08.03.2009
A Testing Ground for Modernization and a Showcase of Success
№1 2009 January/March

Russian support for Abkhazia and South Ossetia, which came about
as a result of a number of circumstances, may play the role of a
catalyst for Russia’s modernization, but the two territories are
very different and require different approaches.

A spontaneous development is likely to turn Abkhazia into a
Russian health spa and military appendage, and this is unacceptable
because it is fraught with complicating relations and losing
existing opportunities. Rather than focusing on using Abkhazia as a
potential health resort, Russia should build the missing financial
and technological elements of its own economy there. By creating
instruments of modernization outside its territory – where they
would be protected from Russian kleptocracy and monopolies – Russia
could see a dress rehearsal of its own modernization.

South Ossetia does not exist as an economic entity due to its
small size and extremely low-level management. Russia must bring
rudimentary order to South Ossetia’s finances and thus lay the
groundwork for the reunification of the Ossetian people within the
Russian Federation.

ABKHAZIA TODAY: PRIMITIVE SERVICES

The Abkhazian economy can be described as providing primitive
services. The war and the blockade have reduced the region’s
population to slightly over 215,000 today from 525,000 in 1989. The
population’s ethnic composition is: 44 percent Abkhazians; 21
percent Armenians; 21 percent Georgians (including Mingrelians and
Svans); 11 percent Russians; and one percent Greeks. More than a
quarter of all residents receive pensions and social benefits.

Abkhazia is a zone of special interest for Russia and Turkey –
where a 500,000-strong ethnic Abkhazian community lives. Trade
accounts for 60 percent of Abkhazia’s GDP, while hundreds of
thousands of Russian vacationers brought in about one third of all
tax revenue and 40 percent of export earnings in 2007.

The electricity generated by the Inguri hydropower plant –
currently operating at 70 percent of its output capacity – is
divided between Georgia and Abkhazia, with the latter exporting
about 40 percent of its share to Russia’s neighboring Krasnodar
Territory. Georgian-Abkhazian cooperation in this case is pegged to
technological objectivity – the plant’s dam is located in Georgia,
while the powerhouse and four diversion-tunnel plants are in
Abkhazia. Another hydroelectric plant near Sukhumi has been
destroyed, and there is no need to rebuild it because of a low
demand for electricity. Before the war, a total of 21 small
hydroelectric plants were operational, but only two of them could
resume working now.

The government deems it unnecessary to raise foreign investment
in the energy sector, yet the deteriorating state of the main
assets there calls for large-scale investment and the problem is
still open about where to get the money. Electricity prices
increased sharply in 2008.

The state of highways leaves much to be desired. Old cars and
buses account for the bulk of vehicles and the region has no money
to replace them. However, Abkhazia has two convenient airports with
newly-repaired runways and three fit-for-operation seaports.

The region’s railway is single-track and is used to take
tourists to Sukhumi and to export coal. The railcars are worn out
and need either capital repairs or a write-off. Station buildings
are in a state of disrepair, although ticket offices have been
connected to the Russian Express-3 system of railway ticket
reservations and sales. The last domestic Abkhazian passenger train
stopped running in 2008.

Mobile phone operator A-Mobile, a joint venture between the
Abkhazian government and businesses, broke the monopoly of the
Akvafon company, affiliated with Russian mobile giant MegaFon, in
late 2006.

The promotion of essential-oil plants, tobacco and vegetables
dominated Abkhazia’s agricultural sector prior to the war, but
their export and processing stopped in later years. Farming turned
into a tool of survival and almost all agricultural land is now
used to grow corn and some tobacco to meet local demand. The
livestock, goat and sheep population has decreased sharply – first,
because of theft and slaughter, and also because of shrinking feed
stockpiles.

The production of vegetables and citrus fruits for Russia and to
meet tourist demand continues to grow, but remains an artisan
activity. Until very recently, Abkhazia’s own production of meat
and dairy products met only 40 percent of local demand. Even
vegetables, fruit and vegetable oil are now imported in large
amounts. The number of tractors and other farm equipment has
plummeted and 90 percent is long overdue to be replaced.

Abkhazia did not have a single functioning beef, dairy or
canning plant until very recently when Russian investment started
coming in; and the essential-oil industry has not sent any signals
of being alive. Only 60 production facilities out of 183 are
operational at the moment, and general production output has
plunged more than 90 percent.

It is worth noting, however, that 2007 saw an increase in the
manufacture of construction materials – in the run-up to the 2014
Winter Olympics in Sochi, while tourism is providing stimuli for
agriculture and winemaking.

The Abkhazian economy saw heavy losses in the first quarter of
2008; profit totaled 59 million rubles, but only made up 53.4
percent of total losses of 110.4 million rubles. Total losses grew
36.2 percent over the previous year. The budget for 2007 – and for
2006 as well – was deficit free, as the region simply did not have
enough money to cover the deficit. Revenues of 1.43 billion rubles
were 15.1 percent above the initial target, with “injections from
abroad” – quite possibly Russian aid – totaling 434 million rubles.
Expenditures stood at 1.42 billion rubles and education was the
main area for state spending (174.8 million rubles) after the army
and the police (484 million rubles). The 2008 budget showed revenue
increasing to 1.6 billion rubles and spending rising to 1.59
billion rubles (with almost one half of this amount, or 733.6
million rubles, to be used to pay salaries). Amid a background of
inflation and continuing economic growth, this testifies to the
waning role of the budget in GDP.

The banking system is made up of fourteen small banks that
started opening correspondent accounts in Russia in 2004. The
system became profitable in the first quarter of 2008 – a fact that
reflects its move from the shadows into daylight.

Exports and imports correlate as 3:7 and the shortfall is
covered by earnings from tourism. Russia accounts for two-thirds of
Abkhazian foreign trade. Raw materials and unprocessed agricultural
products make up over 90 percent of commodity exports, of which
citrus fruits account for 35 percent; coal (80,000 to 100,000 tons
annually), fruit (mostly persimmons), hazelnuts, tea and vegetables
for 20 percent; and round timber for 20 percent. The latter mostly
consists of valuable species of trees cut through predatory
practices in mountainous old-growth beech, oak and chestnut forests
and exported to Turkey.

Abkhazia leases its sea shelf to Turkey for fishing and this
brings in up to 15 percent of all export revenue, but locals say
the Turks have largely thinned the fish population in the shallow
coastal waters.

The Bzyb timber factory, which sells sawn lumber, parquet and
other fine wood products to European countries, and Abkhazian Wines
& Waters – which used to export 1.5 million bottles of wine a
year to Russia before a trade embargo was imposed on Abkhazia –
provide for the larger part of the region’s industrial exports and
up to 10 percent of all exports. Moreover, Abkhazia offers
investors a wide assortment of investment projects, the greater
part of which will be snatched up after the recognition of
independence.

AREAS OF SPORADIC DEVELOPMENT

The recognition of Abkhazia by Russia has reanimated production,
as producers, who were previously targeted at providing services to
tourists or at preparations for the 2014 Winter Olympics, are
expected to receive access to the Russian market. The revival
concerns citrus fruits and wine production, although one should not
underestimate the stringent internal barriers in Russia (such as
difficulties in gaining access to Moscow’s markets).

The traditional specialization of the farming sector is likely
to re-emerge in three to five years, as the growing of
essential-oil crops and tobacco will oust corn from the fields.

Budget revenues may increase due to the possible production of
oil by Russian companies on the Black Sea shelf (data that Georgia
submitted to U.S. companies in 1998 puts the shelf oil reserves at
200 million tons). However, the damage to the environment may spoil
the region’s main resource – recreation, and impair bilateral
relations over the long term if the project does not include
environmentally-friendly technologies.

Small-scale privatization – the sale of shops, catering
facilities and abandoned construction sites – is unfolding in
Abkhazia. Standing next in line is the privatization of large
facilities with the participation of foreign investors. Here the
Abkhazians intend to do everything in their power to keep the
balance between Russian and other investors, above all from
Turkey.

Modernization in exchange for ownership will become the main
line of action, as Russian investors hope to appropriate the
facilities they will modernize. The mismatch of interests (the
authorities will seek maximum control) will trigger commercial
conflicts that will be settled individually.

The application of standard schemes of development is quite
possible – privatization will provide the government with money for
modernizing the transport and energy infrastructure (for instance,
the physical wear of power transmission lines outweighs the
benefits of the republic’s excessive energy supplies). This, in
turn, will facilitate the growth of tourism, which will work as a
drive for agriculture and the services sector. The scheme
“construction-operation-leasing” will be first applied to tourist
facilities and then to some larger facilities.

Russian experts claim that the Abkhazian coast might become “a
golden coast of the Black Sea and the gold vein for Russian
tourism,” since it is “a second Sochi” – and more conveniently
located. While the tourist market was artificially nurtured in
Sochi, its rise in Abkhazia – in Gagra, Pitsunda and Sukhumi – was
historic and took shape many decades ago.

The revival of tourism – about one million tourists a year
visited Abkhazia during the Soviet era through a voucher system and
about the same number came on their own – will require transparency
in the structure and history of real estate ownership, so as to
dispel apprehensions about the illegal seizure of property.

In recent years, Russian investors have been actively buying up
land (or, more precisely, the rights to long-term rent) in
Abkhazia. They choose to keep their acquisitions quiet, considering
them the groundwork for the future. It will take investors about
two years to assess Abkhazia’s attractiveness (and the authorities
could shorten this period) and another two to three years to build
new and renovate old hotels.

A reverent and almost religious treatment of nature by the
Abkhazian people and their commitment to the idea of independence,
including independence from Russia, constitutes an important
feature when considering the situation in the region. Abkhazian
officials have promised to stand in the way of possible “grabbing”
by foreign investors, thus exposing their patriotism, which is an
unalterable factor of Abkhazia’s investment climate.

This patriotism is sometimes overshadowed by the worst traits of
the local mentality in the coastal resorts, which many Russians
visiting the Sochi region know from experience – the desire to
sponge off of others, thinking along the lines that “all outsiders
are my debtors,” laziness and envy even towards the small
achievements of others.

According to Abkhazia’s Chamber of Commerce and Industry, when
the Russian Conti Group purchased “the remainders of the walls” of
Hotel Abkhazia in Sukhumi for 60 million rubles, some politicians
used the transaction as a ploy for demagogy. Russian industrialist
Oleg Deripaska offered to buy Stalin’s dacha for $10 million, but
politicians and the media caused a stir around the proposal. As a
result, the dacha remains abandoned and dilapidated. Frequent cases
of groundless overpricing and extortion among the local bureaucracy
scare away even Russian investors.

ABKHAZIA AS AN OUTSIDE TESTING GROUND FOR MODERNIZATION

The greater part of the region’s potential can be tapped only
with the aid of Russian financing and through access to its
markets, which makes Moscow’s policy a key factor in Abkhazia’s
development.

The key task is to raise the quality of management in the
region, including state administration. Management today combines
zeal with the absence of elementary skills. It is enough to mention
that Abkhazia does not accumulate data for calculating the
inflation index and the authorities have to make judgments about
the economy based on cost indicators.

The transfer of trivial knowledge and skills by Russian managers
and experts, which was previously blocked because Abkhazia was not
officially recognized, will speed up its development and will help
Russia train specialists for its own modernization. These people
will be unique due to their experience with constructive creative
activity in Abkhazia (rather than stealing) and because of their
zeal to win (as opposed to the current defeatism of Russian red
tape).

Abkhazia needs standard mechanisms for promoting its image,
including making its virgin and fervently-protected natural
surroundings popular. It should stress the idea that the denial of
Abkhazian recognition is fraught with destruction of the
environment. The West is usually not prepared to help people, but
it quite often supports them together with some nice-looking
“shrubs.” Just a single film about Abkhazia’s natural wonders on
the National Geographic Channel would do more for the region than
any big investor.

Communication systems must be developed to a level where they
can be embedded in the global financial network. It is also
important to develop education and medical consultations via the
Internet.

Russia needs its own offshore zone, as such zones are not only
tools for tax evasion, but also levers of global manipulation of
capital. Big business needs such zones, including Russian business.
The latter has to use the offshore zones of other developed
countries now, which makes business more dependent on those
countries. In addition to the partial disclosure of data by
offshore companies, unofficial channels are available to Western
countries to monitor money flows in the zones they control, which
provide them with clues on how to influence the owners of the
capital.

As Russian business makes its way to the global arena, it will
need offshore zones controlled only by Russia. These zones will
turn into instruments of global maneuvering for Russian capital
along with the inflow of foreign capital. It would be dangerous to
place offshore zones inside mainland Russia because they will be
instrumental in evading taxes, like what happened in the 1990s.
That is why these zones should be located in special outside
territories.

Abkhazia may take on the role of an offshore financial center,
along with the Kaliningrad Region. Since most countries have not
recognized Abkhazia, the functions of a registration center may be
delegated to a Russian town close to the border. Abkhazia would get
dividends in the form of salaries of token directors and business
activity, while Russia would get an instrument of global business
maneuvering not subject to external controls.

Russia needs a seaside resort that is close, but along with
assigning that role to Abkhazia it is essential to protect the
environment. The region may grow into an analogue of Montenegro for
Russians in terms of it being an inexpensive seaside holiday and
there could be investment in real estate as early as in the next
two years. It is time to drop the Soviet-era mania of erecting
concrete edifices, oil refineries and all such things in
recreational areas. Poverty dictates that the Abkhazians cannot
choose investors, so control over environmental standards of
production facilities in the region should become Russia’s
responsibility.

Tourism from Russia, the main factor in Abkhazia’s development,
needs an infrastructure. The Soviet-era defense industry has
developed a mass of efficient technologies, including so-called
“killer technologies” which make all previous technologies
impractical. Small hydro stations that can produce electricity for
customers virtually with any water source, as well as the
production of super-cheap gasoline, cement, modular structures,
etc. could give a powerful boost to Abkhazia’s economy.

In Russia, these technologies are blocked by domestic and
international monopolies that exploit old technologies, and by
bureaucratic inertia. Sukhumi is free of such bureaucracy and
monopolies, while it badly wants development “at whatever price.”
That is why Abkhazia could become a testing ground for the
large-scale employment of such technologies; even more so because
it already played this role in the Soviet Union in what concerned
research in the dolphinarium, the apery, and at defense
facilities.

SOUTH OSSETIA TODAY: A DISASTER

The Republic of South Ossetia covers 3,900 square kilometers,
which makes it larger than Moscow only by a factor of three. It is
located on the southern slopes of the Greater Caucasus Range.
Assessments indicate that prior to the Georgian attack in August
2008, it was home to about 80,000 people, of which 40,000 lived in
Tskhinvali, the region’s only city (24,000 of those citizens have
become refugees). Georgia’s aggression erased the greater part of
remaining production facilities and left a sizable number of
buildings damaged.

The region’s poverty threshold stood at 3,062 rubles a month in
the forth quarter of 2007, or 23.5 percent below Russia’s average,
while South Ossetians have incomparably smaller incomes. This is a
sign of impoverishment.

South Ossetia’s industry consisted of 22 small factories before
August’s Five-Day War. In essence, these were workshops that turned
out 61.6 million rubles worth of products, not including VAT
(according to 2006 figures), and output was shrinking. The quality
of state administration can well be seen in the fact that there
were still no statistics for 2007 when Georgia launched its
military operation.

A total of ten factories out of all the existing enterprises
report to – that is, are controlled and administrated by – the
Economics and External Economic Relations Ministry. Only seven of
them functioned in 2007, while output fell 11.6 percent, or by 3.3
million rubles, even without factoring in inflation. The greater
part of production facilities stand idle and the operating
equipment is in constant need of repair. Even successful factories
have a shortage of workers, are in debt and have a shortage of
working capital.

The area planted with wheat soared more than ten-fold in 2008 to
1,500 hectares from 130 hectares, and the authorities expected a
harvest of more than 2,500 tons of grain. This huge increase was a
result of plans to purchase milling equipment by September 20 – the
18th anniversary of South Ossetia’s declaration of independence.
This would have justified growing wheat in the region. The flour
would then be taken to the republic’s state-run bakery, which has
been importing expensive flour over the last 15 years, thus killing
its own business. Officials promised that domestic flour production
would reduce the cost of flour to 8 rubles per kilogram from 15
rubles. Also in 2008, the South Ossetian Agriculture Ministry
solemnly imported two DT-75 tractors with equipment, and purchases
of several more “pieces of farm machinery” were expected before the
year-end.

SELF-RELIANCE AS A GOAL

Russia’s goal is to bring South Ossetia’s economy and living
standards to the average level of Russian regions that make up the
South Federal District (all of which are in depression except for
the Rostov Region, the Krasnodar and Stavropol Territories) by
2011.

A total of 16 billion rubles will be allocated to restore the
first 750 examined facilities under a restoration plan for
2009-2011 and another 9.5 billion rubles will be needed for
priority measures. In all, allocations for the restoration of South
Ossetia will reach 25.5 billion rubles (10 billion rubles in 2009)
and this figure will likely increase. For instance, Russian
Transport Minister Igor Levitin has requested 40 billion rubles to
rebuild roads in North and South Ossetia from 2008-2015.

Some of the money will come from the budget of North Ossetia,
which means that South Ossetia will be plugged into Russia’s
budgetary system. One can also surmise that the region could be
united with North Ossetia after it reaches the average economic
level of the South Federal District.

Exports of South Ossetian products to Russia will remain
insignificant due to limited transport and production capacities. A
poor infrastructure and low-quality – mainly for psychological
reasons – services impede the development of tourism.

In addition to the rehabilitation of housing, transport and
energy infrastructure, South Ossetia needs a few more things to
prosper:

  • A military base to defend against possible future aggression
    (after the Georgian Army regains its combat capability); the
    maximum involvement of the local population in building and
    servicing the base and who will serve under contract in the Armed
    Forces;
  • A focus on using local resources rather than those imported
    from Russia;
  • Training of local personnel.

The lack of financial control constitutes a specific local
feature.

While Abkhazia has risen as a state, South Ossetia has emerged
as a community of people who defended themselves against
extermination. Statehood has not taken shape there – mainly due to
a small population and scarce natural resources.

The scale of economic activity in the region is insignificant.
One of the biggest local plants, Emalprovod, has a workforce of 130
employees, and the director of a timber factory, one of the
more-or-less successful enterprises, said that the sale of 50 tons
of equipment as metal scrap was the most realistic source of
income. He said the 175,000 rubles (minus shipping costs) the
factory might get for it “will give a real stimulus to the
production development.”

From the 1990s to 2004, South Ossetia received the lion’s share
of its earnings through smuggling from Georgia to Russia, and an
attempt by the commander of the Border Guards of Russia’s Federal
Border Service to stop the smuggling resulted in his
resignation.

Georgian President Mikheil Saakashvili stopped the smuggling in
order to weed out separatism, and although some private trade with
Georgia still exists, South Ossetia has actually changed over to
living in dependence on Russia – despite denials of the fact.
Experts have more than once accused the Russian military and the
South Ossetian authorities of financial embezzlement due to gross
overstatements in the number of people eligible for benefits from
Moscow.

In 2008, South Ossetia’s Committee for State Control and
Economic Security held inspections at the instruction of the
region’s leader Eduard Kokoity. They discovered huge
misappropriations of electricity and natural gas, mostly by private
companies. The main cause of shortages in the collection of
payments for electricity and gas was the lack of electricity meters
in villages, untrimmed trees that often caused cable breakdowns on
power lines, and wear and tear of the gas pipeline equipment. In a
number of cases power line maintenance technicians called on the
public to damage meters and promised them the chance to not pay for
electricity in exchange for bribes.

The recognition of South Ossetia’s independence creates
prerequisites for financial control, including control over Russian
money. The region’s development must set an example of how to
establish rigid financial control in conditions that are the least
conducive to it, as well as show that there are financiers capable
of exercising such control.

The measures specified above will be quite sufficient for South
Ossetia’s success provided financial control is introduced, as no
sensible policy will be possible without it. That is why South
Ossetia needs outside financial administration. If the measure
proves efficient, the region may move on to self-financing (which
means the implementation of defense, infrastructure, tourist and
personnel training federal programs on its territory without direct
budgetary transfers).

The objective of the South Ossetia project is to normalize life
in the region with a view to reunifying the North and South
Ossetian people within the Russian Federation. Given South
Ossetia’s full dependence on Russia, it will set an illustrative
example for other ethnic groups in Georgia to judge Russia’s
ability to promote development. Turning South Ossetia into “a
showcase of prosperity” will weaken the political regime in
Georgia. However, if South Ossetia remains a showcase of misery
with living standards even more dismal than those in the
impoverished regions of Georgia, this will mean Moscow has
failed.