In No Hurry to Catch Up

Russia stands alone as the only major economy that hasn’t increased industrial production in the last 20 years. While China expanded its industrial production 4.3 times between 1994 and 2008, and India 2.1 times, Russian industrial production is today well below its level at the end of the Soviet era. While its BRIC “colleagues” exported $1.42 trillion in industrial goods in 2008, Russia’s industrial exports were a mere $32 billion. Industrial workers make up only 16 percent of Russia’s workforce and are 6.7 times less productive than their counterparts in the United States.

Deindustrialization began with the collapse of the Soviet Union but accelerated during the Putin era. Instead of restoring Russia’s industrial growth, Putin’s government preferred to rely on growing oil and gas incomes, redistribute them via the state budget and return them to the people and businesses via pensions, salaries, and investment – what might be called “Putinomics.” As a result, Russia was the only rapidly growing country in which GDP grew faster than industrial production: from 1996 to 2007, Russian GDP grew by an average of 5.9 percent annually, but industrial production grew by only 4.9 percent.

Although politicians and experts are now finally talking about modernization, there is still little chance of making it a reality. There are several reasons for this:

• There is no consensus in favor of modernization. In most countries that have successfully modernized in recent years, there was a widespread feeling that the country was trailing not only the great powers but even its regional partners. Modernization drives are the natural product of a shared perception of underdevelopment and a shared determination by both the elite and the general public to catch up. However, the political elite claims that Russia is already successful, while a large part of the entrepreneurial class and the ruling bureaucracy derives its riches from oil and gas extraction and other resource-producing companies, and is therefore not interested in modernizing industry.

• There is little understanding of what modernization actually requires. Modernization is often confused with the development of a high-tech knowledge economy rather than improvements in manufacturing industry. Russian experts and policy makers seem to think they can omit the mass-production stage in economic development and jump directly into a post-industrial future. Even President Medvedev believes that modernization will come from aerospace projects, nuclear power plants, and super-computers. However, such projects are not feasible without a developed industrial complex and an educated work force to staff these high-tech industries.

• Russia has nothing like the Japanese Ministry for International Trade and Industry (MITI). The government is therefore unable to force the pace of modernization even in state-run companies such as Gazprom (which spends three times less on R&D than any other energy major in the world) and Russian Technologies (which has been unable to develop a modern car). For example, new quality standards for fuels sold on the domestic market have been postponed six times after pressure from state-owned oil companies.

• Russia’s monopolistic economic structure allows raw material and energy producers to push up commodity prices. From 2000 to 2007, gasoline and natural-gas prices increased dramatically and are now three to four times more expensive in Russia than in China. As a result, industrial production or investment in Russia is very expensive. For example, Russia badly needs new roads, but one kilometre of paved road costs on average three times more than in Western Europe.

Russia in 2009 thus differs enormously from Japan in the 1950s, South Korea in the 1960s, Malaysia and Brazil in the 1970s, and China in the 1990s. It lacks a national consensus on modernization, its elite prefers “energy superpower” status, all the major “national champions” do their business in the primary sector, and people are happy with rising living standards alongside rocketing oil prices. Nor do I see any possibility for this situation to change. Since the beginning of the economic crisis, the Russian political elite has done little to change the structure of the economy. The government’s so-called “anti-crisis program” focused instead on helping the least effective 48 enterprises – technically bankrupt conglomerates such as Oleg Deripaska’s Basic Element – to survive.

TWO CHOICES

I want to propose two possible paths to modernization, but I should point out from the very beginning that, given present circumstances, it is quite nlikely that either will become reality. If this is to change, Russia needs to recognize that it is a middle-ranking industrialized country that needs to “catch up” in industrial production and technology. Above all, Russia should abandon its current role as Europe’s source of energy and strive to become a producer and exporter of industrial goods. Russia simply cannot be modernized when its main exports are oil and gas, and when more than half of its budget comes from custom duties (a position the US was in back in the 1890s).

The first possibility is a classic state-led reindustrialization of Russia’s economy. Three main obstacles stand in its way: high resource and labour prices, an inadequate system for allocating investment, and the general ungovernability of the national economy. The first can be tackled by dramatically decreasing production costs and the price of energy and other natural resources. The second by promoting direct investment – both domestic and foreign. The third by turning the state into an active modernizer of Russia’s economy. This type of authoritarian modernization can be accomplished without a dramatic overhaul of the political system that has evolved in the country in recent years, though it will definitely hurt the vital interests of those currently at the top.

To begin with, the government will have to deprive the resource-producing industries of their “natural monopolies” and turn them into a cash cow for financing Russia’s catch-up. Resource prices must be decreased (either directly or through currency devaluation) in order to provide access to cheap resources for anyone who wants to create a new highly productive enterprise in any branch of Russia’s economy. The government should also help Russian companies to buy technology and equipment from abroad as the Japanese government did in the 1950s. In this respect at least, the economic crisis is an opportunity of sorts, as capital goods are now cheaper than at any time since the early 1990s.

Conditions for market entry must be eased as much as possible. For example, the state should abandon the practice of forcing property developers to make “plugin” payments for utilities and remove bureaucratic hurdles. On the other hand, the government should also take steps to stop corruption by businessmen – for example, the practice of bribing local officials to accept faked low returns and thus escape taxation. In total, such measures could cut production costs in major industries by half in five to six years, allowing these businesses to grow rapidly.

The next step is the promotion of long-term capital investment – not just by cutting taxes but also by addressing the competitive advantages that established production facilities have over new enterprises. Industries that were privatized in the 1990s were amortized long ago, giving their owners a competitive advantage. Entry costs to the market can therefore be enormous. As a result, not one new oil or metal-processing plant has been built in Russia since the breakup of the Soviet Union. I propose cutting taxes for newly established industrial enterprises and subsidizing energy prices for the first three years of operation.

The current financial crisis also shows that Russia’s banking system cannot solve the country’s mounting economic problems on its own. The combined assets of every bank in the Russian Federation are less than those of the 20thlargest bank in the world, Spain’s Banco Bilbao Vizcaya Argentaria. Russian banks and industrial companies cannot therefore become a source of long-term strategic investment – which is why domestic companies borrow in the West. However, there is no recognition in Russia of the importance of foreign direct investment.

Reform of the Russian financial system is also essential if modernization is to be successful. A profit tax as high as 75 to 80 percent should be levied on all stock market profits from investments that last less than seven days (this tax could diminish to zero for investments of three years or longer). In recent years, Russian companies wasted so much energy trying to take each other over that they neglected the foundations of organic growth. To prevent this continuing, mergers and acquisitions must be made much more difficult.

Finally the Russian state must turn itself into a classic developmental state. This will require three kinds of measures:

• Much stricter regulation in energy saving, product quality and ecological standards. As in the EU, the state must force businesses to cut energy use and improve the quality of their products. New quality requirements should be imposed on liquid fuels, automobile engines, energy consumption and construction materials.

• Reform of Russia’s bureaucracy to minimize direct contact between officials and entrepreneurs. Tax forms should be submitted via post or the internet; the amount of documentation must be reduced; and starting a business should be made much easier.

• The establishment of a governmental body responsible for enforcing modernization similar to Japan’s MITI. It should be responsible for disseminating new domestic and foreign technologies, and could also provide companies with loans for buying new technologies and production facilities.

In short, the Russian state should take the country down the path that other developing countries have already taken. However, I remain skeptical about whether this is likely to happen. For 20 years or so, the Russian state has failed to act in the national interest. Not only is it now corrupt, but also it has been hijacked by various interest groups who see a position in the bureaucratic structure as a business asset. Russian policy-makers now think and act as businessmen. In order to modernize, Russia must first change its political leadership.

There is a second possible path to modernization that doesn’t require such a strong developmental state but nevertheless requires radical political decisions to be made. Eastern European states have based their recent economic success on adopting EU practices. If Russia were to accept the EU-wide regulations known as the **acquis communautaire,** comply with European ecological, competition, trade and some social protection standards, and agree to submit to the decisions of the European Court of Justice, it would not only open Russia to European investment and promote a more competitive climate, but also gradually introduce the rule of law into a country in which the elite behaves as if there were no rules at all. Like Turkey, Russia could aim to join not the EU itself but the “European co-prosperity zone.”

However, the Russian government is also unlikely to follow this path. The Russian political elite values nothing so much as its sovereignty. Russia has opted out of many binding international treaties and it seems incapable of producing any regional integration model or obeying the rules of any trading bloc. There is no reason to believe that Russia will want to participate in any grouping where it cannot dictate the rules, however theoretically valuable this participation may be.

In short, Russia today lacks the will to modernize, whether through a state-led reindustrialization or by accepting EU practices and standards. The choice of whether or not to modernize is one that many other countries around the world have faced. Those who chose the first path – for example, South Korea, Singapore and Malaysia – evolved into successful countries. Those who chose the latter path – for example, Venezuela, Nigeria and Angola – ended up in a mess. I can easily imagine Russia taking this second path and transforming itself into what Peruvian economist Oswaldo de Rivero used to call a classic non-developing nation. I still have some hope, but little confidence, that Russia will avoid such a fate.