 89 administrative-territorial units.

If the latter continues to expand and combine with the impending

decline in the numbers of 18-year-old males (beginning in 2005, 18

years subsequent to the major decline in births commencing in

1987), then the pressure on the military to reduce its demand for

manpower is clear from this point of view, let alone from budgetary

or national security concerns.21 Beginning in 2000, three-fourths of

new cases were diagnosed in Moscow city, Moscow and Irkutsk

Oblasts; until 1999, 80 percent were found in Kaliningrad Oblast.

The spread beyond just one oblast must be very worrisome to the

military.

Sexually transmitted diseases have seen incredible rates of increase during the past decade. These diseases cripple and kill,

damage reproductive health, and are associated with the spread of

HIV/AIDS. The causes can be traced to the explosion of pornography and promiscuity; the growth of prostitution, notably among

10- to 14-year-old girls; and, especially, drug abuse involving

shared needles and syringes. In 1997, the Ministry of Internal Affairs estimated that the market for illegal drugs was around $7 billion, 600 times greater than in 1991 (assuming little inflation in

prices during the period). Drug abuse and addiction is getting

younger and more widespread. According to Dr. Tatyana

Dmitriyeva, a former Russian Minister of Health, and head of the

well-known Serbskiy Psychiatric Institute (with a history of political involvement), is quoted by Interfax about the devastating increase of addiction among young people. Whether she is paraphrased or quoted is not clear, but in the report of July 8, 2001

from Interfax, she is cited as indicating that:

‘‘the number of adult drug addicts has increased 8 times;

over the past 10 years, that of teenage drug addicts has

multiplied 18 times. The growth of drug addiction among

children under [15] years of age is even more shocking—

by 24.3 times . . .’’

Exacerbating even these numbers is her revelation that ‘‘the percent of children [that is, those of 0 to 14 years of age who are drug

abusers] has increased from 5 percent in the late 1980s to 26 percent in 2000.’’ Even Moscow now does not have the highest rate of

drug addiction, she notes, but Siberia at 313.2 addicts per 100,000

population, is distinctly higher than even the Far East (at 184.8

per 100,000 population), but the Far East is higher than in Moscow, with a figure of 154.3 per 100,000 population. While one could

hope that the reference to ‘‘addiction’’ is more in the line of ‘‘abuse,’’

295

22There were 342,657 new cases recorded in 1998 and 271,699 in 1999. Zdorov’ye . . ., 2000,

p. 55. 23 Cited in Yelena Salina, ‘‘Vchera v Rossii nachali sazhat bol’nykh. Narkomafiya kayfuyet!,’’

Komsomol’skaya Pravda, 16 April 1998, p. 1. The Open Society Institute, funded by George

Soros, issued a report prior to the UN General Assembly Conference on HIV/AIDS held in June

2001, stipulating that ‘‘Authoritarian governments in states of the former Soviet Union which

punish illegal drug users’’ are enhancing the potential for a marked increase in AIDS. Agence

France Presse, ‘‘Punishing drug users fueling risk of AIDS explosion in former U.S.S.R.: report,’’

June 23, 2001. From the press coverage of the report, this clearly includes Russia. For the

United States, see the Centers for Disease Control (CDC) report of May 18, 2001 issue of the

Morbidity and Mortality Weekly Report (vol. 50, no. 19), p. 377.

and not yet quite so serious, but even the latter is a foreboding precursor for the future health of the population of Russia.

The Russian Ministry of Health reported 450,000 new cases of

syphilis in 1997, and Goskomstat published a figure of close to

405,000. Even if there is a 10 percent difference in the two numbers, these are the last reasonably accurate statistics we are likely

to have, thanks to a 1998 law that imposes prison terms on

syphilitics who contract the disease and are drug abusers. Presumably, the new law has reduced the number of persons willing to

seek treatment. Therefore, the numbers of persons recorded as having the illness are below the ‘‘correct’’ figures since that date. Just

as one would predict, the number of registered new cases of syphilis declined in 1998 and 1999.22 However, the explosion in new

cases of HIV, and a concomitant increase in the estimated number

of drug addicts, belie the latest figures on syphilis. The ‘‘epidemiological synergy’’ between HIV/AIDS and other sexually transmitted

diseases (including gonorrhea, which is vastly under-reported in

Russia) suggests not only that syphilis is more widespread than reported but that further increases in the incidence of HIV/AIDS can

be expected.

The 1998 law that classified drug addicts as criminals ensured

that few addicts—a group at high risk for HIV—will seek treatment. Dr. Oleg Zykov, president of the No to Alcoholism and Drug

Addiction Foundation, in 1998, warned that as a consequence of

this law:

‘‘We will see an increased risk of complications and

overdoses; the death rate among drug addicts will rise; incidence of HIV/AIDS will rise; [and] the illegal market of

drug-related services will begin to develop quite intensively.’’ 23

All predictions unfortunately are beginning to be reflected in the

subsequent period. U.S. experience also clearly follows this pattern

according to the Centers for Disease Control (CDC): ‘‘Approximately one third of acquired immunodeficiency syndrome cases and

one half of new hepatitis C cases are associated with injection drug

use.’’

The contribution of IDU individuals to the soaring HIV rate, as

well as those with venereal diseases (and non-IDU groups of the

population) was documented by Pokrovskiy early in 2001, covering

the years 1994 up to September 1, 2000 (Table 2).

While the overall number of persons who were found to be HIVpositive among those who were examined—therefore possibly leaving out a significant number who were not examined—jumped from

161 in 1994 to 39,052 by September 2000. The internal distribution

296

24 In absolute terms, the number increased from 124 to 860 in the 5 year period. K.K.

Borisenko, L.I. Tichonova and A.M. Renton, ‘‘Syphilis and other sexually transmitted infections

in the Russian Federation,’’ International Journal of STD & AIDS, no. 10, 1999, p. 667.

shown here encompasses a variety of transmission etiologies, with

IDU the largest (at 16,646 cases), the incarcerated (5,088), those

with venereal diseases (1,552), and other categories, including

adults who are found positive when ‘‘clinically detected’’ (which

would seem to mean that the illness was asymptomatic and possibly at a late stage of development), and an ‘‘other’’ category not

shown in the original source, but which is derived as the residual

from the other groups and the total. It would appear to be a catchall category for doctors who could not find the direct cause of the

infection. Nonetheless, it is one-fifth to one-fourth of the total number of new cases per year.

TABLE 2.—NUMBER OF HIV POSITIVE IN RUSSIA, BY CATEGORY, 1994–2000

Category 1994 1995 1996 1997 1998 1999 2000 1

Drug addicts ......... 0 0 442 1,286 929 6,171 16,646

Persons with venereal disease ...... 27 19 90 201 231 829 1,552

Blood donors ......... 3 6 23 59 69 189 378

Pregnant women ... 8 8 18 92 122 296 480

Prisoners ............... 3 5 218 893 800 3,010 5,088

Clinically detected

adults ............... 61 59 385 932 799 5,195 5,366

Other ..................... 59 96 385 890 1,085 4,439 9,182

Total ............. 161 193 1,511 4,353 4,035 20,129 39,052

1 As of September 1, 2000.

We are also informed of the number examined in each category,

and the rate of infection per 100,000 of those examined. For drug

addicts, the rate ranged from an unlikely zero in 1994 to 3,315.14

per 100,000 examined by September 2000. And the latter rate (of

3,315) is more than 20 times higher than the rate for all categories

examined (at 153.62), clearly demonstrating the impact of the IDU

scourge, and inexorably related to the growth figures given by

Dmitriyeva, cited above (Table 3).

Perhaps linked to this risk of complications cited by the author

is information about the number of pregnant women who are simultaneously found to be afflicted with syphilis. The number of

those ill per 100,000 pregnant women in Moscow Oblast increased

by 8 times in only a few years. That is, from 92 to 710 per 100,000

in the 5 year period 1993 to 1997.24 The number of pregnant

women tested ranged from 135,000 in 1993 to 121,000 in 1997.

The data on the impact of syphilis by age group demonstrate that

youth is not a deterrent to the spread of the disease. A systematic

set of data on notification rates, that is new incidence, by selected

age group and the total population, by sex, in the years 1990 to

1997, demonstrates this clearly (Table 4). Females aged 0 to 14

were found to be syphilitic at a rate (including congenital syphilis)

297

per 100,000 population in this age group at 0.1 in 1990, and at 14

per 100,000 in 1997. This rate of increase must reflect not only better reporting, the increase in pregnant women with this illness, as

well as child prostitution which bodes ill for reproductive health in

the future.

TABLE 3.—HIV POSITIVE RATE PER 100,000 PERSONS EXAMINED IN RUSSIA, 1994–

2000

Category 1994 1995 1996 1997 1998 1999 2000 1

Drug addicts ....... 0 0 415.19 733.82 413.14 1,723.98 3,315.14

Persons with venereal disease 3.05 1.97 6.97 13.59 15.43 47.64 77.82

Blood donors ....... 0.07 0.15 0.54 1.5 1.83 4.93 8.94

Pregnant women 0.19 0.24 0.63 3.25 4.99 11.88 18.44

Prisoners ............. 0.58 1.01 43.62 137.35 113.16 361.31 520.49

Clinically detected

adults ............. 1.19 1.33 8.53 19.72 16.54 87.61 83.16

Other ................... 0.83 1.7 5.5 13.45 16.36 64.77 111.54

Total ........... 0.73 0.98 7.71 21.32 20.07 91.34 153.62

1 As of September 1, 2000.

TABLE 4.—NOTIFICATION RATES PER 100,000 POPULATION OF NEW CASES OF SYPHILIS

BY SEX AND AGE GROUP IN RUSSIA, 1990–1997

Category 1990 1991 1993 1994 1995 1997

All ages:

Male ........................................... 5.9 7.9 36.3 92.7 188.8 286

Female ....................................... 4 6.7 31.6 80.3 166.5 266

Ages 0 to 14:

Male ........................................... 0.1 0.1 0.6 1.4 3 8.6

Female ....................................... 0.1 0.2 1.1 3.4 6.7 14

Ages 15 to 17:

Male ........................................... 2.7 4.6 15.2 65.3 129.7 317.1

Female ....................................... 8.8 14.1 89.4 217.4 436.5 564

OTHER HEALTH STATUS ISSUES

The health status of the population is not only a function of the

incidence and prevalence of tuberculosis, HIV/AIDS, and syphilis,

as discussed above. There are issues of smoking, alcoholism, hepatitis B and C, micro-nutrient supply and avitaminosis, which are

discussed briefly in the following materials. Subsequent to this section, materials related to environmental health hazards follows.

More concern over smoking levels in eastern Europe and Russia

has been expressed by the World Health Organization in the past

year. Smoking is a habit among an estimated 70 percent of Russian

males and one-third of females, and multinational tobacco companies aim to increase their sales in the country. The World Health

Organization estimates that some 14 percent of all deaths in 1990

298

25Zdorov’ye . . ., 2000, p. 49. 26Zdorov’ye naseleniya i sreda obitaniya, no. 1, January 2001, p. 34 and CDC, Morbidity and

Mortality Weekly Report, vol. 49, Nos. 51 and 52, January 5, 2001, p. 1169. The U.S. figure

may be some ten times too low based on other CDC publications; the Russian figure probably

also is much higher. 27See especially, two issues of the Kiwanis International magazine Web site, http://

www.kiwanis.org/magazine/99may/99may—russia.html; and http://www.kiwanisinternational.

com/magazine/01june/russia.html; and the Moscow Office of the United Nations Development

Program (UNDP), http://www.undp.ru/eng/NewsletterSepPage7.htm.

in the Soviet Union and eastern Europe were traceable to smokingrelated illnesses; it expects that number to rise to 22 percent by

2020.

Alcohol consumption reflects an epidemic of alcoholism. Russian

vodka produced for the domestic market (usually in half-liter bottles) comes with a tear-off top rather than a replaceable cork or

screw top presumably because it’s assumed that the bottle, once

opened, will not be returned to the refrigerator. An estimated 20

million Russians—roughly one-seventh of the population—are referred to as being alcoholics. Russia’s annual death toll from alcohol poisoning alone may have risen to 35,000 in 2000, as compared

with 300 in the United States in the late 1990s.

Hepatitis B has sharply increased in incidence, between 1998

and 1999, increasing from 52,561 new cases to 64,140, in the 2

years.25 The then sole producer of vaccines for the disease told me

in Moscow in September 2000, that only 1.3 million doses are produced annually to meet a total demand of 13 to 14 million doses;

perhaps 4 million are now produced by a number of firms and imported, but still far short of demand. Perhaps even more alarming

in the long run are increases in the incidence of hepatitis C, an illness that chiefly attacks the liver and requires a very costly, perhaps unaffordable treatment protocol, especially when combined

with other needs for medical services and their attendant costs.

The disease is often fatal. New incidence in Russia is given as

30,254 in 2000, up by almost 2,000 cases in the year compared to

1999. The comparable hepatitis C figures for the United States are

2,895 in 2000, down from 3,111 in 1999.26

Micro-nutrients are in short supply, especially iodine. No iodized

salt has been produced in Russia since 1991, and little or none has

been imported. However, an important contribution of supplies of

iodized salt and production equipment has been made by Kiwanis

International through a $900,000 fund earmarked for this purpose.

The UNICEF office in Moscow, opened in 1997, includes solving the

Iodine Deficit Deficiency disorder as one of its priorities. In young

children, iodine deficiency causes mental retardation. A World

Health Organization cartographic presentation provides a set of

rates among all countries of the world who consume iodized salt

shows that in Russia, only 30 percent of them have iodized salt as

part of their diet. Other information would seem to contradict such

a high proportion.27 The United Nations Development Program

(UNDP) regional offices report that ‘‘only 15 percent of the total

amount of common salt is being iodized’’ throughout Central and

Eastern Europe, the Commonwealth of Independent States, and

the Baltic States. Thus, in Russia alone, it is very unlikely that the

30 percent figure is correct, and all the attendant consequences to

299

28See the section on Nutrition and Health of the Population in Ministerstvo

zdravookhraneniya Rossiyskoy Federatsii, Sanepidnadzor sluzhba, Gosudarstvenny doklad ‘‘O

sanitarno-epidemiologicheskoy obstanovke v Rossiyskoy Federatsii v 1998 godu,’’ Moscow, 1999,

pp. 69–74, especially p. 70.

such a shortfall is clearly another negative potential for young persons, in particular.

Avitaminosis is common. A longitudinal study by the Institute of

Nutrition of the Russian Academy of Medical Sciences finds shortages of folic acid as well as vitamins A, B complex, D, and E among

30 percent of the population. This shortage of vitamins can cause

an individual’s system to be unable to resist pathogens, and may

contribute to the high levels of some diseases. Malnutrition may

well have contributed to the incredible increase in anemia, especially among pregnant women. For all adults, the rate of anemia

per 100,000 population increased from 222.3 in 1993 to 392.8 in

1998. Correspondingly, for children ages 0 to 14, inclusive, the anemia rate increased by 58 percent, from 926.4 to 1463.0 per 100,000

children over the same period of time.28

Heart disease exacts a toll more than twice that in the United

States and Western Europe. The death rate from heart disease per

100,000 population in Russia is 843.8 in the 11 month period of

January–November 2000, up from 810.2 in over the same period in

1999. In contrast, there were 267.7 deaths per 100,000 population

in Belgium, 317.2 in the United Kingdom, and 352.3 in the United

States. Cancer is becoming more common. New cases increased

from 191.8 per 100,000 population in 1990 to 200.7 in 1998, with

a death rate of about 205.0 in 1999 and 206.0 in the first 11

months of 1999 and 2000, respectively (the U.S. age adjusted rate

for the year 1998 is 204.4). The incidence in Russia is likely to rise

as a consequence of long-term exposure to low doses of radiation

from decades of nuclear testing, as well as to benzo(a)pyrene,

dioxin, and other industrial carcinogens. As in so many other cases,

official statistics understate the problem. There is significant

under-reporting of breast cancer, for example, especially among

women of Muslim origin, who are reluctant to seek treatment from

male doctors.

SOME POSITIVE SIGNS

None of this is to say that there are not some positive aspects

in the health provision area in Russia. Three-and-one-half years

after the adoption of a new ‘‘Kontseptsiya of Development of Health

Care and Medical Research’’ in November 1997, a Draft Resolution

on the Progress of this Kontseptsiya of the Board of Directors of

the Russian Ministry of Health, dated 20–21 March 2001, was

adopted. The unpublished document reviewed the goals for the period 2001–2005 and for the period ending in 2010. It is quite frank

regarding problems which still persist, but it also makes some very

reasonable positive remarks about progress in the health care field.

Better financing, more efficient use of these funds, and a reduction

in the deficit are spelled out. In addition, While they do not provide

precise numbers on the number of procedures or on their success

rate, it is impressive that the numbers for the year 2000 suggest

that cardiac operations overall have doubled, bypass surgery has

increased by 150 percent, hemodialysis by 100 percent, kidney

300

29From an unpublished pdf file found in http://www.google.com, entitled: The Ministry of Public Health of the Russian Federation. The Board (Collegium) (Draft) Resolution 20–21 March

2001, Progress in Implementing the ‘‘Kontseptsiya of Development of Health Care and Medical

Research,’’ Objectives for the period 2001–2005 and for the period ending 2010, 27 pp. 30Same sources as for footnote 26.

transplants by 50 percent, and bone marrow transplants by 900

percent. While these probably were small in number in the base period, it is quite an improvement in the availability of medical services. Many new Federal Programs such as anti-diabetes mellitus,

anti-HIV/AIDS, anti-tuberculosis and others are being implemented

(though other information would indicate major shortfalls in their

funding to date), and new programs scheduled for endorsement in

2001 include high blood pressure, oncology, and sexually transmitted diseases. At least the issues are being confronted, but how long

it will take to overcome the very significant size of the problems

is still unclear. Words such as alarming, grave, serious threat, and

similar descriptors are utilized in the review of the status of morbidity levels of various diseases and condition. Priority goals for the

period ending in 2010 include:

‘‘Reduction of the rate of premature deaths from: Cardiovascular diseases; Accidents, trauma and suicides; [and]

Malignant neoplasms; Combating diseases of particular

significance in the present demographic circumstances of

this century: Diseases threatening the reproductive ability

of mothers and neonatal diseases; Diseases of the elderly.

Combating diseases that pose a threat to the health of the

nation as a whole: Tuberculosis; HIV/AIDS; drug addiction;

alcoholism; and sexually transmitted diseases. (p. 8)

More specification of child health other than ‘‘neonatal diseases’’ would be helpful in describing these priorities. But that they are

the priority goals serves to underscore the internal depiction of the

problems they face.

The listing of resolutions and decrees needed and responsible

agencies to implement the Kontseptsiya are quite detailed. It can

only be hoped that they will be successful in these endeavors given

the depth of the problem and its implications for domestic and foreign policy.29

Childhood vaccination rates for tuberculosis, diphtheria, whooping cough, and other diseases have risen significantly since 1995.

Vaccination for rubella (German measles), which causes birth defects when contracted by pregnant women in the first trimester,

was added to Russia’s prescribed immunization calendar, but only

in 1999. However, rubella vaccine is not produced in Russia, and

very little is imported; 597,000 cases of rubella were reported in

1999, and only 453,000 in 2000. In comparison almost no cases of

rubella was found in the United States, due to immunization. The

comparable figures for rubella at all ages and both sexes, in the

United States, are 271 and 152, respectively, in these 2 years.30 As

noted earlier, hepatitis B vaccine is now produced by Russian and

jointly owned firms with foreign manufacturers, nonetheless it still

falls far short of needs. Moreover, contributing to the shortfall in

medications and their supply, is the qualitative issue of laboratory

standards. No laboratories in Russia meet good management practice and good laboratory practice even as late as 2000; they will be

301

required to meet good management practice standards by 2005. A

long time for this to be accomplished and expensive, but very necessary to ensure the quality of vaccines and medications produced

in the country. Hospital to hospital contacts from throughout the

United States and the former Soviet Union have been helpful in

improving the situation, albeit clearly limited so far. Countries

other than the United States also have major contacts and provided services for health needs.

While there are a few encouraging signs, the larger trends support the vision of looming demographic catastrophe. And a number

of other developments also offer dark portents for the country’s future rates of fertility and mortality, and for the general health of

its people, especially its children.

SELECTED ENVIRONMENTAL HEALTH ISSUES

To all the foregoing challenges to the Russian future we must

add a daunting array of environmental ills. Russia will have to

cope with a legacy of industrial development undertaken virtually

without heed of the consequences for human health and the environment, just as it will have to contend with the consequences of

decades of testing and stockpiling of nuclear, chemical, and biological weapons.

The crises that temporarily focus worldwide attention on these

problems, such as the 1986 Chernobyl nuclear power plant accident, only begin to hint at their severity. The news media beamed

shocking reports of the 1994 Usinsk oil spill around the world, but

it was only one of 700 major accidents and spills (defined as those

involving 25,000 barrels of oil or more) that occur every year in

Russia, spreading phenols, polyaromatic hydrocarbons, and a variety of other toxic chemicals. As Victor Ivanovich Danilov-Danilyan,

the former head of the State Committee on Environment, noted

about the extent of all of these oil spills, that these losses are

equivalent to about 25 Exxon Valdez spills per month!

Radioactivity remains a continuing concern. After the 1963 Test

Ban Treaty barred open-air atomic weapons testing, the nuclear

powers continued to conduct underground tests. But there was an

important difference in the Soviet Union. There, many of the nation’s more than 100 nuclear explosions occurred in densely populated regions such as the Volga, as well as in the Urals and the

less densely populated Yakutiya (Sakha) regions. After first denying that any of those explosions had been vented into the atmosphere, then Minister of Atomic Industry Viktor Mikhaylov later admitted when in Norway (not in Russia) that venting had occurred

in 30 percent of the underground blasts.

What the potential for human health hazards within the ten formerly secret nuclear cities devoted to the development and production of nuclear weapons in Russia remains largely a mystery.

Around the city of Chelyabinsk, a thousand miles east of Moscow

in the Urals, some 450,000 Russians face unknown risks from a series of spills and accidents that occurred from the late 1940s to the

1960s. And area rivers may have been tainted by seepage from nuclear waste directly injected deep underground at the Krasnoyarsk,

Dmitrovgrad, and Tomsk nuclear-related sites. Near the Tomsk–7

facility, the site of a serious nuclear accident in 1993, Russian and

302

31See the summary of the Novyye Izvestiya article of December 1, 1998, p. 2 and of Segodnya

of December 3, 1998 p. 7, in The Current Digest, vol. 50, no. 48, 1998, p. 17. Also FBIS translated the text of the ‘‘Segodnya’’ broadcast of November 30, 1998, on NTV, at 1900 gmt. The

latter source called it the ‘‘biggest environmental disaster of recent years.’’ From FBIS, ‘‘Siberian

Plant Accused of Massive Environmental Damage,’’ FTS 19981201001018, December 1, 1998.

American environmentalists found evidence of phosphorous–32, a

radionuclide with a half-life of only about 2 months. The discovery

strongly suggests that radioactive wastewater used in cooling

Tomsk–7’s two remaining plutonium producing plants was illegally

dumped. Thus, health hazards emanating from nuclear contamination is not only a matter of past practices.

Chemical pollution is widespread. Even in Moscow, which is

home to much heavy industry, there is evidence that pollution has

caused genetic deformities in the young. In a study of the impact

of chemical, petrochemical, and machine-building industries on

human health, the Russian Ministry of Health found that

newborns suffered congenital anomalies at a much higher rate (108

to 152 per 10,000 births) in industrial cities than in rural localities

(39 to 54 per 10,000). Dangerous toxic emissions from the mining

and metallurgical combine in Norilsk, still is reported (in Novaya

Izvestiya, 28 April 2001, pp. 1, 4) as emitting 8,450 kilograms (8.45

tons) of industry-produced poisons per capita per year; 98 percent

of which is sulfur dioxide. Alarming cases of mercury pollution,

which causes illness and birth defects, have been reported (though

aggregate official data have never been published). Three years

ago, 16 tons of mercury was released upriver from the major northern city of Arkhangel’sk. A plant in Usol’ye-Sibirskoye of Irkutsk

Oblast, when shutting down, spilled 25 tons of mercury. Due to

mercury poisoning, mental deficiency and hypoxia was reported by

Segodnya (on December 3, 1998, p. 7) among the illnesses suffered

by 100 (sic) percent of newborns in Angara. Mercury has accumulated in the systems of area residents, and the dilapidated tanks

leaked almost all the mercury into the ground. Moreover, in the 25

year period the plant had been in operation, some 550 tons ‘‘at

least’’ had penetrated the ground near the facility, as well as in the

Angara River. Perhaps ‘‘in 10 years’’ it will be safe for the residents

of the area. Simultaneously, mercury reportedly has affected the

population of Sayansk city, as well as the Bratsk reservoir.31

Another heavy metal, lead, is the underlying factor in a widespread pattern of nervous system and psychological impairments.

Detailed data and information are now available from a joint Russian and American effort to determine the amount of lead contamination in the country and its human health impact, particularly on

the young. The results show that the load rates far exceed the Russian (and U.S.) PDK (maximally allowed considerations). In the

survey, it was found that 44 percent of children in 120 Russian cities ‘‘may have blood lead levels (BLL) that exceed the Centers for

Disease Control standard of 9.9 micrograms per deciliter (mcg/dl)

and a total of nearly 2.4 million children’’ may be affected. But

based on recent evaluations published in American medical literature indicating that a BLL above 5.0 mcg/dl is harmful, then

some portion of the 2.6 million children with 0–9 mcg/dl detected—

perhaps 1 million, for a total of 3.4 million children are affected.

If there are some 27 million children under age 15, then the 3.4

303

32P. 124, in the full report, Doklad . . . cited below. A follow-up summary of the activity was

published for USAID by MEASURE Communication, Lead in the Environment and Public

Health in Russia; Five Years of American-Russian Collaboration. 1995–1999. (Place and date are

not given, but likely is Washington, DC, in the year 2000. The original summary report in

English, was published in Moscow in 1997, under the title: White Paper: Lead Contamination

of the Environment in the Russian Federation and Its Effect on Human Health, Issued by the

State Committee for Environmental Protection of the Russian Federation, 48 pp. The Russianlanguage, full report, also issued by the State Committee, is: Doklad o svintsovom zagryaznenii

okruzhayushchey sredy Rossiyskoy Federatsii i yego vliyaniii na zdorov’ye naseleniya. Moscow,

1997, 233 pp. 200 copies.) 33Lead in the Environment, op. cit., p. 13. Also see the unpublished paper by Valerie M.

Thomas, Princeton University, and Anna O. Orlova, Johns Hopkins School of Hygiene and Public Health, entitled. ‘‘Soviet and Post-Soviet Environmental Management: Lessons from a case

study of lead pollution.’’ The paper was accepted for publication in AMBIO of June 22, 2000. 34 Ibid., p. 12.

million total affected by neuropsychological and mental deficiency

problems, would represent some 12 percent of all children. And this

is from lead pollution alone.

The incidence of mental retardation among children (0 to 14

years of age) ensuing from such levels is noted to be as much as

75.7 percent in Krasnoural’sk, a town located in Sverdlovsk Oblast

in the Middle Urals region, where lead car batteries were produced

and copper smelting took place. There, the average content of lead

in the blood of children is 13.1 ± 0.5 mcg/dl. If one utilizes a broader definition, of complications of the nervous system and impaired

psychological development, the share increases to 82.5 percent of

all children 0 to 14 years of age, inclusive, in this city.

Krasnoural’sk plants emit some 155 to 170 tons of lead per year;

an unbelievable level, and devastating for the future of the city.32

Serious attention to this issue has led to a new method for producing car batteries, which will at least save some youngsters from

such health hazards in the future.

The most striking information for current purposes of this paper

is the information from a set of bar charts (without precise numbers) on the ‘‘Percentage of children with elevated blood lead levels

in selected Russian cities.’’ From this chart, we can determine

(roughly) that in Krasnoural’sk, the city referred to above, 78 percent of all children had high blood lead levels, split between 63 percent of all children (0 to 14 years of age) who had elevated blood

levels over 9.9 to 14.9 micrograms per deciliter (mcg/dl), and 15

percent who had 15.0 or more mcg/dl. Belovo was the next worse

city with 51 percent of all children affected, followed by GusKhrustalnyy with 36 percent, Saratov with 23 percent, Volgograd

with 28 percent, and so forth.33

Using the survey of 43 cities designated as Lead Project Sites, it

was estimated using this same U.S. Environmental Protection

Agency (EPA) biokinetic model, that 1.9 million children throughout urban Russia were likely to have behavior and learning problems because the lead content of their blood was between 10 and

19 mcg/dl. Some 400,000 additional children had 20 to 44 mcg/dl

lead in the blood and needed a medical check-up and a subsequent

test for lead in their blood, and 90,000 children with 45 to 69 mcg/

dl lead content were in immediate need of therapy within 48

hours.34 Hopefully treatment and other measures were promptly

and properly undertaken. A number of appropriate steps were initiated, including adoption of a national program to decrease lead

contamination. The 1999 National Environmental Action Plan and

304

35 Ibid., p. 16.

the 2000 National Environmental Health Action Plan, set a very

high priority on lead reduction. Leaded gasoline production is expected to continue to decrease.35 However, the national plans may

be aborted if the new environmental administration sets other priorities. The new environmental administration, the Ministry of

Natural Resources, which absorbed the functions of the State Committee on Environment, now is headed by its third Minister in 1

year’s time; whether there will be continuity in following up on this

very serious problem is clearly not discernible at this juncture. The

main function of the new ministry is to develop and exploit the nation’s oil and gas reserves, and not to protect the environment and

human health.

Other heavy metals such as cadmium and arsenic are prevalent

in the air and land throughout much of Russia. In the Arctic north,

wind-blown heavy metal salts and other pollutants from the city of

Norilsk’s nonferrous metallurgical plants have left the land barren

and treeless for 75 kilometers to the southeast. Lakes and rivers

everywhere are badly polluted by heavy metals dumped by industry and allowed to run off farmland. Estimates by the Yeltsin-era

Ministry of Ecology and more recent observers suggest that only 25

to 50 percent of Russia’s fresh water is potable.

FOREIGN ASSISTANCE AND UNMET NEEDS

The world has not been blind to Russia’s plight. By late 1998, the United States and other donors had sent a total of more than $66

billion in aid, according to a U.S. Government estimate. The list of

donors includes even South Korea, and recently officials of the European Union and the World Health Organization have recognized

the need to act aggressively. But the aid has been inadequate and

piecemeal, and/or its delivery has been hampered by corruption and

inept administration. The frightening reality is that it may already

be too late to help.

In a pessimistic assessment, perhaps deliberately hyperbolic to

draw attention to the various problems of the economy and society,

Andrey Iliaronov, an economic adviser to President Putin, has

pointed to 2003 as the year of reckoning, when the demographic

crisis, the crumbling infrastructure, and the burden of massive foreign debt may combine to deal a crippling blow to Russia’s remaining productive capacity—and thus, to its ability to help itself.

Where will the money come from for all the myriad improvements needed in reproductive and child health, for tuberculosis

prevention and treatment, for HIV/AIDS cocktails of protease inhibitors? (Especially now that the Putin government has rejected a

proposed $150 million loan from the World Bank for these specific

needs.) Who will supply the $200 billion needed to clean up the

water supply over the next 20 years, or the $79 billion over 10

years for highway transport improvement as stipulated by Prime

Minister Kasyanov or the $10 to $12 billion to clean up chemical

weapons storage sites, or the hundreds of billions of dollars to clean

up nuclear waste? Yet at the same time, It is reported that Moscow

spends $1 billion per year conducting the war in Chechnya. The list

of needs is depressingly long, and the Russian Government has not

305

always taken the right steps to address them. And yet, despite how

dismaying the task may seem, and how long the odds of success,

we cannot simply ignore the ruin in Russia. The United States and

other nations of the world have a profound interest in helping to

avert an economic and demographic Chernobyl that would give a

fearful new meaning to the word meltdown.

(307)

SOCIAL WELFARE: A SOCIAL CONTRACT

By Judyth L. Twigg 1

CONTENTS

Page

Summary .................................................................................................................. 307

The Collapse of the Safety Net and Its Social Implications ................................. 308

Inequity and the Search for a Unifying Idea ........................................................ 314

The State Response to Social Crisis ....................................................................... 318

Sources of Societal Cohesion and Identity ............................................................. 321

Conclusion—Looking to the Future ....................................................................... 324

1 Judyth Twigg, Ph.D. in Political Science from MIT, is currently Associate Professor of Political Science, Virginia Commonwealth University. Segments of earlier versions of this paper were

originally prepared under the auspices of the Social Cohesion Study of the Carnegie Corporation

of New York’s Russia Initiative (available at www.carnegie.org), and for the Carnegie Endowment for International Peace, to be included in its forthcoming volume Russia: Ten Years After.

The author thanks Andrew Kuchins of the Carnegie Endowment and Deana Arsenian and David

Speedie of the Carnegie Corporation for their permission to reprint the work here. Thanks also

to John Hardt for important comments on previous drafts.

SUMMARY

A large number of the Russian people have suffered significant

losses from the dissolution of the social contract they enjoyed with

the Soviet regime. The sudden withdrawal of a meager but comprehensive safety net covering health care, pensions, employment,

housing, and other services has resulted in widespread poverty and

disillusion. Health and demographic crises, increasing drug and alcohol abuse, and family breakdown are both causes and symptoms

of unprecedented post-Soviet psychological alienation and withdrawal. Thus far, the government response to these social crises

has been uneven. However, a handful of effective societal coping

mechanisms, including strong interpersonal networks, non-governmental ‘‘civil society’’ institutions, and the re-emergence of a significant middle class, provide some cause for optimism.

The human costs of the Soviet regime were unquestionably and

unbearably high. Few would argue for a return to the political repression, pervasive economic and bureaucratic inefficiency, corruption, and general malaise that plagued late Soviet society. From

the perspective of the Russian people, however, not everything

about the Soviet Union was bad. In particular, an extensive and

universal social safety net was an important positive element of Soviet rule. Free education and health care, a comprehensive and diverse system of pensions and social benefits, job security, and extensively subsidized housing, basic foodstuffs, public transportation, child care, and vacations all contributed to a meager but reliable floor of living standards for the vast majority of the Soviet

people. Upward social and economic mobility may have been seVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00333 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.014 CRS1 PsN: CRS1
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2See Bertram Silverman and Murray Yanowitch, New Rich, New Poor, New Russia: Winners

and Losers on the Russian Road to Capitalism (Armonk, NY: M.E. Sharpe, 1997), p. 22.

verely limited, but there was little reason to worry about slippage

down the socio-economic ladder.2

Despite ubiquitous and sarcastic undercurrents about the flaws

in the safety net and the inadequate labor incentives provided by

the command economy—‘‘we pretend to work, they pretend to pay

us’’ being the most popular expression of a common sentiment—the

implied social contract of the Soviet era was a critical thread in the

fabric of Soviet society. People accepted a low standard of living in

exchange for economic and social security and equity. While economic inequalities did indeed exist, in the form of an extensive network of perks and privileges for the politically powerful and wellconnected, they were carefully and mostly successfully hidden. To

the extent, therefore, that Soviet consumers were aware of and

craved unavailable luxury or convenience items—or even basic essentials of decent quality—there was a sense that the lack of consumer goods affected everyone equally. Everyone enjoyed the security of a rudimentary but all-encompassing social welfare network.

On the flip side, living standards were not high, and the routine

inconveniences borne of material shortages were a constant irritant, but these too were a universally shared fate.

This common economic and social circumstance, together with a

slow but gradual improvement in living standards during the late

Soviet period, was a critical source of societal cohesion. A significant portion of the Soviet Union’s national identity and political legitimacy derived from its provision of social benefits. As long as everyone viewed the state as the guarantor of some basic level of material comfort and survival, and to the degree that this guarantee

extended universally to all segments of the population, the Soviet

people could ‘‘buy in’’ to at least some portion of the regime’s propaganda about the success of the socialist experiment.

Over the last decade, the stress of market reform has ripped

apart the Soviet safety net. The jolt of the sudden transition to capitalism has left the state unable to maintain the bulk of the social

benefit package that generations took for granted, producing unprecedented poverty, material inequities, and socio-economic

schisms. As a result, Russian society has become unanchored. One

of its major sources of national identity and cohesiveness—the perception of socialist equity—has been fractured. The high expectations engendered by the early promises of reform have been devastated by a decade’s worth of suffering and hardship. The Russian

people’s well-documented yearning for order and stability derives at

least in part from nostalgia for the days when the social contract

was honored, the safety net was intact, and life for many was not

consumed by a daily struggle for basic survival.

THE COLLAPSE OF THE SAFETY NET AND ITS SOCIAL IMPLICATIONS

The Russian Government’s acceptance of fiscal responsibility in

the early 1990s forced it to slash social spending. Budgets for

schools, kindergartens, health facilities, sanatoria, day care, and a

myriad of other formerly state-provided services plummeted. Wage

arrears for workers in the state sector reached epidemic proporVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00334 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.014 CRS1 PsN: CRS1
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3Michael Slackman, ‘‘Sold for His Organs,’’ Newsday, November 5, 2000; Valery Filonenko, ‘‘A New Method of Obtaining Disability Benefits Threatens to Sweep Omsk: Infecting Yourself

with Tuberculosis,’’ Noviye Izvestiya, October 21, 1999, p. 5; ‘‘Poverty Hits Across the Country,’’ RFE/RL Newsline, Vol. 5, No. 35, Part I, February 20, 2001; ‘‘Russians Buy More Bread as Poverty Bites,’’ ITAR–TASS, October 5, 2000; Igor Semenenko, ‘‘State Debates Poverty As Wealth

Gap Grows,’’ Moscow Times, October 18, 2000; Christopher Williams, ‘‘Economic Reform and Political Change in Russia, 1991–1996,’’ in Christopher Williams, Vladimir Chuprov, and Vladimir

Staroverov, eds., Russian Society in Transition (Aldershot: Dartmouth Publishing Company,

1996), pp. 11–12.

tions. At the same time, workplace-based social benefits, substantial during the Soviet era, were also eroded by the sudden demand

for enterprises either to become profitable or to go out of business.

Inflation decimated savings, and wage and benefit increases could

not keep up with even more rapidly rising prices. The state could

no longer afford to subsidize a basic floor of material living standards for the entire population.

As a result, a significant percentage of the Russian people have

sunk into poverty. Anecdotal horror stories surrounding this phenomenon abound: the grandmother arrested in Ryazan in October

2000 for trying to sell her grandson for $90,000 so that his organs

could be removed and sold in the West, or patients in Omsk with

multi-drug-resistant tuberculosis (TB) marketing their diseasesaturated phlegm to desperate customers anxious to infect themselves so that they can buy food with the money from a disability

pension. But these sensationalist accounts should not mask the

larger and more important fact that 30 to 40 percent of Russians

now grind out a living below the poverty line, with those estimates

varying depending on how poverty is defined. Most analysts agree,

however, that the government’s definition of a ‘‘minimum subsistence’’ income—the amount of money required to purchase a basket

of basic food and other consumer goods, and the figure on which

pensions, child allowances, and other post-Soviet-era benefits are

based—is woefully meager. In other words, these poverty levels, at monthly incomes of around $30 to $45, or the equivalent of less

than $1 a day, represent real hardship. One analysis in early 2001

showed that the minimum monthly income in Novgorod Oblast

could barely feed five cats. Bread production in Russia continues to

increase each year, since it remains one of the few affordable staples as the overall purchasing capacity of the population dwindles.

For the average Russian citizen, consumption levels have fallen by

half since 1992, and only one family in six is better off now than

it was then.3

The root causes of poverty in today’s Russia are unemployment

and low-paying jobs. Although official unemployment figures hover

around 2 percent, these statistics are notoriously difficult to interpret. On the one hand, they mask a significant level of underemployment among workers still officially categorized as enterprise

employees but who actually perform little or no work and therefore

receive few or no wages. These ‘‘unpaid vacations’’ may encompass

as much as another 7 to 8 percent of the work force. On the other

hand, the official statistics also miss what may be a significantly

larger phenomenon, the substantial number of people working in

the shadow economy, with wages paid off the books (largely for

purposes of tax evasion). But these workers’ unreported incomes

most often involve unskilled labor, poor work conditions, and low

pay. Both reported and unreported wage rates in Russian indusVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00335 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.014 CRS1 PsN: CRS1
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4Sophie Lambroschini, ‘‘Russia: Report Says Women Bear Brunt of Poverty,’’ Radio Free Europe/Radio Liberty, September 27, 2000; Anna Badkhen and Anna Andreyeva, ‘‘Lack of State

Support Hits Single Parents Hard,’’ Moscow Times, September 7, 2000. 5 ‘‘Only 30 Percent of Russian Births Are ‘Normal,’ ’’ RFE/RL Newsline, Vol. 4, No. 194, Part

I, October 6, 2000; Children in the CIS Countries: Statistical Handbook (Moscow: Interstate Statistical Committee of the Commonwealth of Independent States, 2001), pp. 118–119; ‘‘Russia

Sees Huge Rise in Incidence of Mental Illness,’’ Interfax, April 5, 2001; ‘‘70 Percent of Russian

Youth Said Unhealthy,’’ RFE/RL Newsline, Vol. 5, No. 61, Part I, March 28, 2001; ‘‘Russian

Health Ministry Points to Deterioration of Russian Teenagers’ Health,’’ Interfax, March 27,

2001.

trial enterprises and business offices remain frequently at levels

comparable to developing countries, meaning that getting a job is

no security against poverty.

Poverty in today’s Russia is also largely a female phenomenon.

In the late 1990s, nearly 80 percent of Russia’s unemployed people

were women. The vast majority of single parents are women, and

more than 80 percent of them have no job at all. The Russian labor

code guarantees that a new mother can take a 3 year unpaid leave

without losing her job, but employers almost never comply, and

many employers hesitate to hire a woman with small children for

fear that she will take frequent sick leave. Few single mothers receive child support, and the alimony law is rarely enforced. Bureaucratic red tape prevents many of the neediest single parents

from claiming the scanty, untargeted child benefit offered by the

state; only 30 percent of the poorest families claim their monthly

child stipend.4

Although Russian culture still prides itself on cherishing its children as a precious national asset, the declining material and social

position of children has been one of the most alarming consequences of the post-Soviet transition. The single most potent predictor of poverty during the transition period has been the birth of

an additional child to a family. The poverty rate among families

rises steadily with the number of children, to the point where nearly three-fourths of families with four or more children are poor.

Thanks to these economic trends, well over 1 million children in

Russia aged 14 to 18 have been unable to finish high school in the

last decade.

Substandard living conditions are taking their toll on children’s

health, starting at the very beginning of life. According to the Russian Academy of Medical Sciences, because of an overall decline in

the health of the population, poor prenatal care, and other factors,

only 30 percent of Russian births can now be classified as ‘‘normal.’’ Leading Russian physicians now speak of the ‘‘deceleration,’’ or the

mental and physical deterioration, of children and teenagers. More

than 70 percent of Russian young people aged 10 to 15 suffer from

chronic diseases, the number of disabled persons in that age group

is growing at an alarming rate, and the incidence of mental disorders among teenagers has increased fourfold in the last decade.

These statistics are troubling in and of themselves, but when put

into socio-demographic context—this is the post-Soviet generation

that is supposed to transform Russia into an energized, market democracy—they are genuinely alarming.5

The most extreme manifestation of these negative trends is the

problem of abandoned and orphaned children. In the words of one

orphanage director, ‘‘I can tell how bad things are by the way families are starting to ask us to take their children. Families in Russia

311

6 UNICEF, ‘‘After the Fall: The Human Impact of Ten Years of Transition,’’ November 1999;

‘‘Who Cares? A Special Report on Street Children,’’ The World Bank, Spring 2000; Colin

McMahon, ‘‘Russia Slowly Faces Growing Problem: Social Breakdown Sentences Children to Life

on Streets,’’ Chicago Tribune, April 1, 2001; David E. Powell and Heidi A. Holzfaster, ‘‘As Orphans Multiply and Languish, Russia ‘Decrees,’ ’’ Boston Globe, December 10, 2000; ‘‘Homes

From Home: Russian Orphanages Boom as Children Founder,’’ AFP, April 18, 2001; Masha

Gessen, ‘‘Not Good Enough, Even for Orphanages: No One Wants Babies of HIV-Positive Mothers,’’ U.S. News and World Report, April 16, 2001; Viktoria Molodtsova, ‘‘Is An Orphan’s Lot

Always An Unhappy One?’’ Rossiiskaya Gazeta, March 2, 2000, pp. 1, 4; ‘‘Neglected Children

Plagued By Alcoholism,’’ RFE/RL Newsline, Vol. 4, No. 224, Part I, November 17, 2000. 7 ‘‘Problems Mount for Old, Young, and Women,’’ RFE/RL Newsline, Vol. 5, No. 54, Part I,

March 19, 2001; ‘‘Making Transition Work for Everyone: Poverty and Inequality in Europe and

Central Asia,’’ The World Bank, September 2000; Olge Nesterova, ‘‘Russian Family Is Changing,’’ Trud, May 17, 2001; Amelia Gentleman, ‘‘Wanted: More Russian Babies To Rescue a Fast

Dying Nation,’’ The Observer (U.K.), December 31, 2000.

are falling apart.’’ Networks of foster care and adoption services are

still underdeveloped, and therefore almost 700,000 children must

live in orphanages. Having been raised in an institutional environment, the long-term prospects for these children are not positive.

According to recent Russian Government estimates, 40 percent of

them will end up in prison, and another 30 percent will become alcoholics. Even more striking, the country is now home to 1 to 4 million homeless children, with that number largely dependent on the

weather; more kids take to the streets in the summer months, and

return home when the cold becomes unbearable. This seasonal variation hints at the peculiar nature of this ‘‘social orphanhood’’—

more than 90 percent of these street children have one or more living parents who have simply lost the psychological or material

wherewithal to raise their offspring (usually due to alcoholism or

unemployment). Either they have voluntarily abandoned their sons

or daughters, or the state has stripped them of parental rights.6

The plight of parentless children is but one manifestation of the

breakdown of the Russian family. Elderly Russians are increasingly neglected, becoming known as the new bezprizorniki (unsupervised ones) because their adult children are too busy with their

own lives to attend to the needs of their parents. On the whole,

however, elders are generally better off than children and single

parents, since the pension system is one of the few elements of the

social safety net that has remained a political priority. Divorce,

while remaining at about the same rate as in Soviet times, is increasingly costly for women and children. The number of weddings

has declined over the last decade. More and more children are

being born out of wedlock. An increasing number of intact families

are opting not to have children at all, or to have just one child. In

the last 10 years, the number of children in Russia has dropped by

over 4 million, a manifestation of declining birth and fertility rates.

While some of this drop stems from medical infertility, much is due

to conscious choice. Low birth rates are a direct message from people who have lost faith in their society, and who have little confidence that their social and economic circumstance is likely to improve. A recent survey of new mothers in one Russian region

showed that 14 percent had reacted with horrified, suicidal feelings

upon learning that they were pregnant, wondering how they would

possibly support a new, dependent life. Little wonder that there are

two abortions for every child born in Russia.7

Women’s degraded economic positions have caused them to suffer

in other ways as well. Hundreds of thousands of women have volVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00337 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.014 CRS1 PsN: CRS1
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8 ‘‘Pollsters Report Findings on Women’s Issues,’’ RFE/RL Newsline, Vol. 5, No. 48, Part I,

March 9, 2001; Maria Kotovskaya, ‘‘A Modest Little Castle in Switzerland and a Romantic Candlelit Dinner,’’ Nezavisimaya Gazeta, December 25, 1998, p. 14; Valerie Sperling, ‘‘The ‘New’ Sexism: Images of Russian Women during the Transition,’’ in Mark G. Field and Judyth L.

Twigg, eds., Russia’s Torn Safety Nets: Health and Social Welfare during the Transition (New

York: St. Martin’s, 2000), pp. 173–189. 9 ‘‘One-Third of Russians Suffer ‘Psychological Disorders,’ ’’ RFE/RL Newsline, Vol. 5, No. 24,

Part I, February 5, 2001; Yury Bliyev, ‘‘No One’s Safe from Poverty or Illness,’’ Meditsinskaya

Gazeta, October 22, 1999, p. 7; Nina Fokina, ‘‘One Flew Over in a Straitjacket,’’ Trud, October

29, 1999, p. 6; Colin McMahon, ‘‘Russian System Isn’t Coping At All With Surge in Mental Disorders,’’ Chicago Tribune, February 1, 2001; ‘‘One in Three Russians Has Psychological Problems,’’ RFE/RL Newsline, Vol. 5, No. 69, Part I, April 9, 2001.

untarily turned to a life of prostitution, and tens of thousands more

have been duped into sex slavery through an extensive European

and Asian network of trafficking in women. At home, Russian

women are now, even more than in Soviet times, routinely the victims of domestic violence. Between 12,000 and 16,000 Russian

women each year are killed by their spouses, and another 50,000

suffer severe injuries—10 times the comparable U.S. figures. Only

six shelters for abused women exist in the entire country, all the

result of private or local initiatives. Russian culture still sees victims as somehow ‘‘deserving’’ their fate, and a lack of legal protection follows those cultural assumptions.

This view of women is unsurprising, given the blatant sex discrimination and sexualization of women that has accompanied the

market reform process. The ideological doctrine of socialist gender

equity has given way to a routine of overtly sexist remarks during

parliamentary debates, job advertisements that specify positions

for ‘‘attractive’’ females under age 30 ‘‘bez komplexov’’ (without

complexes, or willing to perform sexual favors), and open street

vendor sales of sexually explicit publications. One mid-1990s survey indicated that over half of Russian women had been the recipient of sexual advances by their job supervisors.8

Not surprisingly, breakdown at the societal and family level is

producing individual-level pathologies as well. One in three Russians now have psychological problems, a 50 percent increase in

the last decade, and the country’s suicide rate is now among the

highest in the world (and four times the U.S. rate). Work hours lost

to psychological problems have been a significant factor in the

country’s loss of economic productivity. Over the last 10 years, disability certification for mental health reasons has grown more dramatically than for any other kind of illness. Meanwhile, Russia’s

mental health care infrastructure can accommodate only about

200,000 people, far below the capacity needed to cope with this

growing problem, and even that network of facilities is rapidly decaying for lack of resources and investment.9

Of course, the most well-known and visible manifestation of Russians’ inability to cope with the stresses of the post-Soviet transition is the vodka bottle. The average Russian man now drinks

three half-liter bottles of vodka each week, and consumption levels

appear to be steadily increasing. Alcohol is clearly a major contributor to the country’s demographic crisis, accounting as it does for

the growing rate of traffic and industrial accidents and cardiovascular disease in middle-aged men. Alcoholic parents produce

many, if not most, of the country’s abandoned children. If the country had a functioning network of battered women’s shelters, it

would be filled with victims of domestic violence perpetrated by

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10 ‘‘Alcoholism Is Becoming a National Security Problem,’’ Sevodnya, May 26, 1999, p. 6; ‘‘More

Youths End Up Addicted,’’ RFE/RL Newsline, Vol. 4, No. 249, Part I, December 29, 2000; ‘‘Up

To 5 Million Russians Are Drug Users—Health Ministry,’’ Interfax, February 21, 2001; ‘‘Russian

Drug Addicts Unofficially Put at 3 Million—Parliamentary Official,’’ Interfax, December 28,

2000. 11Fred Weir, ‘‘Russia To Revise Crime, Penalty,’’ Christian Science Monitor, January 9, 2001.

drunken boyfriends and husbands. Yet vodka remains cheaper

than milk, supported by a state that relies on almost $500 million

in annual revenues from alcohol duties. Despite efforts by the

health ministry to call attention to this problem, the government

continues programs like rewarding a few select oblasts over the

May 2001 holidays with additional vodka allocations as a prize for

‘‘good work’’ carried out during the preceding 12 months. A draft

law that would limit advertising for alcoholic beverages and promote public health campaigns about alcohol consumption has remained stalled for several years.

Illegal drug use is also a growing problem, to the point where the

health ministry refers to it as an ‘‘epidemic.’’ Between 3 and 5 million Russians are regular drug users. One-third of the country’s

urban population has tried illegal substances at least once. The

rate of drug addiction has increased more than sevenfold in the

last decade, with an even greater explosion among children and

teenagers and a pattern of usage where Russian young people

abandon ‘‘light drugs’’ for heroin and other more dangerous narcotics far more quickly than is the norm in other countries. Russian

specialists are also concerned about a recent drop in the age

threshold for drug use, from 16 or 17 a few years ago to 12 and

13 today. Injectable drug use is the almost exclusive transmission

vector for Russia’s growing HIV/AIDS problem.10

Illicit drugs are also a major factor in the country’s growing problem with violent crime. Although crime rates fell slightly in the

late 1990s, current levels still represent a significant increase over

the Soviet period. Coupled with an unwieldy, often arbitrary judicial system, these crime levels have bestowed Russia with the

world’s largest prison population. One out of every four Russian

adults has either been in one of the country’s overcrowded,

brutality-ridden prisons, or has had a family member there. The

government’s attempts to reform its penal system have generally

involved mass amnesties, with the unfortunate result that tens of

thousands of actively infected TB patients—Russia’s jails are its

main breeding grounds for a sweeping TB epidemic—have been released into the general population.11

These social pathologies are not limited to Russia’s urban areas.

Rural Russia has become increasingly isolated. Telephone and postal service throughout the country’s vast land mass remains poor

and unreliable, many regions still go without dependable electricity, and transportation to many areas is problematic. Soviet-era

programs to build and maintain rural infrastructure, including

houses and roads, gas and water supplies, and communication networks, have been largely abandoned. As a result, villagers—who

comprise about one-fourth of the country’s population—must rely

solely on radio and sometimes television as their primary contact

with the rest of the country. This social isolation also extends to

the economic realm. In Soviet times, the planned economy moved

agricultural products to the cities, and manufactured goods back to

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12Margaret Paxson, ‘‘The Cultural Dimension of Agricultural Reform: Social Organization and

the Metaphysics of Exchange in Rural Russia,’’ lecture at the Kennan Institute of the Woodrow

Wilson International Center for Scholars, Washington, DC, January 29, 2001; Gennadi

Zhuravlev, et al., ‘‘The Socio-Demographic Situation,’’ and Vladimir Staroverov, ‘‘Antagonisms

in Russian Society,’’ in Williams, et al., Russian Society in Transition, 1996, pp. 66–67 and 122–

124.

the countryside. The lack of investment in rural infrastructure has

now decimated Russian agriculture, to the point where most specialists estimate that it will take two generations to recover, and

the country must routinely import food.

According to several recent studies, Russian rural communities

have responded to this circumstance by becoming autarchies largely outside the market economy. These communities are able to

grow or make most of that they need for their people to survive,

albeit at a relatively primitive level. Barter has resurfaced as the

primary form of exchange of goods and services, and due to

centuries-old village norms of equity and mutual support, nobody

within the community goes without basic necessities. The good

news is that nobody is starving to death, in a country where famine

did indeed ravage the landscape several times in the twentieth century. Despite the existence of this community-based network of mutual support, however, Russia is currently undergoing a process of

rural depopulation. Fewer employment opportunities and lowered

living standards in the villages are pushing young villagers toward

the perceived range of better conditions in the cities.12

INEQUITY AND THE SEARCH FOR A UNIFYING IDEA

Perhaps most important in terms of societal cohesiveness, the

stratification of society according to income level has increased dramatically during the post-Soviet period. The gap between rich and

poor is steadily growing, as is the absolute number of both very

rich and very poor. At the end of the year 2000, salaries for the

10 percent of households with the highest income in Russia were

32 times those in the lowest income decile, and the richest households’ total incomes were 44 times higher. The new rich, or ‘‘New

Russians’’—former Communist Party leaders, bureaucrats, and others who had the skills, connections, and good fortune to take advantage of the opportunities presented by the transition—rapidly

became objects of considerable scorn in the early and mid 1990s.

Their combination of garish displays of excessive wealth with lack

of education and manners made them the butts of a whole new

genre of jokes. (Two New Russians meet on the street. ‘‘Hey, Vasya,

where did you get your nice tie?’’ ‘‘At the Valentino store. Cost me

$2,000.’’ ‘‘That’s nothing, I know where you can get the same tie

for $5,000!’’) But their profligate spending, particularly in Moscow

and other major cities, drove up the price of new housing, public

entertainment, and other goods to the point that ordinary people

suddenly found those things out of reach.

The new poor, by contrast, are those who work for the government or other still-public industries, including a wide array of

skilled workers and former intelligentsia. They have suffered

through the humiliation of meager and often late wage payments,

or in-kind compensation in the form of goods like bras, caskets, and

manure, and the need to supplement the scientific or technical poVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00340 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.014 CRS1 PsN: CRS1
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13 ‘‘25 Russian Regions Extricate Themselves from Poverty,’’ Trud, December 23, 2000; ‘‘Number of Impoverished in Russia Declines,’’ RFE/RL Newsline, Vol. 5, No. 4, Part I, January 8,

2001.

sitions that continue to harness their intellectual capacities with

second and sometimes third jobs as taxi drivers, cooks, or janitors.

For some of these people, the fall from a Soviet-era position of prestige and privilege has been dramatic. Workers in the scientific, industrial, and military sectors, particularly those located in the

‘‘closed cities,’’ realized the best payoffs the Soviet social contract

had to offer. (Indeed, their membership in the ‘‘First Circle’’ carried

with it a unique clause in the social contract: denial of interaction

with the international scientific community and the tightest reins

on their freedom of expression, in exchange for material benefits.)

But those benefits, based primarily on priority allocation of scarce

physical resources, have now disappeared. They have been replaced

by a monetarized system in which current earnings and budget

revenues available to these former elite cannot begin to match the

perquisites that were formerly associated with place of work and

politically mandated access. In this regard, the Soviet-era social

pyramid has been inverted. Oligarchs and traders are now the primary claimants to government largesse, while highly educated specialists (who still, incidentally, suffer from limitations on their freedom of expression in the ‘‘closed cities’’) have suddenly and unexpectedly become beggars.13

One late 2000 Russian Government economic development strategy report described the situation in these terms: socio-culturally

and economically, two unequal social layers have formed over the

last decade. About one-fifth of the population has maintained or

improved on its standard of living since the Soviet era, and a minority of those, about 5 to 7 percent of the population, have been

able to adopt an essentially Western lifestyle, complete with modern spending and consumption habits. These people have been able

to transcend Soviet assumptions and mindsets regarding the personal work ethic and the appropriate role of the state. To them, the

free market rewards those with skills, tenacity, and ingenuity.

Their post-Soviet success has rendered the collapse of the old safety

net irrelevant to them; they no longer need its protections.

By contrast, the almost half of Russians who are subject to persistent poverty have become jealous and indignant over the new inequities. In their world, growing inequality has little to do with the

natural results of free-market competition. Instead, success for the

few has stemmed not from hard work, but from dishonesty and

‘‘blat’’—political and social connections. The gap between expectations and reality for these people has been psychologically as well

as economically devastating. The disappointment and resentment

among those who mistakenly thought they would benefit from the

marketization of the economy has been profound, particularly when

success seems often to stem from criminal behavior and financial

speculation rather than the production of legitimate goods and

services. Surveys have repeatedly shown that most Russians view

the primary beneficiaries of the transition period as ‘‘swindlers and

manipulators,’’ while few agree that ordinary, honest people have

reasonable opportunities to increase their incomes and living

standards. Hard work and a good education do not necessarily

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14 ‘‘Nearly Four-Fifths of Russians Are Nostalgic About Soviet Union,’’ strana.ru, March 15,

2001; ‘‘Russians Have Trouble Recalling Good Times,’’ RFE/RL Newsline, Vol. 5, No. 77, Part

I, April 20, 2001; Gae ̈l Turine, ‘‘Russia’s Homeless,’’ Time Europe, January 31, 2001; Alexander

Khlop’ev, ‘‘The Transformation of the Social Structure,’’ in Williams, et al., Russian Society in

Transition, 1996, pp. 93–106; Vladimir Shlapentokh, ‘‘A Normal System? False and True Explanations for the Collapse of the U.S.S.R.,’’ Times Literary Supplement (U.K.), December 15, 2000;

Masha Gessen, ‘‘Rockin’ To Sad Songs,’’ U.S. News and World Report,’’ March 19, 2001.

translate into a better life, and to the limited extent that they do,

the latter is increasingly difficult to obtain. Declining public support for education and the rise of expensive private schools at all

levels have seriously diminished one of the few remaining channels

of social mobility.

The dynamic of this new, very public division of society into the

haves and have-nots has exacerbated centuries-old Russian anger

at the separation and exploitation of the masses by their masters.

The well-known mantra about what the Russian people currently

crave—order and stability—encompasses not just social and economic stability, but also a fundamental sense of social justice. The

gap between winners and losers in post-Soviet Russia still may not

match the level of inequality in the United States, but the rate of

explosion of inequality in Russia has been so rapid that people indoctrinated in the socialist mind-set have had little time to adjust.

As a result, Russia has lost all sense of a common national identity. In the midst of socio-economic chaos, no common set of unifying principles has emerged to replace the ideal, flawed as it was,

of Soviet socialism. Gorbachev’s perestroika undermined much of

Russian tradition, forcing society to question its history, its political culture, its achievements as a superpower, the essence of its national dignity. For over a decade since then, the Russian people

have been struggling with questions that cut to the core of their

identity. What values do we hold? What values do we want to

transmit to our next generation? How can we regain a sense of

pride and patriotism? For a few, the answer lay in Western-style

individualism borne of the free market and of liberal political democracy. For the majority, however, that path has been tainted by

the stain of crass commercialism and materialism and the gross inequities produced by shock therapy.

Those people have struggled to find alternate social moorings.

They feel isolated and abandoned. Most say that they can now

count only on themselves in times of trouble; only a small minority

claim they can rely even on family and friends. Only 30 percent are

able to recall anything positive that has happened to them recently. Moscow’s most popular radio station airs catchy tunes with

lyrics that reflect the pessimism of post-Soviet life, songs about war

death, death from hepatitis, and most strikingly, a number one single from early 2000 called ‘‘You Have AIDS (And That Means We

Will Die).’’ This national malaise indicates that Russia continues to

suffer a wrenching psychological upheaval. The symptoms of its

discontent extend far beyond what would be considered ‘‘normal’’

for a country undergoing the pangs of economic development, or

even the sacrifices now routine for a post-socialist transition. Almost nobody has had confidence in the ability of public authorities

to put the country back on the right track.14

A dramatic cultural sea change has formed an integral part of

this national identity crisis. Even factory workers and taxi drivers

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15 Vladimir Chuprov and Julia Zubok, ‘‘Youth and Social Change,’’ in Williams, et al., Russian

Society in Transition, 1996, p. 132. 16 ‘‘Russian Youth Seen Turning Left,’’ RFE/RL Newsline, Vol. 5, No. 50, Part I, March 13,

2001; Valerii Solovei, ‘‘Dragon’s Teeth: A Look at Right-Wing Extremism Among Russian

Youth,’’ Vek, No. 17, April 2001.

in the Soviet era could recite Pushkin, wax lyrical about the latest

achievements of the Kirov ballet and the Chekhov theater, or discuss the finer philosophical nuances of Tolstoy and Dostoyevsky.

Stagnant as life may have been under Brezhnev, it afforded people

time and energy to think private thoughts and to place those ideas

within a rich cultural context. The transition to the market swept

away this luxury. Pushkin and Tolstoy have been replaced with the

most base and commercial representations of Western popular culture, with billboards sporting half-naked women advertising LeviStrauss ‘‘dzhinsy’’ or Marlboro cigarettes. The television and film

industries have become similarly dominated by American imports.

Only 10 percent of the movies shown in Russian theaters in the

mid-1990s were actually produced in Russia. And the domestic

Russian media has responded by sinking to the lowest common denominator. Representatives of the Russian Orthodox Church have

blamed Russian television and cinema for many of the ills currently plaguing Russian society, and one of Russia’s leading film directors has accused Russian television of turning today’s children

into a ‘‘generation of monsters.’’

In practical terms, the most common response to the last decade’s social and economic upheaval has been apathy, spiced with a

generous dose of hopelessness. Cynicism reigns. There are no

longer ‘‘honest’’ or ‘‘dishonest’’ ways to make money—just ‘‘easy’’ or

‘‘hard.’’ There have been practically no mass, public displays of discontent over the initial economic contraction in 1992, the financial

crash in 1998, and the months’ and years’ worth of nonpayment of

salaries. Instead, only a small minority of people express an interest in protest actions. Most Russians avoid reading about or discussing politics at all.15

Those few who do seek political expression of discontent are increasingly turning to extremist outlets. A small but expanding

number of young people, even those with good jobs and higher educations, are joining radical Communist and Socialist groups to protest wage inequalities and economic dislocations. Even more disturbing are the growing ranks of neo-Nazi youth groups across

Russia that have been violently targeting non-Russians, particularly those from the Caucasus and Asia. Of the small number of

Russian youth who express a strong interest in politics—no more

than 5 or 6 percent of the total—over half claim to favor fascism.

The two Chechen wars have provided more than ample fuel to this

fire. Although it would be inappropriate to exaggerate the scope of

these trends at the present time, it is a situation likely to be exacerbated if the Russian Government pursues its currently proposed

policy of increased immigration as a solution to its demographic

problems.16

Russian youth, although more individualistic, entrepreneurial,

and adaptable than their parents, may be the most severely impacted by this crisis of values. Society has not offered them the

‘‘vospitanie’’—the process of deliberate instilling of society’s positive

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17 Igor Ilynsky, ‘‘Law and Order,’’ in Williams, et al., Russian Society in Transition, 1996, pp.

234–235. 18 ‘‘Russian Federation Housing and Utility Services: Policy Priorities for the Next Stage of

Reforms,’’ World Bank Report No. 17483–RU, February 25, 1998.

values—that their parents enjoyed, primarily because society has

been uncertain about what those values are. Their formative years

have been ones of turbulence and upheaval. Unable to derive

meaning from society as a whole, lacking crucial societal anchors,

many of them seem to believe in nothing larger than themselves.

While this may bode well for their ability to survive in a competitive market economy, it also has led a significant number of them

into a life of crime; well over half of Russia’s racketeers are under

30 years old, and the crime rate for juveniles under 18 is higher

than that for adults. The country desperately needs a mechanism

to re-engage its young people and harness their considerable energies in a productive direction.17

THE STATE RESPONSE TO SOCIAL CRISIS

The Russian Government’s response to the social crises of the

1990s has been, at best, uneven. The problems have stemmed both

from shortages of revenue, and from ineffective allocation and distribution of the scarce resources on hand. The economic growth

rates Russia has enjoyed over the last 2 years (albeit largely dependent on relatively high world oil prices) provide a window of opportunity for enhanced financing of reform efforts in the social

sphere. But even during times of relative plenty, the budgetary

choices are difficult. Debt servicing, the armed forces and military

industry, and direct subsidies to individuals and regions continue

to hold significant claims to any surplus budget revenues. And

pouring more money into social benefits sectors still plagued by

Soviet-era inefficiencies and perverse incentives does not constitute

effective reform. Ironically, in many cases, austerity may go hand

in hand with improved efficiency. Recent policy in the housing sector is illustrative here. Over the next several years, the Putin regime will phase out subsidies for housing and utilities, purportedly

in an effort to free revenues for badly needed capital investment in

the utilities infrastructure. Citizens who now average 5 percent of

their monthly incomes on rent, heat, and water will be expected to

pay up to 22 percent of their household budgets for these services.

This reform presents both opportunity and danger. Smartly implemented, and with careful and appropriately targeted subsidies for

the needy, it can revive a crumbling physical infrastructure and introduce market-based productivity to a huge sector of Russia’s

economy. Otherwise, however, it will evolve solely as another (monstrously significant) rip in the social safety net, with the basic material needs of a huge percentage of the population once again disregarded.18

Government policies toward health are illustrative of these dynamics as they operate in the social sector as a whole. The government has addressed declining health status through a series of

market-oriented reforms that have produced genuine progress in

some areas, and unintended negative consequences in others.

Chronically underfunded at around 3 to 4 percent of gross domestic

product (GDP) in Soviet times, and cut to barely more than half

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19 Yu. Shevchenko, ‘‘Primary Measures for Development of the System of Health Care in the

Russian Federation,’’ Zdravookhraneniye Rossiyskoy Federatsii, No. 2, 2000, pp. 3–8; Igor

Sheiman, ‘‘Forming the System of Health Insurance in the Russian Federation,’’ Social Science

& Medicine, No. 39, 1994, pp. 1425–1432; Mark G. Field, David M. Kotz, and Gene Bukhman,

‘‘Neoliberal Economic Policy, ‘State Desertion,’ and the Russian Health Crisis,’’ in Jim Yong

Kim, et al., eds., Dying for Growth: Global Inequality and the Health of the Poor (Monroe,

Maine: Common Courage Press, 2000), pp. 155–173; David E. Powell, ‘‘The Dismal State of

Health Care in Russia,’’ Current History, October 1998, pp. 335–341; Judyth L. Twigg,

‘‘Unfulfilled Hopes: The Struggle to Reform Russian Health Care and Its Financing,’’ and Julie

V. Brown and Nine L. Rusinova, ‘‘Negotiating the Post-Soviet Medical Marketplace: Growing

Gaps in the Safety Net,’’ in Field and Twigg, Russia’s Torn Safety Nets, 2000, pp. 43–64 and

65–82; V.E. Boykov, et al., ‘‘Participation of the Population in the Financing of Health Care,’’

Zdravookhraneniye, No. 2, 2000, pp. 32–46.

that today, Russian hospitals and clinics exist on a shoestring. A

system of nationwide compulsory medical insurance instituted in

1993 held out some promise for extra cash but, like the state budget, it suffers from chronic underpayment and late payment of taxes.

Despite the earnest efforts of most physicians and nurses, dreadful

quality of medical care is often the result. A shockingly high percentage of health facilities have no hot water or sewage systems,

and most still use glass syringes and reusable needles, with sterilization procedures far below Western norms. Patients suffer long

waits even for urgently needed care. A long list of medications is

not only unaffordable, but unavailable. Perhaps most disturbing, a

higher quality of services, in a system where comprehensive free

medical care is constitutionally guaranteed, is now routinely provided only to the small number of people with the ability to pay

for it. State-owned clinics openly (and illegally) demand money for

such basic services as a spot at the head of the queue, accurate diagnoses, routine attention from ward nurses, anesthetics and other

drugs, and the like. One recent study found that one-fourth of St.

Petersburg residents were required to pay more than 20 percent of

their monthly incomes for their most recent medical encounter, and

another reports that a shocking 59 percent of all health care spending in the country consists of out-of-pocket payments (compared to

about 25 percent in the United States). Perhaps inevitably, health

care has succumbed to market forces, but in a chaotic and uncontrolled manner that has left the most vulnerable parts of the population unprotected. Universal access to some level of free medical

care, one of the hallmarks of the Soviet system, has been destroyed.19

The crux of Russia’s health problems, of course, lies not only at

the federal level. The 1993 Law on Self-Governance devolved primary responsibility for health and health care to the regions and

municipalities. The situation with now-bankrupt enterprises, and

the resulting taxation and budget crises, have left governors with

unfunded mandates to provide an array of social services, including

health. Corruption and incompetence in some areas have permitted

this situation to fester, untreated, for over a decade. A handful of

Russia’s administrative regions, however, are providing more comprehensive and promising examples of systemic reform. Samara,

for example, is universally heralded as a pathbreaker in this area.

Its progress seems to derive from the confluence of a variety of important factors. First of all, regional political leaders have afforded

health care top and consistent political priority. Diligent efforts by

regional health insurance bodies and landmark legislation passed

by the oblast Duma have resulted in practically full funding of

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20 Alexei M. Lavrov and Alexei G. Makushkin, ‘‘Extrabudgetary Funds as a Channel for Territorial Redistribution of Public Finances,’’ Chapter 7 of The Fiscal Structure of the Russian Federation: Financial Flows Between the Center and the Regions (Armonk, NY: M.E. Sharpe, 2000),

p. 133; Judyth L. Twigg, ‘‘Russian Health Care Reform at the Regional Level: Status and Impact,’’ forthcoming in Post-Soviet Geography and Economics, 2001. 21 Rudolf Galkin, ‘‘They Can’t Discredit Reform,’’ Meditsinskaya Gazeta, January 5, 1996, p.

4; Galkin, ‘‘Samara’s Model of International Health Care,’’ Meditsinskaya Gazeta, March 15,

health care budgets for the past 3 years. It is impossible to overstate the uniqueness of this situation. Literally every other one of

Russia’s 89 regions struggles with late or underpayment of health

insurance taxes, leaving their coffers underfinanced and therefore

their universal coverage promises impossible to fulfill. In contrast,

Samara has voluntarily added benefits to the list of basic health

services mandated by law.20

Samara’s success also stems from its creative efforts to spend

each health care ruble efficiently and effectively. Having abandoned the Soviet-style, central planning-oriented provider reimbursement mechanisms that remain the norm in most of the country, Samara now has in place an array of incentive structures to

discourage wasteful spending at hospitals and clinics. The region is

also developing a network of general practitioners, in an effort to

overcome the Soviet habit of unnecessary and expensive physician

overspecialization. The presence of family doctors affords patients

greater freedom of choice and a higher quality of comprehensive

services on a cost-effective outpatient basis.

Samara also encourages state physicians to offer paid services

within regular polyclinics and hospitals. Due to high start-up costs,

there is still a relatively small number of physicians in private

practice. But many state facilities now offer private, fee-based services alongside those covered by the state, and patients can choose

to make these legal additional payments either for treatments not

covered by basic national insurance, or for higher quality or more

comfortable provision of state-mandated services. This mechanism

has now, for the first time, provided physicians with an incentive

to work harder and offer higher standards of care, despite the fact

that their state salaries are still mandated according to rigid salary

scales. They compete for the opportunity to provide these paid services, and they keep a portion of the proceeds earned from the business they attract. Visits to some of Samara’s clinics that offer paid

services and therefore enjoy this additional income, and those that

do not, offer a striking comparison. The former contain at least

some modern, Western equipment, and are undergoing significant

capital repair, with evident new construction and remodeling. The

latter continue to exhibit the shoddy construction and technical

standards that were a hallmark of meager Soviet health care quality.

The success of Samara’s reforms is difficult to dismiss, with dramatic reductions in infant mortality rates in recent years (12.2 infant deaths per 1,000 live births in 1998, compared with a figure

of 16.5 for Russia as a whole) and an undeniably greater return on

each health care ruble. The lessons of its experience—the importance of stable leadership and policy continuity in the health and

social sector, and the magnitude of what can be accomplished when

high political priority is assigned to these issues—should be instructive for other regions throughout the Russian Federation.21

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2000, p. 6; ‘‘Health Care of a Region: Samara Oblast,’’ Meditsinskaya Gazeta, June 17, 1998,

pp. 5–10; Judyth L. Twigg, ‘‘Samara Leads the Way with Innovative Medical Practices,’’ Russian

Regional Report, Vol. 5, No. 32, September 7, 2000; author’s interviews with health administrators and providers in Samara, March 2000. 22 Christophe Raison, ‘‘Re ́gionalisation et crise sanitaire en Russie,’’ Revue d’e ́tudes

comparatives Est-Ouest, Vol. 29, No. 3, 1998, pp. 207–239; ‘‘Basic Directions in the State Regulation of the Development of Health Care in the Russian Federation for the Years 2000–2010,’’

Problemy Sotsial’noy Gigieny i Istoriya Meditsiny, No. 3, 2000, pp. 3–14; I. Nazarova, ‘‘Reform

of Health Care: Pros and Cons,’’ Zdravookhraneniye, No. 5, 2000, pp. 29–36; V. Shchepin, ‘‘Structural Effectiveness in the System of Treatment-Preventive Care in the 1990s,’’ Problemy

Sotsial’noy Gigieny i Istoriya Meditsiny, No. 3, 2000, pp. 24–27; Yu. Shevchenko, ‘‘Primary Measures for the Development of the System of Health Care in the Russian Federation,’’

Zdravookhraneniye Rossiyskoy Federatsii, No. 2, 2000, pp. 3–8.

Russian reformers at the national level have conceptualized federal policies to regulate the health sector’s transition to a market

economy, taking into account the need for regulatory mechanisms

that maintain access for the poor and discourage wasteful spending. These include reducing the Soviet-era focus on expensive inpatient care, instead performing routine tests, therapies, and even

surgeries on an outpatient basis where appropriate; training a new

generation of family practice physicians to overcome the Soviet

habit of overspecialization; permitting patients to choose their own

physicians, clinics, and hospitals, so that the benefits of competition can be realized; removing physicians from rigidly set government wage scales, so that they feel a monetary incentive to provide

more and better treatment; adopting provider reimbursement

mechanisms other than fee-for-service, or worse, Soviet-style feeper-hospital-bed-occupied, which encourages inappropriately long

lengths of stay and gross inattention to quality of care; and monitoring insurance company and provider behavior to limit adverse

selection and eliminate or regulate the provision of paid services.

In a handful of Russian regions, these and similar policies have

been implemented to varying degrees, some with impressive results. Samara’s example demonstrates that the key ingredients to

success are attentiveness to the health sector and political will

among leaders at the regional level, which should be applauded

and encouraged where they exist. Certainly a significant increase

in health budgets should be one of the first priorities of Russian

social policy. However, given the obvious difficulties in achieving

meaningful increases in health budgets, measures to improve fairness and efficiency are essential to ‘‘cure’’ Russian health care. But

while the federal and some regional governments have, to varying

degrees, conceptualized some appropriate and even innovative policies, the legacy of Soviet-era institutions and mind-sets has in most

regions continued to put the brakes on reliable, consistent implementation of effective reform.22

SOURCES OF SOCIETAL COHESION AND IDENTITY

Given the government’s mixed success at addressing the country’s ongoing social difficulties, how has Russian society survived

the last decade’s assault on its most basic structure and principles?

Russian people and families have relied on a variety of coping

mechanisms, some involving social structures held over from the

Soviet past, others newly emergent from the chaos of market reform. Primary among the former are informal interpersonal networks. These ‘‘kitchen table’’ groups are close circles of family and

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23 Cynthia Buckley, ‘‘Family Matters: Intergenerational Wealth Transfers and Survival Networks,’’ presentation at conference ‘‘From Red to Gray: Aging in the Russian Federation,’’ University of Texas, Austin, April 6, 2001. 24Scott Peterson, ‘‘A Russian Resurrection,’’ Christian Science Monitor, December 21, 2000;

Giles Whittell, ‘‘Moscow Tightens Its Grip on Rival Faiths,’’ The Times (U.K.), January 2, 2001;

Paul Goble, ‘‘Russia: Analysis from Washington—A Religious Flowering,’’ Radio Free Europe/

Radio Liberty, April 19, 2001; U.S. Department of State, ‘‘2000 Annual Report on Religious Freedom: Russia,’’ September 5, 2000; Elliott Abrams, ‘‘In Russia, ‘Liquidating’ Churches,’’ Washington Post, November 14, 2000.

friends that, during the Soviet era, not only served as trusted confidants but also as networks of mutual provision of scarce consumer goods. Now, in many cases, these informal circles continue

to provide material and psychological support, serving as the primary or only remaining source of cohesion and stability for many

people. A similar psychological and economic impact is being engendered by intergenerational transfers of wealth. It is well known

that some young adults who have navigated the transition period

relatively successfully have financially supported their less adaptable middle-aged and elderly parents throughout the last decade.

Recent studies have further indicated that family survival in many

other instances is being maintained almost entirely by older Russians ‘‘giving until it hurts’’ to their adult children and grandchildren, particularly in rural areas—food from the dacha, money,

whatever they have.23

In addition, many Russians are returning to the symbols, if not

fully to the substance, of the Russian Orthodox Church. Well over

half of Russians now call themselves Orthodox, and millions of baptisms were performed in the aftermath of the Soviet collapse. The

Church has deliberately tried to place itself at the center of a postSoviet Russian national identity, referring repeatedly to a uniquely

Orthodox ‘‘Russian idea’’ or ‘‘Russian soul.’’ But over the last decade, while successful in opening new parishes and monasteries, the

Church has been less effective in bringing its essence to the center

of people’s lives. Basic knowledge of Orthodox doctrine and theology remains low. As a result, many Russians have turned to other

faiths, a phenomenon to which the Orthodox Church has responded

jealously. It has masterminded a law that restricts, and may ban,

the activity of many of the thousands of non-Orthodox religious

groupings in Russia, excepting only those deemed ‘‘traditional,’’ such as Islam, Buddhism, and Judaism. Officially sanctioned discrimination against religious minorities, to the extent that it fosters a climate of divisiveness and intolerance, may undermine spirituality and religion as a sustainable source of family stability and

societal cohesion.24

Russia is also now home to a burgeoning network of over 300,000

registered non-governmental organizations (NGOs), with many designed to provide families and individuals with social services and

support. The obstacles these groups face are substantial, from ridiculous bureaucratic registration requirements to monitoring of their

activities by the federal security services. Fund-raising also remains problematic for these groups, although some are now beginning to navigate the waters of public-private partnership, and others have been blessed by the largesse of well-known tycoons like

Potanin and Berezovsky anxious to create positive public images

for themselves through philanthropy. And many of them still suffer

from public suspicion based on the fact that corrupt businessmen

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25Sophie Lambroschini, ‘‘Russia: NGOs Just Beginning To Take Root,’’ Radio Free Europe/

Radio Liberty, October 13, 2000; Joseph Boris, ‘‘Russian NGOs Threatened, Praised by Officialdom,’’ UPI, January 4, 2001; ‘‘Good Works,’’ The Economist (U.K.), March 24–30, 2001; ‘‘Putin

Wants Dialogue with Civil Society, Welcomes Its Growth,’’ RFE/RL Newsline, Vol. 5, No. 112,

Part I, June 13, 2001; Marcia Weigle, Russia’s Liberal Project: State-Society Relations in the

Transition from Communism (University Park, PA: Penn State University Press, 2000), pp. 333–

379; 1999 Human Development Report for the Russian Federation, pp. 114–125; James Richter,

‘‘Promoting Activism or Professionalism in Russia’s Civil Society?’’ and ‘‘The Case for Assisting

Russian NGOs,’’ Policy Memos 51 and 137, Program on New Approaches to Russian Security

(PONARS), November 1998 and April 2000; Jeffrey Checkel, ‘‘Access, Influence, and Policy

Change: The Multiple Roles of NGOs in Post-Soviet States,’’ Policy Memo 80, PONARS, October

1999.

and politicians often set up illegitimate NGOs for purposes of

money laundering. Nevertheless, many of Russia’s most talented

people are choosing careers in this ‘‘third sector.’’ To the extent

that they grow and thrive, these networks of NGOs may prove instrumental in progress toward a climate of self-generated social

welfare to replace the paternalistic model of state provision. Even

more important, to the extent that they can link their efforts

through regional and national associations, they can provide the

foundation for a genuine civil society, creating a sense of ‘‘common

good’’ and perhaps also the foundation of a stable, liberal democracy.25

Government authorities have also recently attempted quite deliberately to re-establish a positive, distinctively Russian national

identity. In a clear effort to build a new foundation for political legitimacy, President Putin is overtly cultivating a new patriotism,

a new national pride—a sense that the country’s past and present

are nothing to be ashamed of, an attempt to step out of the shadow

of a decade of socio-economic turmoil and more recent disaster such

as the sinking of the Kursk. The restoration of the old national anthem was the first step; the second was the restoration of basic

military training and patriotism classes in the public schools. In

March 2001, the government announced a full-blown, $6 million

‘‘patriotic education’’ program designed to counter a wave of ‘‘indifference, individualism, cynicism, unmotivated aggression, and disrespect for the state’’ evident since the collapse of the Soviet Union.

Over the next 5 years, the project will attempt to reshape the education system through new history and other textbooks, influence

the mass media (with prizes offered to journalists, writers, and

filmmakers whose work exemplifies the goals of the program), and

create a network of ‘‘military-patriotic youth clubs’’ around the

country. Whether these efforts are intended to foster positively directed Russian nationalism or a cult of personality around Putin

himself is debatable, but in many ways they are clearly falling on

fertile ground. Recent consumption patterns—‘‘nasha’’ products are

now preferred over Western brands, and not just because of the

price differentials with imported goods resulting from the August

1998 ruble devaluation—and numerous public opinion polls are

now revealing a rejection of things Western. Consumer nationalism

is leading advertisers to stress the ‘‘Russian-ness’’ of their products—even if those products are made by Western firms. U.S. confectioner Mars’ newly launched candy bar, for example, is called

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26Mark Franchetti, ‘‘Russian Children to Train for War,’’ The Sunday Times (U.K.), September 3, 2000; Susan B. Glasser, ‘‘Letter from Russia: Patriotism, Selling Like Hot Cakes,’’ Washington Post, May 9, 2001; ‘‘Russia’s School for Patriots,’’ AFP, March 15, 2001; Fred Weir, ‘‘Moscow Pitches Patriot Games,’’ Christian Science Monitor, March 22, 2001. 27 ‘‘Russia’s Middle Class Emerges from the Wreckage,’’ AFP, November 6, 2000; Rob Parsons,

‘‘The Rise of Russia’s Middle Class,’’ British Broadcasting Corporation, January 11, 2001; Paul

Starobin and Olga Kravchenko, ‘‘Russia’s Middle Class,’’ Business Week, October 16, 2000; Anna

Raff, ‘‘Middle Class Is Back and Growing,’’ Moscow Times, September 26, 2000; ‘‘Looking for the

Middle Class,’’ Finansovaya Rossiya, No. 4, February 2001, p. 5; Tatyana Maleva, ‘‘Middle Class:

The Doors Are Closing,’’ Vremya Novostei, August 8, 2000, p. 3.

‘‘Derzhava’’—the Russian word for ‘‘power,’’ and an unofficial slogan of the strong Russian state.26

One important constituency for a new, positive Russian nationalism is the emergent middle class. Significant evidence suggests

that this new middle class has energetically arisen from the rubble

of the 1998 financial crisis—middle class not only in income and

wealth, but also in outlook and behavior. They vacation abroad.

They frequent cinemas and theaters and the country’s most recent

craze, bowling alleys. On average, they hold a significantly more

optimistic view of the future than the rest of the population. Many

of them are young professionals who believe in the virtue—and in

the possibilities—of hard work, and they are determined to build

a Russia within which they and their children can succeed. They

manage to save some money, and they purchase major durables

like cars and houses. They typically invest whatever profit they

make back into their ventures, creating jobs and the foundation for

a stable economic base. Although it constitutes no more than 10 to

15 percent of the population, remains vulnerable to shifts in the

economy, and is located primarily in Moscow and a handful of

other major cities, this emergent social stratum, plugging the gap

between rich and poor, could serve as a powerful foundation of the

necessary context for stability and cohesiveness. They are a significant cause for optimism.27

CONCLUSION—LOOKING TO THE FUTURE

The Russian people have been subjected to seemingly unbearable

humiliation and hardship over the last decade. It’s hard not to ask

why they’ve tolerated it. Why aren’t masses of impoverished, disaffected, alienated Russians marching in the streets, demanding an

improvement in their living conditions and in their social environment? Some Russian analysts cynically—but perhaps with a grain

of truth—claim that the history of the Russian masses demonstrates a love of suffering, a craving for martyrdom. Others observe that many Russians have quite evidently chosen a more individualistic form of protest through withdrawal to the vodka bottle

or the heroin needle, or more broadly, through withdrawal from active participation in society as a whole. Still others might cite a

fear of disorder, of even more disruptive and destructive chaos if

significant demands for change are made. And many observe that

most Russians have been too preoccupied and exhausted by the

daily struggle for survival to muster up the necessary energy to

complain. Centuries-old Russian stoicism—an older Russian, looking back on her life, might observe that the last decade represents

just one of many ups and downs for Soviet and Russian society—

325

certainly goes a long way toward explaining the Russian people’s

acceptance of their fate.

Perhaps the cultivation of symbols and slogans can serve as a

rallying point around which people can restore the national identity they so desperately need. But resurgent patriotism, no matter

how heartfelt, will not erase the grinding poverty and gross inequities that continue to plague the Russian socio-economic landscape.

The most important social questions for Russia today cannot be

solved by surface propaganda. They can be addressed only by moving a significant portion of the truly depressed people and places

throughout the Russian Federation stably into that new middle

class. Regenerating the necessary degree of social mobility will require a restoration, albeit significantly amended and adapted to

market circumstances, of the old social contract.

Why, beyond the obvious humanitarian concerns, should these

social issues in Russia assume importance for U.S. policymakers?

Elsewhere in this volume, Russia’s historical endowment with superior natural and human resources is noted. Appropriate concern

is voiced over the deterioration of the country’s physical infrastructure—its roads and bridges, communications networks, and utilities. But perhaps even more important for the long term, largely

because its repair is a much more complex and long-term proposition, is the degradation of Russia’s human capital. The evidence

presented here suggests that the physical and psychological health

of Russia’s human resources have suffered tremendously during the

transition period, as has the incentive structure governing human

development. This decline, due in large part to the rupture of

Soviet-era social safety nets, carries with it enormous economic and

political implications. Democracy, economic reform, and stability in

Russia are largely dependent on the emergence of a stable middle

class engaged in the development of a robust civil society. A social

landscape stratified into haves and have-nots, with the majority of

the population disengaged from a government it no longer trusts to

provide even a minimal safety net of social protections, may nudge

the Russian voting public toward a preference for a return to the

past. Only a healthy, energetic, positively motivated population can

provide the necessary spark to reform the country’s economy, revitalize its society, and rebuild its national security institutions. And

a politically, economically, and militarily stable Russia is much

more likely to emerge as a friend and partner to the United States

than is a Russia filled with uncertainty, insecurity, and continued

collapse and decay.

(327)

LONG-TERM PROSPECTS FOR RUSSIA’S

ECONOMIC GOVERNANCE

(329)

LONG-RUN PROSPECTS FOR THE RUSSIAN

ECONOMY

By James R. Millar 1

CONTENTS

Page

Summary .................................................................................................................. 329

Introduction .............................................................................................................. 330

The Current Condition of the Russian Economy and of Economic Reform ........ 332

Economic measures .......................................................................................... 332

Politics, military reform and foreign policy .................................................... 334

Putin as leader .................................................................................................. 336

Why is Putin popular? ...................................................................................... 336

Implications for the sustainability of economic reform and growth in

Russia in the near future ............................................................................. 337

Prospects for the long run ................................................................................ 338

The future of Russia as a market economy: the transition in historical

perspective ..................................................................................................... 339

The probable structure of the Russian economy in the long run ................. 341

References ................................................................................................................ 344

1 James R. Millar is a Professor of Economics and International Affairs and the Director of

the Institute for European, Russian and Eurasian Studies at the George Washington University,

Washington, DC.

SUMMARY

Long-run forecasts are particularly hazardous, and that has to be

especially the case when it comes to Russia. Enormous changes

have taken place over the past one and a half decades. Gorbachev

undermined the stability of the system in his attempt at reform.

Yeltsin destroyed the old political and economic system in what can

properly be called a revolution. His replacement, Putin, remains

largely a mystery. How committed is he to continued market reform and to democratic processes? It is too early to tell with any

confidence.

One thing is clear, the economic transition, defined as radical

change, is over. The population is exhausted and opposed to further

radical change. The Putin government has benefited from the beneficial effects of the 1998 financial crisis upon Russian domestic industry and upon an unusually high and steady price of oil on world

markets. In the short run, the economy appears relatively healthy.

There are warning signs on the horizon, however, for the price effects of devaluation are wearing off, and the world market price of

oil is unlikely to rise further or to remain at the current level. Consequently, steps need to be taken to provide alternative sources of

economic growth. Putin’s words thus far have been impressive. His

actions have been more ambiguous.

330

Chances are good that the economy will falter in the short run,

or, at best, improve gradually. The best prospect for continued

gradual reform in Russia is represented by the proximity of the European Union (EU). It is a major customer for Russian exports, and

so are the Eastern European countries now in line for accession to

the EU. The conditions for admission to the EU are essentially

identical with those required for a successful economic transition to

a workable market economy, and the charter spells out these requirements in chapter and verse.

Long-run prospects of developing a complete market economy in

Russia are quite good. An examination of world economic history

reveals what appears to be an inexorable trend away from economies based on custom and command toward market relations. The

current emphasis upon globalization represents a continuation of

this trend. In historical perspective, the Soviet economic experiment with central planning represented a deviation from the trend

line. Thus, Russian and the other transition states are returning

to the trend line, to a more optimal relationship between markets

and government intervention in the economy. Although prospects

are good that this movement will continue in Russia, it does not

follow that progress in economic welfare will be achieved readily.

A market economy may be the best solution for the allocation of resources, but until individual countries and/or the international

economy learn to steer clear of currency crises, trade conflicts and

depressions, sustained economic growth will be difficult to attain.

Russia will be fortunate to reach the status of Brazil or Mexico in

the long run. Catching up with the G–7 countries, with the EU or

even with the leading countries of Eastern Europe appears unlikely

for the foreseeable future.

INTRODUCTION

Burke ever held, and held rightly, that it can seldom be

right . . . to sacrifice a present benefit for a doubtful advantage in the future. . . . It is not wise to look too far ahead;

our powers of prediction are slight, our command over results infinitesimal. It is therefore the happiness of our own

contemporaries that is our main concern; we should be

very chary of sacrificing large numbers of people for the

sake of a contingent end, however advantageous that may

appear. . . . We can never know enough to make the chance

worth taking. There is this further consideration that is

often in need of emphasis: it is not sufficient that the state

of affairs which we seek to promote should be better than

the state of affairs which preceded it; it must be sufficiently better to make up for the evils of the transition.

(John Maynard Keynes, Treatise on Probability, cited in

Robert Sidelsky, John Maynard Keynes. The Economist As

Savior, 1920–37, p. 62.)

Lord Keynes is here discussing Edmund Burke’s philosophy of

governance and reform. The statement was condensed in The General Theory, where Keynes stated simply that ‘‘in the long run, we

are all dead.’’ The quote from Burke represents Keynes commitment to what has been the Anglo-American tradition of avoiding

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2Millar, James R. ‘‘The Failure of Shock Therapy.’’ Problems of Post Communism, Fall 1994. 3 Hedlund, Stefan. Russia’s ‘‘Market’’ Economy: A Bad Case of Predatory Capitalism. London,

UK: UCL Press Limited, 1999.

Bush, Keith. ‘‘The Russian Economy in June 2001,’’ Russia and Eurasia Program, CSIS (June

2001), E-document.

revolutionary change in favor of step-by-step, brokered reform of

the economic system.

In contrast, economic reform under Boris Yeltsin was radical and

utopian. Shock therapy was expected to entail large costs for the

population in the short run, but provide substantial benefits in the

future. It turned out, however, that the cost was much greater and

the period of sacrifice much longer than the radical reformers and

Western advisors anticipated.2 They clearly did not ‘‘know enough

to make the chance worth taking,’’ and the benefits of the reforms

in Russia have yet to prove ‘‘sufficiently better to make up for the

evils of the transition.’’

Russia from the time of Peter the Great through the Soviet period has a history of radical change imposed from the top on the

population, change that has almost always entailed very large costs

on the contemporary population in the name of future benefits. The

Bolsheviks carried out a series of campaigns, such as mass collectivization, rapid industrialization, the Virgin Lands program, that

were typically imposed from the top and implemented with little

concern for the underlying population, whether opponents or not.

Yeltsin followed this tradition like a good Bolshevik despite his renunciation of the Communist Party. Price liberalization in 1992

wiped out personal savings of the population at large. Hasty privatization of Soviet enterprises and natural resources transferred public wealth into a very small number of private hands to a degree

unprecedented in history. Real income crashed for most Russian

citizens. Poverty and unemployment caused untold misery for Russian pensioners, the working class and the farmers. Only a few

have benefited in the short run. Some improvement is now taking

place in the medium term, after 10 years, but much remains to be

done to turn the Russian economy into a workable and stable market economy. And there is no assurance that the positive rate of

growth of gross domestic product (GDP) that Russian has experienced for the past 2 years can be sustained.3

Vladimir Putin has thus far eschewed radical economic reform,

preferring instead to work with the Duma to promote a series of

measures designed to make the economy more responsive to markets and the global economy. He may be labeled a gradualist to

date, and willing to compromise with the foes of a liberal market

economy rather than confront them. What is the prospect that he

will indeed be able to achieve gradually what his predecessor Boris

Yeltsin failed to achieve by brute political force? What does the

long run hold for the Russian economy? The concern of this paper

is to try to specify what that long-run prospect is likely to be, with

due deference to how ‘‘slight’’ our powers of prediction are and the

uncertain command Russian leaders have over results.

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4Millar, James R. ‘‘The Post Cold-War Settlement and the End of the Transition: Implications

for Slavic and East European Studies,’’ NewsNet, The Newsletter of the AAASS (American Association for the Advancement of Slavic Studies), January 2001, v. 41, no. 1. 5Johnson’s Russia List #5295; Reuters: Jon Boyle.

THE CURRENT CONDITION OF THE RUSSIAN ECONOMY AND OF

ECONOMIC REFORM

An examination of reform successes and failures among the 25

independent countries that emerged from the Soviet Empire reveals that a strong, unambiguous commitment to economic reform

has been an important, if not the most important, variable. The

most successful states have been those that wanted desperately to

get out from under Soviet power. They have sought to link their

fortunes with Europe, especially to the European Union. Also critical, almost all had experienced a period of independent existence

as states before coming under Soviet influence.4 As in almost all

of the former republics of the U.S.S.R., the leadership in Russia

has been ambivalent about introducing the reforms necessary to

create a workable market economy and ambivalent also about its

relationship to Europe.

Yeltsin’s commitment to economic reform was never constant,

and it diminished over the years of his erratic rule. His successor,

Vladimir Putin, remains something of a mystery. Is Putin a cautious, but determined reformer seeking step-by-step reform in the

spirit of Lord Keynes and Edmund Burke? A recent statement on

Russia Day, a celebration of the tenth year since Russia was declared a republic, might qualify Putin for this title: ‘‘Everything we

endured over the past decade, all our experiences, successes and

failures, shows one thing—any reform only makes sense when it

serves the people.’’ 5

Or is he primarily concerned with maximizing political power

primarily in order to keep himself in power? Putin has certainly

talked like a real reformer, but his actions have been more difficult

to interpret. The high world market price of oil has provided a

large windfall gain for Putin’s government, as has the vigorous response of Russian industry to the benefits of the devaluation of the

ruble that followed the 1998 financial crisis. The question is: How

effectively has Putin utilized this period of relative prosperity?

What has he actually done to sustain economic growth after the

windfall gains of 2000 and 2001 have been exhausted?

ECONOMIC MEASURES

At the outset of his presidency, Putin indicated that he planned

to reduce the political and economic power of the wealthy individuals known as ‘‘oligarchs’’ who benefited so greatly from privatization of Russian industry and natural resources. Thus far two of the

most prominent and vocal oligarchs, Boris Berezovsky and Vladimir Gusinsky, have been thoroughly undermined. Gusinsky has apparently lost his media empire, and Berezovsky has gone from

kingmaker (for both Yeltsin and Putin) to political outcast. However, Putin’s motive appears to have had less to do with economic

power than with the desire to quiet criticism from their media enterprises. Putin obviously does not appreciate criticism, and he has

effectively crushed the independent media in Russia by underminVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00358 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.015 CRS1 PsN: CRS1
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6 New York Times, May 30, 2001. 7 Russian Journal, June 29, 2000. 8Lipman, Masha. ‘‘The Indecisive President.’’ The Washington Post, February 6, 2001. 9Semenenko, Igor. ‘‘Illarionov Warns of Looming Gloom.’’ Moscow Times, January 17, 2001. 10 Izvestia, June 4, 2001.

ing Berezovsky and Gusinsky. More recently,6 Putin engineered the

removal of Rem Vyakhirev, who had been CEO of the giant natural

gas monopoly Gazprom since 1992, and replaced him with Aleksei

Miller, a long-time Putin loyalist. Vyakhirev was a variant type of

oligarch, one appointed essentially by the government to manage a

huge partly private, partly state enterprise. In replacing

Vyakhirev, Putin has strengthened his hand in many respects because Gazprom is such an important cash cow for the budget. If

Miller manages Gazprom more efficiently and does not use access

to its great wealth mainly for his own personal enrichment, this

change will represent a major economic advance. That is yet to be

seen. The verdict on Putin’s policy toward the oligarchs is, therefore, not yet in. The remaining oligarchs, with the exception of

Anatoly Chubais, who has metamorphosed from radical reformer to

oligarch and now runs the national electricity monopoly, are lying

low politically, which may be the price they must pay to keep their

ill-gotten wealth intact.

The Minister of Economic Development and Trade, German Gref

has produced a 10 year plan for the Russian economy that was officially adopted by Prime Minister Mikhail Kasyanov in June 2000,7

but it has yet to be truly engaged. Curiously, the plan has certain

earmarks of Soviet-era long-term plans, and it may meet the same

fate—to be announced with great fanfare and then forgotten.

Meanwhile, Presidential economic advisor Andrei Illarionov has

bitterly criticized Gref’s plan as insufficiently reformist and unrealistic. Illarionov, who seems to be something of a loose cannon, continues to quarrel with Anatoly Chubais, CEO of RAO UES (Unified

Energy Systems of Russia), concerning reform and management of

the energy monopoly. He has also criticized the Prime Minister

sharply for even suggesting earlier this year the possible postponement of payments of principal and interest to the Paris Club,8 and

they have had other public quarrels too. Meanwhile, Putin has

maintained silence regarding these conflicts among his economic

advisors. Apart from a tax reform and, more recently, urban land

tenure reform, progress on the many economic reforms that are

needed has been modest at best. Everyone agrees, for example, on

the need for better corporate governance, but no one seems to be

doing anything other than talking about it. Similarly, restructuring

and reform of commercial banking and the financial system generally have been oft mentioned but rarely acted upon convincingly.

Andrei Illarionov also forecast (wrongly it now seems) bleak economic performance for 2001 to the European Business Club in Moscow January 16: ‘‘The party is over and the hangover is about to

begin.’’ He stated that the Prime Minister had had nothing to do

with successful economic growth in 2000. It was ‘‘sparked by skyhigh oil prices and the rapid depreciation of the euro to the U.S.

dollar.’’ 9 In June, Illarionov, addressing members of the American

trade chamber, amazed his audience by arguing that ‘‘Russia has

no need of investments or credits.’’10 Meanwhile, Kasyanov has

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11Lambroschini, Sophie. ‘‘The Government Uncertain Role to Land Privatization.’’ Part 1,

RFE/RL, February 9, 2001. 12Moscow Times, Editorial, January 29, 2001. 13Johnson’s Russia List #5226, April 27, 2001.

been urging investment in Russia during his foreign trips. The

question is: Where was Putin? Are his economic advisors allowed

to say anything they want; to quarrel publicly without official resolution of the issues?

Privatization of rural land remains deadlocked. Putin has urged

the regional governors to support ‘‘coherent land legislation’’ and a

federal land code. German Gref, Mikhail Kasyanov and Andrei

Illarionov all agree on the economic benefits private land tenure

would bring about. Recent developments indicate that urban land,

which comprises less than 10 percent of all land area in Russia,

will be opened to private, and perhaps even foreign private, ownership. But the opponents of privatization of rural land in the Duma

continue to oppose it on ideological and historical grounds.11

Urban land has been controlled by mayors and regional governors for local ends and personal profit, and they may still find

ways to frustrate or restrict private ownership. Agricultural land

has always been treated as commons or as communal property, and

even most peasants want it to stay that way. The result is that action on land tenure continues to be controversial and stagnate,

which contributes to a poor environment for foreign direct investment.

POLITICS, MILITARY REFORM AND FOREIGN POLICY

What is true of economic policy is true generally. Putin’s policies

have been anything but bold, coherent and decisive. Putin has had

relatively good relations with the Duma, but he has yet to push reforms through it vigorously. He was successful in establishing federal control over the various provincial regions last year, at least

pro forma. The regional governors were ousted from Parliament,

but, in the end, they were allowed to appoint their replacements.

Also, the maximum of two terms for the 89 regional leaders was

revised in January 2001, allowing 69 of them to run for a third

term. As one observer put it, ‘‘In other words, as long as the governors don’t challenge Putin’s authority, they can continue to rule

as they have been [doing] . . . .’’12 The jury is still out on how effective Putin’s seven presidential super-governors will be in reigning

in the regional governors. A recent Radio Free Europe/Radio Liberty (RFE/RL) Russian Federation Reform Roundtable discussion

among American scholars suggests that the reform has been quite

ineffective.13 The jury is still out on how effective Putin’s seven

presidential supergovernors will be in reigning in the regional

bosses.

Putin has also succeeded in silencing media criticism of him and

his government. Grigory Yavlinsky, head of the small liberal party,

has described Putin’s policies harshly as ‘‘National Bolshevism.’’ What is happening to the country, he stated recently, is ‘‘sham

freedom of speech, sham independent judiciary, sham elections,

sham multi-party system and a sham separation of powers.’’ The

Putin regime displays, according to Yavlinsky, ‘‘Absence of any noVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00360 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.015 CRS1 PsN: CRS1
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14Johnson’s Russia List #5058, Moscow Times, January 30, 2001. 15Dr. Christopher Hill, British Ministry of Defense, London, Briefing, January 31, 2001.

tion of the value of human life, any idea that there are inalienable

rights and freedoms.’’14

Some progress has been made recently on military reform. The

conflict between the chief of the general staff, Anatoly Kvashnin,

and the minister of defense, Igor Sergeev, over what the relative

priorities ought to be between strategic missiles and conventional

weapons and troops may have been resolved in favor of Kvashnin

recently, but it is too early to tell. But no resolution is apparent

regarding the deep reforms of the military that budgetary constraints require. The military continues to deteriorate, along with

the defense industry, which is deeply in debt. Russian military

leaders have yet to confront the limitations they face after years of

budgetary priority in the Soviet period. Today the budget for the

military is, at best, one-fifth that for the U.S. military.15 Once

again Putin has not spelled out a clear cut policy. The submarine

Kursk episode shows that Putin is prepared to allow the military

to lie to the public and the world about the probable cause of the

sinking. This recalls Soviet times when high officials and military

personnel sometimes maintained a lie despite the fact that only the

least informed foreigner or domestic citizen believed them.

In foreign policy Putin has sought to restore economic and political relations with the Soviet Union’s old allies: Iran, Iraq, Cuba,

and North Korea. It has also strengthened relations with China.

The Foreign Minister, Ivanov, has stated that the Near Abroad,

that is, the former republics of the U.S.S.R., falls within Russia’s

sphere of influence. The implication is clear, Putin has been seeking to restore Russia’s dominant position in the region and, to the

extent possible, restore the Soviet empire through energy dependency, aggressive military exercises, showing of the flag, and

minatory behavior in the Caspian region. With the exception of

China, the countries Putin is reaching out to are either global outcasts or economic basket cases. It is an alliance of losers. The policy

could be, therefore, a costly one internationally and economically.

The attempt to attain hegemony over the so-called Near Abroad

represents a serious drain on Russia’s resources. So does the apparently interminable war in Chechnya. What the new conflict between the United States and Afghanistan portends for Russian foreign policy is still not clear, but it has all the makings of a quagmire that Russian might not be able to avoid.

Interestingly, and related to ‘‘empire envy,’’ is the restoration of

some Soviet symbols and the creation of new patriotic ones. The

Soviet hymn has been resurrected and refurbished. Red banners

have been restored for the military, perks have been created for the

President that are competitive with those received by the American

president. And Putin has traveled abroad to high visibility events

where he can be photographed consorting with the world’s powerful

leaders. These activities, which have little to do with reform, have

been met with approbation by the general public.

Putin’s positive response to the terrorist attack on the United

States and to America’s declaration of war on international terrorism appears to contradict his policies to date designed to restore

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16Putin’s January 1, 2000 speech, ‘‘Russia at the Turn of the New Millennium.’’ Web page

of Russian Federation, http://pravitelstvo.gov.ru. 17 ‘‘The Politics of Mind Over Matter,’’ Time-Europe, January 22, 2000. 18 Jamestown Foundation Prism, A Monthly on Post-Soviet Studies, January 2001, Vol. VII,

Issue 1, Part 2 19Time-Europe, January 22, 2000.

former allies and republics of the U.S.S.R. to Russia’s sphere of influence and support. Not only has he moved sharply back toward

the Western camp, he has acceded to U.S. action in Afghanistan

and, more surprisingly, to the placement of U.S. troops and other

military assets in Uzbekistan and perhaps elsewhere in Central

Asia. He will ultimately have to choose between creating a ‘‘multipolar’’ counterweight to U.S. hegemony in the world and becoming

a junior partner in the international alliance against terrorism. It

is too early to tell how he will resolve this contradiction, but he

cannot waffle for very long.

PUTIN AS LEADER

On balance, Putin appears to be rather indecisive. If one reads

only his speeches, Putin provides accurate diagnoses and reasonable prescriptions as remedies, but the follow through has been

weak.16 Putin avoids direct conflict with his subordinates. When

trouble arises, he tends to back down, or to claim he knew nothing

about the issue, or that he has no authority in the case in question,

or remains silent. Time-Europe correspondent Paul Quinn-Judge

writes:

‘‘The pessimistic variant is that, when major problems

arise, Putin will opt for the easy way out—blaming enemies, stifling criticisms and muddling through.’’17

According to Alexandr Tsipko:

‘‘Like many of his predecessors, solving moral and political problems comes more easily to Putin than solving social and economic problems.’’

‘‘Gorbachev’s glasnost rehabilitated truth, ethics and

common human values. Putin has rehabilitated Russian

patriotism, national dignity, statist integrity and the consolidation of Russian statehood.’’

‘‘The task of maintaining . . . the national consensus . . .

will be in constant conflict with the task of modernizing

Russia and implementing market reforms.’’18

WHY IS PUTIN POPULAR?

Survey research specialist Yuri Levada states that: ‘‘He has

given Russia leadership.’’ Paul Quinn-Judge writes:

‘‘Putin’s first year has turned out to be a remarkable example of mind over matter in public opinion. There have

been few major accomplishments, several disasters and

some ominous developments in the field of human rights

and press freedom.’’19

The simple answer may be a variant ‘‘Linda Tripp’’ phenomenon.

Judging by his behavior, Putin does not really have to consult the

polls because he is ‘‘just like them.’’ He clearly regrets the breakup

337

of the U.S.S.R. and Russia’s loss of military power and respect in

the world community. He is suspicious of markets and prefers state

control of heavy industry, the military-industrial complex, communications and the media, banking and transportation. He is in favor

of a paternalistic and strong state. The public agrees on every

count.

IMPLICATIONS FOR THE SUSTAINABILITY OF ECONOMIC REFORM AND

GROWTH IN RUSSIA IN THE NEAR FUTURE

The outlook for economic reform and continued economic growth

over the next year or so is positive, but only marginally so. Gorbachev sought to reform the Soviet socialist economy, to make it more

humane and more responsive to the popular will by introducing

certain elements of a market economy. The reform failed. Yeltsin

led a revolution that destroyed the coordinates of the Soviet economy and attempted to replace it with market institutions. The revolution achieved partial success. The planned economy was destroyed totally, but the disastrous economic consequences of the

revolution for the population at large and the capture of it by the

nomenklatura caused it to grind to a halt. Putin is now leading a

partial restoration of Russia, a pause in the radical changes that

have been taking place since perestroika and glasnost were introduced in 1988–1989. In this sense the economic transition is over,

but, of course, a good deal remains to be done to complete market

institutions.

Putin is restoring hope for the future, the sense that Russia will

again assume her proper place as a major power in the world, that

domestic order will be restored, corruption will be curtailed and

that the economy will rebound. He has also created the hope that

these ends may be accomplished without further violent disruptions to society. In the short run these aspirations are doomed to

disappointment. Economic growth is more likely to stagnate than

to be maintained, for too much depends at present upon the uncertain price of oil and of other natural resource exports, such as gas

and metals, and upon the diminishing boost to domestic production

from the 1998 devaluation. Foreign direct investment is unlikely to

increase significantly until reforms in corporate governance, commercial banking and competition policy are enacted. The distraction caused by empire aspirations will continue to drain the treasury and inhibit economic reform. Also, despite brave statements to

the contrary, Putin has yet to tackle the problem of public or private corruption.

Thus far, Putin has been more focused upon the accumulation of

power than upon its exercise. This is a sign of insecurity by a leader who, above all, wants to remain in power. Completion of the reforms necessary to turn the Russian economy into a functioning,

workable globally competitive economic system will require the expenditure of power and the risk, as Gorbachev discovered, of removal from power. Putin’s caution may, therefore, slow the reform

process and highlight instead the pageantry and ritual of the process of restoration. This is not to say that the Soviet economy or the

Communist Party will be restored. They are dead and gone and

cannot be resurrected. What Putin is trying to restore is the national pride and will of the Russian people. This is a necessary but

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20Weist, Fred. Christian Science Review, February 15, 2001. 21 Holmes, Oliver Wendell. ‘‘The Wonderful One-Hoss Shay.’’ http://www.library.utoronto.ca/

uetl/rp/poems/holmes9.html. 22The Soviet Economy Toward the Year 2000, p. 419.

insufficient condition for the completion of market reform and successful entry into the competitive global economy. At present, however, the most likely outcome is gradual change, with economic

stagnation a close second. A much bleaker picture was presented

in a recent Russian Government Report, which forecast the conjuncture of three major negative trends in the year 2003. The economic infrastructure will crumble. The demographic crisis will

peak. And external debt service will become overwhelming.20 Like

the ‘‘wonderful one-hoss shay,’’ the Russian economy might go ‘‘to

pieces all at once . . .’’.21

PROSPECTS FOR THE LONG RUN

In October 1980 a conference was held at Airlie House in Virginia which ‘‘had as its theme the long-term prospective growth of

the Soviet economy.’’ The conference was organized by Professors

Abram Bergson and Herbert Levine, two very senior specialists on

the Soviet economy. The list of contributors and participants reads

like an honor role of Soviet specialists. Their charge was to appraise economic prospects to the year 2000.

Participants considered several scenarios, but, in the end, the

consensus was that the Soviet economy would continue to ‘‘muddle’’

on without radical changes for the next two decades. In summing

up his reaction to the presentations, Seweryn Bialer, in ‘‘Politics

and Priorities,’’ concluded:

In sum, we can anticipate no fundamental changes in

the Soviet Union during the 1980s despite intense and divisive discussions concerning economic reforms, a number

of organizational policy initiatives, experimentation with

the economic structure, and significant political conflict.22

Needless to say, the forecasts produced in 1981 were history by

1988 much less 2000. The picture painted for the year 2000 was

totally off, whether predictions of GDP, population, agricultural

production, development, planning and management or politics.

Like everyone else, the top specialists on the Soviet economy were

blindsided by Gorbachev and Yeltsin.

Soviet specialists’ experience in this attempt to project current

trends 20 years into the future must give pause to any attempt to

do the same today with Putin’s Russia. The analysis and forecast

that follow differ in two respects from those produced at Airlie

House. First, The Soviet Union had experienced a decade or more

of stagnation under Leonid Brezhnev. Russia, by contrast, has undergone radical change and much political and economic instability

over the past decade. Further radical economic change is highly unlikely because the population is exhausted and opposed to new economic experiments. Putin appears to oppose radical change too.

The transition is over for Russia. Second, the Bergson-Levine volume was not based on any explicit theory of economic and social

change. Pure extrapolation is always dangerous.

339

23Marx, Karl. Capital: A Critique of Political Economy, New York, NY: The Modern Library,

1906. 24 Hayek, Friedrich A. The Road to Serfdom. Chicago, IL: The University of Chicago Press,

1957. ———, ed. Collectivist Economic Planning. London, England: Butler & Tanner Ltd., 1935.

THE FUTURE OF RUSSIA AS A MARKET ECONOMY: THE TRANSITION IN

HISTORICAL PERSPECTIVE

Peering into the future cannot be based merely on an extrapolation of current trends. An examination of Russia’s place in the

historical process of economic development may provide some insights into what we can expect the Russian economic developments

to be over the next several decades.

A debate engaged Western economists during the 1950s and

1960s over the possible convergence of socialist systems, such as

the Soviet Union, and capitalist systems, such as the United

States. The debate over convergence appears in a quite different

perspective today in the light of the universal collapse of the Soviet

command economy and the contrasting vitality of capitalist systems. Two positions in the debate were considered extreme and

highly unlikely outcomes by most participants in the debate. Marxists anticipated the overthrow of capitalism and worldwide convergence on a Communist economic system. The expansion of Soviet

power in East Europe, Mao’s success in China, and the attraction

of Marxism for many underdeveloped countries provided a foundation for the viewpoint. For the Marxists, market institutions represented merely a transitory stage in human history, one that

would be followed by equity in economic allocations and, consequently, an end to economic conflicts caused by scarcity.23

The other extreme view was expressed most fully by Friedrich A.

von Hayek. He expected the abandonment of central planning in

the socialist economies because of the inherently superior efficiency

of market economies in solving the crucial ‘‘economic problem,’’ that

is, the rational allocation of resources among competing alternative

uses. The argument held that central planning cannot substitute

for markets because there are simply too many supply and demand

equations for any central agency to solve satisfactorily. Decentralized decision making by private individuals represented the only

successful way to do so historically.24

Neither argument for unilateral convergence gained much traction in the debate of the 1950s and 1960s. Mutual convergence was

instead the prevailing view. Capitalism and socialism were conceived as occupying opposite ends of a spectrum, with the U.S. and

Soviet economies near either extreme. Proponents of mutual convergence viewed socialist and capitalist economies as moderating

their distinctive institutions and becoming more alike. Welfare capitalism was developing in the West, and, at the same time, socialist

economies were experimenting with the introduction of market elements.

The most sophisticated version of mutual convergence was put

forward by the Nobel Prize winning economist Jan Tinbergen. His

main contribution was the ‘‘theory of the optimal regime.’’

Tinbergen recognized the inevitability of a trade off between economic efficiency and economic equity in any actual human society.

There exists, he assumed, an optimal regime that rational men and

340

25Tinbergen, Jan. ‘‘Do Communist and Free Economies Show a Convergence Pattern?’’ Soviet

Studies. 1961, vol. 12, n. 4, pp. 335–341.

———. ‘‘The Theory of the Optimum Regime,’’ in Klaasen, L.H., L.M. Koyck and H.J.

Witteveen, eds. Selected Papers. Amsterdam, Holland: North-Holland Publishing Company,

1959, pp. 264–305.

women would ultimately recognize and work toward, one that balanced the benefits of efficiency against those of equity. If so, extreme regimes, such as the United States and the Soviet Union,

would prove unstable, and each would approach the mean. Thus,

he predicted convergence under which the Soviet Union would

gradually introduce markets, reduce government intervention in

the economy and allow a greater role for private property. Similarly, the United States would develop increasingly as a welfare

state, strengthen government regulation of markets and increase

public ownership of productive property. Capitalist and socialist

systems would, therefore, converge over time on the optimal economic regime.25

In retrospect, Tinbergen’s theory, and others like it based on rational choice and political pragmatism, appears seriously flawed.

The implicit assumption that the U.S. and U.S.S.R. economies were

equidistant from the optimal regime may be seen today to have

been wrongheaded. Von Hayek’s analysis has fared much better as

a prediction. When the planned economies were opened to the global economy they wilted like tropical plants deprived of a hothouse.

The egregious extent to which these economics had become distorted as a result of central planning based on quantitative orders

and arbitrary pricing of final goods and services confirmed Hayek’s

point. Soviet-type socialism was clearly highly inefficient in the allocation of resources and in fostering innovation. The problem was

efficiency, not equity. Command economies may be highly effective

in mobilizing resources for a specific purpose, such as a war or to

develop the atomic bomb, but they have failed to compete successfully with capitalist economies in the long run. For longer periods,

the absence of flexible prices, entrepreneurship and local decision

making was costly in efficiency and growth.

It is not necessary, however, to abandon Tinbergen’s notion of an

optimal regime, a regime that balances equity and efficiency. The

Soviet economy was, it seems, the historical outlier, and it is now

presumably being modified in the direction of the optimal regime.

Support for this view is provided by another Nobel Prize winner,

J.R. Hicks, in his Theory of Economic History (1969). Hicks is interested in the rise of the market as an historical phenomenon, and

he views the non-market economy, which includes the command

economy, as an older form of economic organization. He traces the

evolution of markets from the earliest periods of recorded history.

Markets originated for the conduct of external trade, but gradually

penetrated the domestic economy. First, there was the growth of

internal trade in goods. Second, was the extension of the market

to include labor services. Subsequently, land and capital became

subject to the market. Domestically, the market has continued to

broaden its coverage, displacing, for example, what had been considered family obligations to children and parents with paid services. The system of custom and command has gradually retreated

as we have moved toward a cradle to the grave market economy.

341

26 Copeland, Morris. Essays in Socioeconomic Evolution. New York, NY: Vintage Press, 1981.

The temporal sequence by which markets have penetrated personal

as well as business relationships is telling, for a similar sequence

may be seen in the transition economies of today.

Morris Copeland, quite independently, developed a complementary theory of economic history, one that stresses the critical role

of money and credit in market economies as sources of economic

discretion, and, by implication, rationality. Money implies the existence of prices, wages and interest rates and thus the possibility of

multilateral trade. The spread of pecuniary institutions codeveloped with markets and facilitated efficient trade.26

Seen in this light, the Soviet-type socialist economy was an historical regression, a deliberate, conscious attempt to reverse fundamental historical processes. Soviet economic institutions were

created for the explicit Marxist intention to minimize and eventually eliminate markets, money, credit, prices and wages. It is not

surprising that the Soviet economy performed well in WWII as a

way to mobilize and concentrate resources on a limited number of

goals. However, the attempt to maintain the command economy indefinitely implied the need for a permanent emergency, and the

cold war afforded a rationale. The Hicksian-Copeland understanding of the spread of the market economy implies, therefore, that

Russia is today back on the track of normal evolution of markets

and market instruments after a long and costly deviation. Russia,

and the other former republics of the U.S.S.R., traveled the longest

and farthest along this historical deviation. As the theory suggests,

it has been the most difficult for Russia and the other former republics of the U.S.S.R. to redevelop those markets that were relatively underdeveloped at the time of the 1917 Revolution, such as

the markets for urban and rural land, or that were extirpated thoroughly by the Bolsheviks, such as investment, financial and existing productive asset markets. It has also proven difficult for them

to establish true commercial banking systems, effective and equitable corporate governance institutions and workable competitive

markets. Attempts to catch up with capitalist institutions in the

more advanced countries have been opposed by Marxist ideologues,

Soviet traditionalists, and a deep-seated and widespread popular

belief in the uniqueness of Russia’s mission in the world. Economic

interests vested in the monopolistic and oligopolistic structure of

enterprise ownership that Russian-style privatization created have

also been obstacles to further reform.

THE PROBABLE STRUCTURE OF THE RUSSIAN ECONOMY IN THE LONG

RUN

At the outset of radical economic reform under Yeltsin in Russia

there were a number of economists and policy makers in the West

who dreamed of creating the perfect capitalist system in Russia.

The collapse of communism and central planning was viewed as a

‘‘clean slate.’’ Jude Wanniski, for example, wrote in 1992:

It is possible to imagine a future of Russian capitalism

that asserts itself early in 21st century as the envy of the

world. . . .

342

27Quoted in Millar, James R. ‘‘The Economies of the CIS: Reformation, Revolution, or Restoration?’’ in The Former Soviet Union in Transition, Volume 1, Study Papers submitted to the Joint

Economic Committee Congress of the United States. 103d Congress, U.S. Government Printing

Office, Washington, DC: 1993, p. 36. 28Millar, James R. ‘‘Empire Envy, Stop-Go Economic Policies, and Political Constraints in

Economic Reform in Russia.’’ Problems of Post-Communism. 1998, vol. 45, no. 3.

———. ‘‘Prospects for Economic Reform. Is (Was) Gorbachev Really Necessary?’’ in Lee, J.J.

and Walter Korter, eds. Europe in Transition: Political, Economic and Security Prospects for the

1990s. Austin, TX: Lyndon B. Johnson School of Public Affairs, 1991. 29Millar, James R. ‘‘The Economies of the CIS: Reformation, Revolution, or Restoration?’’ in

The Former Soviet Union in Transition, Volume 1, Study Papers submitted to the Joint Economic Committee Congress of the United States. 103d Congress, U.S. Government Printing Office, Washington, DC: 1993, pp. 34–54.

The Russian people are now engaged in nothing less

than designing the basic architecture of a brand new country. Why not consider all possibilities? Why not design the

Russian system of capitalism to be the best? 27

By the ‘‘best’’ Wanniski clearly meant an economy in which state

ownership and intervention in the economy would be even less

than in the most advanced capitalist countries, such as the United

States. As a more ‘‘pure’’ capitalist system, the transformed Russian economy would outperform the rest. Jan Wanniski’s idea that

Russia might leapfrog the west in perfecting capitalism has proven

an idle dream. Old economic institutions and behaviors do not ordinarily disappear without a trace, and especially where the they

have continuing support from the population at large, including the

leadership.

The Gosplan has disappeared, but surveys both before and after

the collapse of the Soviet economy reveal that very substantial majorities still expect the government to provide, for example, price

stability, job security, subsidized housing, free medical care, and

free public education through college. Similarly, the majority has

repeatedly indicated a preference for public ownership of railroads,

airlines, heavy industry, communications, banks and other largescale enterprises such as the defense industries.28 In addition,

many enterprises and public institutions still operate like company

towns and have yet to rationalize employment. The Russian economist Nikolay Shmelev aptly pointed out that it had taken ‘‘three

generations’’ to build the ‘‘insane asylum’’ that was the Soviet economy and that it would take at least three more to escape from it.

To escape will require changes in both the thinking and the behavior of citizens and leaders alike.29

In the 1920s Vladimir Lenin persuaded the Bolsheviks to give up

the attempt to go directly from capitalism to socialism. The Great

War and the revolutions and civil war that ensued had left the

economy in ruins, and Lenin realized that the Bolsheviks were too

few and too inexperienced to build a new economy from scratch.

Consequently, the Bolsheviks introduced the New Economic Policy

(NEP), which permitted small-scale private enterprise both in rural

and urban areas, but reserved what Lenin called the ‘‘commanding

heights’’ to state ownership and control. The commanding heights

included heavy industry, electric power generation, transportation,

communications and banking. It was anticipated that eventually

the superiority of the socialist state sector would allow it to crowd

out the private sector. The New Economic Policy was relatively successful, and, partly for this reason, it was destroyed by Joseph StaVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00368 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.015 CRS1 PsN: CRS1
343

30 Implications for Slavic and East European Studies,’’ NewsNet, The Newsletter of the AAASS

(American Association for the Advancement of Slavic Studies), January 2001, v. 41, no. 1.

lin’s introduction of rapid industrialization and forced mass collectivization in the 1930s.

What has been developing in Russia over the last decade is not

Wanniski’s pure capitalism, but a modified version of the NEP.

Let’s call it the neo-NEP. Small business is private, but the ‘‘commanding heights’’ are mostly shared by the state and the oligarchs.

Privatization in Russia often did not break cleanly with state ownership. The state, as in the case of Gazprom for example, maintained either a controlling or a significant minority position as

shareholder. Thus, the state also has appointed members of the

boards of these enterprises and, occasionally, even the director

himself. This kind of sharing between the state and private capital

is not uncommon in Europe, and it is likely to remain a feature in

Russia for the indefinite future.

Although Russia is not now a candidate for accession to the European Union, the institutional structure of the EU can be expected

to shape Russian economic and legal institutions in substantial degree in the future. In fact, the EU is much more likely to influence

economic development and reform in Russia than are the International Monetary Fund (IMF) and World Bank, both of which are

associated with major policy failures in the transition economies.

The EU is an important trading partner and likely to become increasingly important over time, if only because Russia is such an

important source of energy supplies to Europe. Russia also trades

with East Central and East Europe, and many of the countries are

either on the path to accession or hope to be in the near future.

The EU has spelled out in chapter and verse just what a country

needs to do to harmonize its institutions with those of Europe. Russia is certain to be influenced both directly and indirectly to harmonize with Europe. This is the most optimistic outlook for the future of capitalism in Russia.30

As many observers have noted, the criteria for accession to the

EU are essential the same as the requirements for a successful

transition to a workable market economy from the Soviet-type

model. Accession indicators that are used to determine eligibility

for membership include measures of the extent of large-scale and

small-scale privatization, of success in restructuring enterprises to

harden budget constraints, rationalize production and improve corporate governance. They also seek to measure the degree to which

markets are competitive, prices have been liberalized and import

and export restrictions have been eliminated. In addition, banking

and financial institutions are evaluated against international

standards of regulation and performance. Basically, the accession

process involves modeling the transition economy upon the most

successful members of the EU.

Countries are scored on each of the eight principal indicators on

a scale ranging from ‘‘1’’ for little progress, to ‘‘4+’’ for achieving

standards and performance typical for advanced industrial economies. According to my own rough estimate, Russia’s scores today

range from a ‘‘2+,’’ for example, on large-scale privatization and

corporate governance, to a ‘‘3+’’ on price liberalization and foreign

344

trade and foreign exchange system policies, for an overall score of

‘‘3’’ or ‘‘3¥.’’ These scores would not be sufficient to earn Russia

membership, but they are indicative of the progress that has been

made in market reform since 1991. The neo-NEP model described

above as most nearly characteristic of the Russian economy today

need not hamper further progress so long as enterprises controlled

by the state singly or jointly with private interests meet governance and other requirements. The long-run outlook is, therefore,

positive if the Putin government continues to press consistently for

gradual reform and avoids foreign policy adventurism and domestic

distortions caused by corruption and an ambiguous commitment to

join the world economy as a full member.

Russia is moving haltingly, therefore, toward the ‘‘optimal regime’’ Jan Tinbergen envisioned. It will never get there, of course,

but the historical processes of marketization and pecuniarization

are back at work in Russia, after 70 years or so of regression. Russia’s economy is not going to be closed to the global economy. International trade is too profitable and memory of the failure of

autarky and central planning is too fresh for that.

It is highly likely, therefore, that Russia will become a fullfledged market economy in the European style. It does not necessarily follow that the market economy that develops will be any

more successful than many other late developing market economies, such as Brazil, Mexico or Argentina. Stop-go economic policies are the most likely policies in these countries because reform

will always run into public resistance. The adverse economic consequences of stopping reform eventually generate another round,

which, in turn, again generates public resistance. Escaping from

this circular process is Russia’s challenge in the long run, as it is

for so many countries aspiring to develop. Putin may not to be up

to the job, it is too early to tell, but a successor may do so if Russia

continues to focus on Europe as a trade partner. On the other

hand, empire envy may prevail, thereby limiting Russia’s options

in the long run as well as today.

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Restoration?’’ in The Former Soviet Union in Transition, Volume 1, Study Papers submitted to the Joint Economic Committee Congress of the United States. 103d Congress, U.S. Government Printing Office, Washington, DC: 1993, pp. 34–54.

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6, pp. 84–90.

(347)

RUSSIA’S EVOLUTION AS A PREDATORY STATE

By Peter J. Stavrakis 1

CONTENTS

Page

Summary .................................................................................................................. 347

The Predatory State: Model and Characteristics .................................................. 349

Official corruption, cronyism, and clan politics .............................................. 349

Ambiguous boundaries between key societal sectors and institutions ......... 351

Difficulty in consolidating the rule of law ...................................................... 352

Efficient informal communication networks .................................................. 353

Societal withdrawal and economic marginalization ...................................... 354

Recentralization and atrophy of regional authority ...................................... 355

Explaining Russia’s Affinity for the Predatory State ........................................... 356

Old wine in new bottles: the ‘‘recomposition’’ of traditional Russian

power .............................................................................................................. 357

Appearance matters: ‘‘presentability’’ and the image of democracy ............. 359

The legacy of imperial success ......................................................................... 361

Conclusions and Implications for the West ........................................................... 363

1Dr. Peter J. Stavrakis is in the Political Science Department of the University of Vermont.

His doctorate was from the University of Wisconsin. 2 Jeffrey Tayler presents the pessimistic view that the past decade has been the beginning of

Russia’s long—and seemingly permanent—descent from Great Power to international nonentity,

‘‘Russia Is Finished,’’ The Atlantic Monthly, May 2001.

SUMMARY

The decade since the collapse of the Soviet Union has seen the

lively debate regarding the future of Russia move from early exuberant optimism, through growing concern, to deep pessimism. Official pessimism.2 Official Western policy has avoided either extreme, but there is little doubt that America’s vision for Russia

early on reflected considerable optimism for the transition to free

market democracy. Regrettably, Russia proved to be more complex

than prevailing theories of democratization and development could

have anticipated. The end of the Yeltsin era left scholars and policymakers hopeful for Russia’s future, yet deeply concerned that

their hopes might not be fulfilled.

President Vladimir Putin has now been in office for more than

eighteen months, yet there has still been no persuasive account of

the direction in which the new president is leading Russia. This is

partly because many in the West have no persuasive, coherent

model for understanding Russia other than as an emerging liberal

democratic society. The purpose of this essay is to present an alternative framework for understanding Russia and, in so doing, provide policymakers with a model that more reliably informs them of

Russia’s future development. The central premise of the model is

straightforward: post-Soviet Russia is not destined to be a liberal,

free market democracy. Instead, a form of elite rule is being conVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00373 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.016 CRS1 PsN: CRS1
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solidated that, while principally corrupt, nevertheless retains considerable economic regenerative capacity. Understanding this

emerging political system—the predatory state—makes it possible

to recognize the motive forces driving Russia toward considerable

social stability, a primarily productive economy, and a potentially

influential role in global affairs.

This is not to deny the considerable achievements in Russian reform during its first post-Communist decade: tolerably free democratic elections, the emergence of a free press, mass privatization,

and considerable decentralization of governance, to name a few.

The worrisome thing, however, is that President Vladimir Putin

has aggressively pursued a prominent rollback of key reform

achievements, and provided clear signals that Russia will move in

directions different from those of liberal democracy: (1) prospects

for economic recovery have improved, yet capital flight remains

high and the revival of production is reliant on the vagaries of the

oil export market; (2) privatization consumed Russian reform, but

the state and a handful of economic oligarchs retain control over

core enterprises and private ownership of agricultural land remains

taboo; (3) state power is being recentralized and evidence accumulates daily that societal institutions such as a free press are being

suppressed by renascent security organs; (4) earlier images of

democratic governance have been replaced by an informal network

of clan and crony rivalry, suffused with a kind of violent politics

and corruption that harkens back to the first days of Soviet power;

and, (5) previous hopes for the emergence of a limited state have

been eclipsed by the renaissance of the strong state.

The Putin era differs from the freewheeling chaotic struggles of

the Yeltsin era—a period more akin to the populist despotisms seen

elsewhere in the developing world. Under Putin, talk of state weakness has ceased, and clan politics continues, albeit in a more regulated fashion than previously. There is in the record of the past 2

years a sense that the basic elements of liberal democracy are

being forcibly molded to suit Russian tastes and filled with a more

familiar traditional content. Putin’s policies reflect less a qualitative break with the past than a re-ordering of the ranks of privileged oligarchs and the institutionalization of the norms of political

conduct—it is a bureaucratized variant of the disorderly blend of

post-Communist populism that characterized the Yeltsin years. The

rough edges of elite conflict have been smoothed off, the state has

returned to its privileged position in society and economy, foreign

investors now mull over not whether, but when and how, to reenter the Russian market; and being from St. Petersburg or the

Federal Security Service (FSB) has gained a level of respectability

and influence that grates against the sensibilities of the Muscovite

elite. This is no democracy, to be sure, but it is unmistakably the

case that some form of order is taking shape out of the ruins of the

past decade. Russia, in Shakespeare’s words, may be madness, but

there is method to it.

The remaining sections are devoted first to an explanation of the

nature of the predatory state and illustrations of its core characteristics present in contemporary Russia. A section devoted to explaining why Russian elites prefer the predatory state to the alternative

of liberal democracy follows this. On the face of it, it is difficult to

349

3 A similar case of predatory state behavior was earlier observed in Africa: ‘‘hybrid regimes

[in which] an outward democratic form is energized by an inner authoritarian capacity, especially in the realm of economic policy.’’ Thandika Mkandawire, ‘‘Crisis Management and the

Making of ‘Choiceless’ Democracies,’’ in Joseph, Richard ed. State, Conflict and Democracy in

Africa (Boulder, Co.: Lynne Rienner, 1999). 4More detailed examples of these processes can be found in Peter Stavrakis, Shadow Politics:

The Russian State in the 21st Century (Carlisle, Pa.: U.S. Army War College, Strategic Studies

Institute, December 1998). 5 In 1999 Transparency International ranked Russia as 76th—a mere 9 places away from the

rock bottom score of 85th. This suggested a level of corruption similar to that found in Nigeria,

Indonesia, and Ukraine.

comprehend why a system interpenetrated by pervasive criminalization and corruption; weak legal and administrative institutions;

and extensive state intervention (or ownership) would be preferred

to the stability and productivity that liberal democracy promises.

The final section presents some of the implications of the predatory

state model for Russia’s future, and its relations with the West.

THE PREDATORY STATE: MODEL AND CHARACTERISTICS

Russia’s recent past and more distant future are best explained

by the model of the predatory state derived from the experience of

post-imperial and post-colonial polities. The developmental path of

these societies moves from state crisis to an equilibrium in which

authoritarian elites exploit informal networks and corrupt practices

to enhance their power and wealth at the expense of society. This

produces a pattern in which an externally strong state undergoes

a period of (often substantial) growth and influence. The economic

and social marginalization attendant to predatory practices, however, generates growing vulnerabilities that in time may return the

state to instability and crisis.3 Predatory elites sustain themselves

through the arbitrary, coercive absorption of successful autonomous

spheres of economic and social life.4 Free markets and civil society

are hostage to political elites who are free to intervene whenever

and wherever this appears financially profitable or politically useful.

A brief review of some of the main features of the predatory state

reveals its success in capturing key aspects of contemporary Russian experience.

OFFICIAL CORRUPTION, CRONYISM, AND CLAN POLITICS

Perhaps the most glaring defect of post-Soviet Russia is the pervasiveness of official corruption, which extends up to the highest

level of the political elite and is so widespread it is often assumed

to constitute an aspect of ‘‘normal’’ life. Transparency International

has consistently ranked Russia as one of the most corrupt countries

in the world, placing it firmly in the neighborhood of post-colonial

societies where predatory practices abound.5 Enormous transfers of

wealth occur within the framework of transitional societies, so

some corruption linked to the reform process is unavoidable. What

distinguishes Russia from most other states, however, is the scale

of corrupt practices and the actors involved: Russia’s ambitious privatization program was among the largest transfers of property in

history, whether measured by the number of enterprises affected,

or the potential wealth that changed hands. Still more importantly,

corruption was not restricted to a narrow segment of economic acVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00375 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.016 CRS1 PsN: CRS1
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6 Author interview with Iuri Iurievich Boldyrev, Deputy Chairman, Accounting Chamber of

the Russian Federation, January 15, 1997. Boldyrev also covers this episode in ‘‘V strane

sozdany ideal’nye usloviia dlia korruptsii,’’ Novaia ezhednevnaia gazeta, October 28, 1996, p. 1. 7 Vladimir Mau, ‘‘Rossiiskie ekonomicheskie reformy glazami zapadnykh kritikov,’’ Voprosy

ekonomiki (1999) no. 11. Mau is an economist sympathetic to the privatization policies of

Chubais and Potanin. 8 Chrystia Freeland, Sale of the Century: Russia’s Wild Ride from Communism to Capitalism

(New York: Crown Business, 2000), p. 169. 9 Boris Berezovsky affirmed this in unequivocal terms in an interview for the Financial Times, December 1, 1996.

tors, but was instead embraced by government officials—even ‘‘reformers’’—and quickly became accepted practice.

The second stage of the Russian privatization process is perhaps

the best example of the interwoven nature of corruption and cronyism in the setting of predatory practices. Following the voucher

stage of privatization (which brought its own form of graft with it),

Anatoly Chubais, former Chairman of the Russia State Property

Committee and Chief of Staff to Yeltsin, and Vladimir Potanin,

former head of Uneximbank, concocted the ‘‘loans for shares’’ privatization. A select group of seven ‘‘court’’ banks were provided controlling shares in the crown jewels of the Russian economy in exchange for loans the Russian Government needed to cover its budget deficit. This arrangement ostensibly permitted the government

immediate access to finances while preparing the ground for the

sell off of key industries that would generate still more revenue.

The scheme was blatantly corrupt, however, as the favored banks

all had intimate links to the reform government, and they subsequently purchased Russia’s richest assets at far below the market

value.6

The loans for shares scheme also demonstrated the willingness

of Russian reformers to use economic reforms to preserve their hold

on political power. The need to use the privatization process to create a critical political counterweight to clans opposed to Yeltsin has

been acknowledged recently by Russians involved in the struggle

for reform.7 The scheme had its origins as far back as 1994 and

amounted to a ‘‘crude trade of property for political support’’ 8 that

played a pivotal role in bringing into existence the financial oligarchy. Russian oligarchs such as Boris Berezovsky, Vladimir

Gusinsky, Mikhail Khodorkovsky, Peter Aven, and others returned

the favor by providing crucial financial and media support for

Yeltsin’s re-election in 1996.9

The reliance on cronies and clans at the expense of formal government capacity meant that Russian elites had to actively undermine the efforts of agencies responsible for combating corruption.

Hence, Russia was witness to numerous bizarre instances of alleged reformers attacking or debasing the very institutions and individuals they ostensibly sought to imbue with effective authority.

When, for example, Yuri Skuratov began to take seriously his position as Procurator and initiated investigations of Kremlin officials—including Yeltsin’s family—he was soon the target of

kompromat: the release by Skuratov’s opponents of compromising

documents, whose negative political impact outweighs their often

questionable legal status. The tactic succeeded, as Skuratov soon

found himself embroiled in a scandal that resulted in his removal

from office. Even out of office, Skuratov defends the validity of his

investigation, and has recently released the names of top-ranking

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10 ‘‘Former Prosecutor Fingers Top Politicians for Money Laundering,’’ Russia Today citing

Agence France Presse, August 22, 2001, http://www.europeaninternet.com/russia. Skuratov also

alleges that Russian officials sold their insider information to the West, and claims that members of the ‘‘so called Harvard Project [used] U.S. taxpayers’ money to buy GKO bonds.’’ 11More information on civil service reform is in Stavrakis, Shadow Politics. Boldyrev’s interview with the author (note 5 above) also confirmed this. 12‘‘Putin Forms Commission to Reform State Service,’’ Russia Today, August 22, 2001,

http://www.europeaninternet.com/russia. 13Details on cronyism and the creation of the economic class in Russia can be found in: Olga

Kryshtanovskaia and Stephen White, ‘‘From Power to Property: The Nomenklatura in

Postcommunist Russia,’’ in Graeme Gill, ed. Elites and Leadership In Russian Politics (London:

Macmillan, 1998); and, Olga Kryshtanovskaia, ‘‘Smert’ oligarkhii: oligarkhiia soderzhala

gosudarstvo v litse ego kliuchevykh chinovnikov,’’ Argumenty i fakty, no. 46, November 11, 1998,

p. 5. Jean Francois Bayart captures the essence of this in the African setting: ‘‘The state is the

prime (though not the only) channel of accumulation . . . Even the successful businessmen in the

informal sector are highly dependent on the state because they need constantly to circumvent

regulations and obtain official permits. It is, therefore, otiose to seek to establish a conceptual

difference between the private and public sectors.’’ Bayart, ‘‘Civil Society in Africa,’’ in Will

Continued

officials whose illegal dealings in Russian treasury bonds (GKOs)

he maintains helped trigger the 1998 financial crisis: both of

Yeltsin’s daughters, Chubais, Viktor Serov, former foreign minister

Andrei Kozyrev, and five deputy finance ministers.10

A similar fate befell the effort to form a professional civil service,

which had not existed in Russia since the October Revolution. In

an effort to assume direct control over the process, Chubais used

foreign assistance funds to construct Russia’s massive privatization

program. Russian Privatization Centers (RPCs) were created to implement the program, yet the RPCs needed to recruit personnel. A

ready pool of labor was found among government personnel loyal

to Chubais, who were secretly paid for their consulting services.

Chubais could count on finding many recruits because his government was responsible for the low wages paid civil servants. Privatization thus triumphed in Russia only by compromising the possibility of a genuine civil service.11 Putin has recently ordered the

formation of a commission, headed by Prime Minister Mikhail

Kasyanov, and charged it with developing a plan for reforming the

civil service by the end of 2001.12 It is, however, the third such effort to address civil service reform since the collapse of the Soviet

Union.

AMBIGUOUS BOUNDARIES BETWEEN KEY SOCIETAL SECTORS AND

INSTITUTIONS

In contrast to modern democracies, which place extraordinary

importance on a clear delimitation of the legal and political boundaries among institutions, predatory states eschew formal efforts to

sustain such meaningful divisions. This sacrifices considerable clarity and efficiency, but the trade off for post-imperial elites comes

in their ability to remain key players in virtually all spheres of society. An entrepreneurial class independent of state activity has

clearly emerged in Russia over the past decade, but it is overshadowed and increasingly constrained by far more powerful ‘‘entrepreneurs’’ who owe their existence to the state’s decision to vest

them with property and protection. In doing so, predatory states retain the ability to select the specific composition of the ‘‘entrepreneurial’’ class and thereby retain direct influence over the development of the market. This process has been documented in postSoviet Russia,13 but it is most vividly illustrated by the governVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00377 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.016 CRS1 PsN: CRS1
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Reno, Corruption and State Politics in Sierra Leone (Cambridge: Cambridge University Press,

1995), p. 16. 14Statement of Deputy Prime Minister Viktor Khristenko on August 6, 2001; RFE/RL Security Watch , August 13, 2001; http://www.rferl.org/securitywatch/index.html 15 ‘‘Electricity Monopoly Reform Plan Adopted,’’ Russia Watch no. 6 (June 2001), p.

2; http://www.ksg.harvard.edu/bcsia/sdi. 16Marina Volkova, Vladislav Kuzmichyov, ‘‘Ssora Grefa i Illarionova stavit vlast v situatsiiu

buridanova osla,’’ Nezavisimaia gazeta, June 20, 2001. Gref and Chubais are both from the ‘‘St.

Petersburg clan’’ that has dominated much of post-Soviet politics. 17 Vadim Volkov, ‘‘Politekonomiia nasiliia, ekonomicheskii rost i konsolidatsiia gosudarstvo,’’

Voprosy ekonomiki (1999) no. 10. 18 Coulloudon maintains that Russia’s numerous anti-corruption campaigns have had a moralistic aim, with no real effort to attack structural problems underlying corruption; ‘‘Corruption

and Governance in Russia.’’

ment’s formal policy of having top government officials sit on governing boards of the country’s major economic enterprises, such as

Unified Energy Systems (UES, the state electricity monopoly) and

Gazprom. Putin’s recent ouster of Gazprom chief Rem Vyakhirev

and replacement with Aleksei Miller was an excellent opportunity

for serious structural reform, yet the Russian Government has

maintained that even after reforms, Gazprom will retain its monopoly over gas exports.14 Similarly, the reform of UES recently approved by the government calls for the break up and privatization

of power generation but creates a state-owned monopoly to operate

the entire national grid.15 This also appears to reflect a victory of

the informal clan network over formal institutions. It is the brainchild of Economic Development Minister German Gref and largely

ignored the recommendations of the State Council in favor of a

plan that allows Anatoly Chubais to retain control over energy reform—and custody of the state-owned power grid.16

DIFFICULTY IN CONSOLIDATING THE RULE OF LAW

Given the centrality of illegal practices to sustaining elites in

power, predatory states reflect a profound weakness in consolidating effective judicial and police institutions, despite a formal commitment by elites to combat crime and corruption. In this respect,

Putin’s goal of restoring ‘‘law and order’’ carries with it a hypocritical ring present in developing economies: coherent formal institutions of coercion and control will emerge, yet they will intentionally refrain from enforcing meaningful distinctions between

public and private, legal and illegal, formal and informal.17 Western exhortation and advice to fight crime is therefore unlikely to

alter Russian elites’ preference for using coercive institutions to advantage one set of clans at the expense of others in the struggle

for control over resources.

Indeed, despite having pledged to restore legality in public life,

Putin has in actuality done little more than revive the coercive

power of the state by resuscitating security organs.18 The principal

thrust of more efficacious enforcement bureaucracies, however, has

not been on eliminating the shadow (underground) economy and

corruption in society at large. Instead, Putin has marshaled his

forces toward the goals of molding clan behavior to his satisfaction

and restraining the sphere of civil rights. This explains the simultaneous crackdown against the likes of Berezovsky and Gusinsky,

while ignoring credible claims that Prime Minister Mikhail

Kasyanov (known popularly as ‘‘2 percent Misha’’) owes most of his

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19When the author referred to Kasyanov as ‘‘7 percent Misha’’ in conversation with a senior

official at Iukos Oil Company, the official shook his head and immediately added the correction:

‘‘It was 2 percent Misha, a fact he could confirm from his own experience’’; June 26, 2000. 20The CBR in 1999 conceded that it channeled some of its reserves (some sources claim as

much as $50 billion) into FIMACO, an obscure off-shore corporation in Jersey, principally to prevent its recapture from Western creditors. Sergei Aleksashenko, former Deputy Chairman of the

CBR, admitted that the sequestering of bank funds was done to protect them from Western

creditors. FIMACO was a French corporation chartered in Jersey. It was 78 percent owned by

the Russian Government. The reform team had deftly exploited western financial practice to securely channel money to themselves—out of reach of creditors. More information on the

FIMACO affair can be found in Kommersant and well as in IMF documents. 21 Interesting in this regard was the fate of the internal phone network that in Soviet times

was accessible only to high-ranking party members. It never disappeared, but was instead appropriated by the new elite who later replaced it with a system more in tune with current fashion in technology—the predatory elite has gone high tech and cellular. 22This is especially true whenever foreign assistance funds are concerned. This is in marked

contrast to the slow and deliberate pace of Western aid agencies. The author was involved in

several such cases, where Russian organizations were able to filter information from Washington, DC, through Moscow to the regions and back again all in less than 24 hours. 23The author was present in August 1999 when one governor—clearly ‘‘in the loop,’’—used

his cell phone from his regional office to juggle successive calls to and from Anatoly Chubais

and Viktor Chernomyrdin. He later explained that Yeltsin was angered by the declaration of

a ‘‘left’’ electoral bloc by Yuri Luzhkov and Evgenii Primakov in advance of the December 1999

Duma elections, and had ordered Chubais to undertake the formation of a ‘‘right’’ bloc. Chubais

asked the governor in question to serve as mediator between Chubais and Chernomyrdin to lay

the groundwork for subsequent negotiations. An agreement proved elusive, but the speed and

means by which it was arranged was impressive.

considerable wealth to kickbacks.19 Here Russian behavior is consistent with the predatory state: strong bureaucratic structures exploiting vague and shifting boundaries between illegal and legal activity. This feature of the state allows the Russian president to exploit illegal means when useful, yet still rely on formal institutions

to implement such policies. Reformers in the Central Bank of the

Russian Federation (Central Bank of Russia or CBR) exhibited

similar skill in exploiting ambiguities in international financial

regulations to reap additional profits.20

EFFICIENT INFORMAL COMMUNICATION NETWORKS

In contrast to expectations, predatory states possess a highly efficient informal communications network, but it is one restricted to

a charmed circle. Those individuals blessed with favorable access

to the informal communication network can, whenever circumstances require it, circumvent formal bureaucratic structures to

achieve their goals.21 The speed at which communication can be

passed within Russia is often staggeringly short—and becomes

shorter still whenever the issues revolve around an opportunity to

acquire money.22 These networks were developed under Yeltsin

and remain intact under Putin; indeed, there is every reason to

maintain them, for they are remarkably efficient at relaying information in a short period of time. The common perception of Russia

as incapable of accomplishing anything is misguided: formal Russian state structures can often accomplish little, yet the capacity of

elite networks to fill in the gap remains impressive.23

The combination of efficient informal communications, weak and

malleable legal institutions, and institutional ambiguity helps explain how predatory states are successful in extracting profit. Several examples reveal how an interventionist state can move into

any promising sphere of economic activity, molding legal institutions to suit its needs. The arbitrary nature with which tax laws

were interpreted and enforced, for example, so frustrated General

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24Financial Times, 20 March 1997. 25Financial Times, 10 April 1997. 26The Independent, March 15, 1997. Another instance of expropriation of western interests

occurred when the Russian Government terminated the work of NM Rothschild in developing

a $1 billion telecommunications share offer. The government turned it over to MOST Bank and

Alfa Bank, both of which were members of the charmed ‘‘group of seven,’’ The Financial Times,

November 26, 1996, p. 1. 27Moskovskii komsomolets, 23 May 1997.

Electric that it elected to close its Moscow subsidiary.24 Similarly,

Australia’s Star Mining learned that its purchase of part of

Lenzoloto, a small gold mining business, was invalidated because

it purportedly violated privatization rules. The problem was that

‘‘the laws are so vague, the bulk of the Russian stock market could

easily be deemed to have breached these rules.’’ 25 Trans-World

Metals, a London-based metals company that has acquired a substantial portion of the Russian aluminum industry, was also caught

in the maelstrom of elite conflict. Trans-World’s sin was to acquire

its investments under the patronage of former Kremlin security

chief Alexander Korzhakov and former First Deputy Prime Minister Oleg Soskovets. Once Yeltsin fired both of these men and the

aluminum industry came under suspicion of supporting Aleksandr

Lebed, Trans World became an easy target for state agencies controlled by Chubais and Viktor Chernomyrdin. Not surprisingly,

local Russian officials soon nullified its stake in at least one major

smelter.26

Domestic actors are also fair game for the predatory state. Moscow Mayor Yuri Luzhkov succeeded in 1998 in using a modest municipal payroll tax on Moscow residents to generate a road fund of

approximately $645 million. Yet the federal parliament—evidently

with executive support—entered the picture and passed a law requiring that at least half this amount be spent on the national road

system. This effectively stripped the mayor of control over part of

the municipal budget.27

SOCIETAL WITHDRAWAL AND ECONOMIC MARGINALIZATION

Russia’s predatory proclivities have had a significant negative

impact on society. Despite having invested considerable energy in

developing an institutional framework for articulating public sentiment, Russian civil society has slid toward greater apathy in civic

life. Demonstrations marking the tenth anniversary of the failed

Soviet coup (August 19 to 21) were noteworthy only because the police outnumbered those who felt it important enough to show up on

Red Square—a pale echo of the remarkable and courageous resistance to communism a decade ago. Public sentiment appears resigned to viewing its relations to state power solely in tributary

terms: the state takes what it demands, and individuals seek to

achieve their objectives primarily by circumventing its authority.

Predictably, the most significant political parties today are the

Communists and those created at the instigation of the presidential

administration

Political withdrawal is paralleled by economic withdrawal. Since

productive activity is viewed by state elites as something that can

be either expropriated or arbitrarily taxed, producers retreat from

the legal economy to preserve autonomy. This explains the persistence and growth of the extra-legal, ‘‘informal’’ economy in postVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00380 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.016 CRS1 PsN: CRS1
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28This was the image of Russia—strikingly similar to many African societies—described by

an official in Putin’s administration; conversation with Vladimir V. Shemiakin, Advisor to the

Administration of the President of the Russian Federation, June 30, 2000.

Soviet Russia. Consolidating a stable tax regime in this environment becomes a challenge, for if a tax regime is viewed by producers merely as a means of being identified for future expropriation,

they have strong incentives to move production underground where

chances of detection are smaller.

Finally, the marked disparity between Moscow’s affluence on the

one hand, and severe economic deprivation in the rest of Russia,

is leading to the creation of a two-tiered economy in which the vast

majority of the population is economically marginalized and sees

little to no chance for improving their lives.28

It is precisely here that predatory politics sow the seeds for potential future instability, for no society can sustain itself indefinitely on the basis of an economy based principally on the material

well being of its capital city. Failure to provide the Russian public

a meaningful stake in economic life will lead to an insufficient revenue base that undermines government policy. Similarly, Russian

elites should by now appreciate the fact that a resigned or alienated population in the context of sagging economic expectations is

a combination likely to produce a serious challenge to their legitimacy.

RECENTRALIZATION AND ATROPHY OF REGIONAL AUTHORITY

Whereas Boris Yeltsin initially urged Russia’s regions to take as

much sovereignty as they could, the style and substance of President Putin’s regional policy has moved in the opposite direction.

The earlier momentum of efforts to decentralize governance in Russia has slowed significantly, as the presidential administration’s

policy initiatives have adopted a more pragmatic style, leavened

with a distinct preference for a recentralization of political authority. The disorderly parody of federalism that emerged under Yeltsin

certainly made some degree of recentralization a rational means of

restoring order. But such recentralization was also consistent with

the logic of predatory states, as it maximizes access to potential

sources of economic wealth and deprives regional politicians of the

safety of a constitutional framework. While it is true, as some commentators have noted, that Putin has yet to clearly articulate his

ultimate objective in regional policy, recent events support a disturbing trend toward the growth of central authority. In place of

the personalistic style of Yeltsin (which Putin is said to disdain),

the Russian president has organized the country’s regions into

seven administrative districts. The heads of these sit, along with

federal authorities, on the recently created State Council, whose jurisdiction remains ambiguously defined. The impact on regional influence is clearer to discern, however: the state Duma, or lower

house of parliament is increasingly marginalized, and powerful regional governors have gravitated to lobbying the State Council.

More importantly, while still a prime minister, Putin announced

his view that the various bilateral treaties concluded during the

Yeltsin era that formed the basis for regional power ought to be

scrapped. Accordingly, President Putin delegated to Tatarstan

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29 Vladimir Lysenko, ‘‘Otryzhka demokratiei,’’ Novaia gazeta July 19, 2001. 30 Even Yeltsin era elites initially committed to reform felt reforms could only be achieved

quickly. Hence, Chubais and Boris Nemtsov viewed their tenure in office as short and accordingly endorsed a ‘‘shock therapy’’ approach. Nemtsov, in particular, was fond of characterizing

himself as a ‘‘kamikaze’’ reformer.

President Mintimer Shaimiev (who is a member of the State Council) the responsibility of elaborating a clear division of powers between the federal and regional governments. But Shaimiev’s working group concluded that the central government ought to fully legalize these regional treaties and use them as the basis for a

broader regional policy. This displeased the President so he disbanded Shaimiev’s group, ignored their proposals, and appointed

Dimitrii Kozak, (member of the more loyal presidential administration) to a new working group on regional issues. This time, however, Kozak has made plain that his goal is to formally re-establish

the primacy of Moscow (the so-called ‘‘power vertical’’) in regional

affairs.29 In Putin’s Russia, the Kremlin appears likely to demand—and receive—the right to greater intrusiveness in regional

and municipal life than was envisaged in the more optimistic predictions of the previous decade.

EXPLAINING RUSSIA’S AFFINITY FOR THE PREDATORY STATE

If the preceding analysis proves more useful in making sense of

developments under President Putin, then it strengthens considerably the conclusion that Russia has deviated from progress toward

free market democracy. It is moving toward a predatory state

model that consolidates an authoritarian elite whose principal objective is in managing social contradictions to its benefit. This

raises a central question: Why have Russian elites rejected the

promise of liberal democracy in favor of a political system that embraces pre-existing inefficiencies and retains the tension between

an overly powerful central elite and marginalized society that will

surely prove the source of future discord?

Clearly, a major factor at work is the fundamentally different

way in which Russian elites view the potential payoffs of any reform. Western strategies of reform focused on how short-term obstacles and dislocations could be managed to achieve longer-term

economic transformation. But in Russia, Imperial and Communist

legacies created a predisposition to predatory practices, with the result that precious few Kremlin elites ever had the political security

to focus on long-term goals. They instead preferred to concentrate

their energies on achieving short-term gains by using familiar institutions and political styles.30 Simply put, the benefits of pursuing immediate gains through traditional means were preferred to

the potential rewards of a risky and uncertain future.

The impulse toward predatory practice can thus be broken down

into two component parts: a preference for retaining traditional political styles and values, and the consequent need to situate them

in an institutional setting acceptable to the outside world. In Russia, an additional factor proved decisive: the ineradicable memory

of success in achieving the status of Great Power as an empire

whose practices rested heavily on the political precursors of predatory rule. A brief examination of each of these factors helps explain

357

31The term was first employed by Achille Mbembe, ‘‘Democratization and Social Movements

in Africa,’’ Africa Demos 1 (1990) no. 1; Richard Joseph, ‘‘The Reconfiguration of Power in Late

Twentieth-Century Africa,’’ in Richard Joseph, ed. State, Conflict and Democracy in Africa

(Boulder, Co.: Lynne Rienner, 1999).

how Russian elites could find the rewards of predation greater than

those of a liberal democracy.

OLD WINE IN NEW BOTTLES: THE ‘‘RECOMPOSITION’’ OF TRADITIONAL

RUSSIAN POWER

The recomposition of power,31 refers to the process whereby traditional forms of state power are placed into a modern institutional

infrastructure. This results in modern state agencies operating in

distinctly traditional ways. Eurasian and African states have proven remarkably adept at this: as new political institutions replace

earlier ones, they are filled with a traditional cultural content. This

preserves the ability of elites to function as in the past (recomposition); while allowing institutions of power to acquire the external

appearance of respectability.

The reason Russian elites would prefer this outcome is clear:

their new responsibility to build a modern state and economy necessarily entails ceding large spheres of their authority and subjecting their own actions to the rule of law. But who among them could

willingly consent to this limitation of their own power? The preferred alternative is to hold on to the institutional resources of the

autocratic center. Reformers thus become seduced by the very entity they seek to eliminate, which explains why many veteran reformers of the 1990s find it impossible to leave the political arena.

The traditional weakness of society also militates against a

breakthrough to modern governance and in favor of a resurrection

of traditional authority. Imperial Russia exemplified the tragic consequences of perfecting autocratic power in advance of a free economy and national consciousness. The state simply overwhelmed

and dominated nascent civil society, depriving it of the opportunity

to develop its own independent identity. Post-Soviet experience repeated this pattern, as a small group of state elites assumed responsibility for creating the new property owning classes and decreeing the formation of political parties and social organizations.

The combination of strong state and weak society helps explain

why no political elites—reformers or otherwise— abandoned the familiar context of Russian clan rivalry in favor of establishing a limited decentralized government and genuinely free economy. Predatory behavior is linked to the political elite’s inability to see beyond

its short-term gains to the more distant rewards of reform, hence

their preference for political intrigue, a weak legal regime, and a

market with only contingent freedom. State and society drift away

from commitment to genuine reform, as a narrow clique of rulers

contents itself with augmenting the number of select clans eligible

to struggle for central power. Indeed, some scholars have argued

convincingly that the Russian reforms in January 1992 were converted into a political struggle among ruling elites as early as April

of that same year, as then prime minister Yegor Gaidar opted for

compromise with the ‘‘red-brown’’ opposition made up of ComVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00383 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.016 CRS1 PsN: CRS1
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32The most thorough treatment of this period can be found in Peter Reddaway and Dimitri

Glinski, The Tragedy of Russia’s Reforms: Market Bolshevism Against Democracy Washington,

DC: United States Institute of Peace, 2001), chap. 6 passim. 33 Vadim Radaev examines this phenomenon of the state as the largest and most influential

mafia in society; ‘‘O roli nasiliia v rossiiskikh delovykh otnosheniiakh,’’ Voprosy ekonomiki

(1998) no. 10. 34This comports with the view of Yuri Yurievich Boldyrev who, as Vice Chairman of the Russian Government’s Accounting Chamber, had extensive experience in battling corruption and efforts to enforce the rule of law, ‘‘Corruption in Russia as an Element of a System of Total Lawlessness,’’ paper delivered at the Princeton University-Central European University Joint Conference on Corruption, Budapest, Hungary, November 5, 1999 (http//:www.coc.ceu.hu). 35 Rents are those opportunities for economic gain created by the state’s restriction of the free

market. In Russia, government licenses, restrictions on free trade, state intervention in enterprise decision making, and rationing of foreign exchange, were ‘‘rent havens’’ exploited by wellconnected businessmen and bureaucrats. Russia’s second stage of privatization, by restricting

eligible recipients of state property, also fits this category. 36On this point, see: Joel Hellman, ‘‘Winners Take All: The Politics of Partial Reform in

Postcommunist Transitions,’’ World Politics 50 (1998) no. 2, pp. 203–234. This phenomenon has

far broader applicability: Roger Tangri, for example, (1999) has observed in that Uganda, Kenya,

Ghana and elsewhere in Sub-Saharan Africa, privatization programs came to focus more on the

dispensation of lucrative rents to privileged and well-connected elites than to the original goal

of getting the state out of the private sector; Tangri, Roger. The Politics of Patronage in Africa:

Parastatals, Privatization, and Private Enterprise (Trenton, NJ: Africa World Press, 1999).

munists on the one hand, and industrialists and entrepreneurs on

the other hand.32

The Soviet regime’s toleration of illegal and criminal practices in

its later years also provided an important route for the infiltration

of predatory behavior. The Kremlin must remain first among

equals, whether dealing with financial oligarchs, regional leaders

or organized criminal structures (mafias). Hence, instead of challenging the legitimacy of these actors or seeking their elimination

in favor of a more equitable order, the predatory state aspires to

be the largest economic oligarch, the most potent of all mafias, and

the most dynamic of all the regions.33 Its possession of the reins

of formal state power provides it with a decisive advantage; for the

Kremlin alone among competitors can claim the right to interact

with the outside world. Moscow thus parlays its privilege into that

of a legal entity willing to undertake illegal actions.

The rule of law in this setting is a direct challenge to autocratic

power; for it implies an institutional framework that would inhibit

the power of the elite to intervene arbitrarily in society and the

economy.34 And while rents 35 typically generate the bulk of elite

revenues at society’s expense,36 predatory states can—where profitable—evince profound interest in economic development. It is not

development they disdain; rather, it is the need for working within

a legal framework. This allows them to exploit any lucrative economic activity that emerges in the informal or criminal sector of society. Their paramount concern is to exploit this, rather than to

find a legal context within which entrepreneurial dynamism can

flourish. Ultimately, what sustains predatory rule is not some abstract fear of progress, but the toleration by ruling elites of a political style that is sufficiently familiar and rewarding in the shortterm to arrest the impetus for genuine reform. Russian elites are

not afraid of the free market; they simply find it far more profitable to tailor the market to their interests, rather than risk allowing it to determine the winners and losers in society.

359

37 It is true that many states do not possess these attributes in full. Some of these are undoubtedly admitted for the ‘‘formal’’ reasons discussed below. Another factor is that Western industrialized nations and multilateral institutions are not fully confident that potential Russian

misbehavior, unlike that of most other states, can be managed with existing institutional remedies. China also falls into this exceptional category. 38 Recent discussions of ‘‘virtuality’’ in democratic practice echo similar sentiments. See: Richard Joseph, ‘‘Democratization in Africa after 1989: Comparative and Theoretical Perspectives,’’

Comparative Politics 29 (1997) no. 3, pp. 367–368; Fareed Zakaria’s ‘‘illiberalism,’’ discusses the

similar same phenomenon, though he does not view culture as the determining factor, ‘‘The Rise

of Illiberal Democracy,’’ Foreign Affairs 76 (November/December 1997) no. 6 passim.

APPEARANCE MATTERS: ‘‘PRESENTABILITY’’ AND THE IMAGE OF

DEMOCRACY

States in the contemporary international system cannot afford either the luxury of isolation or the burden of exclusion, so it is important to understand how a predatory state survives in a

globalized world. Economic globalization presses states to demonstrate a commitment to maintaining domestic institutions ensuring some predictable measure of transparency, legality, and democratization. Without this, the foreign investment flows essential to

participation in the global economy simply cannot be guaranteed.

Yet, none of the predatory state’s internal characteristics reflect

even modest adherence to these preconditions.37 This contradiction

between the international and domestic norms is managed through

the practice of presentability, in which the formal institutions of

market democracy are paralleled by the informal embrace of practices, norms, and institutions that are animated by pre-existing political culture. This is necessitated because predatory states must

mediate between promising opportunities in an international economy they cannot control, and a domestic socio-economic environment they have structured to their advantage.38 Russia’s elites

skillfully embrace the rhetoric of democracy and the free market

while yielding little in the way of public accountability or effective

economic reforms.

Western policy has played an important—if unsuspecting—supporting role in the evolution of presentability, as key Eurasian, African and Asian states deemed by Western institutions as too important to fail are evaluated solely on the basis of formal, rather

than substantive, criteria. Democratic reform acquires a brittle

skin-deep quality, though sufficiently opaque to permit the process

of political recomposition to proceed. The end results are modern

formal institutions filled by a more familiar traditional political

substance.

The elites’ preference for presentable, as opposed to substantive,

democratic reform receives a powerful impetus from the recomposition of traditional power. Since predation is largely a function of

elite political culture and is indifferent to the architecture of formal

institutions, Russia can absorb much of the formal infrastructure

of free market democracy even as the substance and style of its politics fills these institutions with more traditional values. The new

Russia conforms neither to the West’s desired image of it, nor is

it a simple return to the past—Czars, boyars, commissars and

democrats have blended the dark arts of autocracy with the ‘‘dismal science’’ of economics and a pretense of populism, molding reform to preserve their interests.

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39See, for example, Kokh’s ‘‘Gusinsky has Made ‘Freedom’ a Bad Word,’’ Russia Watch, no.

6 (June 2001), pp. 19–20; http://www.ksg.harvard.edu/bcsia/sdi. 40Tim McDaniel, The Agony of the Russian Idea (Princeton: Princeton University Press, 1996),

p. 153. 41Mkandawire, ‘‘Crisis Management and the Making of ‘Choiceless’ Democracies.’’ Other

variants of democracies lacking a democratic essence: Igor Klyamkin and Lilia Shevtsova compare Yeltsin’s regime to an ‘‘elective monarchy,’’ Nevavisimaia gazeta, June 24, 1998; still othKey political and economic developments over the past decade

vindicate the image of Russia as a presentable society: Democratic

presidential elections were largely determined by a narrow elite

with access to state resources. In Yeltsin’s case, his initial support

by a cluster of ‘‘reformers’’ was augmented to include financial

oligarchs. Putin, by contrast, was virtually anointed by Yeltsin as

the latter’s successor, with strong endorsement from the Kremlin ‘‘family,’’ Chubais, and Putin’s allies from St. Petersburg. Political

parties are formed by presidential diktat and sustained in large

part by funds drawn from state coffers. And Putin’s appointment

to high office of his former colleagues from within the former KGB

has aided the re-entry of the secret police organs back into the fold

of Kremlin politics. Finally, the rhetoric regarding separation of

state from economy is belied by a policy in which the government

retains crucial share holdings in huge economic enterprises and

government ministers sit on governing boards of enterprises.

The recent behavior of former privatization chief Alfred Kokh

provides a vivid example of the transition from reformer devoted to

Russia’s transformation, into loyal combatant in the predatory

state. In his current incarnation as head of media relations for

Gazprom, Kokh spearheaded the successful effort to crush NTV,

Russia’s only independent television network. In barely 3 years’

time, Kokh shifted from a reformer advocating for free market democracy to a high-ranking member of the nebulously-defined Russian ‘‘private sector,’’ doing the Putin administration’s bidding by

crushing an independent voice of opposition to government policy.39

Presentability is in certain respects the key aspect of the predatory model, for it explains why Western policy toward Russia tolerated the persistence of traditional Muscovite politics. Once Western

states had resolved that only Yeltsin could implement reform, it became imperative to permit him to secure his domestic political position. Yeltsin, however, had learned his political survival tactics in

the old school; hence, if the he were to survive as president, he had

to resort to the familiar world of clan politics and not democratic

processes. The West felt obliged to accept this reality, and did so

on the condition that the leading clan reflect the interests of free

market democratic reform. Yeltsin responded by developing what

might be a textbook recipe for a ‘‘presentable’’ transition: (1) seizing

the rhetorical high ground and imposing upon all Russian elites

(excepting the Communists) the vocabulary of reform; (2) producing

sufficient substantive changes to permit the West to declare transition a success; (3) exploiting Communist ineptitude to cast them as

the perfect villain. This allowed Yeltsin to declare outright war on

the ‘‘red-brown’’ opposition while simultaneously replacing many of

his shock therapists with old-style economic managers and restoring state subsidies to enterprises.40 This is the unsettling reality

of predatory Russia, which resembles closely the ‘‘choiceless’’ democracies in Africa: 41 the domain of electoral rights are broadened

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ers, such as Terry Karl, have noted the phenomenon of ‘‘electoralism,’’ where the election procedures function, but a meaningful choice is absent. 42Western scholars have also concluded that these are the most likely outcomes for much of

the developing world. See, for example, Robert H. Jackson, Quasi-states: Sovereignty, International Relations, and the Third World (Cambridge: Cambridge University Press, 1990). The

more contentious issue, however, is whether such an outcome will prove beneficial or detrimental to socio-economic development.

with great fanfare, even as the range of meaningful policy options

presented to the public narrows to the vanishing point. The popular election of a Russian president is indeed an event unprecedented in history; but this achievement must be balanced by recognition that in 1996 and 2000, the Russian public has had the opportunity only to legitimize the candidate pre-selected by the elite.

That is why presidential elections in Russia have to date been won

only by former Communist Party bosses and operatives of the secret police.

THE LEGACY OF IMPERIAL SUCCESS

The third fundamental dimension of Russia’s evolving predatory

regime distinguishes it from all other similar systems: Russia is a

country with demonstrated success in achieving Great Power status in the 18th, 19th, and 20th centuries, and a society familiar

with the challenges of extracting extraordinary results from dysfunctional institutions. It is precisely for this reason that the thrust

of this analysis is not about inherent Russian weakness but about

the challenges of managing the consequences of Russia’s restoration, and preparing for the next contraction that signifies yet another turn in the wheel of Russian history. The focal point is Russia’s adaptive response to its historical crises, which has allowed it

to develop a polity distinct from Western models, and to achieve a

substantial measure of international power and prestige.

Whether as Czarist or Soviet regime, Russia acquired extensive

experience in the global competition for power. The belief is widespread in Russia that power is a key element in maintaining a

state’s—especially a Great Power’s—independence in the international system. The alternatives to this, Russians fear, are to be

penetrated by other states or become the objects of territorial aggrandizement.42 Russia has vivid memories of both and its ruling

elites will find it intolerable to again be at the mercy of other powers—a view that is increasingly articulated by oligarchs, bureaucrats, Putin himself, and even democratic reformers. The dictates

of the International Monetary Fund grate against Russian sensibilities and Russia has the potential to be far less accepting of the

constraints imposed by international assistance than many other

societies. NATO’s military intervention in the Balkans further reinforces the desire of Russian elites to position themselves out of the

grasp of Western institutions they see as either depriving them of

sovereignty or limiting their freedom of maneuver. The festering

Russian offensive in Chechnya was made presentable to the West

by Putin’s exploitation of the vocabulary of Western politics—as

well as its fear of Islamic fundamentalism—arguing that Russian

actions follow the NATO precedent and seek the objective of destroying alleged Chechen/Islamic terrorists.

The globalization of capital and investment flows is another factor complicating the predicament of predatory states, and with

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which Russia must contend. Increasingly, economic processes challenge sovereignty without resort to territorial expansion, and the

price to pay for entry into a globalized world is greater transparency and predictability in the legal and economic environment.

Many other states grappled with this reality for decades while Russia remained insulated behind the walls of communism. Russian

elites therefore had to contend with a second shock in addition to

the loss of empire: economic progress threatened a loss of control

over domestic life. This sense of vulnerability and the new requirements and resources for competition in the state system may prove

precisely the factors capable of persuading Russian elites to become

more than rentier capitalists. Global rivalry may eventually compel

Russia’s rulers to focus on raising productivity in order to restore

the institutions (i.e., the military) that can return Russia to the

concert of Great Powers. But this still cannot ensure the transformation of Russia into a law-governed state. Indeed, the elites’ evidenced skill in using the illicit side of the global economy suggests this may be their preferred means for exploiting opportunities

there.

Another factor with a distinctive impact on Russia concerns still

unresolved questions of national identity. Russia was the center of

a multinational empire that denied the existence of constituent nations. Recent imperial memory lingers in the Russian consciousness, interacting with memories of power lost. To the extent that

the Soviet mythic legacy continues to dominate Russian popular

thinking, elites will find fertile soil in the public mood for building

a Russian state that restores a substantial measure of the influence it wielded in previous eras. Even if not expansionist in content, such a conception retains the close link between identity and

state power. National self-definition, with prodding from political

elites, could reinforce popular resentment arising from the loss of

sovereignty and serve as an important element to revive national

power.

Russia also possesses a human and natural resource base that

defies comparison with the any other predatory system. Even with

its environment and population threatened, the enormous investment in education and training in the natural sciences by the Soviet regime has left a skilled workforce that can be harnessed

quickly. Unlike post-colonial societies that tend to bristle with

economists and political scientists, Russia can marshal millions of

trained engineers, physicists, chemists and other professions essential to catalyzing a post-Soviet economic transition. Russia’s

present malaise, moreover, should not ignore the reality of a substantial nuclear stockpile and residual military power. Even a modest improvement in Russia’s economic fortune could allow these

military resources to have a profound impact on international security.

Finally, there is the unavoidable reality that Russia simply possesses too much potential for mischief to be left to the whim of

entropic forces. Hence, the dialogue between the Putin government,

international financial institutions, and Western governments will

remain important. But the concessions already made to Russia’s

predatory pathway mean that it will seek only the necessary mix

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43Some of these points are amplified in an Occasional Paper prepared by the author for The

Atlantic Council of the United States: ‘‘After the Fall: U.S.-Russian Relations in the Next Stage

of Post-Soviet History,’’ December 1998.

suade the West that it is in transition to a reassuring destination.

If the past decade is any guide, Russia will certainly attempt to

achieve what it desires while making the West feel good about

what it is.

CONCLUSIONS AND IMPLICATIONS FOR THE WEST

Viewing Russia as a predatory state carries important implications for expectations of its domestic development, as well as for

multilateral and bilateral efforts to engage Russia in international

affairs. Russian-American relations will be far more complex than

the recent or even Communist past.43 The United States has in the

past dealt with dysfunctional developmental regimes as well as

Great Powers, but the coincidence of the two in one state is rare,

if not unique. The following points are therefore intended to project

into the future some of the main lines of development of a predatory Russia, with some of its implications for international politics.

(1) Russia is not destined for development as a free market democracy, nor is it likely to remain an irresponsible power.—The

predatory model suggests that Russian elites will succeed in integrating a state-economic elite that responsibly exercises power in

pursuit of its own interests, often at the expense of society. Such

a system will undergo considerable development and restoration of

power, but the burdens associated with sustaining it militate

against permanent stability.

(2) The consolidation of the predatory Russian state does not exclude the development of capitalism.—On the contrary, some form

of capitalism is inevitable. It will, however, be heavily textured by

an interventionist state and the constraint of civil liberties.

(3) Successful foreign investment in Russia will require the ability to establish and maintain constructive relations with influential

clans.—Russian elites will be keen to encourage investment, but

the low value placed upon a coherent and enforceable legal framework for commercial activity implies that personal and political factors will be the critical determinants of which foreigners gain access to lucrative Russian markets. Moreover, Russian elite motivations will spring from a desire to enrich themselves and their allied

clans, rather than for budgetary revenues. Hence, so long as Putin

remains president, those Russians linked to him and his entourage

will receive favorable treatment, while those outside this group become targets for expropriation and political pressure. In all likelihood, the Putin government will maintain the practice of the

Yeltsin era by offsetting prohibitive or inhospitable formal conditions for investment with informal guarantees that circumvent all

obstacles. Foreign investors may well succeed in Russia, but they

will have to operate in fluctuating political conditions, and place

greater reliance on personal rather than institutional guarantees.

(4) The true test of Russia’s potential over the long-term rests on

the character of the leader or leaders who succeed Putin.—This is

most likely to occur sometime after 2010. The historic pattern of

Russia’s development has been a cycle that moved through a ‘‘time

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of troubles,’’ then to state consolidation, and finally, power projection. If the past is any guide, the next stage in Russia’s cyclical development requires a leader with more dynamism than Putin has

exhibited. Russia thus awaits its leader—or vozhd—who blends his

personal authority with the resources of state (which include an

economy with deep organic links to the government elite) to undertake the great task of mobilization that has always been necessary

to produce a quantum change in Russian societal development.

(5) Given his role as a stabilizer rather than a mobilizer, Putin’s

policies—foreign and domestic—will likely be temporizing, focused

on providing the time and space needed for restoration and positioning of Russia for greater future influence in foreign affairs.— Putin and Russia will seek to avoid costly engagements abroad in

preference for consolidating a network of relations that expand its

influence. It presents little immediate direct threat to the United

States or the West.

(6) The potential for Russia’s return to a consequential global

role rests heavily on the qualities of its next leader(s).—If the predatory model holds, Putin’s successors will be vetted by the political

elite and legitimized through popular elections. They will not, as

was once hoped, be individuals who worked their way up from the

lower ranks of democratic society to the upper echelons of power.

(7) A decentralized federalism is not in Russia’s future.—While

it is doubtful that Russia can return to the level of centralization

of Soviet rule, there is little chance that the center will consent to

surrendering large spheres of its authority to regional competitors.

This is one of the most complex aspects of Russia’s future, for it

requires the articulation of a novel form of government—neither

federal nor wholly central—for which there is no precedent.

(8) Corruption, cronyism, and a vast informal economy will be integral building blocks of future predatory Russian society.—The opportunity for the West to radically transform the dynamics of the

informal economy has passed. Privatization resulted in the transformation of political elites into economic elites who now claim

their place at the table of Kremlin power. Their reliance on extralegal measures to attain that status and the future benefits they

can expect to derive from corrupt practices militate against serious

reform. But predatory practice has demonstrated that, given the

proper political conditions, substantial efficient and productive activity remains possible.

(9) The economic and social costs associated with Russia’s development as a predatory state will still leave it vulnerable to periods

of instability.—The predatory project is attractive because of the

short term gains it provides elites; but the long-run economic and

social costs are undeniably high: excessively high barriers to entry

to the elite, enormous expenditure of resources to maintain crony

networks, maintenance of extensive oversight over the economy,

and marginalization of society. These factors echo many of the

same problems present at the end of Soviet power: tightening resource constraints, a diminishing pool of skilled elites, low workplace morale and productivity, and an unwillingness to cede political control for the sake of economic gains. The failure of predatory

elites to address basic social problems and consolidate the foundations of a free market economy may lead to an accumulation of

365

problems that overwhelm self-interested elites. Historically, Russia

has relied on strong leadership to avoid such crises. But the collapse of Romanov autocracy and the implosion of the Soviet Union

are clear reminders that Russia’s institutional structures tend to be

too rigid and inflexible to survive crises on their own. In essence,

Russian elites are more adept at surviving socio-economic crises

than avoiding them. The challenge of dealing with Russia in the future will therefore be more complex than the already daunting task

of dealing with a socio-political order that rejects the basic essence

of liberal democracy; it will also require engaging a society that, despite recapturing significant global influence, retains internal tensions that may undermine stability.

(367)

RUSSIA’S ECONOMIC FUTURE AND U.S.

INTERESTS

(369)

U.S. BILATERAL ASSISTANCE TO RUSSIA, 1992–

2001

By Curt Tarnoff 1

CONTENTS

Page

Summary .................................................................................................................. 369

A Decade of Assistance ............................................................................................ 370

Security programs ............................................................................................ 370

Weapons destruction and dismantlement ............................................... 371

Control and protection of nuclear material ............................................. 371

Demilitarization ......................................................................................... 371

Humanitarian programs .................................................................................. 371

Stability programs ............................................................................................ 371

Economic reform ........................................................................................ 372

Democratic reform ..................................................................................... 372

Social and environmental reform ............................................................. 373

Criticism and Achievements ................................................................................... 373

Criticism ............................................................................................................ 374

Too little, too late ...................................................................................... 374

Too much, too early ................................................................................... 375

Too American ............................................................................................. 375

To the wrong Russians .............................................................................. 376

The wrong strategy ................................................................................... 376

Achievements .................................................................................................... 377

Security program achievements ............................................................... 377

Humanitarian program achievements ..................................................... 377

Stability program achievements .............................................................. 377

The Russia Program Today ..................................................................................... 380

Prospects for the Future ......................................................................................... 383

1 Curt Tarnoff is a Specialist in Foreign Affairs in the Foreign Affairs, Defense and Trade Division of the Congressional Research Service. 2For a discussion of multilateral aid, see the paper ‘‘Russia and the International Financial

Institutions: From Crisis to a Normal Country’’ by Jonathan E. Sanford.

SUMMARY

For nearly 10 years, the United States has supported programs

of bilateral and multilateral assistance to Russia. Although policymakers always anticipated that multilateral assistance through the

World Bank and International Monetary Fund (IMF) would compose the bulk of global efforts to assist Russia, throughout this period the United States has maintained a program of bilateral assistance that more directly and immediately reflects U.S. interests

and priorities. While smaller than the multilateral effort, as a

grant, not loan, program, bilateral assistance can be employed in

a wider range of situations than multilateral aid.2

The U.S. bilateral program has had three overarching and related aims—security, stability, and humanitarian. The United States

has sought to achieve security, both U.S. and Russian, by promotVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00395 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.017 CRS1 PsN: CRS1
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3 Another $908 million was expected to be allocated for Russia programs in 2001.

4The United States also provided loan and other guarantees to support roughly $6 billion in

the face value of U.S. goods and investments to meet trade objectives. As these mostly benefited

U.S. exporters and investors, they are not discussed here.

ing nuclear and chemical weapons non-proliferation activities. It

has sought stability—Russian and world stability—by supporting a

range of programs to create a democratic and economically prosperous Russia that would, as a result, be a cooperative member of

the international community. Its humanitarian programs, like

those elsewhere in the world, transcend specific U.S. strategic and

other interests in Russia—they are a reflection of traditional American values.

As might be evident from the current state of Russia’s economy,

society, politics, and military, the numerous and diverse projects

that were developed in order to achieve these aims have had a

mixed record. Over time, as a consequence of failures, successes,

lessons learned, financial constraints, and program restrictions and

conditions, the aid program today is substantially different in size

and scope than it was early on. How it will change over the next

decade is unclear. But in determining where the program is to go

in the future, it may be helpful to know where the program has

been.

A DECADE OF ASSISTANCE

Through September 2000, about $8.8 billion in grant assistance

has been budgeted for programs in Russia.3 Roughly 37 percent of

these funds have been targeted at security objectives, 32 percent at

humanitarian goals, and 31 percent, at stability objectives (see Figure 1).4

FIGURE 1.—OBJECTIVES OF U.S. ASSISTANCE TO RUSSIA: 1992–2000

SECURITY PROGRAMS

Of the roughly $3.3 billion intended for security purposes, most

has come from the Department of Defense appropriations, largely


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371

authorized under the so-called Nunn-Lugar Cooperative Threat Reduction (CTR) Program first approved by Congress in November

1991. Related programs are also funded and implemented by the

Department of Energy and Department of State. The bulk of security programs are intended to lessen the potential threat to the

United States posed by Russian nuclear weapons, material, and expertise vulnerable to sale, theft, or hire by terrorists or rogue nations. There are several key components of these efforts.

Weapons destruction and dismantlement

The CTR program has helped Russia meet START I Treaty limits by facilitating the elimination of delivery vehicles for nuclear

weapons, including SS–18 missile silos and heavy bombers, and

supporting destruction of its chemical weapons stockpile.

Control and protection of nuclear material

The United States has provided design and construction assistance for a storage facility for fissile material from dismantled nuclear warheads, along with the containers for the transport of warheads and storage of materials. It has sought to enhance the security of warheads and materials during transport, storage, and at

research facilities by such measures as providing super-containers,

inventory control systems, sensors, and personnel reliability methodologies. Customs officials have received training and radiation

detectors have been provided in order to thwart illegal export of

fissile materials.

Demilitarization

U.S. assistance has supported the conversion of Soviet defense

industries into commercial, non-military, enterprises. Several programs aim to employ Soviet weapons scientists in peaceful civilian

research.

HUMANITARIAN PROGRAMS

Since 1992, the U.S. Government has provided Russia with $2.8

billion in humanitarian assistance. Almost all of it has been food

aid, delivered under the P.L. 480 Food for Peace, Section 416(b),

and the Food for Progress programs carried out by the Department

of Agriculture. In some cases, food was given to private voluntary

organizations for distribution to the needy. In other cases, commodities were sold and their proceeds were used to support development objectives—such as the cooperative credit system, child vaccination programs, and the Russian Pension Fund. The U.S. Government has also provided transport costs for medical and other

aid donated by the private sector, and has contributed to international organizations working in Chechnya.

STABILITY PROGRAMS

Programs aimed at creating a stable and peaceful Russia by facilitating its transition from authoritarian communism to a free

market democracy receive particular attention from Congress and

the public. During the past 10 years, $2.7 billion, mostly funded

under the foreign operations appropriations and authorized under

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5 A fourth, miscellaneous, catch-all group, composes 5 percent of stability efforts. These mostly

include funds for the Peace Corps and USAID training programs—cross-cutting activities that

benefited all three stability objectives.

the FREEDOM Support Act has gone to such efforts. Projects designed to meet these objectives have been numerous and diverse.

The breadth of purpose and sectors they cover, many of which overlap, make it difficult to categorize them. They might be put into

three broad baskets.5

Economic reform

More than half (54 percent—about $1.5 billion) appear to have

as their primary objective the economic restructuring of Russia and

development of a strong private sector economy (see Figure 2).

Among the projects that sought to meet this need were efforts to

encourage reform of tax, banking, fiscal, energy, housing, and privatization policies. U.S. funds have been made available for equity

investments in small and medium business, and loans to small and

micro-business. Technical advice has been provided to farmers and

businesses, as well as opportunities to gain experience in U.S.

firms. Various efforts have been made to encourage U.S. trade and

investment in Russia.

FIGURE 2.—U.S. ASSISTANCE FOR RUSSIAN STABILITY: 1992–2000

Democratic reform

By the narrowest definition, only 8 percent of stability efforts in

Russia were directly geared toward the development of democratic

institutions and practices. These would include projects providing

advice to staff of political parties and political election commissions, encouraging the growth of civil society through offering advice and funding to non-governmental advocacy organizations, promoting the rule of law through provision of judicial training programs and expertise on a civil code, and crime and anti-corruption

programs. Democracy programs, more broadly defined, also have

included a wide range of U.S. exchange programs and small grants

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6The former category might include Stephen F. Cohen, Failed Crusade: America and the

Tragedy of Post-Communist Russia, W.W. Norton, NY, 2000. More hopeful views are expressed

by Anders Aslund, ‘‘Underselling Russia’s Economy,’’ New York Times, January 18, 2000, and

Michael McFaul, ‘‘Getting Russia Right,’’ Foreign Policy, Winter 1999–2000.

tated economic reform objectives, but whose effect, through exposure to U.S. institutions or development of indigenous civil society,

has been helpful to democratic development. Just under one-fourth

of stability programs fit into this broader definition.

Social and environmental reform

Social and environmental reform activities account for about 17

percent of stability efforts. Programs to improve the social welfare

and environmental conditions of the Russian public, while meeting

humanitarian concerns, were largely intended to bolster the key

U.S. objectives of economic and democratic reform. Experts have

argued that the Russian public would be more likely to support

these objectives if they experienced fewer negative consequences as

a result of reform efforts. Unenforced environmental standards by

the Communist regime and the end of a cradle-to-grave social system has fostered a dramatic health and environmental crisis in

Russia. Health programs supported by U.S. assistance have sought

to reform health care delivery and financing systems, and they

have targeted specific diseases such as HIV/AIDS and tuberculosis.

U.S. hospitals have provided equipment and expertise to partner

hospitals in Russia. Family planning assistance has been provided

as an alternative to the common practice of abortion. Russian orphanages have been assisted.

Environmental programs have provided small grants to innovative indigenous projects and replication of ‘‘best practices,’’ and

have supported use of the Internet and e-mail to strengthen communication between environmental groups spread throughout Russia. They have supported forest management reform and reforestation, and pilot demonstration anti-pollution and energy efficiency

projects. To avoid a Chernobyl-like scenario, the Department of Energy and the Nuclear Regulatory commission have provided training and equipment to improve the safety of Soviet-designed power

plants.

CRITICISM AND ACHIEVEMENTS

When the FREEDOM Support Act was introduced in 1992, government officials tried to sell the program as a relatively shortterm effort, lasting until fiscal year 1998. However, even then,

many realized that the transition to democracy and free markets

might take a generation or more, depending on the sincerity and

rapidity with which political leaders adopted the basic framework

and laws of a new polity and economy. At the present time, Russia

remains an unfinished work with analysts ranging from doubtful

to hopeful in their views of its future course.6 Views of the U.S. assistance program follow the same trajectory. Both optimistic and

pessimistic perspectives have helped shape the current program

and can provide lessons for its future.

In any case, the role of the aid program in Russia’s progression

to what it is today and to what some expect it to become is hard

to define. Even in countries such as South Korea or Costa Rica

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7 In addition to these substantive, policy-related, critiques, observers have raised concerns regarding the administration of projects, such as the inadequacy of management, ineffectiveness

of implementation, and possible malfeasance of individuals employed in projects. Some have opposed aid to Russia entirely, arguing that funds would be better spent on programs in the

United States. Among more recent critiques are: ‘‘Food Aid to Russia: The Fallacies of U.S. Policy,’’ Mark Kramer, Harvard University, October 1999; An Agenda for Renewal: U.S.-Russian

Relations, Carnegie Endowment for International Peace, December 2000; Collision and Collusion: The Strange Case of Western Aid to Eastern Europe 1989–1998, Janine R. Wedel, New

York, 1998; International Efforts to Aid Russia’s Transition Have Had Mixed Results, GAO, November 2000; Russia’s Road to Corruption: How the Clinton Administration Exported Government Instead of Free Enterprise and Failed the Russian People, Speaker’s Advisory Group on

Russia, House of Representatives, September 2000.

where the aid programs were proportionately large and their political and economic development highly successful, making a connection between the U.S. programs there and specific consequences is

obscured by the numerous variables that come into play. The results of some programs are more easily measured than others, such

as numbers of children vaccinated, which logically means lesser incidence of disease, or elimination of missile launchers, which directly leads to the conclusion that U.S. security is enhanced. The

immediate returns on most programs are often straightforward

such as numbers of micro-loans provided or people trained in business management. How the trainees or loan recipients ultimately

contributed to the broader objective of creating a market economy,

however, is less transparent. If the objective is concrete, the program budget ‘‘sufficient,’’ activities narrowly focused on the goal,

and the recipient environment cooperative, as was more often the

case with security and humanitarian programs in Russia, the results may be more transparent. Stability programs had few of these

features and only the short-term results appear ‘‘measurable.’’ Further, U.S. stability assistance was never expected to be the primary

determinant of a successful Russian transition. Its impact could

only be at the margins. Such considerations should be kept in mind

when judging the impact of U.S. assistance programs in Russia.

CRITICISM

From the time it was launched, critiques of the aid program have

emerged with regularity. Some attacks, many hyperbolic, had ulterior motives—those linking the aid program to Vice President Gore

as the 2000 election approached or the snipes at aid implementors

made by some unsuccessful applicants for funds. But criticism

came also from knowledgeable individuals who sought a more effective outcome. The range of criticism can be summarized as follows: 7

Too little, too late

Efforts to assist the democratic and economic transition in Russia have often been criticized as offering too little funding, too late.

Early on, the George H. Bush Administration was criticized for reacting too cautiously to the dramatic changes taking place in the

Soviet Union in 1991. CTR security initiatives came entirely from

Congress. Although some small stability-related programs were

proposed by the Administration, it was not until the April 1992 announcement of the FREEDOM Support Act, following critical comments from national figures such as former President Nixon, that

a concentrated effort was made to offer U.S. aid and organize supVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00400 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.017 CRS1 PsN: CRS1
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8 A GAO report criticized the DOE Initiatives for Proliferation Prevention program for providing only one third of its funds to Russian institutes for employment of scientists. But most security assistance, in the form of U.S. equipment such as containers, and humanitarian aid—U.S.

commodities—were items requested by the Russian Government. On the other hand, stability

aid was mostly U.S. technical advisers and equipment, key exceptions being monetary grants

to grassroots organizations, equity investments in private sector firms, and grants provided for

on-lending to small and micro-business. The Russian Government had little to do with how stability funds were spent.

port from international donors. To those expecting a new Marshall

Plan in response to what appeared then to be a short window of

opportunity for adoption of revolutionary but painful reforms, the

U.S. contribution was considered paltry and half-hearted, and the

bulk of offered international assistance, loans from the IMF and

World Bank, were not appealing to a country reluctant to add to

its debt.

A year later, the Clinton Administration proposed a significant

increase in U.S. assistance—roughly $1.5 billion. Following this

one-time infusion of aid, annual levels appropriated for Russia

quickly declined, settling below $200 million. Throughout the decade, critics continued to remark on the disparity between the supposed importance of Russia to U.S. interests and the level of funding for efforts to effect change there. Although Russia received a

greater proportion of available funding for the region, neighboring

nations, such as Armenia and Georgia, with significantly smaller

populations consistently ranked higher than Russia on a per capita

basis.

Too much, too early

Some would argue that a major reason for failed projects and

wasted resources in the early years was the impetus to spend before there was a serious prospect of success in certain sectors. Economic reform legislation was developed with U.S. assistance while

a Communist dominated parliament promised to thwart each

measure. Assistance was offered to develop farming before land

was privatized. And foreign investment was encouraged before rule

of law safeguards were in place to protect investors.

Too American

However much the United States claimed to provide to Russia,

the fact is that much of the focus was self-serving, and many of the

funds never left American hands.8 Moreover, many critics complained that Americans with specific knowledge of Russia were

underutilized in the formulation and implementation of assistance

programs. Stability programs designed and run by non-expert

Americans were accused of displaying little cultural sensitivity and

providing advice that was inappropriate. Few Russian staff members were hired to compensate for American ignorance of local matters. This critique was mostly aimed at the large for-profit contractors which focused on government policy reform work and dominated the aid program in the early years. Critics also argued that

inadequate funds were provided to the relatively smaller NGOs

which worked with the Russian grassroots and were more responsive to local realities and needs. As a result, U.S. assistance created a degree of public resentment, critics would argue, instead of

the anticipated good will.

376

To the wrong Russians

Both the George H. Bush and Clinton Administrations argued

that aid should follow reform. However, some argued that, partly

due to the lack of Russia expertise or a misguided effort to support

the Yeltsin government, aid was provided to individuals or groups

that were not reformist. In particular, critics pointed to U.S. support for Anatoly Chubais’ program of privatization, which they

argue exacerbated income divisions and helped foster the so-called

oligarchs. Policymakers, according to critics, blindly provided support to individuals like Yeltsin, despite his inconsistent support for

economic reform and democracy, rather than to democratic ‘‘institutions.’’ When a substantial amount of food aid was provided in

1993, many suggested that proceeds were channeled through corrupt officials who may have used them illegitimately. Others argued that congressional directives funneling funds to specific regions insured ineffective programs by assisting non-reformers.

The wrong strategy

Some critics disagreed with the mix of programs that were funded by the United States. They argued, for example, that stability

programs emphasized economic reform efforts while leaving democracy programs underfunded. Stronger democratic institutions, they

suggested, would have led to more economic reform. Other critics

argued that too much assistance was provided to programs in Moscow and not enough to the regions. Others contended that too much

went to the reform of Russian Government policies and not enough

to grassroots activities and the private sector.

Some CTR critics argued that funding the destruction of chemical weapons was less important than elimination of nuclear weapons; others that more funds should have gone to insuring the security of materials used to produce weapons. Some questioned the

wisdom of defense conversion programs, arguing they subsidized

the Russian defense industry and had no effect on current production capacity. Others suggested that funding weapons dismantlement while Russia continued to modernize its systems simply subsidized modernization. Critics of food aid argued that sale of the

commodities lowered local food prices and harmed Russian farmers,

especially the new independent farmers some aid programs were

trying to encourage.

There are many possible responses to the numerous and disparate criticism made during the past 10 years: It could be said that,

no matter the amount of funds available, little could be done without a strong commitment on the part of the Russian Government

to support the few Russian reformers who emerged in positions of

power. While, there may have been American experts on Russia

who knew more than Kremlinology, few of these had experience in

running assistance programs, and no one had expertise on the

transformation from communism to democratic capitalism. Everyone had a formula for how funds could best be spent. Each donor

had different priorities and did not channel funds into a coherent

program for maximum leverage. Congressional directives caused

dispersal of limited U.S. funds on too numerous objectives.

377

9 A Report Card on the Department of Energy’s Nonproliferation Programs with Russia, January 10, 2000, Russia Task Force, Secretary of Energy Advisory Board, page 1.

ACHIEVEMENTS

In taking aim at individual aspects of the aid program—the privatization effort, corrupt food aid, insufficient support for democratization, etc.—critics often promoted the impression that the whole

aid program was in dispute. While there was much in the critiques

that rang true, there were also many things that could be said to

be right with the program, positive accomplishments, some of

which have been noted by the critics themselves.

Security program achievements

A January 2001 report by the Russia Task Force co-chaired by

former Senate Majority Leader Howard Baker and former White

House counsel Lloyd Cutler found that ‘‘current nonproliferation

programs in the Department of Energy, the Department of Defense, and related agencies have achieved impressive results thus

far . . .’’.9 Among these are elimination of 336 SLBM launchers, 369

ICBM silos, 83 strategic bombers, 422 ICBMs, and 19 SSBNs. Secure storage of fissile materials has been enhanced by delivery of

32,000 containers and by assistance in construction of a storage

center. The stockpile of nuclear weapons is more secure due to upgrades in inventory and security systems. Interdiction capabilities

have been enhanced by providing border crossings with radiation

detection equipment and guards with training. The employment of

thousands of scientists may have helped prevent a brain drain of

sensitive expertise in weapons of mass destruction and to some extent has re-directed it toward peaceful, commercial enterprises.

Humanitarian program achievements

The aid program has provided large quantities of food assistance

to Russia, 1 million metric tons in fiscal year 2000 alone. It has

also provided transport costs to deliver more than $628 million in

privately donated food, medical and other supplies, and contributed

to international organization work in the North Caucasus region.

While some of the food deliveries may not have been necessary,

tens of thousands of displaced persons, children, pensioners, and

other needy individuals received food and pensioners received financial aid from the proceeds of food sales they may otherwise not

have received.

Stability program achievements

While no one will argue that Russia has become a full fledged

western democracy and free market economy, it has changed radically since the end of the Communist era (and continues to evolve

in directions we can only surmise). Tens of thousands of private

businesses now exist, political parties and grassroots advocacy organizations proliferate, travel abroad is unrestricted, an open exchange of information, including the Internet and a free press

exist. Stability programs did not create this situation, but they nurtured it, and, to some facets of the new order, the contribution was

arguably significant. Stability programs sought to affect many discrete aspects of Russian life, but perhaps their greatest cumulative

378

10Work carried out for USAID by Georgia State University. Final Report Evaluation of the

Impact of Technical Assistance on Russia’s Fiscal Reform and the Identification of Possible Future Work, Carana Corporation, March 21, 2000, p. 49. Advice on tax administration and enforcement was also provided by Department of Treasury-appointed advisers in the Ministry of

Finance. 11Work carried out for USAID by Urban Institute. Evaluation Report: The Russian Housing

Sector Reform Project Phases I and II, Carana Corporation, November 1999, p. 4. 12 Evaluation Report: The Russian Housing Sector, p. 28–33. 13Results Review and Resource Request: USAID/Russia, April 2000, p. 14. 14 Implemented by the Department of Commerce, Department of Agriculture, and Library of

Congress, respectively. The vast majority of exchange programs (serving more than 32,000 Russians since 1992) are conducted by the Department of State’s Bureau for Education and Cultural

Affairs; USAID has brought over 9,000 Russians to the United States for project-related training.

impact in the long-term may have been the introduction, dissemination, and practice of new ideas.

Exposure to new ideas.—A large number of assistance projects

sought to change Russia by exposing its government and citizens

to new ideas.

• Policy reform.—U.S. technical experts have provided advice to

national and local governments on legal and administrative reforms in a wide range of sectors. While many reforms have yet

to be implemented, these efforts have introduced officials to

procedures and law in other countries and may influence future reform developments. A program to assist fiscal reform,

for example, provided the Ministries of Finance and Taxation,

the Budget Committee of the State Duma, the regional administrations of six Oblasts, and the municipal administrations of

Novgorod and Tver with analytical models for forecasting the

effects of tax policy. The program also trained a team of Russian specialists in these skills.10 Housing reform project staff

reportedly contributed views on 160 national laws and decrees

and directly drafted 37 legislative acts.11

• Mortgage finance.—Housing reform specialists introduced the

practice of residential mortgage lending to Russia by drafting

a legislative framework for this activity, writing the industry’s ‘‘how-to’’ handbook, and offering technical assistance to banks.

By 1998, 47 banks were making mortgage loans.12

• International accounting standards.—U.S. experts promoted

the use of international accounting standards to Russian business in order to make it easier to attract investors and qualify

for loans and to promote transparency. In 1999 alone, 3,670

were trained.13

• Direct exposure to the United States.—Since 1992, more than

47,500 Russians were brought to the United States for both

targeted education and training and broader familiarization

with U.S. culture and institutions. For example, the SABIT

program provided experience working in a U.S. business (131

in 2000), the Cochran program experience in agriculturerelated concerns (50 in 2000), and the productivity enhancement program management-training internships (425 in 2000).

The Russian leadership program brought promising leaders for

short visits, including home-stays, at the grassroots level

(1,605 in 2000).14

• Person-to-person exposure.—Several programs brought American volunteers to Russia, emphasizing personal contact with

Americans as much as provision of ‘‘know-how’’ at a grassroots

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15The Internet Access and Training Program is carried out by Project Harmony for the Department of State. 16Work carried out for USAID by International Research and Exchange Board (IREX), ISAR,

and others. USAID Results Review, p. 28. 17Work carried out for USAID by Internews and others.

level. During their 2 year term of service, Peace Corps volunteers (100 in 2000) taught English and business skills. The

Farmer-to-Farmer (150 in 2000), Financial Service Volunteer

Corps, International Executive Service Corps, and others provided the technical skills of practicing and retired farmers and

businessmen to their counterparts in Russia on a one-to-one,

short-term basis.

• Advice and training for business.—Emerging businesses and

their employees received both general and specialized training

in business skills as well as targeted, individualized advice.

Many of the volunteer programs noted above were aimed at

providing experts to individual business clients to help solve

specific problems, such as how to improve production or marketing. Nearly 1 million Russian school children were introduced to concepts of capitalist economics through Junior

Achievement programs.

Creating vehicles for dissemination of ideas.—Many aid projects

sought to increase the capabilities of organizations that traditionally act as agents of change and disseminators of new ideas.

• Internet networking.—In the first years of the assistance program, aid was provided to the Initiative for Social Action and

Renewal in Eurasia (ISAR), an organization which facilitated

the sharing of ideas and strengthened the solidarity of environmental NGOs in part by establishing an e-mail network system

linking them. Support for Internet access and training at more

than 50 sites throughout Russia has been provided to alumni

of U.S.-sponsored exchanges in order to build contacts among

them and reinforce positive experiences gained while in the

United States.15

• Think tanks.—To continue the policy reform work provided by

U.S. experts, USAID supported the creation and strengthening

of indigenous Russian think tanks whose expertise—often

former Russian associates of U.S. technical experts—could be

drawn upon by national and regional governments. For example, the Institute for Economies in Transition, run by Yegor

Gaidar, received grants for tax, budget, land code, and other

policy studies and providing advice to the government. The

Moscow School of Political Studies trained young leaders in

democratic principles.

• Developing civic organizations.—The United States has aided

the development of institutions, such as NGOs, political parties, and trade unions, that advocate new ideas and are essential to a healthy civic society. U.S. assistance helped 5,000

NGOs in 1999 through 48 Russian NGO resource centers.16

• Independent media.—U.S. aid has provided training and technical assistance to television and print media. During the 1998

economic crisis, grants were provided to help independent television stations survive despite a drop in advertising revenue.17

380

18Service centers work implemented for USAID by Citizens Democracy Corps, Agricultural

Cooperative Development International and Volunteers in Overseas Cooperative Assistance

(ACDI/VOCA), and others; Morozov schools by the Russian Academy for Management and Market. 19Work carried out by the U.S.-Russia Investment Fund. The U.S.-Russia Investment Fund

also made more than $30 million in equity investments in more than 30 promising Russian

small and medium businesses. The results, however, are not demonstrably positive at this time. 20Work implemented for USAID by the Eurasia Foundation and the Institute for Sustainable

Communities, respectively.

• Developing business support organizations.—Assistance programs provided support to 33 business service centers to provide consulting and other services to small and medium business, and fostered development of business educational training through support to 59 business schools.18

Putting ideas into practice.—Through grants, lending programs

and other means, U.S. assistance has helped individual businesses

and civic organizations apply the new entrepreneurial and democratic concepts often learned through training and technical assistance.

• Loans and guarantees.—The United States provided funds to

Russian institutions for on-lending to micro-, small-, and

medium-sized businesses. USAID programs alone disbursed

more than 7,100 micro-loans between 1995 and 1999. U.S.

guarantees on bank loans promoted introduction of consumer

finance activities in Russia. A U.S. assistance program provided guarantees on loans to enable Russian banks to make

their first residential mortgage and auto loans.19

• Grants.—Several programs provided competitive grants to

NGOs to enable them to conduct programs contributing to reform at the grassroots level. Since 1993, a U.S. funded foundation has provided more than 2,000 grants worth over $50 million to NGOs, local governments, independent media, and private businesses seeking demonstrable positive results in the

fields of enterprise development, public administration, and

civil society. Another program awarded funds (87 grants in

1999, most in the $30,000 range) to replicate successful environmental practices.20

THE RUSSIA PROGRAM TODAY

The U.S. assistance program of today is substantially different

from that of its initial several years. Lessons learned as a result

of failure and achievement, of criticisms and congressional review

during the first years set in motion an evolving re-evaluation of

programs and redistribution of resources. In many cases, programs

were revised internally even before outside criticisms were made.

By fiscal year 2000, the most recent year for which data is available, the program’s broad profile had shifted dramatically (see Figure 3). First, program priorities appeared to have changed. Whereas a 10 year profile showed a near balance between spending on

security, stability and humanitarian concerns, by fiscal year 2000,

there was an overwhelming emphasis on the security objective,

while the stability effort declined significantly. This relationship is

real as well as proportionate. Security funding increased in absolute terms over the period and even began to be drawn from the

381

chief pool of resources available for stability funding, the NIS account appropriations. Meanwhile, stability funding, as suggested by

NIS account levels, was cut (see Table 1). Cuts came partly due to

the perception that the program was slow in meeting its economic

and political reform objectives. They also reflect broad cuts in foreign aid following the accession of a budget-trimming Republican

Congress (that have been reversed since 1999). Moreover, cuts were

made specifically for Russia programs in response to concerns regarding Russian Government behavior abroad and at home.

FIGURE 3.—OBJECTIVES OF U.S. ASSISTANCE TO RUSSIA

[Fiscal year 2000]

TABLE 1.—U.S. ASSISTANCE TO RUSSIA FROM NIS ACCOUNT

[Dollars in millions]

Fiscal year Administration

request

Allocation after

appropriation

1992–1993 .......................................................................

1994 ..................................................................................

1995 ..................................................................................

1996 ..................................................................................

1997 ..................................................................................

1998 ..................................................................................

1999 ..................................................................................

2000 ..................................................................................

2001 ..................................................................................

2002 ..................................................................................

(1)

(1)

$379.4

260.0

173.0

241.5

225.4

295.0

161.9

167.0

$350.0

1,300.0

344.2

137.0

94.8

133.2

161.2

186.6

167.8

—

1 Prior to fiscal year 1995, the administration did not break down its NIS account request by country.


76171.040
382

21Within the security program, percentages devoted to weapons dismantlement, material control, and demilitarization changed little during the period.

Bearing the brunt of budget cuts and criticisms, the composition

of the stability program changed far more sharply during the decade than did the humanitarian or security programs.21 Perhaps the

most striking feature has been a shift in emphasis from economic

reform to democratic reform. For the whole period, economic reform

received 54 percent of stability funds; but in fiscal year 2000, it received only 31 percent (see figure 4). Democratic reform efforts, on

the other hand, were supported with 24 percent of overall funds,

but in fiscal year 2000 received 47 percent. To be sure, the emphasis seems to be on exchanges rather than institution-building, but

even the narrowly defined democracy programs now represent 13

percent of stability efforts versus 8 percent during the whole period. The greater priority now given broad democracy activities reflects the lack of progress in economic reform until recently, past

criticism that not enough attention was being paid to democracybuilding and person-to-person contacts, and cuts in assistance to

the central government of Russia which was the recipient of much

economic reform aid. The cuts were the result of congressionally

imposed conditions that subjected half of aid to the central government in fiscal year 1998 and later years to the requirement of a

presidential determination that Russia had terminated sales or

transfer of nuclear reactor technology to Iran.

FIGURE 4.—U.S. ASSISTANCE FOR RUSSIAN STABILITY, 2000

By 2000, the make-up of the stability program had changed in

a number of other important ways. Extrapolating from the experience of USAID, which accounted for roughly half of stability program activity, very little assistance was still being directed toward

helping the central government of Russia. Although the central

government was the key target of the large number of policy reform efforts undertaken in the 1993–1995 period—in fiscal year

1996, the first year for which data is available, accounting for 17

percent of USAID’s program—by 2000, central government-related

projects accounted for only 7 percent. The proportion is likely


76171.039
383

22 An Administration review of non-proliferation programs in 2001 proposed no significant

change to Department of Defense CTR programs.

smaller today. Support for private sector activities rose correspondingly, from 68 percent of the fiscal year 1996 program to more than

82 percent in fiscal year 1999.

There is also some evidence that, compared with its early years,

the assistance program now has more activities in the regions than

in Moscow and Petersburg (80 percent in the regions in fiscal year

2000), more funds directed toward NGOs (75 percent in fiscal year

2000), and more Russian nationals involved as both implementors

and staff. Many of these changes were featured in the Clinton Administration’s Partnership for Freedom initiative, which was introduced in 1997 largely in response to the criticisms noted above and

in an effort to recover congressional support. A Regional Investment Initiative was introduced at the same time, concentrating aid

on three (now four) regional sites in a bid to attract foreign investment and increase program effectiveness. The two initiatives promised to alter the presiding aid strategy toward Russia, and, in this,

appear to have succeeded.

PROSPECTS FOR THE FUTURE

Ten years after the assistance program was launched, the time

may be ripe for an assessment (and, in the case of stability assistance, a reassessment) of the strategies designed to make each aid

objective achievable. A review of the broader issue of what should

be the objectives of the U.S. aid program in Russia may also be in

order.

While the stability program may now have met the main criticisms of the early to mid-1990s—and scrutiny of individual projects

under this program must continue in order to enhance its effectiveness—it is not clear whether the program adequately meets

present or future needs. This question is put into sharper focus in

2001, as the Russian Government at last appears serious in its

support for economic reform legislation. Some argue that constraints on U.S. support for economic policy reform—restrictions on

aid to the central government and limited availability of funds—

may mean a lost opportunity for a critical U.S. contribution on this

issue. In view of recent threats to freedom of expression in Russia,

the U.S. program’s growing attention to democratic reform would

appear to merit continued, if not strengthened, U.S. support, but

constraints on funding levels and program flexibility may limit U.S.

efforts here as well.

Questions have also been raised regarding the availability of

funding for security programs. The Bush Administration submitted

an fiscal year 2002 request for Energy Department non-proliferation activities—control and protection of nuclear materials and demilitarization programs that fund alternative employment for scientists—that represented a 12 percent decrease from fiscal year

2001 allocations.22 With some observers arguing for significant increases in non-proliferation assistance to Russia—the Baker-Cutler

report called for spending $30 billion over the next 8 to 10 years,

and the September 11 attacks generated heightened nuclear proliferation concerns—Congress restored some, but not all, of the

384

funding, leaving an 8 percent cut. Efforts by one member to redirect $130 million to non-proliferation programs did not meet with

success, but indicated that there is likely to be further discussion

in the coming year on how security programs have met and will

continue to meet critical U.S. interests.

In fact, there is dispute over whether relative proportions of

funding going to stability, security, and humanitarian objectives

appropriately represent current and future U.S. interests. Until

now, policymakers have dealt with stability and security objectives

mostly through different funding spigots and rarely considered the

U.S. effort in Russia as a whole piece. But some analysts would

argue that there can be no sure security for the United States regarding Russia’s weapons of mass destruction unless that country

is a more democratic and economically stable society. All three objectives, according to this view, are intimately intertwined.

The United States continues to hold a very strong interest in

Russia and the outcome of events there. Whatever the accomplishments of the past 10 years, U.S. assistance may continue to play

a role in those events. Whether that role should be expanded—and,

if so, how—is likely to challenge policymakers in the future.

(385)

ARMS EXPORTS AND RUSSIA’S DEFENSE

INDUSTRIES: ISSUES FOR THE U.S. CONGRESS

By Kevin P. O’Prey 1

CONTENTS

Page

Summary .................................................................................................................. 385

The State of Russian Arms Exports ....................................................................... 387

Making money .................................................................................................. 389

Russia’s markets ............................................................................................... 390

The China market ..................................................................................... 391

Cooperation with India ............................................................................. 392

The Iran relationship ................................................................................ 393

Understanding Russia’s Success ............................................................................. 394

The Russian appeal .......................................................................................... 394

Constraints on further Russian success ......................................................... 395

The Rationale for Russian Exports ........................................................................ 397

Excess capacity ................................................................................................. 398

State policy ........................................................................................................ 401

Graft .................................................................................................................. 404

Impact on the Russian Defense Sector .................................................................. 404

Issues for Congress .................................................................................................. 408

The virtual certainty of continued aggressive promotion of arms exports

by Russia ....................................................................................................... 408

The limited effects that export success will have on Russian defense

industrial advancement ................................................................................ 409

The negative impact that these exports will have in terms of greater

proliferation of high technology weapons systems to potential U.S. competitors ........................................................................................................... 409

1Dr. Kevin P. O’Prey is Executive Vice President of DFI International’s Government Practice,

a Washington, DC-based research and analysis firm. The analysis presented here is based on

work he has conducted at DFI International, at the Brookings Institution, and for his doctoral

dissertation for the Massachusetts Institute of Technology. The author would like to thank Ms.

Agnes Lee, Mr. Erik Teleen, and Mr. Graig Saloom for their research assistance and Dr. Eugene

Rumer for providing comments on a previous draft.

SUMMARY

In recent years, Russia has experienced a significant improvement in its arms export performance. During the year 2000, Russia

signed deals making it the world’s second leading supplier of armaments. Moreover, in contrast to Soviet experience, the Russian

Government and defense enterprises actually are making money off

of these commercial deals.

The implications for U.S. national security and the Congress are

several. First, regardless of the state of U.S.-Russia relations, the

United States will have little leverage to overcome Moscow’s very

significant incentives to export as many weapons as possible to

whoever will pay for them. Second, export success will do little to

improve the current poor state of Russia’s military and defense inVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00411 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.018 CRS1 PsN: CRS1
386

dustries. While export revenues have certainly improved the financial health of some Russian defense enterprises, overall they are

not likely to help Russia to develop and produce new, technologically competitive weapon systems. Third and perhaps most important for the United States, Russia’s aggressive approach to arms

exporting will almost certainly contribute to the proliferation of

high technology weapon systems to countries that are potential

U.S. competitors—China and Iran being the most significant cases

in point.

What is the current state of Russian conventional arms sales

abroad and what are Russia’s near-term prospects? What does the

answer mean for Russia’s defense industrial sector, for the proliferation of high technology weapons, and, by extension, for U.S.

national security? In recent years, Russia’s state organs and defense enterprises have improved Russia’s performance as an arms

exporter. This paper examines Russia’s recent success, the factors

that explain it, as well as their broader implications for Russia and

the West.

While Russia’s arms sales successes have had a positive impact

on the financial health its defense sector, their effects have been

decidedly limited in scope. Only about seven to ten of Russia’s approximately 1,600 defense enterprises appear to have benefited significantly from arms sales. Moreover, even for these fortunate few,

arms export achievement has not translated into success in overcoming the many structural challenges to the development of profitable firms in the Russian defense sector. At most, arms export

success appears to have helped a few design bureaus undertake

modest research and development (R&D) initiatives and a few production facilities to maintain a manufacture that, by historical Soviet standards, is modest. Translating this R&D and low manufacturing rate into the production of new, technologically competitive

weapon systems, however, seems exceedingly difficult.

Overall, the infrastructure of the Russian defense sector appears

to be remarkably immutable. Despite a decade of economic privation and repeated attempts to reform or downsize the defense industries, few, if any, defense enterprises have formally gone bankrupt. Rather than shut their doors, many plants continue to operate at minimal production levels. While managerial changes have

occurred in many plants, organizational restructuring has been

very limited.

Against this backdrop, there is a broad consensus among Russian

decisionmakers—in government and industry—on the need to export arms. From the government’s perspective, the value of arms

export ranges from diverting the attention abroad of potential

subsidy-seeking enterprises; sustaining key components of a defense industrial base it can no longer afford; reducing the per unit

costs of defense production; as well as obtaining hard currency revenues for state and, in some cases, personal coffers. For industry,

exports represent the potential to restart or maintain modest production levels; to pay worker salaries; to invest in some new

projects; and to profit on a personal level.

The implications for the U.S. Congress are several. First, the motivations for continued aggressive Russian efforts in the global

arms export arena are profound and, probably, enduring. The

387

2 Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000,

(Washington, DC: Congressional Research Service, August 16, 2001), Figure 1, p. CRS–21.

By November 2001, Rosoboroneksport was predicting export revenues on the order of $4 billion

for 2001. If historical trends hold, that would put the overall revenue Figure for Russian arms

exports at approximately $5 billion. See ‘‘In Brief: Arms Sales Near $4 Bln,’’ Moscow Times, November 16, 2001, p. 6. 3These figures are in constant calendar year 2000 dollars. The data are from Richard F.

Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000, Table 8A, CRS–72.

United States possesses few instruments to discourage Russian efforts in this arena. Moreover, post-9/11 improvements in U.S.-

Russian security relations are not likely to change Moscow’s export

behavior. Second, Russia’s increased arms export success seems unlikely to have much of an impact on Russia’s defense industrial capabilities. While export revenues improve the financial position of

some enterprises, export success appears fundamentally only to

delay inevitable restructuring. Third, Russia’s export efforts will

increase the proliferation of advanced conventional systems to

countries that might pose a threat to U.S. forces—China and Iran

being the most important examples.

THE STATE OF RUSSIAN ARMS EXPORTS

Like the Russian economy more broadly, the Russian defense industries have turned a corner in the last 2 years. After hitting bottom in terms of economic performance, some Russian defense enterprises appear to be showing signs of modest levels of activities.

While a spike in procurement orders due to the war in Chechnya

provided an initial boost, the real basis for this improved state of

affairs has been arms export success. During calendar year 2000,

Russia succeeded in signing arms sales agreements worth approximately $7.7 billion. As Figure 1 demonstrates, this represents an

improvement over 1999 results by nearly 90 percent and a remarkable 270 percent increase over the 1998 figure. According to unofficial estimates, Russia’s performance for calendar year 2001 would

be comparable.2 After a decade of efforts by the government and

defense industries, Russian export promotion is finally paying off.

Part of Russia’s export success can be attributed to a global increase in the level of the arms trade. After bottoming out at $24.3

billion in 1997, the level of worldwide arms transfer agreements increased steadily to $36.9 billion in 2000.3

Yet Russia’s 2000 success also reflects a trend of increasing market share relative to its non-U.S. competitors in the global arms

trade. Although the United States continues to hold the dominant

position in the market—50 percent of year 2000 arms transfer

agreements—Russia has laid claim to a strong second place with

nearly 21 percent of the 2000 value (See Figure 2). Figure 2 also

demonstrates that, with the exception of 1998, when it signed

agreements worth only $2.6 billion, Russia has occupied either second or third place among global arms exporters since 1995.

The lion’s share of Russia’s recent success can be attributed to

Asia. As Figure 3 depicts, during the 1997–2000 period, the Asian

market accounted for over three-fourths of Russia’s export agreements with the developing world. The lucrative Middle East market, meanwhile, accounted for a 16 percent share of Russia’s agreements. Africa accounted for just over 6 percent.

388

FIGURE 1.—RUSSIAN ARMS TRANSFER AGREEMENTS WITH THE WORLD, 1993–2000

Source: Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000, 2001.

FIGURE 2.—ARMS TRANSFER AGREEMENTS WITH THE WORLD, BY SUPPLIER, 1996–

2000

Source: Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000, 2001.

Even within the Asian market, Russia’s success is highly concentrated to two customers: China and India. Recent Chinese acquisitions include over 20 Su–30MKK and 8 Su–27UBK fighter aircraft; a Kilo-class submarine; 13 Tor M1 surface to air missiles;

and 2 Sovremenny class destroyers. Some reports project China as

potentially accounting for between 30 and 50 percent of Russia’s

arms exports over the next decade. In terms of India, over the


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4 Interfax interview with Konstantin Makienko, ‘‘Military-Technical Cooperation between Russia and China, 17 July 2001, reprinted on www.cast.ru/english/database1.html?article=102. 5See Kevin P. O’Prey, The Arms Export Challenge: Cooperative Approaches to Export Management and Conversion, (Washington, DC: Brookings Institution, 1995), p. 75 and Pavel

Fel’gengauer, ‘‘Rezkoye sokrashcheniye eksporta otechestvennogo: oruzhiya vpervyye obyavleny

ofitsial’nyye tsifry voyenno tekhnicheskogo sotrudnichestva za 1991 god,’’ (Sharp Reduction in

Exports of Our Weapons: The First Releases of Official Figures of Military-Technical Cooperation for 1991), Nezavisimaya Gazeta, September 29, 1992, pp. 1–2.

2000–2001 period, New Delhi signed deals for the purchase or licensed co-production of over 130 Su–30MKI fighter aircraft; 310 T–

90 tanks; and a Kilo submarine.4

FIGURE 3.—RUSSIAN REGIONAL ARMS TRANSFER AGREEMENTS, 1997–2000

Source: Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000, 2001.

MAKING MONEY

Perhaps more important than the overall value of agreements, in

contrast to the Soviet era and the experience of the early 1990s,

Russia appears to be earning hard currency from its recent arms

sale successes. During the 1980s, arms export ‘‘success’’ on the

order of $20 billion a year was tempered by the fact that the

U.S.S.R. typically received hard currency payment for only onethird of its arms exports.5 The situation did not improve markedly

in the early 1990s, as Rosvooruzheniye, the Russian arms export

agency, reportedly negotiated deals that often involved payments in

kind, debt swaps, or ‘‘soft’’ currency, such as Indian rupees. For example, in a deal that sent MiG–29s to Malaysia, Moscow agreed to

accept one-fourth of the payment in the form of palm oil. In another case, the director of the Krasnoye Sormovo shipyard complained that half of China’s payment for two diesel submarines was


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6See Sergey Mashtakov, ‘‘MiG i v Malayzii. Kto eshche kupit nashi istrebiteli?’’ (MiG also in

Malaysia. Who Else Will Buy Our Fighters?’’ Rossiyskaya Gazeta, September 7, 1994, p. 3; Pavel

Fel’gengauer, ‘‘Torgovlya oruzhiyem ne tak vygodnaya Rossiy, kak utverzhdayet

Rosvooruzheniye,’’ [The Arms Trade Is Not As Beneficial to Russia as Rosvooruzheniye Asserts]

Segodnya, March 10, 1995, p. 2; and Unidentified Correspondent, ‘‘Shibayev, Deputy Chairman

of the Committee for Foreign Economic Relations: If Everyone Were Allowed to Sell Arms, the

Unjustified Competition Would Lead to a Fall in Prices,’’ Komsomolskaya Pravda, February 25,

1992, p. 1, translated in Foreign Broadcast Information Service (FBIS) SOV 92–039, pp. 31–32. 7There are no data available for hard currency returns of enterprises operating independently

of Rosvooruzheniye/Rosoboroneksport.

made up of jogging shoes and women’s sandals, all of which reportedly disintegrated within a month of delivery.6

As Figure 4 demonstrates, the situation turned for the better in

1997 and has been improving ever since. According to

Rosoboroneksport, its predecessor as the official Russian arms export agency took in hard currency for approximately 90 percent of

its sales in 1999 and 2000.7

FIGURE 4.—ROSVOORUZHENIYE’S ARMS EXPORTS AND CURRENCY RETURNS, 1995–

2000

Source: Novichkov, Nikolai. ‘‘Russia Exports $3.6B of Arms in 2000, Sees Strong Growth.’’ Jane’s Defence

Weekly, 2001.

RUSSIA’S MARKETS

Although some of Russia’s client relationships appear only to be

curiosities of the international arms market—e.g., purchases by

North Atlantic Treaty Organization (NATO) member Greece and by

the United Arab Emirates, which can afford to maintain relationships with multiple suppliers—the broader picture is more worrisome. From the U.S. perspective, most importantly, the principal

markets for Russian conventional arms sales are some of those

countries that have been the most vocal opponents of America’s

leadership role around the globe. Although commercial sales do not

suggest an anti-U.S. alliance, in some cases, they could pose

threats either through technology transfer or the direct enhancement of military capabilities that might be used against the United


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8Kevin O’Prey, ‘‘Analytical Report of Trip Findings,’’ Unpublished Report for DFI International, December 21, 1999, p. B–3. 9Kevin O’Prey, DFI Trip Report, p. B–3. 10Kevin O’Prey, DFI Trip Report, p. B–2.

States or our allies. The remainder of this section addresses Russia’s most noteworthy partners.

The China market

Beijing clearly ranks as Russia’s most important client for armaments. Although Russia and the People’s Republic of China have

had an on-again, off-again relationship in terms of militarytechnical cooperation throughout China’s Communist period, ties

between the two strengthened considerably during the 1990s. During this period, Russia’s defense complex has come to look on the

China market as essential for its survival. In a series of 1999 interviews with a range of officials from the Russian Government and

defense industries, virtually all respondents strongly defended

arms sales to China as critical sources of revenue for Russian enterprises and design establishments. As one interviewee put it,

Russian defense industrialists may find cooperation with China to

be ‘‘degrading’’ as they would prefer to work with Western hightech partners. However, financially speaking, they find that they

have few options.8

Apparently, only the Russian General Staff had expressed any

objections to military technical cooperation with China. Reportedly,

some General Staff officials argue that in 10 to 15 years, the Chinese military threat could return based on a foundation of transferred Russian technology. Yet these arguments do not carry the

day as Kremlin decisionmaking is more focused on near-term financial and domestic political considerations.9

The full extent of Russian-Chinese cooperation is difficult to determine through open sources. According to one observer, one of the

conditions that Beijing demands for its cooperation with Russia is

absolute secrecy regarding its agreements. Reportedly, the Chinese

Government explicitly threatens to terminate any deals that are

leaked to the public. The Russian Government and enterprise managers evidently view the relationship as important or valuable

enough to comply with these conditions. As a consequence, despite

a general tendency to advertise arms sales success and to discuss

defense industry issues in public, virtually no commentators—official or unofficial—will touch this subject in any but the most general terms, either publicly or privately.10

The only restraint on the China relationship currently appears to

be the product of Moscow’s concern about Chinese reverse engineering of Russian technologies. Historically, China has sought to

use arms imports as a means of technology—rather than hardware—acquisition. In an often-cited example, Chinese industry evidently reverse engineered MiG–21s purchased from the Soviet

Union as the basis for its J7 fighter aircraft development. As a consequence, the Russian Government evidently bars transfer of its

highest technology items to Beijing. In fact, according to one

source, Russia permits India greater access to high technology than

392

11For example, according to one observer, cooperation over the Su–27 program has been constrained by Russian refusal to share advanced hot zone technology for the Lyulka engine. See

Kevin O’Prey, DFI Trip Report, p. B–4. 12 Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000, p.

CRS–8. 13See e.g., Interfax interview with Konstantin Makienko, ‘‘Military-Technical Cooperation between Russia and China,’’ 17 July 2001, reprinted on www.cast.ru/english/database1.

html?article=102. 14 Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000,

(Washington, DC: Congressional Research Service, August 16, 2001), p. 8. 15See Lyuba Pronina, ‘‘Fired Up About Arms,’’ The Moscow Times, September 24, 2001.

it does to China, a fact that has proved to be a continuing sore spot

for Beijing.11

Last, although technology acquisition is still a priority for Beijing, recent agreements suggest that the trend for the Chinese Government currently is in the direction of purchase of foreign systems, rather than the development of indigenous capabilities. This

development might be due to Beijing’s perceived need to build up

its military forces rapidly to match its foreign policy priorities, or

its recognition that its experience with reverse engineering has not

been particularly effective, or some combination of the two factors.

Since the mid-1990s, Chinese deals with Russia have included:

• The purchase of more than 72 Sukhoy 27 fighter aircraft; • The purchase of 4 Kilo class attack submarines; • Co-production of 200 Su–27 aircraft; • 2 Sovremenny-class destroyers and their associated missile

systems; • The purchase of 40 to 60 Su–30MKK fighter aircraft; and • An agreement to purchase at least 4 upgraded A–50E Mainstay airborne early warning aircraft.12

Of particular concern to U.S. national security, many of these capabilities reportedly are being acquired to improve Chinese forces

for a Taiwan Straits scenario.13

Cooperation with India

Long a client of the Soviet Union, New Delhi has continued a robust relationship with the Russian defense industries. In late 2000,

Russia concluded a licensed production agreement with India valued in excess of $3 billion for 140 Su–30MKI combat aircraft. It

also concluded an agreement for the sale to India of 310 T–90C

main battle tanks for about $700 million, and an agreement to retrofit and deliver the Admiral Gorshkov aircraft carrier for over

$650 million.14

In contrast to recent developments with China, New Delhi appears to view its relationship with Russia as a source not just for

armaments, but also for technology to support India’s growing defense sector. For example, India has a long history of co-production

agreements with Soviet and then Russian defense industries. The

trend continues as New Delhi’s recent purchase of 124 T–90 tanks

was exceeded in quantity by the 186 additional T–90s for which

India purchased production licenses.15

Despite the recent improvements in U.S.-India ties, New Delhi’s

military-technical cooperation with Moscow appears to be both robust and likely to persist. For one, as noted below, with a force

compromised primarily of Soviet and Russian weaponry, it would

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16On the Indian arsenal, see The Military Balance, 1999–2000, (London: The International Institute for Strategic Studies), pp. 161–163 and Rahul Bedi, ‘‘India’s T–90 Tank Deal with Russia

Runs Into Difficulty,’’ The Asian Age, December 1, 2000, pp. 1–2. 17 Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000, p.

CRS–8. 18 Illicit transfer of ballistic missile technology and broader nuclear cooperation were notable

exceptions to the rule. 19David A. Fulghum, ‘‘Iran Specifies New Weapons Mix,’’ Aviation Week and Space Technology, March 26, 2001, p. 32. 20David A Fulghum, ‘‘Iran Specifies New Weapons Mix,’’ p. 32. 21 Chris Stephen, ‘‘U.S. Anger as Putin Seals Arms Deal with ‘Rogue’ Iran,’’ The Scotsman,

March 13, 2001, p. 13. 22See Nikolai Novichkov and Vladimir Shvaryov, Vremya MN, October 3, 2001; and Agence

France Presse, October 4, 2001, via Lexis Nexis. 23The total value of that deal was reportedly $150 million. See Vedomosti, November 1, 2001,

reprinted in The Russian Business Monitor, November 2, 2001.

be extremely expensive for New Delhi to further diversify into

NATO-standard equipment.16 Second, Russian weapons are affordable, and Moscow has demonstrated a willingness to supply India

with its most advanced technology.

The Iran relationship

In the past year, Moscow has renewed its cooperation with

Tehran in the conventional military arena. Immediately after the

fall of the Soviet Union, Iran was a major purchaser of Russian

weapons. Among the Russian items acquired by Iran were MiG–29

fighter aircraft, Su–24 fighter-bombers, T–72 submarines, and Kiloclass attack submarines.17 Under pressure from the United States,

Russia largely suspended conventional cooperation with Iran

throughout the 1990s.18 However, as a result of the decline in U.S.-

Russia relations, increased economic pressure at home, or both, in

2000 Moscow notified the United States that it would resume its

arms cooperation with Tehran. True to its word, Russia signed

agreements in December 2000 to provide Tehran with air defense

systems (the S–300 and Tor–M1) and Kamov–50 helicopters.19 According to one Russian source, Tehran acquired the advanced air

defense systems to defend the Bushehr reactor complex.20

Subsequently, during a March 2001 visit to Moscow, Iranian

President Mohammad Khatami presented a more robust wish list

to Russian officials. Among the items Khatami sought were:

• Tanks; • Patrol boats; • The Shkval and other torpedoes;

• Upgrades to its MiG and Sukhoy fighters;

• Yakhont anti-ship missiles.21

In a much heralded October 2001 visit, Iranian Defense Minister

Ali Shamkhami signed a military-technical cooperation agreement

worth up to $300 million annually. Although the agreement constitutes only a framework, press reports described Shamkhami as

negotiating to purchase Inconder long range supersonic missiles,

Yakhont anti-ship missiles, surface-to-air missiles, and stealthy patrol boats.22 Earlier in the summer, Iran had signed contracts with

Rosoboroneksport for 30 Mi–8 cargo helicopters.23

Tehran’s wishes aside, there are a number of reasons to expect

some limits on m Moscow’s future dealings with the Iranians. Most

significantly, Tehran’s wishes certainly exceed its current means.

Regardless of the common cause that Moscow and Tehran have

394

24Marina Koroleva, interview with Ruslan Pukhov, Director of the Centre of Analysis of Strategies and Technologies (CAST), and Konstantin Makienko, Deputy Director of CAST, during

Ekho Moskvy Radio program, 1408 GMT, January 17, 2001, translated in FBIS, January 17,

2001, Document ID: CEP 20010117000369. 25 Vitaliy Shlykov, ‘‘The Potemkin Complex: A Government Program Cannot Solve the VPK’s

Problems,’’ Itogi, April 10, 2001, translated in FBIS, April 9, 2001, Document ID: CEP

200110409000302. 26 Clifford Gaddy and Barry Ickes, ‘‘Russia’s Virtual Economy,’’ Foreign Affairs, vol. 77, no.

5. 27 John A. Battilega, David R. Beachley, Daniel C. Beck, Robert L. Driver, and Bruce Jackson,

Transformation in Global Defense Markets and Industries: Implications for the Future, National

found in fighting Islamic extremists in Central Asia, Iran is a financially strapped state. Moreover, Russia has commercial interests mitigating against a strong relationship with Tehran. In particular, Moscow recognizes the transfer of advanced capabilities to

Iran will potentially alienate the Gulf states, who, both individually and collectively, represent substantially more market potential than Iran.24

UNDERSTANDING RUSSIA’S SUCCESS

Russia’s recent success can be attributed to a broad range of factors, ranging from the appeal of Russian weapons on the global

market, to the need for defense plants to find any resource of revenues in the absence of state orders, to the government’s desire either to divert the attention of needy defense enterprises or to find

international funding for its priority initiatives. Also, for some officials in industry and government, arms exports are personally enriching. Despite recent growth in the economy, it is impossible to

overstate the value of hard currency in Russia.

THE RUSSIAN APPEAL

On the demand side of the equation, Russian armaments are

very attractive commodities in some markets. One of the most important factors behind this appeal is the affordability of Russian

weapons. Because Russia’s defense enterprises are still the beneficiaries of a range of implicit subsidies, Russian weapons typically

are the product of negative net value or value subtraction in production: the inputs to the typical weapon system are worth more

on the world market than the final product itself.25 These subsidies

are generally not the product of a defense promoting strategy on

the part of the Russian Government. Rather, they are a by-product

of what economists Clifford Gaddy and Barry Ickes termed the ‘‘virtual economy.’’ 26 In short, because Russian enterprises do not pay

market prices, key factors of production such as energy are exchanged at prices well below international market rates. Furthermore, because barter persists among enterprises, much of the real

value of economic transactions goes unrecorded. As a consequence,

soft-budget constraints persist and Russian manufacturers can

offer prices for weapons that are considerably cheaper than the

input costs.

Second, despite the financial and technological struggles of the

Russian defense sector in recent years, some Russian systems are

actually quite competitive technologically on the global market. For

example, Russia has been willing to sell the state of the art

Yakhont, an anti-ship missile that uses scramjet technology.27 In

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Intelligence Council Report, Russia chapter, p. 9 (Found on http://www.cia.gov/nic/pubs/

index.htm). 28Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, Bonn International

Center for Conversion, Brief 17, p. 47 29Mark Galeotti, ‘‘Russia’s Arms Bazaar,’’ Jane’s Intelligence Review, April 1, 2001. 30Kevin O’Prey, DFI Trip Report. 31The United Arab Emirates, which is both wealthy and is seeking independence from a single arms supplier, is a notable exception.

addition, Russia also produces reliable space launch systems such

as the Proton rocket at a time when there is global shortage in

space launch.28 Russia’s competitiveness in this area is underscored by the fact that U.S. defense giants such as Lockheed Martin have entered into joint ventures. Furthermore, although their

electronics components are poor, Russia continues to produce outstanding air defense missile systems, such as the S–300.29

Third, Russian defense enterprises and state organs have demonstrated little discretion in terms of end users. Governments that

find themselves internationally ostracized can often find a willing

seller in Moscow. Generally speaking, unless a government is

under United Nations (UN) sanction, Russia will sell to it. For example, as noted above, Russia proceeds with a robust arms sale relationship with China despite Russian General Staff concerns that

Beijing is a likely future military competitor.30

Finally, the Russians have simply gotten better at sales. Western

participants in recent international arms expositions observe that

Russian presentations have become significantly more professional.

From the attire of the industry representatives to the quality of

their glossy brochures, there is a marked improvement in the salesmanship of Russian exporters. Part of the explanation can be

traced to learning. Another part can be attributed to the recently

achieved organizational stability of Russian arms export organizations, which have been reorganized numerous times over the past

decade.

CONSTRAINTS ON FURTHER RUSSIAN SUCCESS

Yet there are a number of reasons to expect that Russia will only

modestly improve upon its arms export success in the coming

years. Any growth will likely come from Moscow’s existing client

base, rather than winning markets in head to head competition

with Western suppliers.

First, interoperability concerns on the part of buyers will likely

continue to hamper Russian arms export efforts. In fact, the continued success of the United States, United Kingdom, and France

noted in Figure 2, underlines the global trend toward NATO-standard armaments. Possessing an armaments inventory that is all of

one standard vastly reduces the complexity of operations and reduces maintenance costs. Few countries can afford and are willing

to maintain an arms inventory that possesses both NATO and Russian standard equipment.31 Even Russia’s former Warsaw Pact allies are shifting to NATO standard equipment in order to position

themselves better for ultimately joining the NATO alliance.

Second, beyond the areas of rockets, airframes, and air defense

systems, Russian weapon systems are generally held in low regard

for their technological levels and overall reliability. In particular,

Russia, for all intents and purposes, missed the electronics revoluVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00421 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.018 CRS1 PsN: CRS1
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32For example, in early 1992, Deputy Minister of Defense, Andrey Kokoshin, lamented that

the Russian electronics sector—a linchpin for any modern economy—lagged terribly behind

world standards. In his view, this lag had a dangerous multiplier effect, hampering Russia’s

ability to compete in the world economy and, for that matter, to defend itself. See Andrey

Naryshkin, ‘‘Andrey Kokoshin ob industrial’noy politike,’’ [Andrey Kokoshin on Industrial Policy], Krasnaya Zvezda, August 25, 1992, p. 3.

For a western analysis, see Harley Balzer, ‘‘Dismantling Russia’s Technotopia: Six Ministries

in Search of an Industrial Policy,’’ in Judith B. Sedaitis, Commercializing High Technology: East

and West, Center for International Security and Arms Control, Stanford University, January

1996, p. 48.

See also Aleksandr Anatolyevich Ivanov, first deputy chief of communications of Russian Federation Armed Forces, and Lev Ivanovich Titov, general director of Telecommunications Systems

Development Fund, Vooruzheniye, Politika, Konversiya, no. 1 (4), 1994, (signed to press August

4, 1994), pp. 45–50, translated in JPRS–UMA 94–056, pp. 29–32. 33 I. Mosin and A. Pokrovsky, ‘‘Conversion without Illusion,’’ Pravda, June 7, 1990, p. 4, translated in FBIS–SOV 90–116, pp. 75–80.

On production obsolescence generally, see Directorate of Intelligence, Central Intelligence

Agency, The Soviet Weapons Industry: An Overview, DI 86–10016, September 1986, pp. 29–30. 34Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 18. 35See Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000,

Figure 1, p. CRS–21.

tion that occurred during the 1980s and 1990s in other industrialized countries. Given the importance of electronics to the effectiveness of most modern weapons systems, Russian arms exporters

are necessarily at a disadvantage. For example, although the Su–

27 fighter reputedly has the highest performance air frame in the

world, it’s poor electronics capabilities—in terms of avionics and armaments systems—make it relatively uncompetitive when compared to analogous systems in the West.32

Decades of Soviet economic inefficiency and backwardness also

took a toll on the capital stock of Russian defense enterprises. Despite niches of high technology distributed throughout the defense

industries, by 1990 overall the sector was characterized by technological obsolescence. For instance, in the late 1980s the chief designer of the Temp aviation design bureau complained that over a

third of his equipment had been produced before 1940.33 Nor did

the situation improve in the weak economy of the 1990s. The decline in investment surpassed the fall in overall industrial output

such that by 1999, the volume of capital investment stood at only

10 percent of its 1990 level.34

The regional concentration of Russia’s export markets is also a

limitation. As noted above, Russia’s success relies heavily on markets in the developing world. Over the 1997–2000 period, among

arms exporting countries only China (92.5 percent of agreements)

was more dependent than Russia (90.9 percent) on developing

world arms markets. The United States, United Kingdom, Germany, and Italy, by contrast, relied on developing markets for less

than 60 percent of their agreements.35 Despite the recent expansion of this market, the developing world by definition lacks substantial financial resources to invest in arms. The weakness of the

global economy is likely to serve as a further brake on this market

in the near term.

Furthermore, within the developing world market, Russia does

not have a strong position in the one consistent bright spot: the

petro-dollar infused Near East market. The Near East accounted

for 47 percent of the developing world market over the 1997–2000

period. As is the case around the globe, the United States domiVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00422 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.018 CRS1 PsN: CRS1
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36See Richard F. Grimmett, Conventional Arms Transfers to Developing Nations, 1993–2000,

Table 1E, p. CRS–44. 37 In October 2001, President Putin reportedly chastised his Cabinet after hearing complaints

from South Korean President Kim Dae Jung. In particular, President Kim complained of the

poor quality of hardware purchased from Russian in the mid-1990s, lack of maintenance, and

chronic delays with deliveries of parts. Malaysia reportedly had similar complaints regarding

the MiG–29s it had purchased.

See Ivan Safronov, ‘‘Russia May Liberalize Arms Exports,’’ Kommersant, October 25, 2001, p.

2. 38See e.g., Mohammed Ahmedullah, ‘‘Russians Say Copycat Firms Robbing Millions in Spares

Sales,’’ Defense Week, vol. 22, no. 41., October 15, 2001. 39Kevin P. O’Prey, The Arms Export Challenge: Cooperative Approaches to Export Management and Conversion, (Washington, DC: Brookings Institution, 1995), pp. 10–11.

nates this market with a 61 percent market share over the same

period. Russia, meanwhile, possessed only a 7 percent share.36

Despite improvements in export salesmanship over the past decade, Russian arms exporters still can not match the West in their

after sale support. Because they were politically driven, after sale

support—in the form of technical training, spare parts, and servicing—were not major features of Soviet arms export deals. Thus,

when Russian arms exporters were thrust out onto a competitive

global commercial market, few or none possessed organizations

with this capability, or, for that matter, experience. Moreover, despite discussion of this liability throughout the 1990s, Russian exporters appear to have done little to improve these capabilities.37

Finally, the collapse of the Soviet bloc has allowed new competitors to crowd into previously loyal Russian markets. Beyond the

Westward tilt of Russia’s former allies in eastern Europe, this phenomenon includes the market for upgrades of Soviet weapons systems. Israel, in particular, has aggressively moved into the upgrade

market for MiG–21 aircraft.38

THE RATIONALE FOR RUSSIAN EXPORTS

The United States and international community appear to have

very little leverage in discouraging Russian efforts to export armaments as widely and in as great numbers as possible. In short,

Russia’s Government and industry possess extremely compelling

incentives to expand their arms sales as much as the market will

bear. Although some of Russia’s incentives are universal to all

arms producing countries, others are particular to Russia’s unique

circumstances

The first set of reasons for seeking arms exports are shared by

virtually all arms producing countries worldwide. By increasing the

overall number of a production run, exports reduce the per unit

cost of any subsequent purchases of that item, making weapons

production more profitable. Even if the a government elects not to

procure more of a particular model, exports provide the producing

firm with more resources to invest in new development projects.

Moreover, if a government seeks to maintain a defense industrial

base on the cheap, foreign purchases can keep production lines

open—‘‘smoothing out’’ production peaks and valleys—in anticipation of future procurement orders.39

Beyond these universal incentives, Russia’s industry and government confront pressures generated by the persistence of excess capacity in the defense industries, the drop in state procurement orders, and the continued political-economic importance of defense

398

40 Clifford Gaddy, The Price of the Past: Russia’s Struggles with the Legacy of a Militarized

Economy, (Washington, DC: Brookings Institution Press, 1996), pp. 24–26 41 Clifford Gaddy, The Price of the Past: Russia’s Struggles with the Legacy of a Militarized

Economy, (Washington, DC: Brookings Institution Press, 1996), p. 25. 42 U.S. Department of Commerce, Russian Defense Business Directory—1993, (Washington,

DC: U.S. GPO, 1993, pp. 38, 36. 43 Although a number of firms possess in excess of ten thousand employees, few possess such

a concentration at a single establishment. See Paul Joskow, et al., ‘‘Competition Policy in Russia

During and After Privatization, p. 312. 44See Ed Hewett, Reforming the Soviet Economy: Equality versus Efficiency, (Washington, DC:

The Brookings Institution), p. 173. 45See Nikolay Belin, ‘‘Izhevskiy oruzheyniki,’’ (The Izhevsk Gunsmiths), Krasnaya Zvezda, September 9, 1992, pp. 1, 4.

enterprises to their local communities. While the rationale behind

Soviet arms exports was geopolitical—to buy influence among Moscow’s client states—during the Russian period the rationale has become predominantly commercial, oriented toward domestic politics.

The remainder of this section deals with each of these factors in

turn.

EXCESS CAPACITY

From the perspective of Russian industry, the most compelling

reason for greater levels of arms exports is the persistence of a very

large defense industrial base with very little domestic demand.

When the Soviet Union collapsed in 1991, it bequeathed to Russia

a defense industrial base with a size and diversity worthy of a superpower. In all, Russia inherited approximately 1,700 state owned

defense enterprises and industrial establishments organized into

nine functional ministries (e.g., Ministry of Aviation Industry). Beyond the official defense complex, defense procurement orders

reached far and wide in the Soviet-Russian economy. According to

Clifford Gaddy, more than one third of all industrial enterprises

had some role in arms manufacture.40

Perhaps as problematic as the sheer number of Russian defense

establishments at a time when the cold war demand was slacking

off was the vast size of these enterprises. By U.S. standards, these

enterprises were enormous. Within the Soviet defense industries

there were approximately 100 enterprises with over 10,000 employees.41 For example, a single facility such as the Moscow ‘‘Znamya

Truda’’ [Banner of Labor] Machine Building Plant—a builder of

MiG aircraft—employed 30,000 personnel in 1990.42 In contrast, it

appears that there are no more than a handful of U.S. industrial

establishments with more than 10,000 employees.43

Part of the reason for the enormous scale of Russian defense enterprises was related to the logic of Soviet economics. The exigencies of the command economic system encouraged a degree of concentration and autarky in defense industry organization that is

rarely encountered in the U.S. economy. Constant conditions of

scarcity in the supply system created pressure for self-sufficiency

in material inputs as enterprise managers sought to minimize the

degree to which they depended on outside help.44 The Izhevsk Mechanical Plant is a case in point. A producer of small missiles, the

enterprise possessed shops for the manufacture of all the electronics components for its missiles, as well as virtually all of the

tools necessary to produce the electronics.45

399

46 Vitaliy Shlykov, ‘‘The Potemkin Complex: A Government Program Cannot Solve the VPK’s Problems.’’ 47See Julian Cooper, ‘‘The Soviet defence industry heritage and economic restructuring in

Russia,’’ p. 36; and Yegor Gaydar, ‘‘The Race with the Crisis,’’ Novoye Vremya, no. 48, 1991, p.

13, as cited in Anders Aslund, How Russia Became a Market Economy, (Washington, DC: The

Brookings Institution), p. 66. 48Oleg Vladykin, ‘‘Novaya Armiya so starym oruzhyem. Nuzhna li Rossiy takaya

perspektiva?’’ [A new Army with Old Weapons. Is This the Kind of Prospect Russia Needs?]

Krasnaya Zvezda, August 19, 1992, pp. 1–2. 49See Peter Almquist, ‘‘Soviet/Russian Procurement Database;’’ Marina Chernuka and

Vyacheslav Terekhov, interview with First Deputy Minister of Defense Andrey Kokoshin, ‘‘Nation and Society’’ feature, Interfax, 0545 GMT, July 24, 1992, translated in FBIS–SOV, 92–143,

July 24, 1992; and Aleksey Shulunov, ‘‘K chemu vedyet byudzhetnaya strategiya pravitel’stva.’’ 50Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 4. 51 Vitaliy Shlykov, ‘‘The Potemkin Complex: A Government Program Cannot Solve the VPK’s

Problems.’’ 52 In 1999, then Prime Minister Putin established defense production for domestic consumption as a priority over conversion and arms exports. Furthermore, Deputy Prime Minister

Klebanov pulled several converted enterprises back from civilian to military production. The effect of these measures was to generate 80 percent growth in the procurement budget in 2000.

Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 17.

At both the micro- and the macro-levels, the trend was toward

mass scale at the expense of efficiency. Consequently, Russia inherited a defense sector that was—and continues to be—grossly inefficient by Western standards. When comparing the personnel size of

the Russian and European aerospace and missile production sectors, Russia performs extremely inefficiently. According to Vitaliy

Shlykov, a Russian defense industry observer, Europe’s combined

aerospace and rocket industries generate approximately $2.2 billion

in revenues with 98,000 personnel. However, it takes the comparable Russian industry 800,000 personnel to generate $2 billion

in revenue.46

During the cold war, the Soviet Government was willing to absorb the opportunity cost of such a large, inefficient defense sector

because it was producing vast quantities of weapons to support its

superpower competition. However, when the cold war ended with

the collapse of the Soviet regime, the defense industries saw the

domestic demand for their wares drop off dramatically. One of the

first measures of Yegor Gaydar as acting Prime Minister in 1992

was to reduce state orders for arms procurement by 68 percent.47

State expenditures on tactical aircraft, missiles, as well as antiaircraft and air-launched missiles were cut by 80 percent. Tanks

and field gun expenditures were cut by a dramatic 97 percent.48

Taking the historical view, the cuts in weapon procurement were

remarkable. For example, 3,500 tanks were built in 1988. But the

state ordered only 20 tanks in 1992.49

Nor did the cuts in Russian defense orders stop there. Figure 5

depicts the relative decline in state arms procurement spending

from 1984 to 2000. Overall military output in the defense complex

in 1999 accounted for only one-third of the 1991 level.50 This year

only 10 percent of Russian defense enterprises have any state orders for defense output. Moreover, there will be no deliveries this

year to the Russian Government of combat aircraft, helicopters,

tanks, or other armored vehicles.51

Although Russian procurement levels have increased over the

past 2 years, the net effect has not been significant.52 As Figure

5 demonstrates, even with this increase, state arms procurement

funding in 2000 was still only 76 percent of the 1994 level. Given

the low levels of the procurement budget, the practical impact of

400

53Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 40. 54 Interview with Mikhail Pogosyan, General Director of Sukhoy Aircraft Military Industrial

Complex, ‘‘Only a Definite Strategy Can Attract Money,’’ Eksport Vooruzheniy, May–June 2001,

p. 18. 55See Anatoliy Sitnov, Chief of Armaments, Ministry of Defense, interview in Eksport

Vooruzheniy, November/December 1999, pp. 20–22, as cited in Kseniya Gonchar, Russia’s

Defence Industry at the Turn of the Century, p. 17. 56Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 33. 57See A.A. Kokoshin, First Deputy Minister of Defense, ‘‘Protivorechiya formirovaniya I puti

razvitiya voenno-tekhnicheskoy politiki Rossiy,’’ (Contradictions of Formation and Ways of Developing the Military-Technical Policy of Russia), Voyennaya Mysl, #2, 1993; and Lt. Colonel

Valentin Rudenko, ‘‘My sposobny proizvodit unikal’noye oruzhiye i etu sposobnost nel’zya

uteryat,’’ (We Are Capable of Producing Unique Weapons and This Capability Must Not Be

Lost), Krasnaya Zvezda, March 11, 1993, p. 2.

these investments is small. For example, in 1999, the procurement

budget funded only ten Topol-M missiles, ten satellites, and one

Tu–160 strategic bomber.53 In 2000, the aviation industry leading

Sukhoy design bureau received state orders only for an aircraft upgrade development project, which ended up amounting to only 10

percent of the bureau’s business for the year.54

FIGURE 5.—PERCENTAGE INDEX OF 1994 RUSSIAN ARMS PROCUREMENT BUDGET PLAN

[In constant 1996 prices, where the 1994 value = 100]

Source: Kseniya Gonchar, Russia’s Defense Industry at the Turn of the Century, 2000.

The net effect of these cuts in defense orders without comparable

contraction in industry, of course, was substantial excess capacity.

In late 1999, Russian defense sector still had the capacity to

produce 3,500 tanks and 4,500 pieces of movable artillery per year.

Approximately 40,000 people are also currently employed in duplicating R&D within the strategic missile program, when the Ministry of Defense estimates that 8,000 to 10,000 would suffice.55 The

aviation industry is capable of manufacturing about 350 fixed-wing

aircraft and 300 helicopters per year. The actual output in 1998,

however, reached only 100 pieces.56 In an indication that this problem of excess capacity was broadly understood, Ministry of Defense

industrial plan in the early 1990s stipulated that only 220 of the

1,700 defense enterprises would be essential for Russian security.57

In this environment, arms exports have proven to be the most

important source of income for the defense industries. As Figure 6


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401

demonstrates, military production for the domestic market accounted for only 17 percent of defense industry output in 1999. Production for arms exports, by contrast, accounted for 37 percent of

the defense sector’s production. Table 1 provides more tangible evidence of the disparity in output terms, by specific weapons type.

FIGURE 6.—SHARE OF RUSSIAN DEFENSE COMPLEX OUTPUT, 1999

Source: Kseniya Gonchar, Russia’s Defense Industry at the Turn of the Century, 2000.

TABLE 1.—ESTIMATE OF NUMBERS OF WEAPON SYSTEMS MANUFACTURED FOR

DOMESTIC AND INTERNATIONAL SALES, 1992–1999

Weapon system Domestic

procurement Export sales

Ships ........................................................................................... 2 11

Tanks .......................................................................................... 31 435

Submarines ................................................................................. 2 10

Aircraft ........................................................................................ 7 278

Helicopters .................................................................................. 8 98

Air defense systems ................................................................... 1 22

Armored vehicles ........................................................................ 17 217

Source: Kseniya Gonchar, Russia’s Defense Industry at the Turn of the Century, 2000.

STATE POLICY

Excess capacity persists in the Russian defense industries in

large part because the Federation Government has avoided imposing fundamental reform on the sector throughout the 1990s. As

Kseniya Gonchar argues, Russia’s ideal pattern of defense planning—drafting of the military doctrine, long-term planning of supply and procurement, and finally contracting—has been replaced by


76171.035
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58 Boris Kuzik, Oboronno-promyshlennyy Kompleks Rossii: Proryv v. XXI Vek [The Russian Defense Industrial Complex: Breakthrough to the 21st Century] (Moscow: Russkiy Biograficheskiy

Institut, 1999), cited in Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 15. 59 Julian Cooper offers the estimate of 9 million while Andrey Kokoshin estimates the number

of Soviet defense industry jobs as ranging between 12 and 14 million. Julian Cooper, ‘‘The Soviet

Defence Industry Heritage and Economic Restructuring in Russia,’’ in Lars B. Wallin, ed. The

Post-Soviet Military-Industrial Complex, FOA Symposium—October 20, 1993, (Stockholm: The

Swedish Nations Defence Research Establishment, 1994), p. 30; and Andrey Kokoshin, ‘‘Defense

Industry Conversion in the Russian Federation,’’ Russian Security After the Cold War: Seven

Views from Moscow, in Teresa Pelton Johnson and Steven E. Miller, eds, (Brasseys, U.S., 1994),

p. 48. 60 Adjusting to the Drawdown, Report of the Defense Conversion Commission, pp. 17–18. 61Stepan Sulakshin, ‘‘Dva kvartala na golodnom paykye;’’ [Two Quarters Starvation Rations],

Krasnaya Zvezda, May 28, 1994, p. 3. 62See Julian Cooper, The Soviet Defence Industry: Conversion and Economic Reform, (NY:

Council on Foreign Relations Press, 1991) and Clifford Gaddy, unpublished trip notes, Summer

1992. 63Logistics Management Institute, Impacts of Defense Spending Cuts on Industry Sectors, Occupations Groups, and Localities, Table 3–2. 64See, e.g., Yelena Druzhinina, ‘‘The Defense Industry is Revealing Its Cards,’’ Delovoy Mir,

November 2, 1991, p. 8 in JPRS–UMA 91–031, pp. 62–64. 65Kseniya Gonchar, ‘‘Employment Aspects of Defense Conversion in Russia,’’ mimeo, May

1994, footnote 13. 66 Aleksey Shulunov, ‘‘K chemu vedyet byudzhetnaya strategiya pravitel’stva.’’

an adjustment to minimal funding, lobbying, and the implicit

prioritizing of the nuclear forces.58

Both reform-oriented and more conservative administrations

have viewed the defense industry problem as something to be put

on the back burner. Although neither the managers nor the labor

forces of Russian defense enterprises were powerful political

groups, no Russian Government has had the appetite to take them

on directly.

The primary reason that successive Russian Governments have

been reluctant to take on real defense industry reform has been the

social ramifications of the militarization of the Russian economy.

Estimates of the number of personnel who worked in the Soviet defense establishment—the lion’s share of which was located in Russia—at the height of the cold war range from 9 to 14 million.59 By

comparison, in 1990 U.S. defense industry work provided employment to only 1.5 to 1.9 million workers.60

Perhaps as many as 70 Soviet cities were developed around a

single defense enterprise.61 In the extreme case, the republic of

Udmurtiya depended upon defense work for 57 percent of its industrial workforce. Six other oblasts—the Soviet/Russian equivalent of

a state in the United States—depended upon defense work for over

40 percent of their industrial labor forces.62 In contrast, in 1991 defense work accounted for only 8.3 percent of non-farm, private sector employment in the most defense industry-dependent state in

the United States, Connecticut.63

Beyond their role in providing employment, Soviet defense enterprises played a major role in providing social services to their regions. In the majority of cases, a Soviet defense worker and his/her

family depended on the defense plant to supply their housing, hospitals, kindergartens, and, even, vacation facilities.64 Even after

the onset of Russian reforms, in some enterprises the social infrastructure employed over 20 percent of the plant’s staff.65 One defense industry official later reported that in 1994, 9 to 25 percent

of funds in the defense complex were devoted to maintaining social

infrastructure.66

403

67 Alexander Golts, ‘‘A Dead-End. The Defense Industry is Not Deeply Distributed in Depth:

Military Production in Russia is Living on Foreign Orders for the Time Being but That Can’t

Continue for Long,’’ Itogi, October 24, 2000, translated in FBIS October 31, 2000, Document ID:

CEP 20001031000156. 68 ‘‘Russia: State Planning to Boost Defense Sector Contracts,’’ Interfax, 1351 GMT, March 30,

2001, reprinted in FBIS March 30, 2001, Document ID: CEP20010330000296. 69Dmitry Safonov, ‘‘Military Industry Reform Approved,’’ Izvesitya, July 28, 2001. 70 ‘‘RF Government Has Approved Federal Targeted Program for Reform and Development of

the Defense Industrial Complex for 2001–2006,’’ Agenstvo AK&M, July 27, 2001, translated in

FBIS, Document ID CEP2001 10727000193. 71 Nikolay Burbyga, ‘‘Boris Yeltsin: Russia Has No Special Secret Policy Regarding Nuclear

Issues,’’ Izvestiya, Feb. 24, 1992, pp. 1, 3 in FBIS–SOV 92–036, pp. 35–39.

Therefore, the net effect of this militarization of the Russian

economy is the creation of a direct link between the financial

health of a Russian defense enterprise and the socio-economic welfare of the surrounding community. For example, because the

Komsomolsk-na-Amure Aviation Production Association

(KnAAPO)—the producer of Su–27 aircraft exported to China—accounts for 78 percent of the industrial output of the Khabarovsk

Krai, KnAAPO’s welfare is the region’s welfare.67

In political terms, the Russian Government has been left with

few options. Moscow has had neither the resources nor the inclination to increase defense procurement significantly. When Deputy

Prime Minister Ilya Klebanov announced the 2010 defense program, he promised that the government would increase the value

of defense industry contracts from the current level of approximately 2.6 percent of GDP to 3.5 percent of GDP in 2006. But in

a blow to any hopes for the development of new systems and the

opening of new series production efforts, the first 7 to 8 years of

this 10 year plan emphasize the upgrading and modernization of

existing defense systems.68

Nor has Moscow been willing to undertake the politically painful

process of streamlining the defense sector by permitting, encouraging, or even directing failing enterprises to close. In the same initiative, Klebanov promised to address excess capacity by reducing

the size of the defense industry from its current level of enterprises

from 1,700 to 1,000. The initiative would also address organizational and efficiency issues by overseeing the reorganization of

leading defense enterprises into 30 to 40 holding companies.69 For

example, by 2006 the reform would concentrate the aircraft sector

by creating two holding companies: one merging MiG, Tupolev, and

Kamov and the other integrating Sukhoy, Ilyushin, and Mil.70

However, defense industry officials and outside observers could

not be criticized for their pessimism that the reform would come to

pass because it resembled in significant detail previous, muchheralded government reform proposals. In particular, Klebanov’s

plan looked a lot like Kokoshin’s plan of 8 years earlier as well as

a series of draft initiatives in between. Although all of these plans

got it right in terms of objectives, none were ever seriously implemented.

Consequently, rather than carry out real reform or cave in to industry demands for financial support, both the Yeltsin and Putin

Administrations sought the less painful ‘‘third way’’ of encouraging

industry self help through arms exports. As early as January 1992,

President Yeltsin was urging defense enterprises to find arms exports customers.71 In a move that probably cost it little financially,

the Yeltsin government relaxed restrictions on the types of armaVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00429 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.018 CRS1 PsN: CRS1
404

72See Nadezhka Potapova, ITAR–TASS, June 8, 1992 in FBIS–SOV 92–111, p. 63; and

Vremya, Moscow Television, July 21, 1990, in FBIS–SOV 90–143, p. 76. 73For example, even the westward leaning Foreign Minister Kozyrev described arms export

promotion as one of the main reasons for his May 1992 trip to the Persian Gulf region. See Aleksandr Golts, ‘‘Andrey Kozyrev Spends Six Days in Six Countries Seeking New Partners for Russia,’’ Krasnaya Zvezda, May 6, 1992, p. 3.

On at least one occasion the cash-strapped Federation Government actually provided credits

to a foreign government in order for it to purchase Russian weapons-related technologies. In

March 1992, the Russian Federation Government agreed to provide credits to India for the purchase of Russian weapons. Although the Federation is required to spend some of its revenue

in India, the money will also go toward the purchase of goods that will go directly to Russian

defense enterprises. See Correspondent Nikolay Paklin, Radio Rossii, 1100 GMT, March 26,

1992 in FBIS–SOV 92–060, p. 22.

ments that could be exported and vastly increased the share of revenues that enterprises received from their exports.72 The government also took an active role in promoting defense industry exports.73

GRAFT

Beyond all the other factors providing incentives for Russian

arms exports, perhaps the most compelling one throughout the past

decade has been personal profit—or outright graft—by state officials and industry managers. Because (1) the state of the Russian

economy has generally been poor, and (2) Russia has little that it

could export for hard currency, arms exports have joined the energy industries as the objects of fairly intense political competition

at the top of the Russian political system. The frequent turnover

of the Russian Government’s arms export agencies as well as the

periodic reorganization of these agencies themselves were evidence

of constant competition among elite groups around Presidents

Yeltsin and Putin. For example, in order to help finance Yeltsin’s

successful campaign for re-election in 1996, members of the ‘‘Family’’—the political faction of Yeltsin boosters that included his

daughter, Tatyana Dyachenko—put their own people in charge of

Rosvooruzheniye in order to get access to the hard currency revenues from arms exports.

The benefits for the ‘‘Family’’ and anyone else who has access to

arms export deals are not limited to skimming off the top of any

transaction. Merely controlling hard currency bank accounts and

benefiting from the interest provides a range of benefits that are

not available to capitalists exploiting wholly domestic Russian sectors.

Although defense enterprise managers have argued that they,

not the state organs, should control the export revenues that they

generate, there is no evidence that they are more magnanimous

than state officials. On the contrary, they appear to be equally oriented toward using their control over these hard currency accounts

for their personal enrichment.

Thus, beyond any well-reasoned policy or political impulse supporting Russian arms export efforts, there is a more fundamental

reason—elites stand to make more money.

IMPACT ON THE RUSSIAN DEFENSE SECTOR

Despite the positive overall picture for Russian arms export performance in recent years, the effects on the state of Russian defense industries has been limited in scope. For the small number

405

74 Interview with Aleksandr Mikheev, Director of the Air Force Department of

Rosoboroneksport, ‘‘Our Obligations are Being Fulfilled in Time,’’ Eksport Vooruzheniy, July– August 2001, p. 6.

of enterprises that have found foreign demand for their manufactures, export revenues have provided economic resuscitation. Yet

given the very significant economic and organizational challenges

confronting these enterprises, to use a medical analogy, they have

moved from being on life support to intensive care. Arms exports

have improved their performance, but none of these enterprises appears to resemble a financially solvent firm. Nor do the prospects

seem much enhanced for technological or procurement breakthroughs as the widespread economic malaise in the defense industries will be a barrier to significant R&D and production.

The effects of Russia’s arms export success have been fairly concentrated in a handful of enterprises. Figure 7 details the Russian

sources of arms agreements during the year 2000. As the Figure

depicts, most the 2000 arms export revenues were funneled

through state coffers. Rosvooruzheniye, Rosoboroneksport, and

Promeksport—three state agencies at the time charged with promoting exports—accounted for three-fourths of the year 2000 Russian arms trade. Within this category, 70 percent of exports were

aircraft and related services. The largest of these projects were

supplies and licensed production of Sukhoy combat aircraft.74

FIGURE 7.—ENTERPRISE ORIGINS OF RUSSIAN ARMS TRANSFERS, 2000

Source: Makienko, Konstantin. Preliminary Estimates of Russian Performance in Military-Technical Cooperation with Foreign States in 2000, 2001.

In contrast, only three individual enterprises shared the remaining one-fourth of export revenues. Of these, the Antey Concern—

the producer of the Tor–M1 surface to air missile system—was the

big winner among individual enterprises, taking in roughly $500

million. The Tula Instrumentmaking Design Bureau—the designer

and producer of tracked air defense systems such as the Pantsir—

took in roughly $100 million. The corporate successor to the famed


76171.036
406

75Dr. Mark Galeotti, ‘‘Russia’s Arms Bazaar,’’ Jane’s Intelligence Review, April 1, 2001. 76On the success of these sectors, see Kseniya Gonchar, Russia’s Defence Industry at the Turn

of the Century, p. 4. 77Kevin P. O’Prey, Russian Defense Enterprise Adaptation—1984–1995: Coping with PoliticalEconomic Reform and Transformation, MIT Doctoral Thesis, January 1998.

This figure tracks with current estimates of economist Kseniya Gonchar, who argues that only

one-fifth of the entities within the defense industry show signs of stability and long-term viability. See Kseniya Gonchar, Russia’s Defence Industry at the Turn of the Century, p. 4. 78Twenty-one percent of surveyed defense enterprises—the ‘‘basket cases’’—were experiencing

periodic shut-downs due to a variety of financial maladies, including an inability to pay energy

bills, wages, and so forth. These shut downs typically involved the enterprise management locking the gates and sending the workforce on unpaid leave for weeks at a time.

The majority (67 percent) of surveyed enterprises could be performing in a way that could

only be characterized as ‘‘muddling.’’ Although they by and large kept their doors open, they

clearly lacked products whose revenues could sustain them as currently constituted. See Kevin

P. O’Prey, Russian Defense Enterprise Adaptation—1984–1995: Coping with Political-Economic

Reform and Transformation, MIT Doctoral Thesis, January 1998. 79 Col. Stanislav Lunev, ‘‘Russia’s Arms Sales Destabilizing Gulf Nations,’’ Newsmax, March

28, 2001, reproduced on http://www.newsmax.com.

Mikoyan design bureau and production facilities, RSK MiG, also

took in the remainder—approximately $100 million.

These enterprises also are concentrated in just two sectors: aircraft and air defense systems. The MiG–29, Su–27, and Su–30 aircraft variants account for two-thirds of Russian exports. Air defense systems—principally the competing versions of the S–300—

account for most of the remainder of Russian exports in 2000.75

The picture became a little more complex in 2001 with the large

sale of tanks to India. Moreover, this picture does not capture the

export success of Russia’s nuclear and space industries, which are

no longer counted within the defense complex.76

The principal effect of arms export success has been to create a

class of relatively successful Russian defense enterprises. Throughout the 1990s, arms export revenues were the dominant factor in

explaining the relative success or failure of Russian defense enterprise performance. In a survey of 72 defense enterprises over the

1990–1995 period, I found that only 15 percent were performing in

a way that could be considered to be relatively successful—e.g.,

they appeared to be more or less covering their operating expenses

with some mix of revenues and state subsidies.77 The feature that

separated this group from the 21 percent that were failing outright

and the remainder that were ‘‘muddling’’ at best was the fact that

they had foreign markets for their arms products.78

Perhaps the best sign of the relative prosperity of arms exporting

enterprises is the fact that they have been hiring workers. The S–

300 producing Antey Concern in Moscow is looking to hire another

10,000 employees to add to its existing 40,000 personnel. A 1998

report described the Tula Instrumentmaking Design Bureau—the

developer and producer of the Pantsir air defense system—as hiring 400 new engineers to support its export-led business.

Uralvagonzavod, the beneficiary of the 2000 agreement to supply

310 T–90 tanks to India, was similarly reported to be hiring personnel to support renewed production after an extended down period.

Exports have also helped some enterprises undertake the development of new systems. Most notably, the Tula Instrumentmaking

Design Bureau’s deal to sell the Pantsir air defense system to the

UAE apparently includes explicit UAE financing of the system’s

final development.79

407

80 Interview with Mikhail Pogosyan, ‘‘Only a Definite Strategy Can Attract Money,’’ p. 19. 81 Interview with Mikhail Pogosyan, ‘‘Only a Definite Strategy Can Attract Money,’’ p. 18. 82See comments by Ruslan Pukhov in Guy Chazan, ‘‘Russia to Reduce Weapons Producers

in a Bid to Streamline the Defense Sector,’’ Wall Street Journal, July 31, 2001.

On Yeltsin era efforts, see Dmitry Safonov, ‘‘Military Industry Reform Approved,’’ Izvesitya, July 28, 2001.

Yet the Pantsir case appears to be more the exception than the

rule. Without a robust, multi-year government defense R&D budget, the development of fundamentally new systems appears to be

exceedingly difficult. In the aviation sector, despite the change of

nomenclature, the Su–30 aircraft being sold to China and India are

upgrades of the Su–27. Despite frequent press references to the imminent development of a fifth generation Russian fighter to succeed

either the MiG–29 or the Su–27, no financing appears to be in the

offing. According to Mikhail Pogosyan, the General Director of the

Sukhoy design bureau, the biggest obstacle is the lack of state financing: ‘‘Everyone understands that it is impossible to carry out

all the R&D related to the new generation with [current levels of]

budget funding alone.’’ Thus, the Sukhoy design bureau invests

some of the revenues from exports, and hopes to convince foreign

clients to invest in the development of new systems, or to encourage foreign joint development.80

The Sukhoy complex of enterprises also provides an illustration

of how export success cannot overcome the obstacles created by the

organizational vestiges of the Soviet system. The Soviet-era Sukhoy

complex included four geographically dispersed, organizationally

distinct entities. In addition to the Moscow design bureau, there

were three production facilities for Su–27 variants: the

Komsomolsk-na-Amure Aviation Production Association (KnAAPO),

the Irkutsk Aviation Production Association (IAPO), and the

Novosibirsk Aviation Production Association (NAPO). Since the collapse of the Soviet-era aviation ministry, the managers of these enterprises have resisted repeated efforts to create a unified firm. In

particular, as the producers of the exported aircraft, each of the

production associations has sought to keep the resulting revenues

for themselves.

Today, the divided approach appears to have mixed results.

While the design bureau and KnAAPO are doing relatively well,

the Novosibirsk and Irkutsk plants hare having difficulty fulfilling

their orders.81

Perhaps partly in response, like the Yeltsin Administration before it, the Putin government is seeking to create a unified firm of

all of Sukhoy’s components. However the prospects for this effort

are dubious due to the differing forms of ownership across the different Sukhoy enterprises.82

Finally, while arms export success appears to provide a palliative, it cannot overcome the fundamentally weak state of the Russian defense economy. Across the board, it is clear that arms export

revenues—when they reach the individual enterprise—can help enterprise directors to pay their bills and, perhaps, to fund some new

initiatives. However, none of these enterprises appears to be profitable, as they could not cover their costs without substantial explicit

and implicit subsidies. Nor can they help these plants overcome the

challenges of operating in the transitional Russian economy. In a

telling example, Uralvagonzavod is reportedly finding it difficult to

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83 ‘‘Russia: Uralvagonzavod Not Prepared to Produce Tanks for Indian Contract,’’ Vremya

Novostey, March 14, 2001, p. 1, translated in FBIS, March 15, 2001, Document ID: CEP

20010315000367.

produce T–90s for its India export orders because its former subcontractors have either failed or have moved to other pursuits.83

ISSUES FOR CONGRESS

There are three compelling issues for the U.S. Congress that

emerge from this analysis.

• The virtual certainty of continued aggressive promotion of

arms exports by Russia.

• The limited effects that export success will have on Russian

defense industrial advancement.

• The negative impact that these exports will have in terms of

greater proliferation of high technology weapons systems to potential U.S. competitors.

In short, despite the improving climate of U.S.-Russian relations,

the United States possesses few levers against Russia’s efforts to

sell high technology weapons systems to anyone who will pay for

them. Sanctions or attempts to create diplomatic linkages are highly unlikely to overcome the very significant incentives for Moscow

to continue to promote exports. While it is difficult to envision arms

export success helping the Russian defense sector rebuild itself

anew into a competitor with the United States and the West, the

proliferation impact could pose challenges to U.S. forces. The remainder of this section addresses each of these issues in turn.

THE VIRTUAL CERTAINTY OF CONTINUED AGGRESSIVE PROMOTION OF

ARMS EXPORTS BY RUSSIA

As described above, it is a virtual certainty that Russia will continue to aggressively promote arms exports for the foreseeable future. There are virtually no stakeholders in the Russian political

system who have an interest in constraining Russian arms exports.

For the government, arms exports help to maintain priority defense

industrial capabilities on the cheap while reducing industrial demands for bail outs for the state. Given the likely enormous

amount of financial resources and time that it would take to reform

the defense industrial base—thereby reducing the political pressure

to export—it is difficult to imagine any government choosing any

other course. Moreover, as arms continue to be one of the only hard

currency generating items that Russia can export, there will always be prominent figures in the government who stand to profit

personally from export promotion.

For Russian defense industries, export revenues represent the

difference between success and failure. Russian defense industrialists recognize that aside from intercontinental ballistic missile

(ICBM) manufacture, there are virtually no prospects for meaningful state R&D or production orders over the next 5 years at a minimum. If these industrialists do not find foreign markets for their

weapons, they are faced with very bleak prospects.

Unfortunately, the United States has very little in the way of

moral suasion on this issue. As the dominant player in the military

409

export market over the past decade (see Figure 2), Washington cannot credibly appeal for Russian restraint in terms of general export

promotion efforts.

THE LIMITED EFFECTS THAT EXPORT SUCCESS WILL HAVE ON RUSSIAN

DEFENSE INDUSTRIAL ADVANCEMENT

Russia’s arms export success is not likely to be a vehicle for the

reinvigoration of the Russian defense industrial complex. Russia’s

defense industries today are very sick. They have not overcome the

organizational vestiges of the Soviet period and few, if any, enterprises have developed into viable firms. By U.S. standards, none of

these organizations is profitable.

Given this environment coupled with the lack of government resources, the prospects for the development and production of a

wholly new weapon system appear to be very bleak. While the Russian system can turn out modifications of existing systems such as

the Su–27 fighter, fundamentally new programs require the largescale, multi-year funding that appears beyond the reach of the Russian Government and enterprises for the foreseeable future. Simply

stated, at a time when Russian enterprises are trying to stay

afloat, it is extremely unlikely that they can take on a robust development program that would be taxing to even advanced defense industries like that of the United Kingdom, France, or Germany.

From the U.S. perspective, therefore, the worst-case scenario is

that Russia could return to manufacturing large quantities of older

generation weapons. In the unlikely event of renewed military competition with the United States and the resulting political

prioritization of domestic Russian investment, and given the persistence of a large defense industrial infrastructure, Russia could

once again turn out large numbers of ICBMs, artillery, tanks, and

aircraft. However, continued limitations in electronics and other aspects of modern military systems would likely hobble this military

in actions against any Western force.

THE NEGATIVE IMPACT THAT THESE EXPORTS WILL HAVE IN TERMS OF

GREATER PROLIFERATION OF HIGH TECHNOLOGY WEAPONS SYSTEMS

TO POTENTIAL U.S. COMPETITORS

The more significant problem for the United States and the West

is the proliferation of advanced Russian weapons systems to potential regional competitors. There is little doubt that the rationale for

China’s and Iran’s acquisition of Russian weapons and technologies

is at least partly based on improving their capabilities vis-a`-vis the

United States. If Iran were to acquire Yakhont anti-ship missiles,

for example, it would put Tehran in a position from which to

threaten U.S. naval forces and international shipping in the Persian Gulf. Modern air defense systems, furthermore, might help

Iran defend its nuclear facilities from preemptive strikes. Similarly,

Chinese acquisitions of high performance aircraft and other weapons are likely based on a desire to improve Beijing’s capabilities in

regional competition with the United States.

In this area the United States does possess some options. Moscow still appears to respect international legal restrictions. Moscow

abides by UN sanctions on its former arms client in Iraq. It also

410

officially respects the terms of the Missile Technology Control Regime (MTCR). Although there are serious questions about illicit cooperation between Russian missile manufacturers and Iran, among

others, it appears that Moscow is responsive to international pressure whenever these relationships are exposed. Continued efforts to

strengthen existing international legal regimes governing arms

trade—and, perhaps, developing new ones—appears to be a good

return on U.S. diplomatic investment.

Targeted sanctions, however, do not appear to offer much promise. Although U.S. sanctions against particular individuals or enterprises puts the international spotlight on problems, they cannot

overcome the fact that the United States does not possess economic

levers over Russian industry. Most importantly, Russian enterprises do not care if they are subject to U.S. sanctions because they

do not generally do any business with U.S. firms anyway. Moreover, in extreme cases, it is hard to foresee how a cut-off of all

Western business with a Russian enterprise would hurt more than

one sizeable contract with a country like Iran. The only exception

to the rule appears to depend upon tactical diplomatic efforts. In

the case of Iran sales, for example, the United States can encourage the Gulf states to break off current cooperation and/or rule out

future Russian purchases. The opportunities for similar efforts with

respect to China, however, appear to be limited by the fact that few

Asian countries represent market opportunities for Moscow.

In sum, therefore, the rationale for Russian arms exports has become largely based on commercial interests and domestic politics. Gone are the days when geopolitics drove Soviet arms transfers. As

a consequence, the United States is likely to have an exceedingly

difficult time finding anyone in Moscow or Russian defense industries willing to listen to appeals for restraint unless it is in their

economic interest. For the foreseeable future, the Russian Government and defense industries will be focused on the near-term opportunities offered by arms exports. Thus, as the Bush Administration and the Congress evaluate the evolving U.S.-Russian relationship, both must recognize that the arms trade is almost certainly

going to be a continuing source of disagreement.

(411)

U.S.-RUSSIAN TRADE AND INVESTMENT: POLICY

AND PERFORMANCE

By Inga Litvinsky, Matt London, and Tanya Shuster 1

CONTENTS

Page

Summary .................................................................................................................. 411

Policy Goals and Vehicles ....................................................................................... 412

Bilateral Trade ......................................................................................................... 414

Russia, U.S. major trading partner in Central Eastern Europe, not in

the global economy ........................................................................................ 414

Trade imbalance increased, 1995–2000 .......................................................... 414

U.S. exports to Russia varied but leading exports were stable .................... 415

Some U.S. imports from Russia increased consistently ................................ 416

Bilateral Investment ............................................................................................... 417

Foreign direct investors into Russia ............................................................... 417

U.S. investors in Russia ............................................................................ 418

Regions attracting foreign investment .................................................... 418

Business Environment Issues in Russia ................................................................ 419

Good governance ............................................................................................... 419

Commercial taxation with international accounting standards (IAS) ......... 420

Commercial energy development .................................................................... 420

Russia’s accession to the World Trade Organization (WTO) ........................ 421

U.S.-Russian treaty on mutual protection of investments ............................ 421

Outstanding Trade Issues with the United States ............................................... 421

Russia’s non-market economy status .............................................................. 421

Trade implications of the Trade Reform Act of 1974 Jackson-Vanik

Amendment ................................................................................................... 422

1999 Steel agreements ..................................................................................... 422

Prospects for Trade and Investment ...................................................................... 422

1 Inga Litvinsky is the Senior Russia Desk Officer and Matt London is the Russia and

Caucasus Desk Officer for the U.S. Department of Commerce, International Trade Administration. Tanya Shuster is Deputy Director and Senior Russian Specialist with the Business

Information Service for the Newly Independent States (BISNIS), U.S. Department of Commerce.

BISNIS provides market research, business leads, and expert guidance and assistance to U.S.

companies with interests in the 12 Newly Independent States (NIS) countries

(www.bisnis.doc.gov). Chang Suh, an intern with the Department of Commerce, also contributed

to this article.

SUMMARY

The U.S. Administration would like to see business become a

bedrock for overall U.S.-Russian relations. At the same time, President Putin and the Russian Government are banking on foreign investment and integration in the global economy led by the United

States to expand and sustain Russia’s gross domestic product

(GDP) growth. Thus, U.S. and Russian interests and policies appear to be in alignment to commence a new bilateral commercial

era.

In order, however, to turn these intentions into increased commercial opportunities so that bilateral trade and investment can fiVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00437 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.019 CRS1 PsN: CRS1
412

2For a good overview of the Administration’s commercial policy toward Russia, see October

5, 2001 remarks by Secretary of Commerce’ Donald Evans to the U.S.-Russia Business Council

at www.doc.gov.

nally take off, concrete steps will be required by both sides. Finishing Putin’s reform agenda with financial, rule of law, and other institutional reforms are essential conditions precedent to developing

a new Russian business climate capable of attracting significant

new investment. Specific improvements in corporate governance,

tax policy and commercial energy developments are likewise required. Implementation of bilateral treaties fostering commercial

relations and Russian accession to the World Trade Organization

(WTO) would also be catalysts for increased trade and investment.

If Russia moves closer to integration into the international economic institutions and the global market, the United States would

need to reexamine its domestic trade laws in order to address Russia’s concerns regarding trade restrictions, access to the U.S. market and expansion of appropriate trade and investment promotion

measures.

U.S.-Russian trade and investment increased over the decade of

the 1990s from a very low base. Russia’s financial crisis in 1998 accelerated the trade imbalance and interrupted the overall upward

trends, leading to a setback from which bilateral trade and investment performance have not yet fully recovered. Even at the past

low level of trade turnover, some American sectors and enterprises

fared rather well, e.g., machinery and poultry. While foreign direct

investment (FDI) to Russia was minuscule, the United States led

the advanced western nations as a supplier of FDI. Russia has

been far and away the leading U.S. commercial partner in the region formerly controlled by the Soviet Union. If trade and investment were to substantially increase, sectors and enterprises already in the Russian market would expect to be primary beneficiaries of the expanding commerce. However, new participants

such as small- and medium-sized businesses may also be able to

flourish in a new business-friendly environment.

The current U.S. Administration is emphasizing the leading role

of the private sector in driving the bilateral commercial relationship and has warmly welcomed the formation of the RussianAmerican Business Dialogue.

POLICY GOALS AND VEHICLES 2

As the United States seeks to advance its relations with Russia

in all spheres, including development of a new security framework,

the Bush Administration is giving priority to the bilateral commercial relationship. The Administration would like to see private business relations become a bedrock for overall U.S.-Russian relations.

For their part the Russians, under President Putin and the economic reform team led by Economic Development and Trade Minister Gref, are banking on increased foreign investment and integration into the global economy. This development would sustain

and expand the country’s GDP growth and favorable balance of

payments, which have been primarily fueled by high oil prices and

depreciation of the ruble in recent years. Thus, in principle, U.S.

413

and Russian interests and policies are in alignment to commence

a new bilateral commercial era.

While the first Bush Administration and Clinton Administration

conducted business with Russia through a bilateral Commission

made up of eight Committees, the new Bush Administration has

de-emphasized formal intergovernmental structures and stressed

the role of the private sector in relations with Russia. They have

disbanded the previous Administration’s principle vehicle for economic discussions with Russia, the Joint Commission on Economic

and Technological Cooperation (or ‘‘Gore-Chernomyrdin Commission’’), and have opted for a more informal and decentralized approach to commercial enhancement.

At the first meetings between Presidents Bush and Putin at the

Ljubljana, Slovenia and Genoa Summits (in May and July 2001),

commercial issues were high on the agenda. In Genoa, Italy, the

two Presidents announced formation of a private sector-led

Russian-American Business Dialogue to promote new business opportunities and make policy recommendations to the two governments. The creation of the private sector led Business Dialogue is

a recognition that our bilateral commercial relations are at the beginning of a new era, one that will be driven by the two countries’ private sectors rather than by the governments.

Following up on the economic discussions between the Presidents, Commerce Secretary Donald Evans and Treasury Secretary

Paul O’Neill went to Russia in July 2001 to begin to chart a new

business-driven policy with the stated purpose of expanding bilateral trade and investment. Subsequently, at the request of President Bush, Commerce Secretary Evans led a successful business

development mission of senior U.S. executives from a variety of sectors, including Committees on Energy, Aviation, and Information

Technology, to Russia in October 2001. Several companies, including those new to the Russian market, signed investment protocols

during that visit.

In order to turn these positive intentions into increased commercial opportunities, trade liberalization and business environment

issues will need to be addressed by both sides. It is generally acknowledged by trade and investment specialists in both countries

that critical improvements are needed in Russia’s business climate,

including corporate governance and rule of law for business, commercial taxation, and improvements in the banking system. While

Russia is still perceived as a risky place to do business by domestic

and foreign businesses alike, there have been positive changes in

the past year, including in commercial tax reform and simplification of business licensing requirements.

Russia’s accession to the WTO would be a major catalyst for increased trade and investment as it would reinforce Russia’s economic reform program and would ensure that Russia abides by

international trade rules. As Russia moves closer to WTO membership, the United States will need to re-examine its domestic trade

laws. If both sides are to reap the full benefits of Russia’s accession

to the WTO, reconsideration of the Jackson-Vanik Amendment to

the Trade Reform Act of 1974 may be necessary so that permanent

normal trade relations (PNTR) status may be accorded to Russia.

The United States may also need to address Russia’s concerns reVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00439 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.019 CRS1 PsN: CRS1
414

3The analysis of trade and investment performance has been prepared by Tanya Shuster,

Deputy Director of BISNIS. Additional information on U.S. trade and investment with Russia

and other CIS countries, including data on exports from individual U.S. states to the NIS, is

available via BISNIS Online, www.bisnis.doc.gov. For a more comprehensive summary of trade

between the United States and Russia in 2000, see BISNIS U.S.-Russia Trade Profile, available

via the Russia page of BISNIS Online www.bisnis.doc.gov/russia.html. Data in this article is

from authoritative official sources. 4 U.S. platinum (palladium) imports from Russia nearly doubled between 1998 and 2000, to

more than $1.6 billion. 5 Russia’s trade surplus with the United States grew 350 percent between 1995 and 1998,

while Russia’s trade surplus worldwide grew 240 percent. 6 Initial U.S. Department of Commerce data for January–June 2001 indicates a small decline

(4 percent) so far for the year in U.S. imports from Russia, which is attributable at least in

part to declining prices for fuel and other commodities imported from Russia. 7 Japan’s exports to Russia dropped 57 percent in 1999 over 1998. The value of U.S. imports

declined 48.5 percent. The European Union (EU) experienced a 45 percent decrease.

garding access of Russian products, such as steel, to the U.S. market.

BILATERAL TRADE 3

RUSSIA, U.S. MAJOR TRADING PARTNER IN CENTRAL EASTERN EUROPE,

NOT IN THE GLOBAL ECONOMY

A more detailed examination of the U.S. and Russia trade activities provides some, perhaps unexpected, perspectives. Russia has

emerged among all countries from Eastern Europe and the Newly

Independent States (NIS) as the United States’ leading trading

partner in the region, but nonetheless accounts for less than 1 percent of total U.S. foreign trade. In 2000 this pattern largely held

true, with Russia capturing 80 percent of U.S. trade with the NIS.

In this trade, Russia provided nearly 40 percent of platinum, 14

percent of aluminum and 3 percent of iron and steel imported into

the United States.4

TRADE IMBALANCE INCREASED, 1995–2000

According to Russia’s Ministry of Economic Development and

Trade, the United States accounted in 2000 for less than 5 percent

of total Russian foreign trade but ranked third as a market for

Russian exports, after Germany and Ukraine. However, if oil and

gas are excluded from consideration (the United States imports a

disproportionately low level of oil and gas from Russia compared to

other leading trade partners), the United States ranks second

among all countries as a recipient of Russian exports. In short,

while Russia plays a minor nominal role in U.S. imports and exports on a worldwide scale, it remains very important as a trade

partner in the region (former Soviet-bloc countries). The United

States ranked lower (in eleventh place) as an exporter to Russia.

The U.S. market is especially important to Russia as a recipient of

certain products.

U.S.-Russian trade differ from worldwide trade trends because of

significant growth in Russia’s trade surplus with the United

States.5 (See Table 1 and Figure 1). Russia had solid growth in its

exports to the United States each year since 1996,6 while there was

a the sharp decline in U.S. exports to Russia in 1999 following the

financial crisis. The deficit in U.S.-Russian trade was far more pronounced than Russia’s overall worldwide trade performance, although less severe than that experienced by Japan.7 While Russian

415

total trade worldwide in 2000 was roughly the same level as in

1995, U.S.-Russian total trade reached all-time highs in 2000. The

total dollar value of U.S.-Russian trade grew more than 50 percent

between 1995 and 2000 largely attributable to the 93 percent

growth in the value of U.S. imports from Russia during the period

(the value of U.S. exports in 2000 was only 82 percent of the level

in 1995).

TABLE 1.—U.S.-RUSSIA TRADE, 1995–2000

[In billions of dollars]

1995 1996 1997 1998 1999 2000

U.S. exports .......... $2.826 $3.340 $3.289 $3.585 $1.845 $2.318

U.S. imports ......... 4.035 3.561 4.290 5.734 5.805 7.796

Total trade

turnover .. 6.681 6.901 7.579 9.319 7.650 10.114

Trade balance ...... ¥1.209 ¥0.221 ¥1.001 ¥2.149 ¥3.960 ¥5.478

Source: BISNIS.

FIGURE 1.—U.S.-RUSSIAN TRADE, 1993–2000

[In billions of dollars]

■ U.S. exports b U.S. imports

Source: BISNIS.

U.S. EXPORTS TO RUSSIA VARIED BUT LEADING EXPORTS WERE STABLE

Initial U.S. data for the first 6 months of 2001 indicate that the

modest recovery continues, although if performance in the second

half of the year is consistent with the first, the United States will

attain year-end export levels only on par with the mid-1990s.

Growth in U.S. exports to Russia of 25 percent in 2000 over 1999

showed some recovery from the effects of ruble depreciation and

other factors. The U.S. exports to Russia were only $633 million for

January–June 1999. For the same period of 2000, U.S. exports


76171.032
416

8Determined according to the dollar value of the exports on the basis of the first two-digits

of HS classification. Using two digits is a fairly broad way of categorizing products. In contrast,

a complete HS classification for a specific product can be up to ten digits long. 9Specifically, frozen chicken quarters, which came to be known as ‘‘Bush legs’’ in Russia and

the CIS for their forceful appearance on the market during the Presidential Administration of

George H.W. Bush. 10 In 1999 clothing did not make the ‘‘top ten’’ list, but vodka did.

were valued at $1.23 billion. The value of U.S. exports to Russia

for January–June 2001 was nearly $1.4 billion. U.S. export levels

in 2000 and 2001 remained far below levels achieved each year between 1993 and 1998.

Some Russian demand for U.S. imports has emerged in waves.

First, in the early 1990s came demand for U.S. food products, followed by strong demand for U.S. consumer products. 1995 saw a

surge in demand for construction materials, hotel and restaurant

equipment, and furniture. Following the 1998 ruble devaluation

and financial crisis, Russian consumers cut back heavily on many

imported consumer and manufactured goods, with Russian companies benefiting from a cheap ruble and stepping up production, and

quality, to meet increased domestic demand.

Still the Russian demand for core U.S. exports was more stable.

The overall portfolio of leading U.S. exports to Russia 8 has remained fairly consistent since the late 1990s, although the relative

importance of some categories of goods has shifted. The leading

U.S. exports to Russia in 2000, in order of dollar sales were: poultry,9 aircraft, oil/gas machinery and parts, uranium, corn and

wheat, computers and components, beef and pork, telecommunications equipment, electrical machinery, and other machinery.

Meat products (which shifted from a balance of pork, beef and

chicken in the mid-1990s to predominantly chicken in 2000), and

machinery have remained in the top tier of U.S. exports throughout

this period. Prior to 1998, U.S. prepared foods, including sausages,

were among the strong export categories for the United States—

these categories have been all but absent from U.S. exports since

1998. The granting by the Russian Government of tariff waivers on

U.S. aircraft generated a record-breaking dollar value of aircraft

exports in 1998; this achievement was not repeated in 1999 or

2000. U.S. food aid and grain packages resulted in high volumes

of wheat exports in 1999 in particular, although this dropped in

2000.

SOME U.S. IMPORTS FROM RUSSIA INCREASED CONSISTENTLY

Russian exports to the United States continue to consist primarily of raw materials. Platinum (palladium), aluminum, uranium, oil, seafood (crab and fish fillets), iron/steel, clothing, and

nickel were the most important Russian exports to the United

States in 2000 by dollar value. Although iron/steel played a larger

role in the U.S. import profile from Russia prior to 1999, as did fertilizers, the general group of items in this ‘‘basket’’ of leading imports has remained fairly consistent. Clothing was the only finished

good export that showed strongly on Russia’s export profile to the

United States in 1998 and 2000.10

417

11 Additional information about U.S. investment into Russia is available in the BISNIS Commercial Overview for Russia, available at www.bisnis.doc.gov/russia.html. 12Official Russian data on total investment reflects direct + portfolio + other investment, the

latter of which includes trade credits and foreign loans. Estimates of FDI in Russia can vary

widely by source. 13 Note: Cumulative FDI does not equal the sum of annual FDI due to divestment. 14Germany, which has provided more trade credits and ‘‘other investments’’ has had the highest total investment levels into Russia, but the United States leads all countries as a foreign

direct investor into Russia.

BILATERAL INVESTMENT 11

Foreign investors have been attracted to Russia because of its

large domestic market, vast supply of natural resources, and

skilled and well-educated labor force. However, the risks in the

Russian market have kept many investors at bay. Russia’s longterm sovereign rating by the international rating agency, Standard

& Poor’s (S&P), is currently B¥ with a stable outlook, a rating also

given to Turkey and India. While FDI in Russia far outpaced FDI

for CIS countries, foreign investment levels into Russia in 2000 fell

far behind the levels S&P reported for China ($46 billion) and

Eastern European countries such as the Czech Republic ($5 billion). Meanwhile, many potential domestic investors have sent

their money abroad as ‘‘flight capital.’’

Russia reported record-high levels of FDI for 2000, although Russian estimates for total foreign investment 12 indicate that the

country attracted higher levels of total investment in 1997 and

1998. Cumulative FDI into Russia as of January 2001 was $16.13

billion.13

TABLE 2.—ANNUAL FOREIGN INVESTMENT IN RUSSIA, 1993–2000

[All countries, in billions of dollars]

Year

Foreign direct

investment

(FDI)

Portfolio investment

2000 ....................................................................................

1999 ....................................................................................

1998 ....................................................................................

1997 ....................................................................................

1996 ....................................................................................

1995 ....................................................................................

1994 ....................................................................................

1993 ....................................................................................

$4.43

4.26

3.36

3.90

2.05

1.50

1.30

1.36

$0.145

0.031

0.191

3.3

3.2

1.5

2.5

0.300

Source: BISNIS.

FOREIGN DIRECT INVESTORS INTO RUSSIA

The United States has been and continues to be the leading foreign direct investor into Russia, accounting for nearly 35 percent

of all cumulative FDI.14 Table 3 indicates the leading foreign direct

investors into Russia according to cumulative investments as of

January 2001.

418

U.S. investors in Russia

Many major U.S. companies have approached Russia with an eye

toward developing a long-term commercial strategy. As indicated

above, U.S. companies are active across many sectors. While the

level of U.S. activity in Russia slowed following the financial crisis

in August 1998, the majority of U.S. direct investors remained in

the country, reportedly to protect sizable investments and further

their long-term prospects.

TABLE 3.—TOP FOREIGN DIRECT INVESTORS IN RUSSIA

[By cumulative investment levels as of January 2001]

Country Cumulative FDI Leading investment sectors in 2000

United States ...................... $5.49 billion ......... Transportation, fuel, communications, engineering

Cyprus ................................. 3.24 billion ........... Food, transportation, fuel, construction

Germany .............................. 1.26 billion ........... Advertising/auditing, food, forestry

Netherlands ........................ 1.18 billion ........... Transportation, food

Great Britain ....................... 982 million ........... Construction

Sweden ............................... 610 million ........... Communications

France ................................. 256 million ........... Chemical/petrochemical

Japan .................................. 215 million ........... Fuel

Italy ..................................... 160 million ........... NA

NA—Not available.

Source: BISNIS.

The American Chamber of Commerce in Moscow counts some

500 U.S. company members as foreign-directed investors in Russia.

Some of the more well-known U.S. companies who have already

made significant investments developing production capability in

Russia are: Caterpillar (a dealer network in Russia/NIS and in a

factory for road building machinery in Leningrad Oblast), Coca

Cola (bottling and beverage production plants across Russia),

ExxonMobil (oil/gas development), Ford (a factory to produce the

Ford Focus in Leningrad Oblast), General Motors (multiple production projects), Gillette (shaving accessories factory in St. Petersburg), ICN Pharmaceuticals (pharmaceutical production in multiple

Russian locations), International Paper (pulp and paper mill in

Leningrad Oblast), Kraft (instant coffee plant in Northwest Russia), Lucent (telephone line production), Mars (confectionery and

pet food production), McDonald’s (at least 60 restaurant outlets in

Russia), Procter & Gamble (production of detergents and cleaning

agents), Xerox (copiers), and Wrigley (chewing gum production). In

addition to these well-known companies, numerous small- and

medium-sized firms are active in Russia.

Regions attracting foreign investment

According to Goskomstat statistics, Moscow city attracted the

most foreign direct investment in 2000, worth more than $1.47 billion, or roughly 33 percent of incoming FDI. This is consistent with

the city’s overall performance in the years since 1991. Other top reVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00444 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.019 CRS1 PsN: CRS1
419

15 In the summer months, when work on Sakhalin Island’s multi-billion-dollar offshore oil and

gas development projects is in full swing, Sakhalin reports the third-highest U.S. expatriate population in Russia, after Moscow and St. Petersburg. 16To assist U.S. companies and to build Russia’s capacity and institutions of rule of law, the

Department of Commerce has developed several specific programs, including a Handbook on

Commercial Dispute Resolution in Russia, as well as Basic Guidelines for Codes of Business Conduct which was accompanied by training in the United States. There are plans to develop a

Manual on Enforcement of Arbitration Awards and Court Judgement and a Corporate Governance Guidebook for Enterprises in Russia as well. Furthermore, the U.S. Government is providing technical assistance to help Russian Government agencies to stem the high rates of intellectual property rights (IPR)-related crime.

gions for FDI were: Krasnodar Territory (almost $1 billion),

Sakhalin ($246 million),15 Leningrad Oblast (just over $205 million), and Moscow Oblast (just under $205 million). Novosibirsk,

Tyumen, and St. Petersburg city all received between $145 and

$151 million. The Yamal-Nenets Autonomous District in northern

Russia received approximately $100 million in FDI. Volgograd,

Sverdlovsk, Samara, Tatarstan, and Orenburg each received roughly $50 to $77 million in FDI.

While U.S. firms have invested heavily in the cities of Moscow

and St. Petersburg and in the Leningrad Oblast, American companies have also moved beyond these population centers into Russia’s

regions. Sakhalin Island, with its multi-billion-dollar offshore oil

and gas projects, reportedly has the third-largest U.S. expatriate

community in Russia during the summer months. U.S. firms are

also heavily invested into Western Siberia (mostly for oil and gas),

Russia’s Volga regions, and elsewhere.

BUSINESS ENVIRONMENT ISSUES IN RUSSIA

American firms note a number of issues critical to the development of Russia’s business environment, including improved corporate governance, a fair commercial tax system, and an investorfriendly regime for the energy sector. Russian accession to the

WTO.

GOOD GOVERNANCE 16

Good governance is a concept which covers good business ethics,

corporate governance, protection of IPR, and effective commercial

dispute resolution. All of these are institutions of rule of law for

business that are attributes of most successful economies. An evolution in commercial conditions and business thinking is motivating some Russian managers to improve business practices and corporate governance for the purpose of obtaining business partners,

capital, and loans. However, it is generally recognized that much

more needs to be done by the Russian Government and business

community.

Russia has made progress in harmonizing its IPR laws with

international norms, but enforcement of laws and regulations remains poor and the country has not been able to stem the high rate

of IPR-related infringements. Protection of well-known trademarks

is weak, and the high rate of counterfeiting of consumer goods has

become a major issue for U.S. companies operating in Russia. Another major problem is enforcement of commercial arbitration

awards and court decisions. Indeed, notwithstanding awards and

420

decisions in their favor, several U.S. companies have been mired in

long standing battles to have their judgments enforced.

COMMERCIAL TAXATION WITH INTERNATIONAL ACCOUNTING

STANDARDS (IAS)

Russia’s onerous tax laws and their inconsistent application was

the number one complaint of both Russian and U.S. companies in

the 1990s. Since 1993, the U.S. Department of Commerce has cochaired a Bilateral Tax Working Group with the Russian Ministries of Finance and Taxation, which allows the U.S. tax experts

to make recommendations on improving the commercial tax regime. Many of these recommendations have been incorporated in

the new Russian Tax Code. Overall tax laws have been significantly improved under the Putin Administration, with Duma passage of Part II of the Tax Code in summer 2000 and subsequent

actions to reduce the commercial tax burden in summer 2001. Specifically, the personal income tax rate was reduced to a flat rate of

13 percent; social taxes on corporations have been unified; business

expense deductibility has been recognized; and the profits tax has

been cut from 35 percent to 24 percent. While reducing the tax burden on entrepreneurs, these actions have resulted in increased tax

collections. The key issue will increasingly become Russia’s commitment to fair tax administration. American companies still cite arbitrary and confiscatory actions by tax authorities, alleging that foreign companies are targeted as ‘‘cash cows.’’

In order to develop fair and predictable commercial taxation Russia needs to adopt IAS. IAS is important to Russia’s effort to attract investment through fair taxation. In evaluating opportunities,

international investors typically insist on reviewing IAS prepared

financial documents so that they ‘‘know what they are looking at.’’

By contrast, Russian accounting standards have been based largely

on identifying, in some cases, concealing tax obligations. Many of

Russia’s large, ‘‘blue-chip’’ companies have already gone to IAS.

This is a positive development which should be encouraged and

broadened to all companies.

COMMERCIAL ENERGY DEVELOPMENT

Despite Russia’s vast oil and gas reserves and need for world

class exploration experience and technology, U.S. and other foreign

companies have been unable to commit to large-scale investments.

Due to the long-term nature of major oil and gas projects, energy

companies need to be guaranteed a stable tax and tariff framework,

and assured repatriation of profits over the life of the project. In

many resource-rich countries, the preferred vehicle for multi-year

energy projects is a production sharing regime, in which the host

government and the foreign company split the production and revenue of a specific hydro-carbon deposit on an agreed-upon basis.

Russia passed a production sharing agreement (PSA) law in 1996,

but implementing regulations have been stalled for most of the

projects. At this time, the primary impediment is opposition to PSA

by Russia’s own energy firms and in the parliament.

421

RUSSIA’S ACCESSION TO THE WORLD TRADE ORGANIZATION (WTO)

The Russian Government, under President Putin, has made

WTO membership a priority, stating that Russia would like to join

the organization next year in time to participate in a new global

trade round. The U.S. Government supports Russia’s accession to

the WTO on commercially acceptable terms and is providing technical assistance to help Russia meet membership obligations. In

the current interconnected global economy, Russia understands

that it cannot achieve sustained economic growth without an open

trade and investment framework. Adoption of the WTO’s provisions

will complement and reinforce Russia’s broader economic reform

program and promote transparency and the rule of law in trade

and investment. To join the WTO, Russia must implement and enforce the organization’s agreements in such critical areas as IPR,

standards and certification, customs valuation, and industrial subsidies. The adoption of these WTO rules will promote trade and investment liberalization and harmonize Russian laws and regulations with international norms, thereby helping to facilitate access

of U.S. goods and services to the Russian market.

The pace of progress toward eventual membership will be determined by Russia’s actions to adopt WTO rules and to make commercially meaningful market access commitments in goods, services and agriculture to other WTO Members. In this regard, the

Russian Government will need to make hard decisions about the

pace of trade liberalization and the extent to which they will commit to opening up the economy in areas that are priorities for their

major trade partners, including agriculture, civil aircraft, information technology, financial services.

U.S.-RUSSIAN TREATY ON MUTUAL PROTECTION OF INVESTMENTS

Russia’s ratification of the Bilateral Investment Treaty (BIT)

which was negotiated with the United States in 1992 would send

a positive signal to U.S. investors. The BIT, if implemented, would

guarantee non-discriminatory treatment for U.S. investments and

operations in Russia, hard currency repatriation rights, expropriation compensation, and the right to third party international arbitration in the event of a dispute between a U.S. company and the

Russian Government. While the BIT was ratified by the U.S. Senate in 1992, it still awaits ratification by the Russian Duma.

OUTSTANDING TRADE ISSUES WITH THE UNITED STATES

Although Russia continues to enjoy a significant trade surplus with the United States ($5.5 billion in 2000), the Russian Government has consistently raised several trade issues with the U.S.

Government, including a desire to be treated as a Market Economy

under U.S. trade law, a request to be freed from the constraints of

the 1974 Jackson-Vanik Amendment, and increased access for Russian products, including steel, to the U.S. market.

RUSSIA’S NON-MARKET ECONOMY STATUS

The Russians believe that their non-market economy status

makes them more vulnerable to various anti-dumping petitions

422

under U.S. trade law. However, if Russia is deemed a market economy under U.S. trade law, they will no longer be able to negotiate

quota based anti-dumping suspension agreements with the U.S.

Government and will be subject to possible countervailing duty actions.

TRADE IMPLICATIONS OF THE TRADE REFORM ACT OF 1974 JACKSON- VANIK AMENDMENT

The Russian Government sees continued application of the 1974

Jackson-Vanik Amendment as trade-disruptive and a relic of the

cold war. In practice, Jackson-Vanik does not restrict trade as Russia currently enjoys conditional Normal Trade Relations status

with the United States and for some time has been found to be in

full compliance with the emigration requirements of the legislation.

Termination of the application of Jackson-Vanik clause of U.S. law

and granting Russia PNTR status will require Congressional action. Congress will likely review PNTR for Russia as Russia moves

closer to joining the WTO, as has been the case for other acceding

countries, such as Kyrgyzstan and Georgia.

1999 STEEL AGREEMENTS

Russian steel exports to the United States are currently subject

to three agreements: Agreement Concerning Trade in Certain Steel

Products from the Russian Federation (Comprehensive Agreement);

Suspension of Antidumping Duty Investigation: Certain Cut-toLength Carbon Steel Plate from the Russian Federation; Agreement Suspending the Antidumping Investigation on Certain Hot

Rolled Flat-Rolled Carbon Quality Steel Products from the Russian

Federation. The Russian Government has indicated that they seek

renegotiation of the 1999 Agreements to increase the access of Russian steel to the U.S. market.

PROSPECTS FOR TRADE AND INVESTMENT

The history of U.S.-Russian commercial engagement has been

one of small trade and investment with periodic hopes raised for

increases that were consistently dashed by trade and investment

restrictions. Now, for the first time in the long history of U.S.-

Russian commercial relations, including the Soviet period, there is

an expectation of a substantial and enduring commercial relationship between the two countries. If this were to occur, it would represent an historic turning point in the bilateral commercial relationship and represent a major factor in the overall relationship.

The prospective development is based on official policy and national

interest declarations from both the U.S. and Russian leadership,

projected improvement in the business environment in Russia, and

a new mechanism for promoting commerce based on private sector

initiatives in each country.

However, stated policy and expression of national interest would

have to be translated into concrete changes in the business environment and market access in both countries. Improved business

environment in Russia requires substantial implementation of

Putin’s institutional reform and introduction of market-friendly

systems that reduce risk in investment and foster competition in

423

trade. U.S. business enterprises look for improved corporate governance, a commercial tax system, commercial energy development,

adherence to bilateral commercial treaties and agreements and

substantial progress toward accession to the WTO. Russian business interests look to their American counterparts for reduced

trade barriers, such as removal of restrictions on most-favored-nation trade, improved access to the U.S. market, promotion of commercial development of energy production, and development of assistance through a favorable official credit policy.

The tradition of Russian and Soviet trade and investment has

been high on hopes for substantial increases in commerce and low

on favorable, enduring results. Severe setbacks, such as the default

on Russian debt and securities in the 1998 financial crisis have

been characteristic of the past commercial relations. Prudence by

policymakers requires evidence of concrete changes in the bilateral

business environments and performance. Even with U.S. sponsorship and Russian priority for joining the WTO, U.S. policymakers

may be cautious in assuming that by steps toward accession Russia

will effectively join the global capital and commercial market and

develop a new bilateral commercial relationship with the United

States.

Notwithstanding these cautions, there are a number of reasons

to be optimistic about the prospects for the U.S.-Russian commercial relationship over the next several years. First, both the Bush

and Putin Administrations have demonstrated their commitment to

taking business cooperation to the next level. Indeed, as a result

of recent high-level meetings, the two governments are already

pursuing practical solutions to achieve measurable results. A

checklist of issues and corresponding time line is being developed,

including advancing work on Russia’s WTO accession, consulting

on the market economy status for Russia, and exploring new

Export-Import Bank financing programs.

Second, while in the past West European countries have been the

major trading partners and promoters of commerce with Russia,

the new Russian-American business dialogue is designed to provide

an initiative for development of a major, perhaps leading, American

commercial relationship with Russia. The Russian business community clearly recognizes the advantages of developing commercial

ties with the United States, which is the dominant source of international capital, the world’s largest market, and a global technology leader. For the U.S. business community, Russia, despite

the frustrations, remains a market of considerable potential, especially beneficial at a time of domestic economic downturn in the

United States. The new Russian-American business dialogue may

engender greater familiarity and trust between the respective business communities opening the way for new joint commercial

projects, particularly among the small- and medium-sized businesses.

Third, Russia’s economy is growing and offering new market opportunities. Russia’s economic reform program is only now beginning to gain traction, and it is not unreasonable to posit that conditions will improve if reforms are expanded and implemented.

On the other hand, expected advancement of U.S.-Russian trade

and investment may not be forthcoming if past patterns of uncerVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00449 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.019 CRS1 PsN: CRS1
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tainties and instability of bilateral commercial relations return.

The path to increased trade and investment is full of hurdles. Most

notably, Russia’s business climate and culture still does not yet inspire broad U.S. investor confidence. Changing this perception may

not be a short term proposition. Russia may yet give in to impulses

toward economic nationalism and protectionism. Trade disagreements, for example, over Russian exports of steel to the United

States could cloud the commercial relationship. Other advanced industrial countries, particularly the Europeans, may more aggressively compete for the Russian market. Russia’s economy remains

vulnerable to external shocks, such as a significant drop in oil

prices and/or a major global recession, that may impede bilateral

commercial development.

Nevertheless, at this time, both governments expect progress. At

a strategic level, a more robust commercial relationship is in the

interests of both countries, business communities and governments

alike. U.S. companies stand to gain substantial profit if significant

new commercial opportunities are realized. For the Governments of

Russia and the United States, increased bilateral business holds

the promise of stabilizing the overall bilateral relationship.

(425)

RUSSIA AND THE INTERNATIONAL FINANCIAL

INSTITUTIONS: FROM SPECIAL CASE TO A

NORMAL COUNTRY

By Jonathan E. Sanford 1

CONTENTS

Page

Summary .................................................................................................................. 426

Overview ................................................................................................................... 427

A Decade of Special Consideration ......................................................................... 428

Prelude and overture ........................................................................................ 428

Special association ..................................................................................... 428

What is to be done ..................................................................................... 428

The 1992 shadow program ....................................................................... 429

Russia joins the IFIs ........................................................................................ 431

IFI operations in Russia .................................................................................. 431

The IMF ..................................................................................................... 431

The World Bank ........................................................................................ 432

The European Bank for Reconstruction and Development (EBRD) ...... 434

Composition of the IFI assistance programs .................................................. 435

The IMF ..................................................................................................... 436

The EBRD .................................................................................................. 437

The IFC ...................................................................................................... 438

Five Stages in the Transition from Special Case to Normal Country ................. 439

Disburse regardless: 1992–1994 ...................................................................... 440

Synopsis ..................................................................................................... 440

IMF Programs: 1992–1994 ....................................................................... 441

World Bank programs: 1992–1994 ........................................................... 444

Disburse with compliance: 1995 ...................................................................... 445

Synopsis ..................................................................................................... 445

IMF operations: 1995 ................................................................................ 445

World Bank operations in Russia: 1995 .................................................. 447

Disburse despite resistance: 1996–mid 1998 .................................................. 447

Synopsis ..................................................................................................... 447

IMF programs: 1996–1998 ........................................................................ 448

World Bank programs: 1996–1998 ........................................................... 450

Commit in the face of crisis: 1998 ................................................................... 453

Synopsis ..................................................................................................... 453

IMF programs: 1998 .................................................................................. 453

World Bank programs: 1998 ..................................................................... 455

Reconsideration: 1999–2001 ............................................................................ 457

Synopsis ..................................................................................................... 457

IMF programs: 1999–2001 ........................................................................ 457

World Bank programs: 1999–2001 ........................................................... 458

Treating Russia as a Normal Country ................................................................... 459

Concluding Comments ............................................................................................. 462

1 Jonathan E. Sanford is a Specialist in International Political Economy in the Foreign Affairs,

Trade and Defense Division of the Congressional Research Service.

426

SUMMARY

The international financial institutions (IFIs)—the International

Monetary Fund (IMF), World Bank, and European Bank for Reconstruction and Development (EBRD)—provided substantial levels of

assistance and policy advice to Russia during the past 10 years. Between 1992 and 2001, the IMF and the multilateral development

banks (MDBs) approved programs of financial assistance for Russia

which totaled altogether about $59 billion. Of this, $32.5 billion

was disbursed, $24.6 billion was canceled, and the rest is awaiting

disbursement as projects are implemented. All of the money lent by

the IMF took the form of balance-of-payments support tied, to varying degrees, to plans for macro-economic and structural reform. For

the World Bank, over half the money it agreed to lend and nearly

two-thirds the amount it disbursed went for similar purposes.

Many of the World Bank’s project loans have been slow getting underway due to difficulties finding an effective policy environment

for their implementation. Many of the issues which are the focus

of these loans—enterprise reform, reform in the financial system,

corporate governance and the legal framework, etc.—are matters

on which there remains considerable disagreement between reformers and their opponents. Most of the assistance from the EBRD and

from the International Finance Corporation (IFC)—the World

Bank’s private sector aid facility—has gone to strengthen private

firms and promote growth of the private sector. The EBRD and IFC

have had less difficulty implementing their projects because these

are not directed at core policy issues but rather at private sector

growth.

Until 1999, with the strong support of the United States and

other major member countries, the IFIs treated Russia as a special

case. The standards and guidelines for assistance to Russia were

more relaxed and flexible than those applied to other countries at

a similar stage of development Only one non-member country—the

Soviet Union—ever had ‘‘special association’’ status with the IMF

and World Bank and had a major program of technical assistance

committed for its behalf. No other country besides Russia had a

shadow program with the IMF in place before it became a member.

No other group of countries—Russia and the other struggling

former Communist countries—had a special loan account created

for them in the IMF offering loans with such little conditionality.

No other country, considering its relative size—a gross domestic

product (GDP) barely larger than Turkey, smaller than Argentina

and half the size of Mexico and Brazil—received such a disproportionately large amount of money and bulked so large upon the

agenda of the IFIs. No other country received large and increasing

loan commitments from the IMF and World Bank at the same time

that it was failing conspicuously to meet the full performance requirements of its earlier loans.

The IFIs sought through their programs to strengthen the hand

of the Russian reformers and to promote macro-economic and structural reform in Russia. During the early years, the establishment

of macro-economic stability was the primary goal and structural reform—change in the basic way the economy is organized and its

underlying operational principles—was an important but secondary

427

concern. During the latter part of the 1990s, however, the IFIs put

increased emphasis on structural reform. In 1999, the IMF and

World Bank canceled most of their big loan programs for Russia

and they shifted their basic approach. It appears that dissatisfaction with the slow progress Russia was making with many key

types of structural reform was as great, if not a greater, consideration in 1999 than was Russia’s uncertain macro-economic situation.

Today, the IFIs and their major member countries increasingly

view Russia as a ‘‘normal’’ country, that is to say, a country that

does not need special standards and special dispensations. As with

most middle-income developing countries, Russia has major problems and it needs substantial reforms in the structure and operating principles for its economy. No large programs of balance-ofpayments assistance are planned, however, and most MDB projects

are likely to focus on specific projects aimed at improving social

conditions, promoting institutional reform, or encouraging policy

change in specific well defined situations. Russia’s current macroeconomic situation is such that it does not need new IFI stabilization or structural adjustment loans (SALs). Given its performance

with structural reform in prior loans—the substantial overhang of

as-yet unsatisfied commitments—Russia is unlikely to qualify for

such loans even if it needed them. The size of the EBRD and IFC’s

assistance programs in Russia will likely depend, in future years,

on the level of interest shown by foreign investors and the private

sector. The size and focus of the IMF and World Bank’s future assistance programs in Russia will likely depend, by contrast, on the

types of reforms the Putin government puts into effect.

OVERVIEW

There are four principal parts to this paper. The first provides

an overview of the IFI’s operations in Russia. The composition of

their programs are discussed in some detail. The second part discusses the course of events during the 1990s, the way the IFIs

sought to balance their enforcement of conditionality with their desire to provide levels of assistance to Russia sufficient to keep the

hope and effort toward reform underway. The five stages of the

process are labeled here as follows: disburse regardless, 1992–1994;

disburse with compliance, 1995; disburse despite resistance, 1996–

1997; commit in the face of crisis, 1998; and reconsideration, 1999–

2001.

The third section relates the IFI’s views on their experience with

Russia. As it indicates, the concept that Russia is a ‘‘normal’’ country does not imply that it is a country without major problems.

Rather, it is a country whose situation is no longer unique and

whose problems resemble those seen in many other developing

countries. The fourth section provides some concluding remarks.

This paper makes extensive use of public documents available

from the IFIs. It also uses some information obtained through

interviews.

428

2 Interview with John Odling-Smee, Director of the IMF department responsible for the former

Soviet Union, June 14, 2001. On October 14, the IMF Interim Committee said that assistance

would be available ‘‘to assist the [U.S.S.R.] authorities in moving forward with urgently needed

economic stabilization and structural reforms.’’ IMF Annual Report, 1992. Interim Committee

Press Communique ́, October 14, 1991, p. 126.

A DECADE OF SPECIAL CONSIDERATION

PRELUDE AND OVERTURE

Special association

Since 1987, under Chairman Gorbachev, the Soviet Government

had been pursuing—against considerable internal resistance—a

program aimed at restructuring (perestroika) the Soviet economy.

In 1990, the Soviet Union was in the midst of a deep financial and

economic crisis and Gorbachev reached out to the West for advice

and assistance in dealing with the situation. At their summit meeting in Houston, in June 1990, the leaders of the G–7 countries commissioned the World Bank, Organization for Economic Cooperation

and Development (OECD), EBRD, and IMF to do a study of the Soviet economy. Issued in early 1991, the four agency study recommended a comprehensive program of reform. This included the

early and comprehensive decontrol of prices, restructuring of the financial system, clarification of property rights, and commercialization and privatization of industry. It also included trade and investment liberalization, labor market liberalization, and the creation of an affordable social safety net. The West would provide

technical and project assistance and food aid to help facilitate Soviet economic reform.

On October 5, 1991, the IMF and Soviet Union signed an accord

giving the U.S.S.R. ‘‘special association’’ status with the IMF. A

similar agreement with the World Bank was signed on November

5. Because it was not a member, the Soviet Union could not borrow

from the two agencies. However, the IMF and World Bank agreed

to provide technical assistance and advice to help the Soviets stabilize their economy, improve their system for gathering statistics,

reform the banking system, and strengthen their social safety net.

On August 27, the Bank’s executive board created a $30 million

special trust fund (using some of the Bank’s net income) to support

technical cooperation programs in the U.S.S.R. during the next 2

years. Most of the funds were reportedly committed late in the year

and not spent until later. Russia and three other republics eventually signed the agreement. Until October, according to IMF sources,

the Soviet Government insisted that the IFIs deal with and

through the Soviet Government.2 Later, as the handwriting on the

wall became increasingly clear, the IFIs began direct talks as well

with Russia and the other republics.

What is to be done

On October 28, 1991, President Boris Yeltsin delivered a speech

to the Russian Congress of Peoples’ Deputies and the Russian people outlining his plans for radical economic reform and the transition from state socialism toward capitalism and a market economy.

‘‘I appeal to you at one of the most critical moments in Russian history,’’ he said. ‘‘Right now it will be decided what kind of country

Russia will be in the coming years and decades.’’ At the time, RusVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00454 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1
429

sia was not yet an independent country but the Soviet state was

rapidly withering away.

The central focus of Yeltsin’s new economic program was stabilization and economic freedom. Strictly speaking, it was not to be

a ‘‘big bang’’ or ‘‘shock therapy’’ approach, since by intention (and

by actual events) its provisions were phased in over a period of

time. The macro-economic portion of the plan was an orthodox stabilization program emphasizing price liberalization and strict budgetary policy. Major cuts would be made in the budget deficit, state

administration, and subsidies for enterprises. A fixed exchange rate

would be established for the ruble, Yeltsin said, and it would be

made convertible. Restrictions on foreign trade and investment

would also be lifted. Privatization of small- and medium-sized enterprises would be a priority and he hoped that one-half could be

privatized within 3 months.

Yeltsin’s speech showed the direction in which he wanted the

economy to move. On many key issues, though, it was vague. He

said the country’s tax system should be put in order, but there was

no mention of the plummeting rate of tax collections. He said there

should be more competition and a break-up of monopolies, but

there was no discussion of corporate governance or fundamental

change in the structure of state industry. The banking system

should be reformed, but there was no mention of privatization or

new systems of regulation. Monetary and credit policy should be

strictly controlled, but there was no indication whether he believed

the ruble zone should be continued or dissolved or how the Central

Bank of the Russian Federation (Central Bank of Russia or CBR)

would be brought under government control. Yeltsin admitted that

the process of change would be painful and that ‘‘today in the severest crisis we cannot carry out reform painlessly.’’ Living standards would decline and it ‘‘will be worse for everybody for about

half a year.’’ Afterward, though, he said, prices would fall and the

markets would be full of goods. By fall 1992, he said, ‘‘as I promised before the elections, the economy will stabilize and people’s

lives will gradually improve.’’

The 1992 shadow program

Yeltsin called, in his October speech, for the outside world to

come to Russia’s aid. ‘‘We turn officially to the IMF, the World

Bank, the European Bank for Reconstruction and Development and

invite them to elaborate detailed plans in cooperation and participation in economic reforms. He appealed for developed countries

and international organizations to provide technical assistance and

policy recommendations. ‘‘Russia carries out its reforms in its own

interests,’’ he indicated, ‘‘and not under external pressure. Help

from the world community can facilitate our movement along this

road considerably and accelerate the reforms.’’ Yeltsin promised the

West whatever information or collaboration it would desire.

The same day that Yeltsin spoke, the deputy finance ministers

of the G–7 countries and representatives of eight Soviet republics,

including Russia, signed a memorandum of understanding (MOU)

allowing a moratorium on principal payments for Soviet debt owed

to the G–7. Under the terms of the MOU, the moratorium could not

430

extend beyond March 31, 1992 unless the IMF approved a shadow

program for Russia.

It is very rare, if not unprecedented, for the IMF to negotiate a

shadow program with a country that is not a member of the organization. Shadow programs are not unusual. Countries may negotiate

such arrangements with the IMF when they do not need (or could

not qualify) for loans but they wanted to demonstrate (through

IMF endorsement) the basic soundness of their economic policies.

The shadow program allowed the Russian Government to announce

a package of economic policies which had the IMF’s active endorsement. Among other things, this was supposed to create some basis

for international confidence in Russian policy. It was also intended

to assure the country’s creditors that any resources saved through

debt relief would not be dissipated through bad economic policies.

The shadow program was not a condition for Russian membership

in the IMF. However, most people assumed it was a condition for

future IMF assistance. The G–7 also made it clear, when they an- nounced on April 1 their $24 billion assistance package, that Russia needed to qualify for a regular IMF standby loan before it could

gain access to those resources.

Agreement on the terms of the shadow program had been greatly

eased by Yeltsin’s prior announcement that the road to transition

for Russia should lead through fundamental reforms to a new

market-oriented economic system. There might have been little

room for discussion between the Yeltsin government and the IMF

if he had advocated some ‘‘third way’’ between the market and central planning or a more democratic continuation of the old system

of state economic control. On February 27, after discussions with

the IMF, the Russian Government announced that it was putting

a new economic program into effect. A few days later, on March 31,

the IMF endorsed the MOU embodying the government’s plan. In

many ways, the economic blueprint embodied in the shadow program was the first real economic plan the government had adopted.

It was more specific than the government’s prior announcements

and it addressed a number of key issues on which the government

had been vague in the past.

Most of the provisions of the shadow program were based, however, on plans or policy goals the government had announced earlier. It said that inflation would be reduced and the government’s

budget deficit would be cut to 1 percent of GDP, mainly through

reductions in military spending and subsidies to enterprises. The

government would adopt a program of targeted social subsidies to

help the worst off and unemployed. CBR monetary and credit policies would be tightened. Most remaining price controls on goods

and services would be lifted by the end of March, except for rents,

transport, and domestic gas and energy. (The government had removed price controls for most products in January.) Domestic oil

prices would be freed on April 20. The value added tax (VAT) of

28 percent—introduced in January but later withdrawn—would be

restored and would be applied to imports after July 1. A unified regime of export taxes on energy and raw materials would be established. A progressive tax on pay increases by state firms, which exceeded specific norms, would be levied. In June, as promised, the

Russian Government created a unified exchange rate for the ruble,

431

dropping the old system of multiple exchange rates. In November

1992, the ruble was made convertible for Russian residents’ foreign

trade transactions.

RUSSIA JOINS THE IFIS

The Soviet Union never joined the World Bank or the IMF. It

was a founding member (1991) of the EBRD, but by agreement the

amount it could borrow from the EBRD was no larger than the

amount it had contributed. In January 1992, the Bush Administration announced that it supported membership by Russia and the

other former Soviet republics in the IFIs.

In early May 1992, soon after the IMF had endorsed the Russian

shadow program, the executive boards of the IMF and World Bank

invited Russia and the other former Soviet republics to join. Russia

became a full member of the both institutions in June, with seats

of its own on their executive boards. It received a 3.2 percent quota

share in the IMF, making it the ninth largest member. It got a

1.82 percent voting share in the International Bank for Reconstruction and Development (IBRD), the World Bank’s near-market-rate

loan facility, making it—along with Brazil—the fourteenth largest

member. Russia joined the Bank’s other affiliates at this time. The

amount a country may borrow from the IMF is determined by the

size of its quota. This is not so for the multilateral banks. In early

1992, the Soviet Union ceased being a member of the EBRD and

the 12 successor states became members in their own right. (The

three Baltic states joined in 1991.) Russia got a seat of its own on

the EBRD board.

IFI OPERATIONS IN RUSSIA

The IMF

Between 1992 and 1999, as Figure 1 illustrates, the IMF approved six loans to Russia with a total value of SDR (special drawing rights) 33.73 billion (about $42.69 billion by the current exchange rate). Of this, half (SDR 16.16 billion or $20.45 billion) was

disbursed. Access to the rest was terminated due to non-compliance

with loan terms.

FIGURE 1.—IMF LENDING TO RUSSIA

[Special drawing rights (SDR) in millions]


76171.049
432

The World Bank

Likewise, during the same period, as Figure 2 indicates, the

World Bank approved loans to Russia totaling $12.21 billion from

the IBRD. It also approved $412 million in loans or equity investments from the IFC, its private sector assistance facility, as well

as $249 million in guarantees for foreign investment through the

Multilateral Investment Guarantee Agency (MIGA). The IBRD

makes loans to government agencies or with government repayment guarantees on near-market-rate terms. As Figure 3 indicates,

more than one-third of the funds approved for IBRD loans to Russia have not yet been disbursed. According to data provided by the

World Bank’s office in Moscow, $2.79 billion of the total was canceled. The remaining $1.75 billion is awaiting disbursement as

work on the relevant projects or programs goes forward. Table 1

lists the projects the IBRD approved in Russia in the past decade

and the disbursement status for each.

FIGURE 2.—WORLD BANK AID TO RUSSIA (COMMITMENTS)

FIGURE 3.—IBRD LOANS TO RUSSIA (COMMITMENTS AND DISBURSEMENTS)


76171.047
433

TABLE 1.—WORLD BANK LENDING TO RUSSIA, 1992–2001

[In millions of U.S. dollars]

Date Purpose Status Commitment

CanceledUndisbursed

8/5/92 ...... IMF approves first credit tranche loan

8/06/92 .... Rehabilitation 1 .................................... Closed ...... $600.0 ............ 0.0

11/24/92 .. Employment Services/Social Protection Closed ...... 70.0 $14.4 0.0

12/17/92 .. Privatization Implementation Assistance.Closed ...... 90.0 4.0 0.0

6/17/93 .... Oil Rehabilitation 1 ............................... Closed ...... 610.0 196.0 0.0

6/30/93 .... IMF approves Systemic Transformation Facility (STF) loan, releases first tranche

2/17/94 .... Highway Rehabilitation & Maintenance Closed ...... 300.0 19.2 0.0

3/22/94 .... IMF releases second tranche of STF loan

5/19/94 .... Financial Institutions. Development ..... Active ....... 200.0 59.5 $66.7

6/16/94 .... Ag Reform Implementation Support ..... Extended .. 240.0 118.2 4.1

6/16/94 .... Land Reform Implementation. Support Active ....... 80.0 ............ 41.8

6/21/94 .... Enterprise Support Project .................... Active ....... 200.0 ............ 163.1

6/29/94 .... Oil Rehabilitation 2 ............................... Closed ...... 500.0 153.4 0.0

11/8/94 .... Environment Management Project ........ Active ....... 110.0 ............ 55.5

12/15/94 .. Management and Financial Training .... Closed ...... 40.0 ............ 0.0

2/16/95 .... Portfolio Development Project ............... Active ....... 40.0 ............ 19.0

3/7/95 ...... Housing ................................................. Active ....... 400.0 150.7 71.5

3/9/95 ...... Tax Administration Modernization ......... Closed ...... 16.8 0.1 0.0

3/11/95 .... IMF approves first regular standby loan

4/25/95 .... Emergency Oil Spill Rehab/ Mitigation Active ....... 99.0 ............ 5.2

5/2/95 ...... Energy Efficiency Project ....................... Active ....... 106.5 36.5 51.0

5/16/95 .... Urban Transport .................................... Active ....... 329.0 77.6 4.4

6/6/95 ...... Rehabilitation 2 .................................... Closed ...... 600.0 ............ 0.0

11/30/95 .. Standards Development ........................ Extended .. 24.0 ............ 3.7

3/26/96 .... IMF approves first extended fund facility (EFF) loan

3/28/96 .... Bridge Rehabilitation Project ................ Active ....... 350.0 195.3 30.3

4/30/96 .... Community Social Infrastructure .......... Active ....... 200.0 56.5 78.3

5/7/96 ...... Enterprise Housing Divestiture ............. Active ....... 300.0 43.6 215.8

5/30/96 .... Capital Market Development Project .... Active ....... 89.0 33.8 35.9

6/4/96 ...... Medical Equipment Project ................... Closed ...... 270.0 46.5 14.1

6/13/96 .... Legal Reform Project ............................ Active ....... 58.0 ............ 32.6

6/27/96 .... Coal Sector Adjustment 1 ..................... Closed ...... 500.0 ............ 0.0

6/27/96 .... Coal Sector Restructure Implement

Asst.

Active ....... 25.0 ............ 8.8

3/27/97 .... St Petersburg City Ctr Rehabilitation ... Active ....... 31.0 ............ 7.5

6/5/97 ...... Education Innovation ............................ Active ....... 71.0 3.0 57.6

6/5/97 ...... Health Reform Pilot Project .................. Active ....... 66.0 ............ 49.6

6/5/97 ...... Bureau of Economic Analysis Project ... Active ....... 22.6 ............ 6.8

6/5/97 ...... Enterprise Restructuring Services

Project.

Closed ...... 85.0 85.0 0.0

6/5/97 ...... Structural Adjustment Loan (SAL) 1 .... Closed ...... 600.0 ............ 0.0

6/5/97 ...... Electricity Sector Reform Support

Project.

Active ....... 40.0 ............ 37.9

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TABLE 1.—WORLD BANK LENDING TO RUSSIA, 1992–2001—Continued

[In millions of U.S. dollars]

Date Purpose Status Commitment

CanceledUndisbursed

6/25/97 .... Social Protection Adjustment Loan

(SPAL).

Closed ...... 800.0 ............ 0.0

10/7/97 .... Social Protection Implementation

Project.

Active ....... 28.6 ............ 18.0

12/18/97 .. Coal Sector Adjustment Loan 2 ............ Active ....... 800.0 ............ 150.0

12/18/97 .. SAL2 ...................................................... Closed ...... 800.0 ............ 0.0

7/20/98 .... IMF approves second EFF loan and Compensatory and Contingency Financing Facility (CCFF) loan

8/6/98 ...... SAL3 ...................................................... Closed ...... 1,500.0 1,100.0 0.0

12/22/98 .. Highway Rehabilitation & Maintenance

2.

Closed ...... 400.0 400.0 0.0

5/13/99 .... State Statistical System Development Active ....... 30.0 ............ 29.0

7/28/99 .... IMF approves second standby loan

12/22/99 .. Regional Fiscal TA Project .................... Active ....... 30.0 ............ 28.0

5/23/00 .... Sustainable Forestry Project ................. Active ....... 60.0 ............ NYE

12/21/00 .. Water Supply and Sanitation Project ... Active ....... 122.5 ............ NYE

2/6/01 ...... Moscow Urban Transport Project .......... Active ....... 60.0 ............ NYE

3/27/01 .... Municipal Heating Project ..................... Active ....... 85.0 ............ NYE

5/24/01 .... Education Reform Project ..................... Active ....... 50.0 ............ NYE

6/7/01 ...... Northern Restructuring Pilot Project ..... Active ....... 80.0 ............ NYE

.................. Not Yet Effective. Loan approved by executive board but final contract is not yet

signed.

The IFC makes loans to and equity investments in firms in developing countries in order to promote growth and strengthen the

private sector. It also provides technical assistance and other forms

of operational advice. It does not require government guarantees,

and it charges essentially market rates for its aid. At some point,

when a firm has grown and its stock has appreciated in value, the

IFC will sell it shares. If the IFC is an investment bank, the MIGA

is an insurance company. It guarantees investors, for a fee, against

various types of non-economic risk, such as expropriation, restrictions on international currency transfer, and damage from war or

civil strife.

The European Bank for Reconstruction and Development (EBRD)

The EBRD reports that, between 1991 and 2000, it approved

loans or equity investments for Russia totaling 3.41 billion (about

$4.43 billion according to the dollar/euro exchange rate for 1995

and $2.79 billion according to the rate for 2000). Of this amount,

about 733 million is awaiting disbursement and a major portion

of the balance appears already to have been repaid. The EBRD

charges commercial or near-commercial rates for its loans and does

not require government guarantees. The current official figures are

somewhat at variance with data taken from the EBRD annual reports. When aggregated, the annual figures show that the EBRD

435

approved 4.32 billion in assistance to Russia (about $5.61 billion

by the 1995 exchange rate and $3.97 billion by the 2000 rate). The

difference between this and the total published by the EBRD is

probably explained by cancellations or by funds which were not

needed for the completion of approved projects. It is impossible to

determine the years to which the difference should be assigned.

Figure 4 shows the annual amounts the EBRD approved for Russia

during the 1990s.

FIGURE 4.—EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT (EBRD)

ASSISTANCE TO RUSSIA

[In millions of euros]

COMPOSITION OF THE IFI ASSISTANCE PROGRAMS

Most of the programs the IMF and World Bank supported in

Russia during the past decade sought to promote macro-economic

stability and structural reform. All of the IMF’s loans have supported these goals and provided balance-of-payments support. The

IMF does not fund projects. For the World Bank, in terms of the

number of loans, most of those for Russia went for investment

projects or programs of technical assistance and institutional reform. In terms of the amounts of money lent overall, however, most

of the Bank’s assistance to Russia took the form of balance-ofpayments support aimed at promoting broad-based reform in Russia’s economic policies and the structure of its economy. Figure 5

shows that between 1992 and 2001, over half the funds IBRD committed and nearly 65 percent the funds it disbursed went to these

‘‘big picture’’ loans. Loans to strengthen the oil and gas industry (a

major source of exports and tax revenue) comprised another 10 percent of the approvals and 11 percent of disbursements. Loans promoting change in the organization and operations of industry, the

financial sector, the housing market, agriculture and land ownership, and technical procedures accounted for about 16 percent of

commitments and 10 percent of disbursements.


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FIGURE 5.—IBRD LOANS TO RUSSIA

For most active World Bank projects, a large part of the

undisbursed balance will be paid out eventually as implementation

proceeded. By contrast, most of the ‘‘big picture’’ adjustment loans

approved in the past decade were fast disbursing, the proceeds

being made to the borrower as each loan allotment or tranche became effective. Bank-funded investment projects may take 8 to 10

years for full completion. The proceeds from the loan are gradually

disbursed as work on the project is completed and the bills from

contractors or suppliers are received. Most disbursements occur

during the middle years of that period. It is worth noting, though,

that many of the projects for Russia approved in the early 1990s— for example, the loans for financial institutions development, land

reform, enterprise support, environmental management, and housing in 1994—have used only a small portion of the amounts originally approved. In several cases, a large portion of the loan commitment was later canceled due to changes in context or problems

in implementation. In some cases, it seems the Bank is still waiting for the government to take steps or to implement policies which

it endorsed in the original loan agreement. In some instances, it

appears that necessary legislation has not yet been passed making

it eligible for release.

The IMF’s programs generally specified the overall goals and priorities for macro-economic and structural reform in Russia. The

Bank’s adjustment loans often reinforced those objectives and

sought to apply them in particular areas. Many of the Bank’s

projects loans also addressed issues of particular concern. These included, in addition to enterprise reform, privatization, and capital

markets development, other concerns such as agricultural reform

and improvements in tax, legal, and technical systems. The World

Bank had considerable difficulty implementing many of these

loans. (See the amounts canceled or not yet disbursed on Table 1.)

This reflects the problems the IFIs have encountered generally in

their efforts to promote structural reform in Russia.

The IMF

The principal goals of the IMF’s programs in Russia included fiscal reform (controlling expenditures, increasing tax collections, reVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00462 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1

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3 EBRD signed projects in Russia (table) as of 30 June 2001. Available from the EBRD Web

site at http://www.ebrd.org/english/opera/country/rusproj.htm under the general heading ‘‘EBRD

signed projects in Azerbaijan.’’

ducing the budget deficit), monetary stabilization (reducing the

rate of inflation), and a series of structural reforms (for instance,

accelerating privatization, restructuring the banking and finance

systems and corporate governance, and implementing legal reform).

The Bank’s adjustment programs in Russia had similar goals.

Stabilization and adjustment loans provide a direct infusion of

foreign exchange. This helps bolster a country’s balance of payments, relieving pressure and potentially promoting growth. However, this is only a temporary effect. The underlying concept behind

these loans is the expectation that a borrower country can improve

its economic situation only if it makes basic changes in its macroeconomic policies and it adopts structural reforms to enhance the

efficiency and productivity of its economy. In effect, a country cannot reach its goals unless it is willing to change its course. Generally, the key government authorities in the borrower country

want to make these changes (that is, they have some degree of

‘‘ownership’’ of the project plan.) However, they often face stiff resistance from other power centers in their country’s decisionmaking

system. Some of the proceeds from the loan are available right

away. The remainder is available only when the borrower country

achieves certain pre-set reforms or performance standards. Such

conditionality meets both the lender and the borrower’s needs. The

lender knows that the agreed goals of the program are being

achieved and the borrower knows in advance that it will receive access to additional funds if it does certain specified things. Among

other things, this presumably helps to strengthen the hand of the

reformers in their country’s internal policy debates.

The EBRD

By contrast with the programs supported by the IMF and IBRD,

most of the assistance provided to Russia by the EBRD, IFC, and

MIGA has sought to encourage the growth of the private sector and

to strengthen private firms. According to data provided by the

EBRD, less than 18 percent of the funds committed through June

30, 2001 for Russia went to state institutions.3 This includes 8

loans to firms predominantly owned by government and three to

government agencies. It also appears to include loans to firms

which have been privatized but where (for example, many natural

monopolies) the government still own a significant share of the

stock.

Initially, the EBRD put strong emphasis on technical assistance

in connection with its loans and investments. By late 1993, though,

it had shifted its attention mainly to projects. The EBRD began its

operations in Russia expecting to finance projects throughout the

Federation. However, with experience, it shifted plans and consciously focused much of its assistance to regions more open to reform and foreign investment. It has also limited the scope of its activities to areas where it believed it has a comparative advantage.

Figure 6 shows (without regard to public or private ownership)

the sectors of the Russian economy that received EBRD assistance.

The finance sector got the largest share (29 percent). The EBRD

438

put much effort into strengthening Russian banks, finance and insurance companies and in facilitating new entries (mostly foreign)

in this area.

FIGURE 6.—THE EBRD’S RUSSIAN PORTFOLIO

Major shares have also gone to the oil and gas sector (19 percent)

and manufacturing (19 percent). The latter includes privatization,

food, and agro-industry. Most of the EBRD’s approvals for oil and

gas production took place in the first half of the decade, when Russia’s balance-of-payments situation was very tight. Most of the

EBRD’s loans or equity investments in manufacturing were approved after 1995. All loans for mining were aimed at the extraction and production of metals. None were made for coal. The EBRD

did not specify the sector for several loans it had approved for Russia.

The EBRD manages a Russia Small Business Fund which provides funding to small and medium size enterprises in Russia. The

loans are entirely private sector, with no government guarantees or

guidance, and are implemented through the private banking system. The fund is supported by the G–7 countries, by the EU, and

by Switzerland, with an overall capitalization of $300 million. Of

this, $50 million is set aside for technical assistance. Since inception, the Fund has disbursed $431 million through 36,720 loans.

The EBRD also has a special Legal Transition Program which

provides policy and technical assistance to improve the legal and

regulatory environment for commerce. The EBRD says that it has

been very successful in generating proposals for regulating legal

entities and for reforming markets and many of its initiatives have

been adopted. It is also focusing increasingly on issues involving

corporate governance.

The IFC

The IFC began its work in Russia in 1991, focusing on the privatization of state-owned firms and farms near Nizhny Novgorod.

At the request of Russian authorities, it prepared a manual on privatization, based on its experience with small-scale privatization in

that city, for use elsewhere in the country. This led, the IFC reported, to the privatization of some 80 percent of the small enterVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00464 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1

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prises in the country It also says it helped with the sale of 1,100

medium and large enterprises as well as the privatization of the

trucking industry in many parts of the country. The IFC says that

its land privatization and farm reorganization program had helped

several hundred state and collective farms distribute land and

property to their members.

In June 2000, the IFC’s portfolio in Russia consisted of $194 million in loans and $117 million in equity investments. Manufacturing accounted for 55 percent of the total, followed by financial markets (21 percent), oil and gas (10 percent), and other activities (14

percent) (Figure 7). The financial crisis of 1998 seriously undermined many of the IFC’s investments in Russia, particularly those

in the banking and financial services sectors. By January 2001,

however, the IFC had strengthened its portfolio in Russia by restructuring two large problem projects and writing down the value

of several others.

FIGURE 7.—THE IFC’S RUSSIAN PORTFOLIO

FIVE STAGES IN THE TRANSITION FROM SPECIAL CASE TO NORMAL

COUNTRY

During the past decade, the EBRD, IFC, and MIGA have expanded the size of their operations in Russia as conditions permitted. Except perhaps for special effort to identify good project opportunities in Russia, these three agencies did not treat Russia as

a special case and they did not change their standards or orientation as conditions changed. Their activities have focused on the private sector. Funds have been committed and disbursed for projects

which the international agencies believed had substantial prospects

for growth. For the most part, the level and scope of the three

agencies reflect the changing attitudes of domestic and foreign investors in Russia. Total commitments grew rapidly in the first half

of the decade, peaking in 1997. They fell rapidly in 1998, however,

as the prelude to the August financial crisis and the crisis itself—

with default on foreign debts and a major devaluation of the Russian currency—caused a major shift in commercial conditions and


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440

investor attitudes. Since the crisis, the EBRD, IFC, and MIGA

have considerably reduced the size of their operations in Russia.

Most observers agree, however, that as conditions stabilize in that

country commercial prospects will improve and the volume of activity for the three agencies will increase.

By contrast, the operations of the IMF and World Bank in Russia

have been attuned much more acutely to the policy environment.

The Fund and Bank have worked much more closely with the Russian Government in the design and implementation of macro-economic and structural policy change. In some ways, their programs

in Russia have been both counter- and pro-cyclical. When things

were becoming difficult in Russia, it seems, the IMF lent money to

try to counter the undesirable trend. Then, when things seemed to

be going better in Russia, the IMF lent more money to try to encourage the desirable trend.

When the economic situation was most precarious early in the

decade, the IMF and World Bank lent substantial sums. The conditions for their loans during the first several years were relatively

easy and they seem to have disbursed with limited regard to

whether the Russians were complying with conditionality. In middecade, as prospects seemed to improve, the IMF and World Bank

lent larger amounts in order to consolidate and accelerate the reform process. In 1995, the IMF and World Bank increased their assistance, their attention to compliance was more strict, and Russia

met most of the loan terms. The IMF and World Bank continued

to lend substantial sums during the next 3 years. However, they

again seemed to be operating counter-cyclically. They disbursed

funds even as the economic situation was becoming increasingly

questionable and compliance with conditionality was incomplete.

After the financial crisis of 1998, the IMF and World Bank seem

to have reconsidered their approach to Russia. Except for project

loans, they canceled all their outstanding loan commitments and

they pared back the scope of their operations. In the future, the

IMF and World Bank say they will treat Russia the same way they

treat other large middle-income developing countries. As such, they

will likely be reluctant to put large sums into Russia mainly to encourage the transition process and they will likely be more rigorous

in their requirements for future loans.

DISBURSE REGARDLESS: 1992–1994

Synopsis

Between 1992 and 1994, the IMF and World Bank seem to have

disbursed funds to Russia with few restrictions and little serious

conditionality. During these 3 years, the IFIs committed themselves to lend $7.73 billion to Russia—$4 billion from the IMF,

$2.64 billion from the World Bank (of which $1.96 billion is from

IBRD and $680 million is from the IFC), and $1.09 billion from the

EBRD. Of this, $5.71 billion was disbursed almost right away—$4

billion by the IMF and $1.71 billion by the World Bank. Many of

the conditions which the IMF and World Bank attached to their

loans for Russia during these years were not very rigorous or demanding. Those for the World Bank were easily met and the IMF

seemed to have disbursed without strict attention to Russia’s perVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00466 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1
441

4For the IMF’s statement on the loan, see its press release number 92/60 dated August 5,

1992. 5For a detailed chronology of IMF loan programs in Russia from 1992 to 1999, see: U.S. General Accounting Office. International Monetary Fund: Approach Used to Establish and Monitory

Conditions for Financial Assistance. Report to Congress NSIAD–99–168, June 1999, pp. 136–

158. It provides a detailed summary of the goals of each program, Russian compliance, and actions taken by the IMF executive board. For a detailed review of the assistance programs in

Russia sponsored by the IFIs, United States, and Europeans, see U.S. General Accounting Office. International Efforts to Aid Russia’s Transition Have Had Mixed Results. GAO–01–8, November 2000.

formance vis-a`-vis the standards in its loan agreements. On some

occasions, the targets were changed or performance standards were

adjusted in order to permit disbursement to continue.

IMF programs: 1992–1994

In 1992, the World Bank and IMF were under considerable pressure from the Bush Administration and other major governments

to begin lending in order to stimulate the transition process and

strengthen the hand of the Russian reformers. This put the IFIs in

a difficult spot. It was increasingly clear that Russia could not

qualify for regular IMF or IBRD loans. Russia’s macro-economic

situation was deteriorating. It was not in compliance with the modest goals of the shadow program. In mid-1992, the Yeltsin government pulled back from its program of reform in the face of strong

opposition. Key members of the reform team were sacked, to assuage the opposition and maintain some headway on reform. The

new president of the Central Bank of Russia, Viktor Gerashchenko,

appointed in mid-1992, turned out to have theories of monetary

policy which led him to flood Russia and other members of the

ruble zone with cheap credit. This boosted inflation and lessened

the pressure that market forces might have exerted toward enterprise reform.

Nevertheless, on August 5, 1992, the IMF approved a SDR 719

billion ($1 billion) first credit tranche loan to Russia. The amount

countries can borrow from the IMF is a multiple of their quota.

Russia’s quota in the IMF, at the time of its joining, was SDR 2.96

billion (then about $4.3 billion). As countries move into the higher

credit tranches, the conditions for access to IMF funds and the performance criteria for disbursement become increasingly stringent.

This loan was not unprecedented. Most countries will want to borrow more than the first credit tranche can provide. However, some

have limited their requests to this level. By borrowing only the

amount allowed for a first credit tranche loan, countries need to

meet only modest requirements for conditionality and they do not

need to demonstrate compliance in order to receive loan disbursements. Even so, in the case of Russia, the negotiations for the first

tranche loan dragged. To facilitate agreement, the Managing Director of the IMF, Michel Camdessus, flew to Moscow just before the

start of the G–7 Summit Meeting in Munich in early July.4 The

proceeds from the loan were made available right away. Russia

agreed to reduce its budget deficit from 17 percent to 5 percent, but

disbursement was not dependant on its achievement of this goal.

This was less stringent than the 1 percent target in the shadow

program. Russia also agreed to reduce its monthly inflation rate

from 15 to 20 percent to 10 percent.5

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6 John Odling-Smee and Henri Lorie. The Economic Reform Process in Russia. WP/93/55-EA,

July 1, 1993. Odling-Smee heads the office at the IMF responsible for Russia. The report seems

to have been prepared for presentation to the IMF executive board earlier in the year. 7Tokyo Summit Economic Declaration: A Strengthened Commitment to Jobs and Growth.

Tokyo, July 9, 1993. The G–7 urged the international agencies, in the strongest possible terms,

to provide more assistance to Russian. Available from http://www.g7.utoronto.ca/g7/summit/

1993tokyo/communique/job.html.

It was not intended that the IMF’s first tranche agreement with

Russia would cause the G–7 countries to release the $24 billion aid

program they had announced. Officially, the $24 billion assistance

package—and the $6 billion ruble stabilization fund which it contained—would be available only after Russia successfully negotiated a regular standby loan program with the IMF. Russia drew

down the resources for the first credit loan by the end of 1992 and

added them to its reserves. Russia’s budget deficit and inflation

rate did not shrink as planned, however, and Russia was almost

immediately out of compliance with the terms of its first IMF loan.

This severely constrained its eligibility for future IMF loans.

The IMF noted, in early 1993, that the economic problems confronting Russia were comparable to those faced by Japan and Germany after 1945.6 Russia’s need for external assistance was also

comparable. ‘‘Equally important,’’ the IMF reported, however, ‘‘Russia must be willing and able to pursue economic policies that ensure that the external assistance has the desired effects.’’ In particular, these included ‘‘measures to achieve macro-economic stability and rapid progress on a wide range of systemic reforms.’’ Success in those areas, it said, would ‘‘create the conditions in which

market mechanisms will eventually grow.’’

The IMF continued to resist pressure from its major member

countries for expanded assistance for Russia. Russia was not in

compliance with the goals of the first tranche loan and there were

doubts at the time that Russia would be able to comply with any

meaningful conditions the IMF placed on future loans. The IMF

also was reluctant to set a precedent where the normal rules and

standards governing lending were openly waived in the case of

emergencies affecting ‘‘important’’ countries. Fund management

worried that other large developing countries would claim that they

too were ‘‘important’’ and they too faced crucial emergencies.

The G–7 found a way around this problem. During their meeting

in Tokyo on April 14 and 15, 1993, the deputy finance ministers

of the G–7 countries announced that a new IMF loan facility—the

Systemic Transformation Facility (STF)—would be established.7

The STF was a response to the concern, as the G–7 carefully put

it, that the IMF’s regular loan conditionality did not provide

enough flexibility for a positive response to the borrowing needs of

Russia and other formerly socialist states. Though designed originally to benefit the Soviet successor states, eligibility was broadened to include other non-market economies (Albania, for example)

as well.

The STF provided quick-disbursing loans to facilitate stabilization during the early stages of the transition process. The eligibility

criteria were vague. Countries could borrow if they were experiencing ‘‘severe disruptions in their trade and payments due to a shift

in world market pricing.’’ The conditions for access to STF loans

were also easier than those for regular loans. Countries had to

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8Michel Camdessus. ‘‘Supporting Transition in Central and Eastern Europe: An Assessment

and Lessons from the IMF’s Five Years’ Experience.’’ Second Annual Francisco Ferna ́ndez

Ordo ́ez Address, Madrid, December 21, 1993. IMF document 95/2.

demonstrate that they were trying to solve their balance-ofpayments problems and curb inflation and they had to submit a

written statement describing the goals of their reform program and

the steps they planned to take to attain those goals. The proceeds

would be disbursed in two tranches—the first immediately and the

second within 6 to 12 months.

On June 30, 1993, the IMF executive board approved an SDR

2.156 billion ($3 billion) loan to Russia from the STF. The first

tranche—SDR 1.078 billion ($1.5 billion)—was disbursed right

away. Conditions seemed to be improving in Russia at the time. In

December 1992, Yeltsin had won a referendum and this gave the

reformers some political clout to cut spending. In May 1993, the

Russian Finance Ministry and CBR reached an agreement aimed

at reducing the rate of inflation. Steps were also afoot to tighten

the ruble zone. The CBR told other countries they must either

leave the ruble zone or allow the Russian Government tight control

over their monetary policies.

The Russian Government agreed, under terms of the STF agreement, that it would reduce its budget deficit to 5 percent of GDP

and its monthly inflation rate to a ‘‘low single-digit level.’’ These

were, in effect, the unmet goals of the 1992 shadow program and

the first tranche loan. The government and CBR promised not to

make loans to clear inter-enterprise payment arrears. The government also agreed to accelerate reform in the areas of foreign trade,

privatization, and the legal framework.

In March 1994, when the time came to release the second half

of the STF loan, Russia was not in compliance. Nevertheless,

Camdessus and Prime Minister Chernomyrdin reached agreement

on terms for releasing the second tranche of the STF loan. Reportedly, Camdessus overruled his staff, which was his prerogative. He

had strong backing from six of the G–7 governments, including the

United States. The Russians agreed they would take strong action

to implement the planned macro-economic and structural reforms.

The inflation rate would be lowered to 7 percent monthly by the

end of the year. The IMF relaxed (from 5 percent to 7 percent of

GDP) the target for reducing the budget deficit. The government

promised to improve its supervision of commercial banks, to establish a budgetary system devolving responsibilities to the regions,

and to continue privatization. It also promised that, by July, shares

would be auctioned for cash rather than vouchers and new commercial rules would be announced.

In December 1994, Camdessus outlined the Fund’s views on the

transition process in a speech before an economics meeting in Madrid.8 Gradualism was not an effective strategy for the transition

to market economies, he said. Rather, rapid movement to liberalization, stabilization and structural reform was needed and those

countries that moved furthest would come out best. Nevertheless,

he acknowledged, the achievement of structural reforms would take

a number of years and the transition process would have to take

place within an imperfect framework. ‘‘The market economy must,

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9Michel Camdessus. ‘‘Russia’s Transformation Efforts at a Turning Point.’’ Address to a Conference of the U.S.-Russia Business Council, Washington, DC, March 29, 1995. IMF document

95/5. 10The World Bank was unable to provide a copy of the 1993 CAS for Russia. The summary

reported here is based on statements in press releases and other Bank documents issued between 1993 and 1997.

as it were,’’ he said, ‘‘move into a house that is still under construction.’’ The following March, Camdessus made another speech, expressing the view that Russia’s transformation effort had reached a

turning point. Progress to date on structural reform and macro-economic stabilization had been less than disappointing, he admitted.9

However, he said he had confidence that the Russian authorities

would move vigorously in 1995 to reverse that trend.

World Bank programs: 1992–1994

The World Bank’s first country assistance strategy (CAS) for

Russia, approved by the executive board in 1993, specified that

three areas should be given special emphasis in the Bank’s loan

program.10 Programs to promote private sector development, privatization and enterprise reform should be given high priority.

Strong emphasis should be accorded to policy reform and the development of an agreed framework with the Russian Government into

which future operations could be fitted. Finally, the 1993 CAS said

that the Bank should work with the Russian authorities to develop

programs that would help protect the most vulnerable members of

society from the full pain of the transition process. These were all

key structural reform included in the IMF loan programs approved

during these years.

Despite the terms of the CAS, most of the funds the World Bank

lent to Russia during this period went for balance-of-payments support or to increase oil production and oil exports. The day after the

IMF made its first loan to Russia, the World Bank approved a $600

million loan to ease Russia’s balance-of-payments difficulties by financing needed imports. To qualify for disbursement, Russia merely had to demonstrate that $350 million from the loan would be

used for humanitarian imports and the other $250 million for imports needed by the private sector. In June 1993, the World Bank

approved a $610 million loan for Russia to help rehabilitate its oil

industry. A similar $500 million loan was approved in June 1994. All but $160 million of the $1.33 billion in project assistance the

World Bank agreed to provide Russia at this time was approved

about the time the second STF tranche was released in 1994. Of

this, $810 million sought to encourage enterprise reform, privatization, agricultural reform, land reform, and the development of financial markets. Many of these loans, however, ran into serious

difficulties and many of the funds were not disbursed. One loan in

1992 sought to alleviate social needs through the establishment of

unemployment insurance and employment services. It also encountered problems with implementation. A $300 million loan for highway maintenance and rehabilitation, however, was completed without major delay. In late 1994, the Bank approved two other modest-sized loans. One for management and financial training was

fully implemented but another for environmental management ran

into serious problems and remains only half disbursed.

445

DISBURSE WITH COMPLIANCE: 1995

Synopsis

In 1995, the IFIs disbursed substantial sums to Russia and Russia substantially complied with their loan conditionality. In 1995,

the IFIs approved loans for Russia totaling nearly $9.5 billion. Of

this, $6.8 billion came from the IMF, $1.62 billion from the IBRD,

World Bank, and $1.06 billion from the EBRD. Of this, $7.4 billion

was disbursed, including all the funds committed by the IMF and

$600 million fast disbursing assistance approved by the World

Bank. The international agencies believed, at the time, that Russia

had turned a corner and that economic growth would soon follow.

Russia met most of the requirements of the 1995 IMF standby

loan. In the blush of success following the perceived success of that

program, the IMF approved a $10 billion loan for Russia in February 1996. That loan (discussed in the next section) was much less

successful. During 1995, the IFC approved $65 million and the

EBRD approved $1.06 billion in assistance to Russian firms.

IMF operations: 1995

On April 11, 1999, the IMF executive board approved an SDR 4.31 billion (then about $6.8 billion) standby loan of for Russia, a

12 month program. The IMF noted in its announcement that Russia’s economic performance in 1994 was ‘‘disappointing.’’ Efforts to

reduce the budget deficit and inflation rate were ‘‘significantly off

track’’ and the target for accumulating new foreign reserves was

missed ‘‘by a wide margin.’’ In fact, the budget deficit and inflation

rate were twice the levels anticipated by the STF second tranche

agreement. The IMF noted that the CBR had tightened monetary

policy in late 1994 and early 1995, but it said this would not be

sustainable unless major improvements were made in fiscal policy.

In a very unusual step, the IMF specified that Russia’s progress

under the new loan plan would be monitored monthly and funds

would be disbursed only with the consent of the IMF executive

board.

The goals of the new standby loan echoed those earlier plans. Inflation was to be reduced to 1 percent monthly by the end of 1995.

Credit and monetary policy would be tightened further and the

government’s budget deficit would be reduced to 6 percent of GDP.

The government promised to use non-inflationary sources of financing in the future to cover the deficit. In 1994, Russia’s real GDP

declined by 15 percent. The new plan hoped to cut the decline to

9 percent in 1995.

The government also pledged to make a major effort to accelerate

action on a wide range of structural reforms. Prominent were

measures to liberalize the trade regime and oil sector. In particular, the restrictions on oil exports would be abolished. The government and CBR promised once again that they would not extend

credits or loans to clear inter-enterprise debts. The government

would find other means of resolving those pressures and breaking

up the logjam hampering the mutual settlement of debts which

Russian firms owed to one another. The government promised to

continue cleaning up non-performing centralized credits and to

more tightly monitor the financial situation of banks. It also promVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00471 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1
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11Stanley Fischer. The Russian Economy: Prospects and Retrospect. Speech at the Higher

School of Economics, Moscow. June 19, 2001. Available from the IMF Web site. 12Stanley Fischer, Ratna Sahay and Carlos A. Vegh. ‘‘Stabilization and Growth in Transition

Economies: the Early Experience.’’ Journal of Economic Perspectives, 10:2 (Spring 1996), pp. 45– 66.

ised to accelerate the process of land reform and to increase the efficiency of its social spending programs.

In March 1996, the IMF announced that it was very pleased with

the success of the 1995 loan. Reflecting the high hopes it then had

for the future, the IMF executive board approved a new SDR 6.9

billion (about $10 billion) loan for Russia. Disbursements would

take place over a 3 year period (1996–1998) and the repayments

would stretch over a decade. This was the largest extended fund facility (EFF) loan the IMF had ever made and the second largest

overall. The largest was the SDR 12.1 billion loan to Mexico approved in February 1995. After Mexico made an early repayment

on that loan, Russia became the IMF’s largest borrower, accounting

for nearly one-fourth of the IMF loans and credits outstanding at

the end of July 1996. Russia’s compliance with the EFF loan is discussed in the next section of this paper.

The IMF reported that Russia’s performance the previous year

under the 1995 loan program had been quite satisfactory. Inflation

had fallen to low single digit monthly rates by the end of 1995, the

IMF reported. Signs of industrial recovery were visible. Real GDP

remained nearly stable, shrinking only 4 percent in 1995 (not the

9 percent anticipated.). The IMF noted that Russia’s balance-ofpayments surplus (current account) had widened from $3.4 billion

in 1994 to $4.7 billion in 1995. Moreover, it said, the establishment

of an exchange rate ‘‘corridor’’ for the ruble had helped stabilize exchange rate perceptions and was ‘‘generally judged to have been a

success.’’ On the structural front, the IMF acknowledged that Russia’s performance was more uneven. The process of restructuring

the banking sector was slow and the pace and scale of privatization

was below expectations. Nevertheless, it concluded, Russia’s overall

progress had been significant. Stanley Fischer observed in June

2001 11 that Russia’s compliance with the terms of the 1995 standby were ‘‘exemplary’’ and ‘‘for 9 of the 12 months Russia essentially

met all the conditions.’’ Previously an economic professor at MIT,

Fischer had become First Deputy Managing Director of the Fund

in September 1994. He became acting Managing Director of the

IMF in early 2000.

In a paper published in early 1996, Fischer wrote 12 that 1995

had been the key stabilization point for the Russian economy. According to his research, he said, growth usually occurs 2 years after

the stabilization point is reached. However, he cautioned in the

1996 paper, governments must continue pursuing stabilization policies and structural reforms if growth is to continue. Establishing

a pegged exchange rate for the currency was helpful, once stabilization had occurred, he said, but the situation was not sustainable

without prudent government policy and further cuts in the fiscal

deficit. In July 1995, Fischer noted with approval the Russian Government’s decision to institute an exchange rate system where the

value of the ruble would be kept within a certain range in relation

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13 IMF Management Welcomes Economic Progress Made by Russia; Exchange Rate Action Designed to Support Program. News Brief 95/17, July 6, 1995. Quotes positive remarks by Fischer.

to the dollar.13 He observed later, however, in his June 2001 retrospective on the IMF’s programs in Russia, that ‘‘the 1995 loan was

very successful, but it did put in place the crawling band exchange

rate that was a source of trouble in the future.’’

World Bank operations in Russia: 1995

In March 1995, 1 month before the IMF approved the new standby loan, the World Bank commenced a large new program of lending to Russia. That month, it approved a $400 million loan to help

restructure the housing sector in Russia through the establishment

of a new marketplace for housing. During the 2 months following

announcement of the IMF loan, the World Bank approved another

$1.13 billion in loans. This included a $600 million loan on easy

compliance terms to ease Russia’s balance of payments by financ- ing needed imports and $99 million to address a major oil spill

problem. All told, during 1995, the Bank approved $1.62 billion in

loans for Russia, its largest annual total to date.

The Bank’s project loans in 1995 sought to promote growth and

address key structural problems. In addition to the loan which

sought to create a marketplace for housing, the Bank lent $107

million to promote energy efficiency and $329 million to improve

urban transportation. It also approved two smaller loans to develop

standards, identify prospective new loan projects, and to improve

and modernize tax administration. As in 1992 through 1994, the

World Bank did not accelerate its disbursements on these loans nor

did it disburse regardless of compliance. However, in retrospect, it

appears that—as in the earlier period—many of the Bank’s projects

were approved before conditions had matured to a point where they

could be successfully implemented. A major portion of the funds for

the housing and energy efficiency loans were canceled or never disbursed and most of the funds for the urban transport loan seem not

to have been disbursed until 1998 or after. Likewise, a major portion of the funds for standards development or development of the

Bank’s loan portfolio were not spent until 1998 or remain unspent

today.

DISBURSE DESPITE RESISTANCE: 1996–MID 1998

Synopsis

Between 1996 and mid-1998, the IFIs disbursed substantial

sums to Russia even though its compliance with conditionality was

limited and their efforts to promote reform met with considerable

resistance. Heavy spending before the 1996 election expanded Russia’s fiscal deficit and stoked inflation. Yeltsin was reelected but

the opponents of reform were strengthened also. The government’s

ability to deliver on its commitments for stabilization and structural reform diminished. Nevertheless, despite major difficulties

with compliance, the IFIs provided Russia with substantial sums

of balance-of-payments support. Between approval of the EFF loan

in early 1996 and the onset of the financial crisis in mid-1998, the

IMF disbursed approximately $6.78 billion to Russia. The IMF suspended disbursements for the EFF program on several occasions,

448

releasing funds only when the Russian Government complied with

certain conditions of the loan. That compliance often came slowly

and in the face of considerable domestic resistance. Some of that

compliance seems more technical than substantive. Meanwhile, the

World Bank approved nearly $5.14 billion in new loans for Russia.

SALs accounted for $3.5 billion of this total, all the proceeds being

disbursed during 1996 and 1997. The Bank approved project loans

totaling $1.64 billion during these 2 years, mainly in 1996. In retrospect, an unusually large proportion of those loans encountered

serious problems with implementation and the disbursement of a

substantial share of their proceeds was canceled or considerably delayed. Meanwhile, during 1996 and 1997, the IFC approved $28

million and the EBRD approved $2.36 billion in assistance to Russian firms.

IMF programs: 1996–1998

The IMF agreed in March 1996 to lend Russia SDR 6.9 billion

($10 billion) over the next 3 years. Disbursements for the new EFF

loan would be monitored monthly, as had been the case for the

prior loan. After October 1997, during the second year of the program, they would be made on a quarterly basis, as is usual for

most IMF loans. Disbursements would be front-loaded, with 41 percent being available upon compliance in the first year, 34 percent

in the second, and 25 percent in the third. The Russian Government said it did not intend to borrow again from the IMF once this

program was completed.

The goals of the EFF program were basically the same as those

for the previous IMF programs in Russia. There was more emphasis, however, on the need for structural or procedural reforms

and—because it was a 3 year program—it was thought that Russia

would have enough time to implement those reforms. Events

proved, however, because of increased inflation as well as stronger

resistance by the opposition, that achievement of these goals would

remain a difficult task.

In the area of macro-economic policy, the government announced

that it would take strong action to reduce the rate of inflation and

the size of its budget deficit. Inflation would be reduced to a 1 percent monthly rate by year’s end and would decline further, to a

single-digit annual rate, in 1997. The government also declared

that it would take the steps needed to maintain medium-term stability in Russia’s balance of payments. Real GDP growth was expected to accelerate to 2.3 percent annually in 1996 and 5 percent

in 1998 and 6 percent or more thereafter. Consequently, it was expected that Russia’s current account balance of payments would

swing into the negative in 1998, when higher growth would lead

to more purchases from abroad. The Russian authorities said they

would take measures to manage the expected situation without encouraging inflation. Further cuts in the government’s budget deficit

were a critical element of this strategy. The Russians agreed to reduce the deficit from 5 percent of GDP in 1995 to 4 percent in 1996

and 2 percent by 1998. They also agreed that it would take major

steps to improve tax collections and reduce delinquencies and exemptions. This would require special efforts to overcome the politiVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00474 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1
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cal connections and favoritism which often facilitated tax evasion

and tax avoidance of this type.

On the structural side, the government said it would make trade

liberalization and accession to the World Trade Organization

(WTO) a high priority. It would strengthen the banking system

through improvements in the regulatory framework and closer attention to the financial health of banks. It would accelerate privatization while assuring greater transparency and fairness of the

process. It would pursue agricultural reform, reducing the uncertainties of private farmers, expanding land reform, and allowing

the full private ownership of land. The security markets would be

reformed, improving the legal framework, reorganizing weak firms,

and increasing the protection for outside investors. The government

also announced that it would strengthen the social safety net by

targeting assistance more specifically to those who needed it and

using the resultant savings to enhance other social programs.

Despite these plans, most of the IMF’s efforts in Russia during

this period had to do with the government’s difficulty in achieving

the macro-economic goals of the EFF program. The government

made some efforts toward addressing structural reform issues.

However, the results achieved were not proportional to the goals

outlined in the EFF program. The Fund was less vigorous in its efforts to secure Russian cooperation with the targets for structural

reform than it was for those involving macro-economic stability.

In 1996, Russian economic performance and the government’s

economic policies fell well short of the expectations in the EFF

plan. By July, the budget deficit was well over target. The IMF

raised the annual target to 5.25 percent. Government spending had

increased rapidly in the just-concluded presidential election campaign. There was little alternative but to increase the size of the

federal budget to accommodate the higher cost of the government’s

earlier debt and the new debt payment obligations recently incurred.

In 1997 and 1998, however, the Russian Government continued

to have problems with its fiscal deficit. Budget figures seemed to

be prepared more to meet the IMF’s deficit targets than to meet

real budgetary needs. For example, the budget signed by Yeltsin in

February 1997 projected a deficit equal to 3.5 percent of GDP. This

was within the deficit target. The IMF urged the Russians, however, to include money in the budget to cover the government’s accumulating unpaid interest obligations and federal wage and pension arrears. This would have widened the budget gap to nearly 7.5

percent of GDP, well over the target. The Russian authorities were

not convinced by the IMF’s approach to budgetary accounting.

The IMF suspended disbursement of the January installment of

the EFF and Russia received no disbursements for the rest of the

first quarter 1997. The most important threat to fiscal stability was

not rising expenditures but shortfalls in tax receipts. The IMF suspended disbursements on the EFF loan in July and August 1996

until the government adopted a package of measures to increase

revenues. The October 1996 tranche was delayed until December,

when revenues increased by 38 percent. The November and December disbursements were delayed until February 1997, when the

government showed that it had met the December monetary and

450

14World Bank. James Wolfensohn. Statement to the Press. Moscow. May 23, 1996. 15World Bank Optimistic About Russia’s Growth. (Announcing the SAL1 loan.) News Release

No. 98/1492ECA. September 26, 1997. 16World Bank Announces Russia Strategy for the Next Two Years. News Report No. 97/1379/

ECA, June 6, 1997. The 1997 CAS was also not released to the public but its main outlines

were described here.

fiscal targets and had taken steps to improve tax receipts. By the

end of April 1997, though, Russia had drawn SDR 2.34 billion

($3.22 billion) from the EFF line of credit. By April 1998, it had

borrowed another SDR 1.5 billion ($2.04 billion) and it got another

SDR 1.12 billion ($1.52 billion) in August 1998.

In May 1997, the government received word that tax receipts

would be even lower for the year than expected. This would push

the deficit well over the EFF target. The government sequestered

(freezing or withholding from expenditure) more than one-fifth of

the funds in the national budget in order to bring down spending.

Tax evasion, inefficient collection methods, and widespread exemptions were taking their toll. To increase revenues and reduce the

deficit, the government accelerated the privatization process. Income from this source more than doubled. However, many of the

sales were beset with doubts about corruption and serious concern

whether the prices paid reflected the underlying value of the firms.

By the end of 1997, with these increased receipts and the major

spending cuts taken earlier, the government’s budget deficit was

5.5 percent of GDP, slightly higher than the revised IMF target.

The inflation rate for 1997 was 11 percent, down by half from the

previous year but higher than the single-digit goal of the EFF program. Most analysts agreed that sequestering expenditures was not

a sufficient method for achieving those targets. Among other

things, expenditures on social programs had been slashed substantially. Most agreed that the shrinkage in budgetary outlays could

not be sustained.

World Bank programs: 1996–1998

As noted, the World Bank reached new heights in the size of its

loan program for Russia in 1996 and 1997. However, the overall

composition of the Bank’s program shifted as it put increased emphasis on programs addressing the needs of the overall economy

and less on project loans.

In May 1996, Bank President James Wolfensohn echoed the view

that Russia had turned a corner in its transition process. He told

the press that conditions in Russia were much improved and the

Bank would be active ‘‘supporting the major economic reforms

which must be sustained for Russia to achieve transition to a market economy.’’ 14 A year later, the tone of the Bank’s enthusiasm

was somewhat subdued. Nevertheless, in September 1997, Johannes Linn, the World Bank’s vice president for Europe and Central

Asia, reported—while Russia’s performance had been below its potential—the Bank was still optimistic about its prospects.15

In 1997, the Bank added a new component to its Russian program. Adopting a new CAS to replace that earlier adopted in 1993,

the Bank said there should be more stress on structural adjustment and policy reform.16 Emphasis should also continue, though,

on enterprise reform, institutional reform, and improvements in

education and health. More effort should also be given to programs

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17World Bank Supports Russia’s Reforms. December 19, 1997. 18World Bank Announces Russia Strategy for the Next Two Years. News Release No. 97/1379/

ECA, June 6, 1997. Project Information Document PIC5759. Russia-Second Structural Adjustment Loan (SAL2), December 23, 1997. 19World Bank Loan Supports Russia’s Social Reforms. News Release No. 97/1408/ECA, June

25, 1997. Project Information Document PID5638. Russia-Proposed Social Protection Adjustment

Loan (SPAL). June 12, 1997. 20The PID for Coal 1 is not available. However, the program’s objectives are discussed in another publicly available technical document. World Bank Helps Reform Russia’s Coal Industry.

News Release No. 97/1225/ECA. Technical Annex T–6865–RU. Coal Sector Restructuring ImpleContinued

protecting the most vulnerable members of society from the effect

of transition and sustaining the government’s budget for social programs. Linn announced that the Bank’s new emphasis on policy reform and adjustment lending in Russia would ‘‘demonstrate our

clear recognition and full endorsement of the reform measures that

are currently being implemented by the [Russian] government.’’ 17

In 1997, the World Bank approved three large structural reform loans for Russia totaling $2.2 billion. Two were regular structural

adjustment loans (SALs) and the other was a social protection adjustment loan (SPAL). The two SALs were nearly identical, in their

form and purpose, to the loans approved earlier by the IMF. The

$600 million from SAL1 was disbursed right away. The $800 million for SAL2 was disbursed in two tranches, a few months apart.18

Russia agreed that it would take steps to accelerate privatization,

private sector development, changes in bankruptcy law, reductions

in the budget deficit, improvements in tax administration, reform

of the banking and financial sectors, and improvements in the social safety net. The World Bank has not reported what Russia

needed to do in order to have access to these loans. Given the speed

with which they were disbursed, however, one may suspect that

the performance requirements were not particularly demanding. It

does not appear that Russia made major steps toward structural

reform at the time it received disbursement of these funds.

The requirements for the SPAL were somewhat more rigorous.

This loan was aimed at protecting the weakest members of Russian

society against potential injury from the adjustment process. At

$800 million, it was the largest single loan ever made in the Europe and Central Asian region. It sought to strengthen Russia’s social safety net and improve the way Russia targeted and implemented those programs.19 To qualify for disbursements, Russia had

to demonstrate that a certain amount of social spending was included in its budget and those expenditures were being used effectively. In effect, the SPAL was a balance-of-payments support. The

government could use the money from the SPAL to generate the

rubles needed to fund the qualifying social expenditures, but it was

not required to do so. The SPAL did not increase the amount spent

for social programs, but it did help protect the existing programs

against budget cuts. Social spending took a disproportionate share

of the hits, in 1997 and 1998, as the government sequestered budget authority in order meet the IMF’s targets on the budget deficit.

Russia had some difficulty meeting all the requirements of the

SPAL. The final $250 million tranche, which had been scheduled

for release in early 1998, was not disbursed until after 1999.

The World Bank also made two loans, totaling $1.3 billion, to

help restructure the Russian coal industry.20 The first of these

452

mentation Assistance Project, June 25, 1996. The goals for Coal 2 are discussed in the PID for

that program. Project Information Document PID5852. Russia-Coal Sector Adjustment Loan II.

October 29, 1997.

(Coal 1), for $500 million, was approved in 1996. In part, the two

loans sought to ease pressure on the government’s budget. Subsidies to the coal industry had been a major contributor to the deficit. In 1993, these subsidies had amounted to 1 percent of GDP. By

1995, they had been cut to one-sixth that level. The new coal loans

aimed to reduce them substantially further. The loans aimed to

create a competitive and sustainable coal industry by promoting

commercialization and privatization of the mines. The loans were

not intended to offset losses or to refurbishment of capital stock in

the mines. To qualify for disbursement, the government would need

to adopt a socially sustainable framework of assistance for coal

communities, including social services and efforts to improve labor

mobility. As with the two SALs and the SPAL, the government

could use the proceeds from the Bank’s two coal loans for any purpose if it could demonstrate that it was making the appropriate expenditures (in rubles) to sustain the specified service programs.

The second tranche of Coal 2 was contingent, however, on satisfactory macro-economic performance. It was delayed for 2 years (until

the end of 1998) and media reports in December 2001 indicate that

the last portion was just being released.

Parallel with the new emphasis on adjustment loans, the World

Bank also approved many project loans for Russia during 1996 and

1997 which addressed key concerns identified in the IMF’s loan

program and in the 1993 and 1997 country strategy documents. In

1996, $1.27 billion was approved and in 1997 another $286 million

was authorized for this purpose. All told, $608 million was approved for projects addressing social issues, such as education,

health, and community social infrastructure. Another $514 million

was approved for projects aimed at private sector development and

market reform, including loans for enterprise reform, enterprise

housing divestiture, capital market development, and reform of the

electrical sector. An additional $350 million was approved for

bridge rehabilitation and $87 million for improvements in the country’s legal system and its capacity for performing sound economic

analysis.

It appears, however, once again, that the World Bank’s efforts to

encourage structural reform with projects may have been somewhat in advance of the projects’ feasibility. All the major project

loans approved during 1996 and 1997 encountered serious difficulties. In several instances, the resistance to reform was substantial.

Several projects were terminated without ever being put into effect.

Of the total amount approved, $462 million was canceled outright

and $575 million—for some projects, almost the entire proceeds of

the loan—remained undisbursed at the end of June 2001. Many of

the issues the Bank sought to address through these loans—corporate governance, reform of the legal system, privatization of large

enterprise, and the reform of banks and capital markets, for instance—were issues on which there remains today much disagreement between the Russian reformers and their opponents.

453

21 Joint Communique ́ of the Chairman of the Russian Federation and the Managing Director

of the International Monetary Fund. February 19, 1998. Available from the IMF Web site.

COMMIT IN THE FACE OF CRISIS: 1998

Synopsis

In 1998, the IMF and World Bank committed themselves to lend

very large sums in a vain effort to prevent a looming economic crisis. By 1998, the Russian economic situation was precarious. Despite past commitments the government had made to the IFIs,

Russia’s fiscal and monetary performance was questionable and

progress on structural reform was slow. Doubt grew in the market

about Russia’s economic prospects and pressure against the ruble

increased. Previously, when the IMF and World Bank had approved major loans for Russia, they had strong reason to believe

that the government would seek to implement the reform provisions of their loan agreement, even though they knew this effort

might face stiff resistance. In 1998, however, the IMF approved

new loans totaling $11.2 billion and the World Bank agreed to lend

$1.5 billion—the largest credits either institution had ever approved for Russia. They did this, moreover, with little evidence that

the government would be willing or able to pursue its planned program of reform. Very soon after the IMF and World Bank loans

were approved, Russia defaulted on its debts and devalued its currency and the IMF and World Bank suspended disbursements on

their recent loans. Despite Russia’s economic troubles, investors retained some interest. In 1998, the IFC approved $91 million in assistance (most of it likely, however, in the first—July to December

1997—half of the IFC fiscal year.) Approvals by the EBRD in calendar 1998 fell to $304 million, by contrast, one-third the level of

the prior year.

IMF programs: 1998

The Russian Government’s budget plan for 1998 projected a fiscal deficit amounting to 4.8 percent of GDP, a figure that was

again within the EFF deficit target. However, many outside experts

questioned the assumptions underlying its projections and noted

that the planned spending level was about the same as that for the

1997 sequestered budget. The government announced plans for

strong new efforts to increase revenues and to cut federal spending

further. It also announced plans in the 1998 program for major

structural reforms.21

By mid-year, however, Russia was enmeshed in a major economic

crisis. Many analysts doubted whether the government had the capacity or the will to pursue its announced plans. Revenue continued to fall; the government resorted to a pyramid-type borrowing

scheme to cover the deficit. World oil prices declined, removing a

major source of Russia’s tax revenue and export income. The financial system was buffeted by uncertainty. Market confidence was deteriorating, in response to the country’s precarious domestic conditions and contagion from the Asian financial crisis. The ruble was

under heavy pressure in foreign exchange markets and the CBR

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22 Cf. William Cooper, Russia’s Economic Performance Entering the 21st Century, supra this

volume. 23 Russian Authorities and IMF Reach Understandings on 1998 Economic Policy Statement.

News Brief 98/20, June 11, 1998. 24 IMF Approves Augmentation of Russia Extended Arrangement and Credit under CCFF; Activates GAB. IMF press release No. 98/31. 25See the IMF’s description of the new Russian loan program in its 1999 Annual Report, p.

79.26 IMF Management Welcomes Executive Board Support for Russia. News Brief 98/26, July

20, 1998. Fischer was then serving temporarily as acting Managing Director of the IMF. 27 In fact, the two choices are interlinked, as the Argentine crisis of November 2001 has demonstrated. Fischer observed in his June 2001 retrospective review that ‘‘You couldn’t restructure

the debt without being forced to devalue, and you couldn’t devalue without being forced to restructure the debt.’’

was having great difficulty maintaining the specified exchange rate

in the face of that pressure.22

On June 11, the IMF made an announcement 23 clearly aimed at

calming the market. The IMF executive board would meet in a

week, a spokesman said, to release of the next tranche of the EFF

loan if Russia took certain unspecified steps. It was also strongly

implied that substantial new flows of IMF assistance would also be

coming soon. Nine days later, the IMF executive board released the

last tranche of the 1996 EFF loan. It also approved a new loan

package for Russia totaling SDR 8.5 billion ($11.2 billion). This included a new EFF loan for SDR 6.3 billion ($8.3 billion) and an

SDR 2.16 billion credit from the Compensatory and Contingency

Financing Facility (CCFF).24 The new EFF money would be available subject to regular EFF conditionality. The CCFF money would

be available with little conditionality. Russia drew those funds

right away.

The United States and other major member countries strongly

supported the new loan program. One measure of their support

was the source of the funds supporting the EFF credit. Instead of

using its regular funds to finance the new EFF loan for Russia, the

IMF was authorized to draw SDR 4 billion ($5.3 billion) of the total

from the General Agreement to Borrow (GAB). To activate the

GAB, the IMF must have the explicit consent of its member countries. The United States provides one-fourth of those funds and

other advanced industrial countries provide the remainder. This

would be the first time the GAB had ever been activated for use

by a non-participant.25

The Russian authorities promised to take vigorous steps to address the turmoil in the financial markets and to restore public

confidence. It would tighten the budget still further, bolster the

CBR’s foreign exchange reserves through new foreign financing,

stretch out the maturity of its short-term debt, and secure the legislature’s approval for numerous key structural reforms.26

All of this, however, was to no avail. The government took none

of the steps it had promised the IFIs. It had not even recommended

to the legislature that key measures in its reform plan should be

adopted. The government’s budget difficulties continued to mount.

Market confidence in government policy and the Russian economy

continued to fall. Market pressure against the ruble reached new

heights. The government was faced with a choice between unilaterally restructuring its debt or devaluing the currency.27 Ultimately,

it had to do both. On August 17—despite contrary assurances it

had given to the international agencies and after it had pocketed

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28 James Wolfensohn. Address to the U.S.-Russia Business Council, April 1, 1998. Press Release No. 98/1711/ECA 29World Bank Approves Largest-Ever Loan to Russia for Structural Reforms. News Release

No. 99/1919/ECA, August 6, 1998.

the first disbursements on the new IFI loans—the government announced that it was suspending payment on its commercial and official debts and the CBR would no longer to support a specific

value for the ruble. Quickly, the currency fell to about one-third its

prior value. The Russian stock market collapsed. Most private savings were virtually wiped out. Inflation jumped, as prices sought to

catch up with the new lower value of the ruble, and by December

the rate had reached 84 percent for the year.

Shocking many investors and creditors, the IMF did not step in

as expected with major new infusions of cash to sustain the ruble

and cover Russia’s debts. Rather, it suspended disbursements on

its existing loan agreements for Russia. On March 25, 1999, the existing arrangements were canceled ‘‘at the request of the Russian

authorities,’’ as the IMF delicately phrased the news. At their termination, some SDR 1.12 billion remained undrawn from the 1996

EFF program and nothing had been used from the EFF loan approved in 1998.

World Bank programs: 1998

The World Bank’s efforts in Russia during 1998 paralleled those

of the IMF. On April 1, Wolfensohn told the U.S.-Russia Business

Council that there had been real movement toward reform. ‘‘We’re

not only positive,’’ he said, ‘‘but we are supporting our positive view

with real financial resources and real commitment.’’ 28 On July 13,

2 days after the IMF had made its announcement, World Bank

management made a public statement aimed at quieting the markets. It announced that it would be accelerating disbursements on

its existing projects in 1999 and its plan to award a large new adjustment loan for Russia in the very near future. On August 6, the World Bank executive board approved a $1.5

billion structural adjustment loan (SAL3) for Russia. It was the

biggest loan the Bank had ever made in the Europe and Central

Asian region.29 Vice president Linn said the new loan would ‘‘generate greater transparency, secure greater fiscal accountability, foster competition, and improve corporate governance, all of which

should help rebuild the confidence essential for achieving sustained

growth in Russia.’’ Even so, the Bank’s country director for Russian

programs cautioned that ‘‘strong implementation’’ of the reforms

specified in SAL3 ‘‘will now be key to creating confidence in Russia’s economic prospects.’’ The new loan required that Russia push

ahead vigorously with key structural reforms in several areas.

Progress with the implementation of these reforms would improve

the stability and productivity of the Russian economy and help instill new market support for the government’s policies. Eleven days

later, however, without implementing any of the promised SAL3 reforms, the Russian Government defaulted on its debts and devalued its currency. The Bank immediately suspended further disbursements under the loan.

The World Bank approved one project loan for Russia in 1998,

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30 Russian Federation: Recent Economic Developments. IMF Staff Country Report 99/100, September 1999. 31 IMF Approves Stand-by Credit for Russia. Press release 99/35, July 28, 1999.

proved in late December. Previously, transportation loans of this

sort had been implemented with little serious difficulty, notwithstanding the problems the Bank might be encountering with its

other structural reform loans. This project, however, was different.

A key condition of the loan required an independent audit of the

government’s road fund and other similar trust accounts. Little

progress was made in pursuit of the project and it was soon canceled without making any disbursements having been made from

the account.

RECONSIDERATION: 1999–2001

Synopsis

After 1999, the IFIs began to seriously reconsider their approach

to Russia. They terminated many of their loan programs and substantially curtailed their future plans. In 1999, the IMF and World

Bank each made one more effort to encourage sound macroeconomic policy and structural reform in Russia. The IMF approved

a $4.5 billion standby loan for Russia and the World Bank disbursed $100 million from the large SAL it had approved the previous year. Russia almost immediately fell out of compliance with

both, however, and further disbursements were terminated. The

IMF made no further loans. The World Bank approved project

loans totaling $698 million during the next 3 years. Most were for

technical and institutional reform or for humanitarian and social

purposes. Almost nothing ($3 million) has been disbursed on these

loans, however, and only two have become effective. New approvals

by the IFC and EBRD remained low, reflecting the cautious view

that investors were taking of the situation. The IFC approved $123

million in new assistance during these 3 years while the EBRD approved $582 million in 1999 and 2000. (Data for 2001 are not yet

available.)

IMF programs: 1999–2001

The Russian economy rebounded in 1999, spurred by those two

classic remedies for economic stagnation—devaluation and increased export income. The balance of payments (current account)

had shifted from a $2.7 billion deficit in early 1998 to a $4.8 billion

surplus in early 1999. In September 1999, the IMF staff reported 30

that ‘‘the period since the last Article IV consultation with the Russian Federation [1998] has witnessed perhaps the greatest contrast

in the fortunes of the economy since Russia became an independent

state in 1992.’’ Article IV of the IMF Articles of Agreement provides

that the IMF will hold discussions annually with each of its members concerning economic conditions and economic issues affecting

its economy.

On July 28, 1999, the executive board of the IMF approved a new

SDR 3.3 billion ($4.5 billion) standby loan for Russia.31 It would be

a 17 month program, with seven equal disbursements, the first

being released immediately. The board noted, in approving the

loan, that it believed the crisis of 1998 was mainly due to failure

457

32Statement of the Government of the Russian Federation and the Central Bank of Russia

on Economic Policies. July 13, 1999. Available from the IMF Web site under the title Russian

Federation Letter of Intent. 33 ‘‘Why resume lending? Russia’s current economic policies are deserving of IMF support.’’

IMF Survey 28:17, August 30, 1999, pp. 273–274. 34 IMF Concludes Article IV Consultation with Russia. PIN 99/67, August 2, 1999. The IMF

board approved the actions reported in this PIN on July 28, 1999. 35 In particular, he noted, the Russian Government needed to let contracts for financial management reviews (meeting international standards) of the Pension Fund, Social Insurance Fund,

Medical Insurance Fund, and Road Fund. It needed to submit to the Duma draft legislation for

reforming the bankruptcy law to prevent abuses and eliminate related forms of bank fraud. The

Duma also needed to pass such legislation. These and several other matters were actions the

government had pledged to take in connection with the 1999 standby loan but which were not

yet completed.

by the government to come to grips with its fiscal problems and to

implement structural reforms. The current situation gave Russia a

promising opportunity to move forward with reforms. The board

noted that the new loan program would have strict requirements

in both areas. The government and CBR agreed that they would

comply with the measures specified in the 1996 and 1998 EFF arrangements.32 The IMF stated later, in an article 33 designed to respond to skepticism, that ‘‘Russia’s current economic policies are

deserving of IMF support.’’ It noted that several of the reforms included in the 1998 plan had been put into effect by Russia’s more

recent governments.

The IMF executive board indicated, in a commentary released at

the same time, that it believed Russia should try to normalize relations with its creditors. The IMF demonstrated again, as it had in

1998, that it would not be the debt collector or guarantor for foreign creditors. The IMF noted that Russia did not have enough resources to pay its defaulted debts and to service its foreign debt

under present circumstances and it urged Russia to approach its

Paris Club and London Club creditors for rescheduling and new

debt relief.34

Sensitive to criticism that it was lending new money to a country

that had just recently defaulted on its debts, the IMF announced

that proceeds from the new loan could only be used to cover loan

payments which were due to the IMF in the following 18 months.

In effect, the money would not leave the IMF building but would

be moved from one account (disbursements) to another (payments

due) when appropriate. This announced procedure was mainly symbolic. Only if the IMF had actually expected the Russians to default

on their IMF debt payments would the described scenario have

been real. Money being fungible, the proceeds from the 1999 loan

would have allowed Russia to use a comparable amount from its

existing resources for other purposes. The new standby lasted 2 months. Only about $644 million—the

initial first tranche—had been disbursed before the IMF suspended

and then canceled the program.. Russia was out of compliance with

the terms of the July 1999 agreement almost immediately. On December 7, 1999, Camdessus reviewed the status of the Russian program. Important progress had been made on the macro-economic

side, he reported, but this had not been matched by similar

progress in the area of structural reform. Several structural benchmarks set for the end of September remained unmet.35 ‘‘When

these remaining issues have been satisfactorily resolved,’’

Camdessus announced, ‘‘I expect to recommend completion of the

458

36 ‘‘Putin’s aide says Russia does better without IMF credits.’’ ITAR/TASS, April 14, 2000,

p1008104t6721. 37 ‘‘Russians to address new World Bank borrowing principles.’’ ITAR/TASS, April 17, 2000,

p1008106t6932. 38 ‘‘IBRD, IMF experts to fix cooperation programs with Russia.’’ ITAR/TASS, April 24, 2000.

P1008114t7733. 39 ‘‘Russia needs structural reform for steady economic growth.’’ ITAR/TASS, April 28, 2000,

p1008119t8442. 40Memorandum of the President of the International Bank for Reconstruction and Development and the IFC to the Executive Directors on a Country Assistance Strategy of the World

Bank Group for the Russian Federation. Report No. 19897–RU, December 1, 1999.

review to the Executive Board.’’ In effect, this suspended further

action on the 1999 standby. The IMF executive board is very unlikely to initiate a program review or approve a disbursement without such a recommendation by IMF management.

In April 2000, the Russian authorities began making public suggestions that it might be time for the IMF to approve a new loan.

The Russian press quoted Fischer as saying that the IMF hoped a

new program of assistance to Russia might resume ‘‘in the near future.’’ 36 Russian officials indicated that they believed there should

be ‘‘a change of conditions of the very principles of borrowing’’ from

the IMF and World Bank, implying that new agreements should require less conditionality and more cash.37 Russian press reports

even suggested that IMF officials were already in Moscow working

on the details for a new loan.38

On April 28, World Bank vice president Linn diffused any speculation that a new IFI loan program was imminent. Russia’s current

economic recovery was due to temporary conditions he said. Over

the long run, though, it needed to carry out reforms if it wanted

to attract domestic and foreign investors. If Russia does not do this,

he concluded, it should not expect to receive major new credit from

the IFIs.39 Most observers were quick to note that, if Russia were

unable to arrange a new loan agreement with the IMF, it would

not be able to secure debt relief through the Paris Club from its

official creditors, the former being a prerequisite for the latter.

World Bank programs: 1999–2001

The World Bank also reduced the size of its loan program for

Russia substantially after 1998. Exploring whether the Russian

Government might be inclined to move ahead cautiously with the

promised program of structural reforms, the Bank disbursed $100

million in 1999. As with the IMF program, however, the Russians

rapidly fell out of compliance with the revised terms of the SAL3

program. The World Bank suspended and then canceled the program with no further disbursements.

In mid-1999, the World Bank adopted a new CAS for Russia, replacing the one approved in 1997.40 In effect, the new CAS repudiated its predecessor’s heavy emphasis on adjustment lending and

balance-of-payments support. Instead, the CAS said the Bank

should put more emphasis on re-establishing the foundations for

growth and reducing institutional barriers to growth. Responsibility should be shifted from the IBRD to the IFC for operations

where funds are lent to commercial firms and for other commercial

lending. There should be fewer investment projects, more emphasis

on institutional development, and greater efforts to improve the

performance of the Bank’s existing portfolio, which had dipped

459

41Press conference by Michel Camdessus, April 8, 2000. Washington, DC Reported by ITAR/

TASS News Agency, February 14, 2000, p1008039t0176. 42Stanley Fischer. Russian Economic Policy at the Start of the New Administration. Remarks

to the conference at the State University: Higher School of Economics, Moscow, April 6, 2000.

alarmingly after August 1998. The Bank should sharpen its focus

on poverty reduction. It should also strive to improve its understanding of the Russian economy in order to improve the quality

of its future policy advice.

Between 1999 and 2001, the World Bank approved eight projects for Russia totaling $689 million, all of them strictly in accord with

the goals of the 1999 CAS. Sixty million dollars was approved for

improvements in official statistical and fiscal procedures. Another

$338 million was approved for projects with a social or humanitarian focus, such as clean water and sewerage, education, municipal heating, or amelioration of conditions for people living in depressed areas. Another $60 million each was also authorized for

sustainable forestry and urban transport. Only two of these

projects—those for institutional reform—have become effective and

only $3 million has been disbursed. Most of the projects have not

yet been officially signed. In some cases, it appears that necessary

Russian legislation has not yet been adopted. The Bank seems to

be putting a good deal of its effort in Russia into implementing the

projects for Russia it approved in earlier years. Many of these address key structural reform issues and require the adoption of new

policies or procedures before they can be fully put into effect.

Figure 5 shows that disbursements for World Bank project assistance in Russia have been proportionally smaller than those for

Bank adjustment loans. In some respects, however, this gives an

incomplete picture of the situation. Many of the Bank’s projects

have been delayed for technical reasons or because key policy

changes have not yet been adopted. However, in most instances,

Bank and Russian authorities believe these problems will be overcome and most of the proceeds for these loans eventually will be

disbursed. If and when this occurs, the disbursement shares for

these projects shown on Figure 5 will rise.

TREATING RUSSIA AS A NORMAL COUNTRY

In February 2000, at his last press conference as Managing Director, Camdessus observed that the illusion of quick transformations in Russia had been shattered.41 The strength of the resistance to reform there was unique. The IMF had been repeatedly

disappointed, he noted, by insufficient efforts of the Russian authorities to implement agreed economic measures and by the lack

of support from the state Duma. In April 2000, Fischer took a

somewhat more positive but still skeptical view in his first major

statement on Russia as the new IMF Acting Managing Director.42

He listed a number of needed reforms, noting that many or most

had already been elements of prior programs financed by IMF

loans. Russia’s poor effort at implementation, he said, stemmed

from a ‘‘failure to overcome fierce resistance from vested interests

in the face of weak government consensus.’’ There was no lack of

good ideas about reform, he observed. ‘‘What is needed now is to

translate this knowledge and energy,’’ he said, ‘‘into a coherent reform strategy that is backed by strong public consensus and leaderVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00485 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1
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43For further discussion along this line, see: Russian Federation: Staff Report for the 2000

Article IV Consultation and Public Information Notice Following Consultation. IMF Staff Country Report No. 00/145, November 2000; IMF Concludes Post-Program Monitoring Discussion on

the Russian Federation. PIN No. 01/68, July 18, 2001; and Russian Federation: Post-Program

Monitoring Discussions-Staff Report; and Public Information Notice on the Executive Board Discussion. IMF Country Report No, 01/102, July 2001. All are available from the IMF Web site. 44 Johannes F. Linn. Economic Situation and Outlook in Russia and Central Asia. Keynote

Speech, 6th Berlin Financing Conference, Berlin, Germany, July 21–22, 2001. Available from

World Bank Web site. 45 In particular, Linn noted that more progress was needed with reforms in six areas. For the

most part, they were the same structural reforms the IMF and World Bank had been stressing

for years. They included (1) further reforms in the tax administration, treasury, and debt management systems, (2) better corporate governance, including improvements in creditor and

shareholder rights, (3) more predictable legal and regulatory treatment of foreign investors, (4)

less involvement by government agencies— especial local and provincial authorities— in commercial and business matters, (5) a more effective judicial system, and (6) improvements in the

banking and finance system. The government would also need to take steps to encourage foreign

investment and curb the continued flight of Russian capital. 46Michel Camdessus. Russia: In Search of a Vision to Revitalize Reform. Address to the St.

Petersburg Economic Forum, Russia, June 16, 1999.

ship, and that is implemented.’’ (Emphasis in the original.) If that

happens, he concluded, the IMF and the rest of the international

community will be ready to help.43

In July 2001, World Bank vice president Linn summarized the

Bank’s current views on the Russian situation.44 In 2000, he noted,

Russia had high economic growth (over 8 percent), large budget

and trade surpluses, and a major increase in its international reserves. However, he noted, the situation was not sustainable, because it was being supported by high oil prices and a strongly undervalued currency. When oil prices fell and the ruble appreciated

more toward a more appropriate value, he predicted, Russia’s

growth rate would decline. Over the long run, Linn urged, Russia

needed deep institutional reform in its economy in order to achieve

the high investment levels necessary for broad-based productivity

and employment growth.45

Linn observed that the role of the international agencies in Russia would likely be much smaller in the future than it has been in

the past. ‘‘Today,’’ he asserted, ‘‘Russia requires much less foreign

financial support than it did in the 1990s.’’ Therefore, he said, the

World Bank would focus more on analytical, legal, technical, and

institutional concerns. In effect, Linn indicated, there would be

fewer projects for infrastructure and enterprise reform and no

broad loans for structural adjustment. The levels of World Bank

aid seen in prior years were not likely to be seen again.

At some point during 1999, it appears, the IFIs and their major

member countries changed their basic perception of Russia. Certainly, they had grounds for being disillusioned and disappointed

by Russia’s default and devaluation in 1998. Despite the willingness of the IFIs and others to pledge large sums to bolster their

determination, the Russian Government, gave way and failed to

change course or to pursue promised reforms. The echos from the

shock in Russia reverberated around the world, putting many other

emerging market economies—Brazil, for example—in peril and requiring major new commitments of funds by the IFIs.

Camdessus observed, in the month prior to the 1999 loan, that

Russia needed to decide whether it wanted to complete its transition to a full market economy.46 Many key structural reforms remained to be accomplished, but there seemed to be reservations in

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47 In that situation, the CBR diverted $1.2 billion of money lent by the IMF to an offshore

account in the Channel Islands. In 1996, the funds were reportedly converted to rubles and used

to purchase Russian Government bonds. The government was able to use the revenue from

those bonds to avoid insolvency and to pay wage and pension arrears and make other key expenditures during the presidential election campaign. The CBR deceived the IMF as to status

of that account, saying it could be counted among the country’s foreign exchange reserves. Some

critics are deeply concerned that money may have been stolen or used to benefit rich speculators. Other critics worry whether it is proper for IMF resources to be used improve President

Yeltsin’s election prospects during a period when it seemed he might be defeated in his bid for

reelection. CBR Governor Gerashchenko did not inspire confidence in his explanation of the affair, when he told the Duma that the placement of funds in FIMACO was merely an effort by

the CBR to evade paying Russian taxes on the earnings, to hide assets from creditors who might

otherwise be able to collect by lawsuit, and to get a better return on the money than it could

get if the CBR managed the account itself. 48 Russia is Told to Sell its Offshore Banks—IMF Demand is in Wake of ’96 Underreporting

of Central-Bank Funds. Wall Street Journal, October 1, 1999, p. A13. 49 Interview with John Odling-Smee, Director, European II Department, and his deputy,

Ge ́rard Be ́langer, by the author at the IMF, June 14, 2001.

sued. In this, he said, Russia was not unique. Russia had some special economic and political challenges as it emerged from 70 years

of Soviet economic management. Nevertheless, he observed, ‘‘Russia faces a similar range of economic problems—macro-economic

imbalances, incomplete structural reforms, weak system of governance, and heavy use of external borrowing—that were found in differing degrees in other countries in crisis.’’ Russia needed to take steps in several areas, he said, if it were

to surmount its current difficulties. It needed to surmount the barter system and the culture of non-payment. The government needed to make a ‘‘clear and unambiguous commitment’’ to equity in society. Even more central, the state needed to adopt a role for itself

that was more compatible with the needs of a market economy. Instead of trying to be the central actor in the economy, the state

should establish and uphold of the laws and be the ultimate source

of basic social protections. It should be the creator of the legal

framework and the key regulator and monitor of the market’s

standards and practices. Equally important, he said, Russia needed

to more clearly distinguish between the government and the institutions of the economy. In this, Camdessus observed, Russia was

not alone. Many of its problems reflect ‘‘an almost universal syndrome of incestuous relationships between governments, banks and

enterprises.’’ Those who think that Russia is unique, he said,

should look at the newspapers. All around the world, he observed,

one sees demonstrations against ‘‘corruption, collusion, nepotism,’’ criticism of ‘‘crony capitalism’’ and denunciations of ‘‘oligarchism.’’ Some of the change in the IFIs’ view of Russia may have arisen

as a consequence of the Russian Government’s uncertain responsiveness to concerns arising from the FIMACO affair.47 The CBR

seemed to show little concern about whether its activities had

credibility for major foreign countries. In late September 1999, as

consideration was being given to a possible new disbursement on

the 1999 IMF loan, the G–7 called for new mechanisms to monitor

Russia’s use of foreign loans. Specifically, it asked the CBR to undertake quarterly audits of its reserves. CBR Governor

Gerashchenko reportedly said that he thought the idea was ‘‘stupid.’’ 48

In June 2001, the author interviewed the key managers of the

IMF responsible for its Russian programs 49 in order to solicit their

views on the current situation. They sought to minimize the sugVerDate 19-JUN-2001 09:18 Jun 12, 2002 Jkt 000000 PO 00000 Frm 00487 Fmt 6601 Sfmt 6601 D:\DOCS\RUSSIA\76171.020 CRS1 PsN: CRS1
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50 ‘‘IMF does not expect Russia will need loans.’’ Reuters, December 6, 2001.

gestion that the Russians might have been seeking new loans the

year before. They were merely inquiring, the IMF managers said,

whether the IMF might be willing to resume implementation of

their earlier loan program. The Russian situation was complicated.

On one hand, they observed, its current macro-economic situation

and its balance-of-payments surplus are strong. It seems unlikely

that Russia will need to approach the IMF for assistance or that

the IMF would find such assistance appropriate. On the other

hand, they agreed upon inquiry, the IMF is unlikely to lend until

Russia begins implementing some of the structural reforms agreed

to earlier.

This raised questions about the IMF’s basic approach to Russia.

Wasn’t it vital that Russia move through the transition process,

even if this meant compromise on structural reforms? Had the IMF

limited its leverage and lessened its capacity for promoting change

by its announcements that new loans would be available only when

Russia began implementing needed structural reforms? Does this

mean that—as long as it can keep its macro-economic situation

strong—Russia would be able to postpone any further action on

structural reforms? The IMF managers disagreed with the underlying premise of these questions. ‘‘Russia is a normal country,’’ they

reported. It is not unique and the IMF does not need special standards for its programs there. Many other countries are also postponing any need for action on structural reforms through good macroeconomic performance. Several major countries were mentioned.

Some day, the IMF managers noted, these countries may find that

their economic situation is deteriorating and they may ask the IMF

for financial assistance. In that situation, for Russia and for other

countries, the issue of structural reform will come up again, they

said, and the prospective borrowers will know what they ought to

do.

CONCLUDING COMMENTS

It seems likely that Russia will not be receiving major infusions

of assistance from the IMF and the multilateral banks in the near

future. In December 2001, the IMF’s chief spokesman announced

that Russia’s current situation is ‘‘sustainable without need for recourse to the Fund or other points of external support.’’ The Russian Finance Minister agreed that ‘‘We will not need IMF credits.

Russia has enough of its own financial instruments which will be

used to fulfill the budget.’’ 50

After their disappointment of 1998, the international agencies

may harbor some reservations about Russia’s willingness to address the hard problems which remain. Russia’s macro-economic

situation is reasonably good, but it has not yet implemented many

of the structural reforms it agreed to pursue in connection with the

1999 loan. The World Bank will continue funding projects, mainly

those addressing social needs or institutional reform. According to

its latest strategy paper, however, the Bank does not intend to pursue broad systematic reforms or major adjustment programs. The

EBRD will be lending or investing where it sees opportunities, but

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ment programs. Much will depend in the future on the policies the

Putin government pursues and the steps it takes toward structural

change.

There continues to be substantial debate as to whether Russia

benefitted or suffered from its relationship with the IFIs. In large

part, the question depends whether one believes that a market

economy is preferable or whether some type of state-managed economic system is more to be desired. The IFIs played a significant

role in the past decade urging Russia to move toward the former

goal. Among the G–7 and other foreign aid donors, they helped assure that there was some minimal coherence in goals and expectations. No other donor sponsored an alternative program of economic

policy reform with contrary goals or norms. During the 1990s, the

IMF in particular sought to persuade the Russians to reduce the

size of their budget deficit, to limit inflation, to improve fiscal and

monetary procedures, and to undertake a broad range of structural

reforms. The latter included privatization, elimination of subsidies

for large former-state firms, closer regulation of the financial

health and stability of the financial system, land and agricultural

reform, and other matters. Most of these were at the heart of the

political struggle then going on between Russian reformers and the

opposition. Demonstrably, Russia failed to comply with the performance criteria in most of its IFI stabilization or adjustment programs. Toward the latter part of the decade, the budget deficit and

rate of inflation came down substantially but macro-economic stability was still precarious. Achievement of many of the key structural reforms was often partial or incomplete.

Since late 1999, the IFIs have decided that Russia no longer

needs special treatment. From the perspective of the IFIs (and

from that of many of their major member countries), Russia is now

a ‘‘normal’’ country and should be treated by the IFIs in the same

manner as they treat other middle-income developing countries.

Russia’s current macro-economic situation is such that it does not

need new IFI stabilization or SALs. Its performance in recent years

with structural reform—the unmet commitments from prior

loans—is such that it would likely not qualify for such loans even

if it needed them. The IFIs will probably give substantial consideration, in any future discussion of new assistance plans, to the level

of progress Russia will have made in the future with the implementation of such structural reforms.

Æ