TRANSITIONAL ECONOMIES IN THEORY AND PRACTICE The GLOBAL FINANCIAL-ECONOMIC CRISIS and the Russian economy: effects, current issues, and challenges for the future Dr. Richard Connolly Centre for Russian and East European Studies University of Birmingham Email: r.connolly@bham.ac.uk

Structure Part 1: How did the GFEC affect Russia? How does the Russian government propose to deal with the effects of the crisis? Is the existing plan a feasible strategy for success? Part 2: What type of system exists in Russia today? How does this relate to other countries? Will Russia’s place in the world change?

Outline Russia was particularly badly hit by crisis. Russian elite has recognized the need for modernization and diversification (i.e., structural transformation). But this requires a sustained increase in the rate of investment. What has held back investment in Russia? Identifying the binding constraint is the best starting point for guiding policy action.

PART 1: Outline 1. Sources of Russia’s strong pre-crisis economic performance. 2. But investment is relatively low, notwithstanding increase 2005-8. 3. Brief overview of growth diagnostics framework. 4. Application to Russia: what is the binding constraint on investment? 5. Desirability of current policy and prospects for success.

1. Pre-crisis economic performance 1999-2008: one of the fastest $ GDP expansions in the world (e.g., faster than China) Why? 1. Rising commodity prices improve Russia’s terms of trade (rising incomes, corporate profits, etc). 2. Market reforms of 1990s 3. Post-1998 price competitiveness (devaluation) 4. Investment-light growth due to low capacity utilization 5. Low level of monetization, facilitating incoming currency flow absorption 6. Sensible macroeconomic policies (partial implementation of Gref program, but slows after 2005), although oil funds good 7. Favourable demographic tendencies help labour contribute to growth

1. Pre-crisis economic performance 1999-2008: episode of growth acceleration (Hausmann, Pritchett and Rodrik, 2005) But still Russia has made little progress from long-run perspective (i.e., relative to US per cap income)

1. Pre-crisis economic performance But still a laundry list of problems (or why modernize?)... 1. Property rights (domestic and foreign) infringed in NR sectors (Yukos, TNK-BP, etc). 2. Leads to slow expansion of state in ‘strategic industries’ – leads to dual economy (Sutela, 1999; Hanson, 2007) 3. Rent distribution sustained non-productive firms (Gaddy and Ickes, 2010). 4. Productivity still low (c.30 per cent of USA, McKinsey, 2009). 5. Productivity growth lower in state-controlled firms (Guriev et al) 6. Continued low ratings in corruption, ease of doing business, etc. 7. Build up of external debt in private sector, although not excessive by international standards ; fast domestic credit growth in years prior to crisis 8. Persistently low investment rate (even comparatively low as capacity utilization was stretched in later boom years) 9. And, crucially, dependence on favourable commodity prices – source of boom and bust; 10. Russia overshadowed by nearly all emerging market economies in export of medium- and high-technology goods (Cooper, 2007; Connolly, 2008) NEED FOR STRUCTURAL TRANSFORMATION RECOGNIZED BY ELITE

2. The effects of the GFEC on the Russian economy EFFECTS ON RUSSIA: Swing from growth to recession was sharpest among G20 economies (nearly 15 per cent in rouble; c.25 per cent in $ terms); only BRIC economy to experience recession. During crisis (i.e., 2007-2009) Russia ranks 175 out 183 countries in degree of swing between pre-crisis and crisis output. Industrial production (down 10.8 per cent, 2009); investment (down 17 per cent); reserves fell by a third; rouble fell; CA surplus halved; domestic credit collapses. Domestic demand contracted sharply; state has swung from surplus (5.4 per cent in 2007) to deficit (5.9 per cent in 2009). Anti-crisis measures have mainly focused on businesses close to state (see rouble defence as well as direct transfers); measures for poorer more modest (see Yakovlev et al, 2009) – Putin fulfils his side of “protection racket” bargain. Why so severe? 1.Commodity dependency (expectations of oil price being primary driver of confidence). 2. Institutional weaknesses (previous confidence turned out to be fragile) 3. Private sector external debt burden amplified by ‘sudden stop’ (Calvo) and ex rate depreciation. Lessons drawn by elite: Shakes confidence of elite in NR rent- distribution model Reinforces belief that Russian economy needs a new model – diversification and modernization But how? Russia caught between high-tech Europe and low-cost Asia.

3. State-led development agenda 2000-7: Putin (energy-led process – extract more value from resources, use to develop other areas) 2008: Medvedev : ‘four Is’ – innovation, infrastructure, institutions, investment (driven by state) 2009: “Forward Russia” – Medvedev (Commission on the Modernization and Technical Development of the Russian Economy); InSoR report on Russia in 21st Century 2010: Putin’s Commission on High-Technologies and Innovation Both reiterate same themes of modernization first outlined in Putin’s early speeches. Both emphasize role of state in a top-down process. Culminated in MER’s 2020 plan (2008): role of goskorporatsii ; limited FDI in strategic sectors; focus on innovation, raising R&D, reducing corruption, improving state administrative quality, etc. Crisis reduced fiscal capacity of state – assumptions for plan excessively optimistic and unlikely to receive same degree of state backing Also, reorganization of most goskorporatsii to JSCs New ideas from InSoR (Gontmakher, Golts, Yurgens) – modernization conceived in broader political terms Polarization of modernization agenda: liberal (InSoR, Medvedev?) v. conservative (Surkov, Shuvalov, United Russia, Medvedev?)

4. State-led development agenda General aims of 2020 Plan: Fifth largest economy in the world, biggest in Europe ‘Best place on earth for humans to live in’ (Putin, 2008) GDP, % 2007 = 226 Investment, % 2007 = 368 Population, 143 million Life expectancy = 75 Share of middle class, = % 50-70 Average pc income = (2007 = 6000 USD) $30000 Exports, % 2007 = 154 Energy intensity, % 2007 = 55-60 Innovation goals of 2020 plan : Increase in Russia’s role as a trading power, particularly in CIS

5. Growth diagnostics approach: identify binding constraints How to increase private investment and entrepreneurship? Identify ‘binding constraints’ Wholesale reform v. second best reform Target largest distortions Rodrik, Hausmann and Velasco (2006) Appropriate for Russia Wholesale institutional reform unrealistic (will informal behaviour match new formal rules?) Government should focus on a limited number of key areas State administrative capacity is a weakness

GD methodology 1. Any binding constraint should have a high actual or shadow price. E.g., if human capital is binding, the returns to those that receive a good standard of education ought to be very high. 2. Movements on the presumptive binding constraint should be correlated with movements in the aggregate rate of investment or growth. 3. A constant cannot explain a variable (e.g., ‘Russianess’ not the problem). 4. Agents less intensive in the binding constraint should be more likely to survive and thrive, and vice versa. 5. When searching for binding constraints on private investment and growth it is useful to benchmark the performance of an economy against appropriate international comparators.

6. Investment in Russia Investment is pretty low. Table 1. Gross capital formation, 1990-2008 (per cent of GDP) Figure 2. Investment and growth in Russia, 1994-2008 Investment is pretty low. State accounts for c.20 per cent. FDI, though increasing, accounts for a relatively small proportion. Large firms account for much. Regional concentration. Poor quality? Growth is extremely sensitive to investment growth, despite the relatively low level. What accounts for recent growth and previous deficiency?

7. Working down the decision tree 1. Is the problem a high cost of finance? High savings suggest that the problem isn’t liquidity constraint

7. Working down the decision tree 1. Is the problem a high cost of finance? Interest rate spreads are narrowing.... … with investment sensitive to this narrowing (r = 0.72)

7. Working down the decision tree 1. Is the problem a high cost of finance? And yet firms see finance as becoming an increasing problem, particularly after crisis.

7. Working down the decision tree 1. Is the problem a high cost of finance? Doesn’t compare favourably with sample comparators on index of financial sophistication (ranked out of 133 countries, WEF).

7. Working down the decision tree 1. Is the problem a high cost of finance? Russia has a small and poorly performing financial sector Why? 1. State controlled - now around 55 per cent (Vernikov, 2010). - Low competition and negative real interest rates lead to credit rationing. 2. Large number of banks; regional concentration (at least half around Moscow); regions and SMEs poorly served. - A dual financial system. 3. Bank-centric: few alternative sources of finance. - Underdeveloped equity and bond markets; limited pension fund development. 4. Limited role for foreign organizations. - 8 per cent of total assets in 2002 to 20 per cent in 2008. Plus, regional and social concentration tends to follow domestic banks.

7. Working down the decision tree 1. Is the problem a high cost of finance? And yet, as credit supply loosened 2005-8, investment took off.

7. Working down the decision tree 1. Is the problem a high cost of finance? Overall: 1. Investment moves in line with changes in credit supply, suggesting supply, not demand, is the problem. When this eases, investment takes off, growth follows. This suggests investment demand is significant. 2. Agents constrained in factor are not large companies with either close links to state or access to foreign capital (these avoid credit rationing). Conversely, those that perform poorest (SMEs, remote regions) are precisely those most sensitive to changes in the credit supply. In short, poor availability of finance because of supply-side weaknesses appears to be a strong contender for biding constraint.

7. Working down the decision tree 2. Is the problem low social returns? A. Infrastructure? Not bad by international standards. Not widely cited by survey evidence.

7. Working down the decision tree 2. Is the problem low social returns? B. Human capital? Again, comparatively good. Not cited as particularly important in aggregate survey data.

7. Working down the decision tree 3. Is the problem low appropriability of private returns? A. Taxation? Not great by international standards. Ranks high in survey evidence. But, a constant cannot explain a variable: taxation has always been cited as a problem, yet investment grows despite this. It doesn’t move with the dependent variable. A constraint, but is it binding?

7. Working down the decision tree 2. Is the problem low appropriability of private returns? B. Institutions? Among the worst in the world. Ranks top problem in survey data. But investment tends to grow even as perceptions of corruption and poor institutional quality increase! Again, a constant cannot explain a variable. Can this be the binding constraint?

Summary Russia performed badly during global recession. Russia needs an investment boom to modernize and diversify. But investment is relatively low in Russia. Binding constraint appears to be poor financial intermediation: demand is there; supply isn’t. Supply of finance is the only variable that moves with investment (and growth); other variables are constraints, but not binding. Existing state policies do not address the binding constraint; therefore, they are unlikely to result in greater investment, leading to continued structural stagnation. Russia appears to be entering the inertia scenario (see MER, 2008).

PART 2: Outline What type of system prevails in Russia today? How does this help Russia fit in with the external environment? Will the emerging multi-polar world order reflect domestic structures? Exercise in scenario mapping to assess what types of risk exist today in Russia, and what may emerge in the future.

State of the art: Existing contributions focus on either: 1. Domestic structures or interests: e.g., Tsygankov (2009), Wood (2009), Timofiev and Melville (2008) 2. International distribution of capabilities: Freidman (2009), Goldman Sachs (2005) However, need to incorporate both if we are to have any chance of exploring what the future might look like. Domestic forces likely to be shaped by events on international stage, and Russia’s international role likely to be shaped by domestic considerations. Traditional realist accounts of IR: Kissinger, Gilpin, EH Carr, all see world politics as ‘two-level game’ (Putnam)

Methodology: Not an exercise in forecasting. Projections are based on relatively simple assumptions and are used to generate alternative scenarios for future development of both Russia and world. Scenario approach used by business (Shell), government (RAND), military (NIC),and scholars (Gustafson and Yergin, 1995) Purpose here is to set out alternative scenarios to facilitate identification of key variables that will likely shape Russia’s future trajectory, whatever the scenario. As such, can help focus attention on policy priorities to prepare for future. Identify four basic drivers of politics: (1) demographic; (2) economic; (3) military; (4) political

Overview: 1. State Russia’s position on the four drivers at the current time. 2. Outline three scenarios for future Russian development. 3. Describe main contours of world today. 4. Two alternative scenarios for development of world along four variables. 5. How do domestic scenarios interact with international scenarios? 6. Key issues for Russia’s future development.

Russia today: demographic trends Causes: health crisis; low male life expectancy; declining fertility rates.

Russia today: demographic trends End of its final decline in dependency ratio. Implications: lower savings rate, higher state expenditure, labour squeeze.

Russia today: economic trends One of the world’s fastest dollar increases in GDP between 1999-2008. Correlated with rise in commodity prices, but other causes...

Russia today: key economic features Growth caused by: Move to market incentives Final demographic dividend Increased employment Capital utilization Higher productivity Rising commodity prices Appreciation of rouble Current problems: Dual economy (state capitalism) Rising dependency ratio Tighter labour market Low investment (FDI and domestic) Slowing TFP productivity NR dependency Dutch disease Need for diversification Rule of law/corruption

Russia today: the military Main features today: Structure skewed towards officers, conscripts Force structure geared towards old threats (large conventional conflict with NATO) – flawed military doctrine? Low readiness and low effectiveness Low morale (dedovshchina, pay for kontraktniki) Largely obsolete weaponry Mixed quality of modern weaponry Not network-centric Defence industry sustained by exports Defence industry inefficient and dispersed Future challenges: Professionalization (permanent corps of NCOs, less senior staff, contract soldiers) Lighter, more mobile forces to deal with more imminent threats More responsive and effective Improve morale Modernization of weapons Improved communication and information systems New export customers Clear domestic demand profile Consolidation and re-organization of defence industry

Russia today: key political features

Russia today: key political features Main features today: Limited-access order (North et al, 2009) – those in power use rent disbursements to sustain existing power structures Link with economic structure; state control of key sources of rent Patrimonial state uses resources to capture federal and regional politics Low level of demand for provision of rule of law Weak civil society, weak political parties, weak business interests Future challenges: Increased economic competition through diversification of economy Reduction of state control of economy Generate demand from below for rule-based government More and stronger organizations independent of state Move to universally applicable rules as basis for state rule

Three scenarios for future Scenario 1: Optimistic Demographic trends remain same, but higher female participation rate, better education, etc Economic growth model based on: higher investment (diversification), productivity gains (not innovation), reduction in state ownership, sensible fiscal policies, etc. 5 per cent average Military: smaller, professional armed forces (1 mil); budget of 3 per cent of GDP; smaller, more efficient defence industry; focus on fewer, but better equipment Political: not a Western democracy, but more open-access (i.e. more universal application of rules), more representation of organizations that emerge with economic growth and diversification Scenario 2: Muddling through Demographic trends remain same, but no changes in female participation rate, education, etc Economic growth model based on: state ownership of strategic sectors, stagnant investment , modest productivity gains, sensible fiscal policies, continued dependence on NR revenues, etc. 4 per cent average Military: smaller, conscript-based armed forces (1 mil); budget of 3 per cent of GDP; similar inefficient defence industry; equipment quality declining as Soviet investment recedes and exports dry up Political: Persistence of patrimonial Putinist model Scenario 3: Recentralization Demographic trends remain same, but no changes in female participation rate, education, etc Economic growth model based on: state ownership of strategic sectors and some non-strategic, higher investment , lower consumption, lower productivity, populist fiscal policies, continued dependence on NR revenues, etc. 3 per cent average Military: larger, conscript-based armed forces (1.5 mil); budget of 5 per cent of GDP; similar inefficient defence industry; equipment quality declining as Soviet investment recedes and exports dry up Political: No semblance of democracy, arbitrary

The world today: demographic trends

The world today: demographic trends One of the highest in sample One of the lowest in sample Russia

The world today: GDP (current $US)

The world today: military trends Full spectrum dominance of US military Even regional powers relatively weak vis-à-vis US Reinforced by strong alliances Low prevalence of war between countries that can be considered as ‘powers’, usually large v. small

The world today: political tendencies Dominance of democratic, market economies in international institutions Dominance of same countries in share of world population and economic output World order reflects this distribution of power Same countries also the most technologically advanced

The world in the future: two scenarios The fast rise of the rest: USA aside, demographic tendencies suggest rising powers will have more favourable demographic characteristics Sensible economic policies are carried out; orderly shift to greater consumption, less investment Emerging economies take place of US as global consumer No economic or political crises Current leading economic powers suffer from less favourable demographic features, slowing productivity growth, and slower growth associated with being closer to EEF. Military spending stays at existing levels (as % of GDP) No change in political systems In short, Goldman Sachs projections with stable political development The slow rise of the rest: Rising dependency ratios in EEs slow savings, investment, consumption growth, etc. Policies not always conducive to consistent growth. US remains global ‘consumer of last resort’ Next two decades punctuated by periodic economic and political crises Current leading economic powers suffer from less favourable demographic features, slowing productivity growth, and slower growth associated with being closer to EEF. Military spending stays at existing levels (as a % of GDP) No change in political systems In short, lower GDP projections for Rising Powers, but same GS for developed economies

The world in the future: economic (fast rise)

The world in the future: economic (slow rise)

The world in the future: military The fast rise of the rest: US still primary power, but full spectrum dominance compromised by rise of China and other regional powers. Move towards regional alliances; less emphasis on US alliances. Russian armed forces overshadowed by all large powers in all but optimistic scenario – increased dependence on nuclear deterrence. Dominant in ex-Soviet sphere Less emphasis on conventional forces make Russia more vulnerable to low-intensity conflict (primarily on southern border) The slow rise of the rest: US remains primary power, greatest power projection capabilities Only China, and perhaps India, can challenge on a regional level Move towards regional alliances, but US remains the decisive actor (e.g., Indo-US alliance?) Same as fast rise: Russia with no relative power projection capacity outside ex-Soviet sphere. Only optimistic scenario provides capacity to provide security against low-intensity conflict

The world in the future: political In either scenario, the distribution of economic activity and population is strongly in favour of more democratic systems, assuming no change in political organization of states. Slower the rise of the rest, the longer existing practices persist. Only significant difference will be greater relative power of large but poor (per capita) economies – implications for free trade, welfare, etc. For Russia, optimistic scenario provides more scope for alliances based on values, internal structures (because there are more potential allies). However, presence of larger but poorer nations in top group provides room for alliances based on interests rather than values.

Conclusion: Best scenario for Russia is slower rise of rest alongside optimistic domestic scenario. However, in all but worst scenario, Russia will remain a significant actor. Like now, no power to decisively alter trajectory of world politics, but power to cause problems and to act as swing actor in a more fluid environment. However, optimistic scenario will provide other ‘goods’: human freedom, economic prosperity, security from lower intensity warfare, more shared values, etc. In no scenario can Russia improve on its position of relative power that it has now.