Russia’s economic transformation is not yet complete enough to support high and lasting growth. This chapter considers what impediments remain in the way of sustainable growth and what reforms are necessary to remove them. As the postcrisis boom dissipates, reform efforts need to be both appropriately focused and front-loaded, to ensure a smooth transition from the postcrisis boom to a long-term growth path. The chapter assesses the government’s reform agenda in view of these requirements, to sketch out the prospects for Russia’s medium-term growth.
Russia’s Structural Transformation Record
The transformation of the Russian economy before the 1998 crisis was insufficient to unleash Russia’s full growth potential. Significant progress was made during 1992-98 on liberalizing prices and privatizing state-owned enterprises, but the absence of properly functioning market institutions (market entry, hard budget constraints, exit of insolvent enterprises) and supporting financial and judicial systems thwarted growth even when macroeconomic stabilization was achieved in 1995-96. At the same time, a large and increasing share of economic activity took place outside the official economy, thereby circumventing many institutional deficiencies. This spontaneous restructuring of the economy suggested that institution-building did take place, albeit semiofficially at best, and generated some restructuring and growth, which were not included in official statistics.
The reforms undertaken in the precrisis period, however incomplete, helped the economy to exploit the positive external shocks that followed the crisis. Although structural and institutional failures were serious enough to suppress economic growth before the crisis, they were not so severe as to stifle the positive impact of the real ruble depreciation and higher oil prices after the crisis. The macroeconomic improvement could have been even more dramatic if relevant institutional reforms had been successfully implemented, but price liberalization and privatization—particularly in the natural resources sectors—evidently constituted sufficient reform to unlock economic growth after the crisis.
The recent impressive growth record has not, however, yet benefited significantly from the postcrisis structural reform effort, which got off to a slow start except for reforms aimed at restoring fiscal viability. The present government approved an ambitious reform program in July 2000, but the process of enacting reform legislation started in earnest only in summer 2001. The reforms that are already being effectively implemented include tax and federal treasury reforms. Progress in advancing the broader reform agenda through the Duma has clearly improved market sentiment toward Russia, but the impact of this sentiment has been most evident in the asset markets and has therefore contributed to growth only indirectly, at best.
Postcrisis growth has thus mainly reflected transitory factors rather than any fundamental structural change in the economy. The positive impact on growth of the real ruble depreciation in the aftermath of the crisis and the subsequent dramatic improvement in Russia’s terms of trade is already fading away. For three years now growth has been primarily driven by private consumption—an offshoot of the positive external shocks—which is set to be equally fleeting in the absence of investment to support sustained productivity growth across the whole economy. While private investment has grown, it has been concentrated in the natural resources sectors that have benefited from the large export revenue windfall (see Chapters 1 and 2 for details). But unless other sectors of the economy are able to invest and develop, Russia’s dependence on natural resource exports will prevail, and economic growth will fluctuate in tandem with oil and other raw material prices.
An intrinsic characteristic of economic diversification and resilient growth in both industrialized and advanced transition economies—apart from broad-based investment—has been the emergence of a dynamic small and medium-sized enterprise (SME) sector.1 In very rough terms, this sector accounts for between one-half and three-fourths of employment and more than one-half of value added in the United States and Western Europe. In the most advanced Eastern European transition economies, SMEs have roughly doubled their share in employment and value added in the past 5-10 years, reaching one-half of both by the late 1990s.
Statistical problems hamper the analysis of the SME sector in Russia, but it is nevertheless clear that its growth potential has not yet been unleashed.2 The number of small businesses has remained broadly stable in absolute terms since 1995 and declined during the same period as a share of all enterprises from 40 percent to about 25 percent. The small business sector currently accounts for 10-20 percent of both employment and value added, with the latter in steady decline since the mid-1990s. While these figures likely underestimate the relative size of the sector, it appears to have stagnated rather than grown since the mid-1990s. Besides, small businesses are heavily concentrated both sectorally (with trade and catering accounting for one-half and industry and construction about 30 percent of all small businesses) and geographically (with Moscow alone accounting for 30 percent of all small businesses).
The Russian economy and its growth therefore remain dependent on large conglomerates. The postcrisis period has seen a further strengthening of large enterprises and concentration of market power as a result of the formation of chaebol-like financial-industrial groups.3 They are characteristically built around large, export-oriented, and profitable nonfinancial enterprises in pursuit of vertical integration. Observers have identified some 10 key groups, half of which have their core business in the oil sector and another couple in metals extraction and processing. The core enterprises in these groups have benefited from large positive terms of trade shocks since 1999 and used part of the windfall profits to expand up- and downstream and also into noncore activities. While oil companies were already vertically integrated, they have acquired stakes in the pipeline and metallurgical industries directly supplying the oil sector. Large aluminum and steel companies, in turn, have expanded upstream into fuel industry and downstream into car and aviation industries. All in all, the 10 or so key groups now account, by some estimates, for as much as one-fourth of Russian exports.
The record of structural reforms and sources of growth depicted above suggests that the Russian economy has not yet reached a critical mass of structural transformation for self-sustaining growth to emerge. A huge structural transformation is still needed. Even after the recent economic boom, more than one-third of enterprises remain loss-making and production is increasingly energy intensive—production of one GDP unit requires 2-4 times more energy in Russia than in North America and up to 13 times more than in Western Europe.4
A striking dichotomy characterizes the Russian economy at present. On the one hand, there are the conglomerates that have received an export windfall and used it to invest and expand aggressively, thereby driving growth since 1999. On the other hand, there are the old, loss-making, energy-intensive structures emanating from the Soviet era that have managed to escape both restructuring and bankruptcy. In between, there is no dynamic SME sector emerging rapidly that could be expected to support growth when the transitory export windfall withers away.
What are the structural and institutional failures that have contributed to this dichotomy and stood in the way of broad-based investment and growth of the SME sector? What reforms are necessary to correct these failures, to allow Russia to better exploit its long-term growth potential?
From Transitory to Sustainable Growth
The failure of self-sustaining growth to take hold reflects the public sector’s still-pervasive role in the economy. The government continues to control the prices of some of the most important input goods and services—notably, electricity, natural gas, and rail transport—thereby encouraging excessive use of cheap energy and compromising economic efficiency through this distorted resource allocation. Market entry is complicated or even blocked by administrative barriers that serve as a rent-seeking vehicle for both incumbent enterprises and civil servants. The business and investment climate has also suffered from harassment by the authorities in the form of endless inspections, which have opened up another avenue for rent seeking.
Administrative interference tilts the playing field in favor of incumbent enterprises, viable or not. The extension of implicit subsidies for energy consumption, and obstacles to market entry, business activities, and international competition all serve to protect old and often unviable energy intensive enterprises and sectors. The absence of orderly exit procedures has allowed insolvent enterprises to continue operating and blocking entry to new firms. Deficiencies in the bankruptcy regime, aided by ambiguous property rights and a deficient judiciary, have made bankruptcy an instrument of choice for hostile takeovers and asset stripping. All this has thrown sand in the wheels of economic restructuring by protecting old structures from competition and bankruptcy.
This tightly woven web of rent seeking is a key obstacle to reforms and economic restructuring. The prevalence of administrative intervention allows officials to extract bribes from the enterprise sector and, in exchange, incumbent enterprises get protection from competition and bankruptcy, which allows them to reap the benefits of market power or to continue operating even when insolvent. As long as both the state apparatus and the enterprise sector have economic rents to seek, they will oppose reforms to deregulate economic activities and introduce competition.
Many of these structural and institutional failures are particularly severe at subnational levels of government. A recent World Bank study (Broadman, 2002) confirmed, based on case studies and interviews in 13 regions, that market entry is inhibited at the subnational level by the strong relationships between regional governments and incumbent enterprises. Moreover, the study concluded that financial intermediation is insignificant and that this is the main obstacle to sustained investment growth. Enforcement of legal judgments in commercial disputes was also found to be weak.
These deficiencies in the business and investment climate have hit the SME sector especially hard. Small enterprise surveys conducted by the World Bank and the OECD5 find that the main culprits have been implementation of the tax regime, lack of financing, red tape and administrative harassment, and the absence of a predictable and fair legal and regulatory environment.
Small-scale entrepreneurship in agriculture has been growing steadily, but the agricultural sector as a whole has not yet undergone any fundamental restructuring. Subsidies and administrative intervention from the federal government have been significantly curtailed, but regional governments retain considerable autonomy in formulating and implementing agricultural and trade policies, and they use this autonomy to support existing inefficient and unprofitable large-scale farming. This, in combination with the unclear status of agricultural land ownership and lack of financing, has prevented Russia from making the most of one of its main comparative advantages.
Thus, any structural reform effort aimed at creating high and lasting growth needs to address many intertwined problems. Restructuring, broad-based investment, and diversification will only begin once the bias in favor of incumbent enterprises is removed and incentives in the public and enterprise sectors to focus on rent seeking are eliminated.
In more concrete terms, reforms need to focus on removing wide-ranging administrative barriers—especially at the regional level—to business entry and operation as well as to international trade; simplifying and lowering SME taxation; creating an efficient bankruptcy regime to exit insolvent enterprises; and cementing property rights.
To implement these core reforms effectively, a host of other reforms are also needed.
Civil service and administrative reforms must accompany the removal of administrative barriers to business entry and operation for the latter to be successful. Administrative barriers create possibilities for civil servants at all levels of government to abuse the existing licensing, registration, inspection, and product certification and standardization processes for rent-seeking purposes. Until the civil service and the structure of state administration have been reformed to remove the incentives and possibilities for rent seeking, deregulation alone will be impotent.
Closer integration of Russia into the world economy by removing trade barriers and by modernizing customs procedures and administration is key to redirecting the Russian economy to develop and invest in those sectors where Russia has a comparative advantage, including agriculture. To this end, accession to the World Trade Organization (WTO) should be a priority as it will require a reduction in the protection of uncompetitive sectors.
Investment financing needs to be secured by establishing a banking system that encourages movement of savings from surplus sectors to deficit sectors. Financial deepening, along with a strong SME sector, is a characteristic of the more advanced transition economies. The Czech Republic, Hungary, and Poland are already close to, or even at, the OECD average deposits-to-GDP ratio of about 60 percent. However, credit extension to the private sector has lagged even in these advanced transition economies, reaching 50 percent of GDP in the Czech Republic and about 25 percent in Hungary and Poland, compared with 130 percent in the OECD. As with SME sector development, Russia is lagging well behind its Eastern European comparators in terms of financial depth. Deposits and private credit in relation to GDP are only one-fourth of the level in the Czech Republic and less than one-half of that in Hungary and Poland.
Reform of the judicial system is needed, to facilitate the functioning of the bankruptcy regime, the enforcement of property rights, and the enforcement of contractual obligations. As long as the judicial system is dependent on regional political and business elites, ill-equipped in terms of human and material resources, and perceived as corrupt, impartiality and efficiency in legal enforcement are compromised. And as long as this is the case, other reforms to improve business and investment climate will not take hold.
This admittedly daunting set of reforms is needed to support economic diversification, investment, and growth that is both high and self-sustaining. The government has launched a broad and ambitious structural reform effort, but how does it compare with what needs to be done?
Government’s Structural Reform Agenda
The current government approved a comprehensive and detailed socioeconomic reform plan for 2000-01 in July 2000, only two months after assuming office. The reform plan was largely drafted by the Ministry of Economic Development and Trade, and it drew upon earlier work by the Center for Strategic Planning, which was headed by Mr. German Gref before his appointment as Minister for Economic Development and Trade. The government’s reform plan, also known as the Gref program, aimed at a “fundamental modernization” of the Russian economy, entailing in particular fiscal reforms toward financial stability and fiscal sustainability, improvement in the business and investment climate, and sectoral reforms (especially in the banking sector and natural monopolies) to rationalize the structure of the Russian economy.
Despite delays in key areas, the overall implementation record of the “Gref program” exceeded most expectations. Fiscal reforms, including the overhaul of the tax code and the completion of the longer-term reform of the federal treasury, were arguably the boldest, advancing to the stage of actual implementation in 2001. The necessary legal changes were enacted for key reforms to improve the business and investment climate, including deregulation of economic activities and strengthening of property rights. Similarly, legal foundations for the reforms of the pension system and judicial system were laid through the enactment of key laws and amendments in both areas. Finally, the government approved concept plans to reform the railways, electricity, and banking sectors, albeit with significant delays and little or no progress in formulating and taking concrete measures to implement these concept plans.
A medium-term structural reform program for 2002-04 was approved by the government in July 2001. The broad emphasis of the program remains on the improvement of the investment climate for the private sector and on the achievement of long-term sustainability in public finances. A detailed action plan for 2002 to implement the broader reform program was approved by the government in March 2002. Key priorities for 2002 included the enactment of legislation to enable the implementation of reforms initiated in 2001 and the passage of new legislation in other reform areas, such as bankruptcy regime, WTO accession, and social insurance.
The essence of the three main reform areas contained in the two reform programs can be summarized as follows.
Fiscal reforms serve first and foremost to safeguard long-term sustainability in public finances. However, they also support reforms in other areas. This is particularly true for the reform of civil service and public administration, which includes elements that are also critical for the improvement of the business and investment climate.
Improvement in the business and investment climate is conditional on the passage and implementation of many reforms, but the most important ones are the deregulation of business activities (including market entry, business operations, and product certification and standardization); strengthening of property rights; overhaul of the bankruptcy regime to allow orderly exit of insolvent enterprises; strengthening of legal enforcement across the board through judicial reform; and tariff and customs reforms related to Russia’s accession to the WTO.
The reforms of natural monopolies in the energy (or at least electricity) and transportation sectors aim to separate out naturally monopolistic activities from those that are potentially competitive and to subsequently liberalize and privatize the latter. The role of the state would be curtailed to include only (partial) ownership and regulation of the naturally monopolistic activities (electricity transmission, railway infrastructure). Tariff regulation would end, necessitating a reform of communal services provision and related social assistance.
Table 3.1 presents a list of selected key reform initiatives in the areas listed above and shows their current status. The assessment given in Table 3.1 is not clear-cut in a few cases. In particular, pension reform, deregulation, land reform, and labor reform are all in principle already being implemented in the sense that the enacted reform legislation has come into force. However, it can be argued that the implementation is not effective until all necessary supporting legislation has been enacted. In all these cases, amendments to other laws and the issuance of implementing regulations by the government are needed, and in the case of pension reform, even some further primary legislation is needed before the implementation can be deemed effective.
Key Structural Reforms and Their Status1
The status is described as “implementation” if the legislative process has been completed and the reform is being effectively implemented. “Legislation” implies that the legislative process has been completed at least partly but nevertheless insufficient.
Comprising the initial overhaul of the five chapters of the Tax Code, enacted in 2000-01.
Comprising further reforms to small business taxation (enacted) and indirect taxation (planned).
Key Structural Reforms and Their Status1
| Reform Area | Implementation | Legislation | Concept | Pipeline |
|---|---|---|---|---|
| Tax reform2 | * | |||
| Tax reform3 | * | |||
| Treasury (federal) | * | |||
| Treasury (regional) | * | |||
| Pension | * | |||
| Social insurance | * | |||
| Civil service | * | |||
| Deregulation | * | |||
| Debureaucratization | * | |||
| Land (urban) | * | |||
| Land (agricultural) | * | |||
| Labor | * | |||
| Bankruptcy | * | |||
| Judicial | * | |||
| Customs reform | * | |||
| Customs code | * | |||
| Electricity | * | |||
| Railways | * | |||
| Gas sector | * | |||
| Housing and communal services | * | |||
| Banking sector | * |
The status is described as “implementation” if the legislative process has been completed and the reform is being effectively implemented. “Legislation” implies that the legislative process has been completed at least partly but nevertheless insufficient.
Comprising the initial overhaul of the five chapters of the Tax Code, enacted in 2000-01.
Comprising further reforms to small business taxation (enacted) and indirect taxation (planned).
Key Structural Reforms and Their Status1
| Reform Area | Implementation | Legislation | Concept | Pipeline |
|---|---|---|---|---|
| Tax reform2 | * | |||
| Tax reform3 | * | |||
| Treasury (federal) | * | |||
| Treasury (regional) | * | |||
| Pension | * | |||
| Social insurance | * | |||
| Civil service | * | |||
| Deregulation | * | |||
| Debureaucratization | * | |||
| Land (urban) | * | |||
| Land (agricultural) | * | |||
| Labor | * | |||
| Bankruptcy | * | |||
| Judicial | * | |||
| Customs reform | * | |||
| Customs code | * | |||
| Electricity | * | |||
| Railways | * | |||
| Gas sector | * | |||
| Housing and communal services | * | |||
| Banking sector | * |
The status is described as “implementation” if the legislative process has been completed and the reform is being effectively implemented. “Legislation” implies that the legislative process has been completed at least partly but nevertheless insufficient.
Comprising the initial overhaul of the five chapters of the Tax Code, enacted in 2000-01.
Comprising further reforms to small business taxation (enacted) and indirect taxation (planned).
Assessment of Reform Agenda
Based on the reform priorities described above, it is clear that the agenda addresses the worst remaining structural and institutional deficiencies. Reforms to improve the business and investment climate involve an easing of the administrative burden on market entry and business operations, which—in combination with the bankruptcy reform, trade reform, and the reforms of natural monopolies—would reduce the protection of incumbent enterprises and thereby facilitate industrial restructuring. Banking sector reform would allow the financing of this restructuring, and judicial reform would make the process orderly. An overhaul of the civil service and public administration would reduce officials’ incentives to focus on rent seeking and allow the entire reform program to be uniformly implemented at all levels of government.
These reforms would prepare the ground for economic diversification and SME development. By removing implicit energy subsidies and by encouraging financial intermediation, they would free up resources for non-natural resources sectors. And by improving the business and investment climate, the reforms would allow the non-natural resources sectors and SMEs to benefit from these additional resources.
However, while the programs cover the right areas and contain the right measures, the timing and magnitude of the growth impact is critically dependent on the speed and sequencing of the reforms.
Time Profile of Reform Completion
Table 3.2 shows the planned or expected completion dates for each individual reform. The discussion below elaborates and assesses the timing of their growth impact by considering interdependencies between them.
Scheduled Completion of Key Structural Reforms
Comprising the initial overhaul of the five chapters of the Tax Code, enacted in 2000-01.
Comprising further reforms to small business taxation (enacted) and indirect taxation (planned).
Scheduled Completion of Key Structural Reforms
| Reform Area | Scheduled Completion |
|---|---|
| Tax reform1 | 2002 |
| Tax reform2 | 2004 |
| Treasury (federal) | 2001 |
| Treasury (regional) | ? |
| Pension | 2004 |
| Social insurance | ? |
| Civil service | Possibly 2005 |
| Deregulation | 2002 |
| Debureaucratization | 2003 |
| Land (urban) | 2002 |
| Land (agricultural) | 2003 |
| Labor | 2002 |
| Bankruptcy | 2003 |
| Judicial | 2006 |
| Customs reform | Possibly 2004 |
| Customs code | 2003 |
| Electricity | 2010 |
| Railways | 2010 |
| Gas sector | ? |
| Housing and communal services | 2010 |
| Banking sector | 2005 |
Comprising the initial overhaul of the five chapters of the Tax Code, enacted in 2000-01.
Comprising further reforms to small business taxation (enacted) and indirect taxation (planned).
Scheduled Completion of Key Structural Reforms
| Reform Area | Scheduled Completion |
|---|---|
| Tax reform1 | 2002 |
| Tax reform2 | 2004 |
| Treasury (federal) | 2001 |
| Treasury (regional) | ? |
| Pension | 2004 |
| Social insurance | ? |
| Civil service | Possibly 2005 |
| Deregulation | 2002 |
| Debureaucratization | 2003 |
| Land (urban) | 2002 |
| Land (agricultural) | 2003 |
| Labor | 2002 |
| Bankruptcy | 2003 |
| Judicial | 2006 |
| Customs reform | Possibly 2004 |
| Customs code | 2003 |
| Electricity | 2010 |
| Railways | 2010 |
| Gas sector | ? |
| Housing and communal services | 2010 |
| Banking sector | 2005 |
Comprising the initial overhaul of the five chapters of the Tax Code, enacted in 2000-01.
Comprising further reforms to small business taxation (enacted) and indirect taxation (planned).
Reforms That Have Already Had an Impact
The first generation of tax reforms and the reform of the federal treasury are already being implemented and have had an economic impact. The tax reforms, whose implementation started in 2001, have simplified the tax structure and reduced the burden of both direct and indirect taxes on households and enterprises, which has widened the coverage of the tax net and may even have stimulated private demand. The federal treasury reform, in turn, has contributed to the hardening of budget constraints in the economy, thereby increasing economic efficiency.
The recent reforms of the labor and land codes remain to be effectively and universally implemented, but to an extent the implementation merely formalizes existing practices. The old labor code, originating from the Soviet era, only covered a fraction of the workforce as it did not recognize private employment. Therefore, the private sector labor market adapted itself in the precrisis period to the changing economic environment and, by operating outside the legal framework, adopted the flexibility characteristic of a well-functioning market, while nonetheless suffering from the lack of regulation and social protection. Consequently, to the extent that the new labor code limits the spontaneously acquired flexibility of the labor market,6 its implementation might even have a negative economic impact.
Similarly, in the absence of federal laws to allow and regulate the ownership of and trade in land, many regions chose to set up their own legal frameworks before the crisis. While the economic impact of the land reforms was thereby partly preempted, successful implementation of the new land code and the agricultural land law are important steps in cementing property rights and improving the usability of land as collateral. These reforms will, however, have their permanent growth impact only when the judicial system is strong enough to enforce property rights credibly in case of disputes and when the banking sector is restructured enough to allow the utilization of land collateral for borrowing.
Apart from strengthening the economy’s institutions and thereby its growth potential, an important aspect of these reforms is their shifting of economic activities from the shadow economy to the officially measured economy. In addition to the tax, labor, and land reforms, parts of the deregulation package serve this purpose. The elimination of licensing requirements for many activities, in combination with other reforms to improve the business climate and simplification of business registration procedures, will encourage the registration of companies that already operate in a sector that will be delicensed. This, too, will broaden the officially measured economy and thereby have a one-off positive impact on measured economic growth. Obviously, to the extent that measured growth includes any such impact, it exaggerates the rate at which the economy is really growing.
Reforms That May Have an Impact in the Near Term
The second generation of tax reforms may have a significant near-term impact. In particular, the approved simplification and lowering of small business taxation should promote the growth of the SME sector. While the initial impact is likely to consist chiefly of a shift of small businesses from the shadow to the officially measured economy, and while there remains scope for larger enterprises to abuse the new small business tax for tax evasion purposes, the long-term impact of a fundamental strengthening of the business climate for the SME sector would be key to an improvement in the economy’s potential for sustained growth, as has been the case in advanced transition economies.
Reforms That Will Have an Impact Only in the Long Run
Remaining fiscal reforms, including those aimed at enhancing the sustainability of public finances, are all scheduled for completion only after 2004. There is, however, some uncertainty concerning these schedules, including for the pension and civil service reforms. While the pension reform has officially been launched already, some key legislation related to asset management in the fully funded pillar remains to be implemented. Apart from calling the completion schedule into question, these outstanding issues have potential for watering down the impact of the entire pension reform to the extent that they will result in a curtailment of the role of private pension funds in managing the assets accumulated in the fully funded pillar.
Although the deregulation package has merits in its own right and may already be having some impact, its fundamental significance is tied to the completion of civil service reform, which is only beginning, with considerable uncertainty about its completion schedule. The incentives for civil servants at all levels of government to use the regulation of economic activities to extract economic rents need to be curtailed before deregulation can be fully effective. Deregulation may make a difference for the parts of those activities that have been delicensed, but more than 100 economic activities remain licensed, providing civil servants with continued opportunities for rent seeking. Similarly, the registration process for new enterprises may have been simplified, but civil servants’ incentives to abuse the process remain unchanged. Finally, and perhaps most important, although state inspections of businesses have been curtailed, they will still be conducted and abused as long as inspectors’ incentives do not change.
Along similar lines, the success of bankruptcy reform hinges on judicial reform. To eliminate the abuse of the bankruptcy process for hostile takeover and asset-stripping purposes, courts will have to assume a more active role in overseeing the process and its stakeholders. This is particularly important given the envisaged changes to the regulation of arbitration managers. To fulfill this role, the reform of the judicial system needs to be carried out as planned, in particular to improve the professionalism of the judicial system and to increase the status and independence of judges. This will be a time-consuming process, as the supporting government program to increase judges’ salaries and upgrade courts’ infrastructure runs through 2006, on current plans.
Customs reforms and key parts of the debureaucratization initiative are intertwined with Russia’s WTO accession. The recent approval of the new customs code, the incipient reform and upgrading of customs procedures to implement the new customs code, and the easing of standardization and certification requirements are all central requirements for accession, which is unlikely to happen before 2004 at the earliest and will be followed by a lengthy transition period, as for any new WTO member. While nothing, in principle, prevents accession-related reforms from being implemented ahead of accession and transition schedules, both customs reform and the reform of standardization and licensing requirements would need several years to become effective, even under the most optimistic schedule.
Even on paper, the reform of Russia’s natural monopolies is a long-term process and, given the delays that have taken place already at the initial stages of these reforms, there is nothing to suggest that they could be accelerated from their current schedules. While similar reforms are a relatively new phenomenon even in industrial countries and have proved controversial and drawn-out virtually everywhere, reforms of the power, gas, and railways sectors are key to advancing the structural transformation of Russia’s economy. Only when the pricing of competitive segments of natural monopolies’ markets (electricity generation and sales; gas extraction, processing, and sales; and passenger and cargo transportation services by rail) is market based will there be sufficient pressure to restructure production, whose current overreliance on cheap energy and rail transportation is being implicitly subsidized. Market-based pricing is, however, not planned for many years to come, and the earlier plans to introduce even operational cost recovery in the provision of communal services by 2004 have been abandoned, with no new target date yet set.
The economic restructuring that will result from power and gas sector reforms, in particular, is likely to put downward pressure on growth for a transitional period. How significant that pressure is, and how long the transitional period will be, depends on the modalities of energy price liberalization. The negative pressure on growth will, however, at least partly be offset by increasing investment activity in the power sector, as improved profitability will unleash the investment demand that has been suppressed for the past decade or two.
Finally, as described in Chapter 6, the reform of the banking sector will also be a long-term rather than a medium-term process. By correcting existing structural deficiencies within the sector, the reform process aims at accelerating the financial deepening process that has to some extent already started. To this end, banking reform needs support from other ongoing reforms, most notably the introduction of international accounting standards economy-wide; enforcement of other initiatives to improve corporate governance in the enterprise sector; and the completion of judicial reform to ensure contract enforcement.
Medium-Term Growth Gap
As a consequence of the backloading of the most crucial reforms, the current reform effort cannot be expected to boost growth in the medium term—that is, not until at least the latter half of this decade. To put it differently, Russia is now facing a situation where the transitory macroeconomic shocks that have driven growth in the postcrisis period can be expected to fade and where the most fundamental impact of the current wave of structural reforms is at least half a decade away.
What are the consequences of this medium-term growth gap and are there remedies for it? Barring negative external shocks or policy reversals in the macroeconomic or structural areas, growth is unlikely to grind to a halt. If macroeconomic policies remain sound, and if the reform program continues to be implemented in a steadfast manner, there is every reason to expect that the steady, spontaneous, and reform-induced economic restructuring will continue and will support growth. While growth will likely slow down under this scenario from the record-high levels observed since the crisis, it should nevertheless remain positive, albeit well below Russia’s long-term potential.
The acceleration of key structural reforms should help to narrow this medium-term growth gap, while probably not eliminating it altogether. The acceleration of the reforms listed above—reforms of natural monopolies (and communal services), external trade, the judicial system, the civil service, and the banking sector—would contribute significantly to an improvement in the business and investment climate and to the emergence of a dynamic SME sector.
Indeed, the acceleration of key reforms will support economic diversification. As mentioned in the introduction to this chapter, postcrisis growth has been accompanied by a “chaebolization” of the economy, with large, export-oriented, and increasingly vertically integrated industrial groups gaining ground as the economy’s growth engines. While this development is potentially beneficial from a short- and medium-term perspective, as it helps to circumvent existing deficiencies in financial intermediation, it is detrimental from a long-term perspective, as the associated obstacles to economic diversification and the concentration of economic power within sectors would hurt Russia’s long-term growth potential.
All said, it is worth emphasizing that the authorities’ agenda is appropriate and that unprecedented progress has already been made in implementing it. While continued, and accelerated, implementation of this agenda would allow Russia to better exploit its long-term growth potential, it remains to be seen whether this is a politically realistic objective and what factors and events could possibly still derail reforms.
Risks to Further Progress: Political Economy of Reforms
Start and Sequencing
While the favorable macroeconomic environment from 1999 onward provided a window of opportunity to launch a comprehensive structural reform effort, political impetus to launch reform and a strengthening of the central government to implement reform were needed to take advantage of that opportunity.7 They emerged from the election of President Putin in early 2000 and the appointment of reform-minded technocrats to the cabinet’s key economic positions and have been sustained by the president’s continuing popularity (reflecting the favorable economic environment) and his enduring clout vis-à-vis the Duma (reflecting broad ownership of, and muted opposition to, early reforms and also the president’s successes in consensus-building).
However, the political resolve was being called into question until as late as summer 2001. Apart from the tax reforms and the reform of the federal treasury, no major milestones had been achieved by that time in implementing the economic reform agenda. The initial delays undoubtedly reflected the amount of necessary preparatory technical work and political consensus-building and also the president’s early focus on consolidating political power. Nevertheless, the delays resulted in uncertainty about the political commitment to reforms. This uncertainty was effectively removed during summer 2001 when reforms accelerated across a broad front, including government approval of reform plans for the railways and electricity sectors; change of Gazprom’s top management; Duma passage of several major laws right before its summer recess, notably the profit tax chapter of the tax code; the deregulation package; and a law against money laundering. This momentum was subsequently maintained, with the land code, labor code, and important parts of the pension and judicial reforms enacted by year-end.
The sequencing and speed of reforms have reflected both technical preparedness and breadth of support for them. As to technical preparedness, significant preparatory work for some reforms had already been done by the authorities during the precrisis period, some of it in the context of international financial institutions’ technical assistance. This group of reforms includes primarily fiscal reforms (tax and federal treasury reforms, pension reform) but also the reform of the banking sector. Some other reforms—most important of which are those of the natural monopolies, with the possible exception of the electricity sector—had to be started from scratch, with little or no earlier work to draw upon. Most reforms to improve the business and investment climate fall between these two extremes, with technical work necessary but relatively straightforward at the level of primary legislation (reduction in the number of licensed activities; simplification of business registration; permission of ownership of and trade in land, to name but a few examples).
Reforms have, naturally, advanced farthest where opposition has been weakest and consensus-building easiest. In addition to technical preparedness, fiscal reforms, particularly tax reforms, have enjoyed broad-based support, which has allowed them to progress rapidly. Tax reforms, along with judicial reforms, have enjoyed support from key segments of the business elite (the “oligarchs”), who benefit substantially from the reduced tax burden on both corporations and individuals.
The population at large appears to have supported—or at least not vehemently opposed—the reform efforts so far. While some observers attribute the absence of opposition to a Soviet legacy of apathy or even fear with respect to public affairs, opinion polls consistently suggest that the share of population that supports reforms is double the share opposing them. This can be explained by the absence of social costs, as none of the reforms implemented or enacted so far has inflicted direct costs on or taken away benefits from the population at large. On the contrary, many reforms have generated direct benefits (personal income tax reform, land reform, labor reform). Consequently, the opposition so far has been exclusively ideological in character.
Risks to Further Progress and Growth
The factors that were listed above, among the reasons for the emergence and success of the reform effort thus far, suggest that the reform effort is likely to slow down soon. The transitory positive impact of the postcrisis macroeconomic shocks will dissipate, and the window of opportunity to pass and implement reforms will thereby narrow. The authorities’ resolve to advance reforms is being put to serious test as the electoral cycle draws to a close, with Duma elections in late 2003 and presidential elections in early 2004. The reforms that have benefited from earlier technical preparatory work are rapidly declining in number and significance, while more and more resources are needed to focus on the implementation of already approved and enacted reforms—which, in turn, will require tackling a new set of obstacles and opposition from regional and local vested interests. Finally, as the reforms that have enjoyed broadest support have now been largely enacted, consensus-building will become increasingly difficult as outstanding reforms will face fiercer opposition from groups whose influence or income will be directly diminished by them.
In other words, less favorable macroeconomic conditions, coupled with the approaching elections, will likely exacerbate the difficulty of agreeing on, passing, and implementing ever-harder reforms. While the president has already played a key catalyzing and consensus-building role in connection with some reforms (agreement on the strategy to reform the electricity sector; the passage of key primary legislation related to the pension reform; and the initiative to focus on small business promotion), none of these reforms has required direct and irrevocable sacrifices in terms of influence or income by any of the stakeholders. In contrast, to enact and implement the key outstanding reforms will require such sacrifices by one group or the other, which will make the task of catalyzing these reforms and building consensus around them more complex. Prime examples include the reform of natural monopolies and communal services, which would dilute influence and significantly increase costs for all households and most businesses, as well as reforms related to Russia’s accession to the WTO, which would lower trade protection and threaten many protected sectors. As a result of the opposition to reforms, the pace of reform approval is set to slow down and the risk of reforms being watered down in the process of consensus-building is increasing.
Against this background, what reforms are likely to be most affected and what does this imply for Russia’s growth prospects? Of the reforms that have already reached or are close to the implementation stage, the pension reform appears most at risk. There are indications that the consensus-building that allowed key parts of the primary legislation to be passed in fall 2001 may have gone too far in accommodating vested interests, notably the state pension fund that stood to lose influence with the introduction of a fully funded pillar, as they are now waging a campaign to regain control over the entire new system. This would compromise the efficiency and financial stability of the new system, with a harmful long-term impact on the economy’s savings potential and financial stability.
Other reforms at the implementation stage, and a number of reforms at earlier stages, will face resistance from regional and local political elites. Deregulation, land reforms, judicial reforms, and regional treasury reform all threaten to diminish the political and economic influence and independence of regions and municipalities. By resisting effective implementation in their own territories, subnational levels of government can effectively block these reforms and prevent their growth impact from materializing.
The opposition to many reforms at the subnational level stems from close links between subnational governments and local enterprises. Subnational governments and their officials can extract economic rents through their power to block entry of new firms and to divert and extend explicit and implicit subsidies, including by holding down energy prices and allowing nonpayments. In exchange for paying out bribes, local firms get protection from competition and bankruptcy.
As for the key reforms of natural monopolies and WTO accession, powerful vested interests at all levels of government, within the business community, and among the population at large have already successfully slowed down the reforms.
Reform of the electricity sector has advanced further than other reforms of natural monopolies but also encountered strategic delays. It took an unexpectedly long time for the cabinet to approve drafts of the legislative changes needed for the reorganization of the sector and for the Duma to pass these changes.
Another source of delay for energy sector restructuring will be the delay of the reform of housing and communal services. Although the government originally approved a reform program that envisaged operational cost recovery in the provision of communal services (including gas, electricity, and heat) by 2004, this target was abandoned when the relevant legislation was passed by the Duma. While the approaching elections clearly make it difficult to insist on measures that will inflict high costs on the majority of the population, it is equally obvious that this delay will slow down the reform of the power and gas sectors: strategic investors will be unwilling to finance large-scale investments in power generation and gas extraction as long as the yield on these investments remains unclear.
As the negotiations on Russia’s accession to the WTO advance and move to tackle increasingly difficult outstanding issues, domestic opposition becomes more focused and vocal. For example, protection of the Russian automotive industry has long been a difficult issue, but when the accession negotiations started to focus on concrete measures in this area, the domestic automotive industry stepped up its lobbying activities. As a result, before agreeing with the WTO, the government approved a program to develop (and protect) the domestic car industry, including by imposing prohibitive import duties on used cars older than seven years that compete directly with domestically produced new cars. Apart from complicating accession negotiations, this measure serves to postpone the (obviously) necessary restructuring of the domestic car industry by offering it protection from foreign competition.
While it is unlikely that any reform initiative will be completely abandoned, only after the elections in 2003 and 2004 will it be clear which reforms have a chance of being completed within anything like their original schedules. In other words, while there is no reason to expect that the reform effort will grind to a complete halt in the near term, there are good reasons to expect delays in the most difficult reform areas.
Summary and Conclusions
This chapter has reviewed structural reform efforts during Russia’s transition, focusing on the appropriateness of the present government’s reform agenda and the nexus between these reforms and the growth outlook for the medium and long term. It has argued that while the current agenda addresses the key structural and institutional shortcomings, it will take at least another half-decade of successful implementation before the reform initiatives currently under way can have a significant and lasting impact on economic growth. This delay stems from inter-dependencies between reforms, coupled with heavy back-loading of the most significant reform initiatives (reform of natural monopolies, communal services, civil service and public administration, the banking sector, and the judicial system, as well as WTO accession).
Even if reforms are implemented according to their current schedules, a growth gap will emerge for the medium term as the positive impact of the macroeconomic shocks that have supported postcrisis growth so far dissipates. An acceleration of reform implementation, along with continued responsible macroeconomic policies, would serve to narrow the growth gap and allow Russia to exploit its long-term growth potential sooner.
However, a less favorable macroeconomic situation in combination with increasing political obstacles to reform point to the risk of a slowdown, rather than acceleration, of reforms. So far, the implementation of the reform agenda has benefited from a benign economic environment, strong political impetus, technical preparedness in reform design, and the absence of vocal opposition. All these factors are set to change for the worse as Russia’s external environment deteriorates, elections draw closer, the pipeline of pre-prepared reforms is being exhausted, and reforms change character from yielding benefits to most to inflicting short-term costs upon most. As a consequence, and as already visible in key reform areas, delays will occur, with the most difficult reforms (natural monopolies, communal services, WTO accession, banking reform) risking postponement until after the elections.
As the pace of reforms will have a significant impact on the size of the medium-term growth gap, the political resolve and stamina of Russia’s leadership to push ahead with the reform effort, even when risks increase and resistance strengthens, are about to face their most difficult and important test yet.
References
Åslund, Anders, 2002, Building Capitalism (Cambridge: Cambridge University Press).
Boone, Peter, and Denis Rodionov, 2001, “Rent Seeking in Russia and the CIS,” paper presented at the EBRD’s Conference on “Ten Years of Investing for Economic Growth and Transition.”
Broadman, Harry G., 2002, “Unleashing Russia’s Business Potential: Lessons From the Regions for Building Market Institutions,” World Bank Discussion Paper No. 434 (Washington: World Bank).
EBRD, 2001, Transition Report 2001 (London).
Mitra, Pradeep, and Marcelo Selowsky, 2002, Transition: The First Ten Years: Analysis and Lessons for Eastern Europe and the Former Soviet Union (Washington: World Bank).
OECD, 2002, Economic Survey: Russian Federation February 2002 (Paris: Organization for Economic Cooperation and Development).
World Bank, 2002, Russian Economic Report #2 (Washington: World Bank, January).
For a survey of the importance of the SME sector across transition economies, see Chapter 4 of Mitra and Selowsky (2002).
Statistical problems include variations in the definition of SMEs (which has changed several times in the past decade) and the coverage of SME data (they exclude sole proprietorships and many SMEs that are unregistered but operating in the shadow economy). The decline in the number of SMEs in 2000 and 2001 in particular is sometimes attributed to tax reforms, which may have led to a deregistration of phantom enterprises originally set up for tax evasion purposes.
Boone and Rodionov (2001) discuss the size and significance of large business groups in Russia.
EBRD (2001) contains a comprehensive survey of energy sector issues in transition.
See World Bank (2002) and OECD (2002).
A number of deficiencies in the new labor code have been suggested in this respect, including excessive regulation of hiring and termination decisions and higher costs imposed for hiring younger workers and women.
For an analysis of political economy considerations in implementing reforms across transition economies, see Part 3 of Mitra and Selowsky (2002) and Chapter 9 in Åslund (2002).