08.05.2006
Russia’s Economic Policy – Setting Priorities
№2 2006 April/June
Vladimir Mau

Vladimir Mau is Rector of the Russian Presidential Academy of National Economy and Public Administration.

In the last few years, Russia’s economic development has been
characterized by two major tendencies: consistently high economic
growth rates and the growing involvement of the state in the
country’s economic life. In 2005, the growth rate reached 6.4
percent of the Gross Domestic Product, against the 5.9 percent that
had been predicted before the beginning of the year. Importantly,
the growth rate of the Russian economy exceeded growth rates in the
most developed nations and in a majority of the post-Communist
countries.

The Russian government’s policy for achieving high economic
growth rates is comprised of different approaches. On the one hand,
the government continues to improve the general economic management
environment through administrative, tax and budgetary reforms,
together with the monetization of social benefits and other moves.
On the other hand, it is creating mechanisms for a private-state
partnership, which presupposes the emergence of fundamentally new
economic instruments that would ensure the direct involvement of
the state in developing and implementing specific economic
projects.

ECONOMIC GROWTH AND NATIONAL PRIORITIES

For almost two years prior to December 2005, Russia had no
officially approved mid-term program for social and economic
development (this is a noticeable difference from the previous
post-Soviet years; since 1992, the crisis year, there had been no
precedent of a Russian government operating without a program for
even a year). The government cited the absence of a clear
understanding of the mechanisms for doubling the GDP – the goal set
by President Vladimir Putin – as the main reason for the lack of an
officially approved program. Prime Minister Mikhail Fradkov
justifiably argued that, from a political perspective, the absence
of a program was better than a program that did not provide a clear
solution to the problem of doubling the GDP. The Ministry for
Economic Development and Trade, responsible for the program’s
development, declined to assume full political responsibility for
the economic growth program. That was a natural move, as economic
growth is a very complex phenomenon that depends on many economic,
political and social factors. Moreover, economic growth in
contemporary Russia depends not only (and not so much) on the state
of economic institutions as on political and legal factors, such as
viable governance, judicial and law-enforcement systems, together
with the state’s ability (or inability) to ensure execution of its
legislation.

For example, the development of business requires the guaranteed
execution of contracts. However, if the judicial and
law-enforcement systems fail to ensure the necessary conditions,
the businesspeople will be burdened by the costs for ensuring the
execution of contracts. This factor considerably increases the
costs while reducing the competitiveness of doing business. Another
important problem concerns the personal safety of
businesspeople.
More and more people in Russia understand that the country needs
economic growth not per se and not at any cost.

There are several circumstances that the government must take
into account when working out a successful economic growth policy.
First, high growth rates are needed in the long term, rather than
for the government’s reports on its work in the next two to three
years. Second, high growth rates are well grounded only when the
necessary structural transformations accompany them. These include,
most importantly, the diversification of the economy, the reduction
of the economy’s dependence on the fuel/energy sector, and an
accelerated development of post-industrial sectors (high-tech
services).

Moreover, at certain stages progressive structural
transformations may actually be accompanied by a decrease in growth
rates. Third, the growth rate must help Russia reduce the gap
between itself and the most developed countries of the world, that
is, the growth rate of the Russian economy must be higher than the
average world rate and the rate in the most developed states.
Fourth, this must be real growth, not an artificial growth forged
to meet the political situation or to please political leaders.
Fifth, there exists the danger of orientating state policy directly
to the tasks of economic growth without discussing the economic
policy’s quality. It must also be acknowledged that economic growth
can be achieved not only through natural investment and saving
activity, but also through the formation of a mobilization economy
similar to the Soviet model based on forced saving and “belt
tightening.”

This explains why the focus of discussions about economic growth
is increasingly shifting to issues pertaining to structure, quality
and institutions: it derives from the definition and discussion of
strategic priorities for Russia’s social and economic policy.

Throughout its post-Communist development, Russian society has
demanded that the government set long-term priorities for the
country’s social and economic development and outline industries
that the state would support and stimulate by means of budgetary
and tax measures, as well as protect from foreign competition.
However, such decisions could not be made simply for political and
economic reasons.

Politically, priority setting was impossible given the
conditions of the social struggle that accompanied the
revolutionary transformation of the 1990s. From an economic point
of view, it was impossible for the state to set industrial or other
sectoral priorities since the development of the post-industrial
system is incommensurably less predictable than the development of
the industrial system. The experience of the most developed
countries shows that investment in human capital is becoming the
key factor in economic growth today. This type of investment
creates the conditions for steady and dynamic growth, together with
the continuous adaptation of the social and economic structures to
new, unpredicted turns in technological progress. Besides,
investment in human capital creates demand in numerous related
sectors, thus producing significant exponential growth.

Over the last two years, Russia’s political leaders and
government experts have actively discussed the important role of
human capital. The subject was even included in the Russian
president’s State of the Nation Addresses to the Federal Assembly.
Finally, in September 2005, President Putin proposed it as one of
his “national projects” – part of the national priorities for the
country’s development. These include the development of education,
public health services, housing construction (the introduction of
mortgage lending), and the solution of social problems in rural
areas.

The inclusion of these spheres in the national priorities list
actually means the beginning of a new stage in Russian economics
and politics.
Indeed, during the last 15 years Russia passed through two stages
in its development. In the first stage, which comprised the 1990s,
the country struggled through a large-scale macroeconomic crisis
and created basic economic and political institutions – private
property, monetary system, tax and budgetary systems, and
federalism. Those efforts were reflected in the Constitution and
the Civil Code of the Russian Federation. In the second stage
(2000-2003), the emphasis was made on the formation of basic
economic institutions – tax, land and bankruptcy legislation, the
transformation of natural monopolies, the removal of administrative
barriers to business (deregulation), etc. Those decisions only
recreated what existed in all countries with a modern structure of
society, undistorted by the Communist experiment.

“National priorities” are different in essence. On this point,
Russia is not confronted by a crisis related to the Soviet social
system, but rather problems that are characteristic of all
post-industrial countries. Post-industrial challenges, with their
demographic problems, have introduced a crisis of the traditional
“welfare state,” which currently presents many countries with the
need for an in-depth transformation of their social sphere.

Work on each of the aforementioned national priorities requires
two kinds of efforts. On the one hand, it needs the allocation of
extra budgetary funds for raising workers’ salaries in
corresponding industries and groups of the population; on the other
hand, it calls for the implementation of structural reforms in
corresponding sectors. These two kinds of efforts are inseparable
from each other, and it would be politically dangerous and
economically inefficient to address one task while ignoring the
other.

Raising salaries for doctors and teachers, investing in new
equipment, and similar financial decisions are only prerequisites
for solving pressing problems, but not a sufficient condition. The
quality of Russia’s educational and medical services depends not
only on the level of remuneration and the attraction of qualified
personnel into the social sphere, but also on the efficiency of the
respective systems.

Moreover, increased funding without structural reforms may
produce unwanted results. Higher salaries will not help to
rejuvenate personnel but will only conserve them. Thus, many
doctors and teachers who have long lost the qualifications to
perform their tasks will not start to perform more professionally,
even if their salaries are increased one hundred times.

Increased spending on new equipment may result in expenditures
at inflated prices, while the purchased equipment may not be what
the hospitals and laboratories really need.

In the sphere of housing construction, increased funding, given
the present level of monopolization of the market of construction
services, can only boost prices and enrich a handful of businessmen
who have become local monopolists.

Of major importance is preventing budgetary populism in
implementing national projects. The budget must not only remain
well balanced, but it must also be formed on the basis of rather
conservative oil price forecasts. Besides, a very short period of
time (about two years) must be established for specific projects.
During this time, it is possible to predict with high accuracy the
incoming of funds required for specific projects.

MECHANISMS FOR ENSURING ECONOMIC GROWTH

High economic growth rates can be ensured by means of the
following basic mechanisms: improving institutional conditions for
economic development; boosting the state’s role in the country’s
economic life; forming mechanisms for the private-state
partnership; and ensuring macroeconomic stability while preventing
populism in monetary and budgetary policies.

Economists have become divided between proponents of a dirigiste
approach to the consolidation of economic growth and those of an
institutional approach. The polarization between the two camps
became apparent in 2004 when two other variants for solving the
problem of consolidating growth (through development of financial
& industrial groups and through resolute liberalization) lost
their political importance.

However, the acuteness of the discussions between proponents of
the dirigiste and institutional approaches has subsided. The
state’s direct involvement in the economy has acquired more
transparent and institutionalized forms (for example, with the
Investment Fund), which have replaced unsystematic attempts to
interfere in the economy by means of decisions on individual
enterprises or sectors. In 2004, industrial strategies were viewed
as a direct alternative to institutional reforms, whereas in 2005
these strategies made up only one (concluding) section in the
Mid-Term Program, approved by the government on December 29,
2005.

In the last few years, Russia has continued to improve its
economic and social legislation. In particular, it proceeded to
reform individual natural-monopoly industries (except the gas
industry) and develop natural-monopoly laws. Additionally, it
reduced the volume of licensed kinds of activity, adopted important
laws on concession agreements and on special economic zones, and
toughened state procurement procedures with a view to introducing
maximum transparency. Another important event was the adoption of
an amendment to the Civil Code, which has reduced the statute of
limitation on privatization transactions from ten years to three.
This move has in effect legalized the results of the mass
privatizations that took place in the 1990s. This decision can
become an important factor for boosting the investment activity of
Russian businesses.

At the same time, the government made no radical moves in the
institutional sphere, which can be explained by several reasons.
First, the government needed a pause after two years of
administrative reform that had essentially transformed the entire
system of state governance bodies. It needed some time to adjust to
the new reforms, especially as the initial results required
in-depth analysis. Briefly, the transition to a three-stage system
of executive bodies was accompanied by confusion and the loss of
the level of governability that had been characteristic of the
first few years of Putin’s presidency. It was only by the end of
2005 that the new state bodies began to interact more
efficiently.

Another circumstance that delayed institutional reform was the
shock the government experienced from street protests that broke
out in January 2005 following the Kremlin’s decision to replace
non-monetary social benefits with cash payments. The protests made
the government postpone its municipal reform until 2009.

Third, several highly anticipated reforms could not be launched
due to the imperfection of law-enforcement practices.

This last factor poses a serious problem for Russia’s economic
policy. The state of  government, judicial and law-enforcement
systems is a major obstacle to the improvement of economic
legislation. This refers, above all, to antimonopoly regulation,
taxation, and customs policy.

The government is now actively working on new antimonopoly
legislation, which is of vital importance because the monopoly
nature of some areas in the Russian economy has reduced its
competitiveness and stands in the way of long-awaited reforms in
several sectors (for example, it prevents the development of
mortgage lending). The Federal Antimonopoly Service (FAS) has come
out with a new antimonopoly bill, largely based on European Union
standards. If adopted, the bill would serve the important task of
harmonizing Russian and EU legislation. However, the bill has come
under fierce criticism, and not only from monopolists and certain
liberal economists. The main point is that practical implementation
of the antimonopoly law is impossible without the active
involvement of numerous authorized state employees, not to mention
an effective judicial system. In other words, the FAS bill
presupposes the introduction of EU procedures for antimonopoly
regulation in Russia’s law-enforcement environment, which in
practice would only discredit the new legislation.

Tax reform faces similar problems. In 2005, the government
actively discussed further reductions in taxes, in particular a
decrease in the value added tax from 18 to 13 percent.
Characteristically, liberals in the government and the expert
community opposed this measure, above all. They expressed fears
about the budget’s stability and pointed to the inefficiency of tax
management. In conditions when tax inspections may result in tax
charges exceeding the profits of a given enterprise over a
corresponding period, the tax rate ceases to play any role in
devising business strategies. Many businesspeople drew the
government’s attention to this problem. The president, too, in his
State of the Nation Address to the Federal Assembly in 2005 stated:
“Tax agencies have no right to ‘terrorize’ businesses.”

The same refers to taxes covering the extraction of mineral
resources. Perhaps the state – as the owner of the natural wealth –
could gain more if, when calculating this tax, it took into
consideration the variations in natural conditions at different
extraction sites. At the same time, a differentiation of the
extraction tax rate may become a powerful factor for corruption in
those agencies that would set a differentiated tax rate for each
specific extraction site.

STATE MANAGEMENT OF THE ECONOMY

The issue of state management in the economy is one of the most
difficult and contradictory, yet it is vital for the development of
the Russian economy. The situation will likely develop along one of
two possible avenues: there may be the consolidation of state power
institutions, or increased direct interference by the state in
economic life. The latter approach is prevailing in Russia as the
state is becoming increasingly active in the economic process.

These tendencies are manifest by the state’s increased ownership
of the largest companies. Events of the last two years have shown
that the state is going to consolidate its positions as the primary
owner of strategic sectors of the economy, while giving up its
holdings in other sectors. The state has demonstrated that it can
use two different ways to gain control over property: initiating
legal proceedings and purchasing formerly privatized assets. The
former variant was used in the YUKOS case, when concerted actions
by tax agencies and the Prosecutor’s Office ensured the transfer of
the private company’s best assets into the hands of a
government-controlled company. The latter variant was used against
Sibneft, which was bought from its proprietor for $13 billion.
Similarly, the state acquired controlling interest in AvtoVAZ
(bought by Rosoboronexport), Guta-Bank and Promstroibank (bought by
Vneshtorgbank), and several other companies. Moreover, in his 2005
State of the Nation Address, Putin proposed forming a confidential
list of industries or facilities that must remain under
“predominant control of domestic, including state, capital.”

However, it would be wrong to consider the YUKOS model as the
least costly option for the state. The “cheap” purchase of
Yuganskneftegaz produced a much more negative reaction among
investors and the general public than the “expensive” purchase of
Sibneft. Considering the blow to Russia’s reputation that it
produced, losses from that “cheap” purchase may prove very
significant.

The main result of this policy is that the owners of some large
private firms (as a rule, those that took an active part in
shares-for-loans auctions in 1995-1996) seem to have learned the
lesson of the YUKOS-Sibneft affair and are beginning to show a
readiness to sell their assets if offered the right price. Thus,
there emerges a kind of quasi-developer business: businesspeople
who are unsure about the legitimacy of their property holdings are
prepared to sell their assets to the state for good money.

Simultaneously, within the framework of the administrative
reform, the government has over the last few years been reducing
its presence in small-scale businesses and institutions, many of
which have been either privatized or transferred to sub-federal
levels of management.

NEW INSTRUMENTS OF ECONOMIC POLICY

As it pursues the policy of increased participation in the
country’s economic life, the government has introduced
fundamentally new instruments of economic policy that are intended
to boost economic growth. These include special economic zones
(SEZ), a law on concessions, and an investment fund. All these
measures have one thing in common: they presuppose exceptions from
the general management rules, and the government’s pinpoint
influence on economic actors.

The federal law on SEZ, adopted in the summer of 2005, allows
for the establishment of two special types of zones, namely,
industrial and innovative. The government is ready to offer easy
tax and administrative benefits for businesses operating in these
zones. Of over 70 proposals for the establishment of SEZ submitted
to the government, the latter has chosen two industrial zones (to
be established in the Lipetsk Region and Tatarstan’s Yelabuga) and
four innovative zones (Zelenograd, St. Petersburg, Dubna, and
Tomsk). At the end of 2005, a new federal law was adopted on a
special economic zone in the Kaliningrad Region, which has
introduced substantial corrections into the existing mechanism as
it moves away from importer privileges to the stimulation of
production.

The new legislation differs from the previous method of creating
“free zones” in post-Communist Russia and limits the possibility of
abusing this mechanism. First, the new legislation establishes
uniform conditions for SEZ, that is, it has ruled out
“negotiations” with regional authorities and interested businesses
on the special zone mechanism. Second, the law has introduced a
procedure of competitive selection of SEZ, while regional and
municipal authorities must display their material interest in
creating such a zone by allocating financial resources for the
development of the necessary infrastructure. Third, the initiative
has done away with all other special economic zones; these were
established in the 1990s and have not produced the desired effects
(except for the zones in the Kaliningrad and Magadan Regions).
Fourth, the new zones are oriented to the attraction of investment
in new technologies, and to the diversification of the economy,
rather than to the solution of the problems of regional inequality
or economic backwardness.

Another important decision was the formation of an Investment
Fund within the framework of the federal budget (annual and planned
for three years and within conditions of high fuel/energy prices).
Actually, this is money that under other conditions would go into
the Stabilization Fund. Heeding loud demands that petrodollars be
used for the national economy, the government had to make a
compromise decision and allocate part of the money for increasing
state investment. This decision has somewhat increased the
macroeconomic vulnerability of the Russian economy should oil
prices fall, but it is not fatal provided two conditions are met:
first, the size of the Investment Fund remains moderate compared to
the Stabilization Fund, and second, money from the Stabilization
Fund is used in an effective manner, that is, if it results in
higher labor productivity and favorable structural shifts in the
Russian economy (read: its reduced dependence on raw materials).
The government must realize that if oil prices fall, money from the
Stabilization Fund must be used, first of all, to fulfill
commitments under investment projects, and only then to ease the
reduction of other budget spending items.

State support will be used, above all, for implementing projects
aimed at developing infrastructure of national importance, creating
and developing elements of the national innovation system and
ensuring institutional transformations. These three areas are vital
for the stable development of the Russian economy.
A very important criterion for selecting projects involves
guaranteeing equal access to economic agents for receiving state
support, as well as the condition that the proposed projects be
free from financial risk. Certainly, “equal access” is the most
vulnerable point of modern Russian realities.

Other important criteria for selecting investment projects are:
the presence of a commercial organization participating in
investment; adequacy of a project’s objective to priorities of
social and economic development and to the government’s industrial
strategies; positive social effects; substantiation of
impossibility of a project’s implementation without state
participation; the project’s estimated cost, which must not be less
than five billion rubles; and a favorable overview of the project
by an investment adviser with a well established international
reputation.

The preservation and consolidation of the Stabilization Fund’s
role is an exceptionally important factor for ensuring steady
growth rates in the long term. The Stabilization Fund is usually
viewed as a source of reserve funds for maintaining the necessary
level of budget spending in case the global economic situation
deteriorates, or as a financial reserve for “future generations.”
Meanwhile, the primary role of the Stabilization Fund is to prevent
the economy from becoming overly dependent on high oil and gas
prices in particular, and the fuel/energy sector in general. The
Fund’s political role is to prevent Russia from repeating the same
fate of the Soviet Union.

In 2005, attempts were made to use the Stabilization Fund for
investment financing. Given the present level of Russian export
prices, pressure on the government with regard to the use of the
Stabilization Fund will continue to grow. In these conditions, the
government must take at least two additional steps: establish an
“inviolable threshold” for the Fund, not as an absolute value, but
as a percentage of the Gross Domestic Product, and second,
considerably increase the efficiency of budget spending.

CHALLENGES AND TRENDS OF SOCIAL AND ECONOMIC DEVELOPMENT

The further development of Russia’s economic policy will depend
on the following three factors: post-revolutionary stabilization,
challenges of post-industrial society, and the price regime that
has been established over the last few years with regard to basic
Russian exports.

Post-revolutionary stabilization. In the last
five years, a high level of macroeconomic and political stability
has characterized Russia, which is particularly evident in contrast
with the situation of the late 1980s-early 1990s. The full-scale
revolution that Russia experienced while implementing the systemic
post-Communist transformation is over, and the basic state
institutions have been restored. At the same time, the elites have
not consolidated much, and a stable national consensus on basic
values has not been reached. Solving this problem will take
decades. Meanwhile, the lack of consensus on such matters will
result in periods of relative stability alternating with sudden
political turns.

The reproduction of instability is brought about by the
government’s constant maneuvering between social groups of varying
interests. As a result, there emerges a peculiar system in which
stability is ensured by fluctuations inside the government that
seeks to create new coalitions.

Challenges of post-industrial society. Russia
must solve specific tasks related to “catch-up development” under
the new conditions and challenges presented by the post-industrial
epoch. The mechanisms for solving these tasks differ essentially
from the solution of similar problems in the epoch of
industrialization.

Russia requires a deep structural transformation. Meanwhile, as
the experience of the most developed countries shows, the period of
structural reforms is often accompanied by slower growth rates or
even external stagnation (as happened in some Western countries in
the 1970s). This is partly because new sectors (especially
services) are not adequately covered by traditional statistical
methods, and partly because a new technological breakthrough
requires the accumulation of resources.

Economic growth without structural shifts can be easily achieved
by state administration, but such growth will not make the country
richer or the economy more effective.

There are several important principles for achieving economic
growth.

First, the government must give up its attempts to set long-term
sectoral (industrial) priorities on which it could focus its
attention and resources. Practical work on these priorities would
only give prominence to those sectors with maximum lobbyist
possibilities. Much more effective would be a strategy of regularly
correcting the structure, under which the government would be ready
to protect, flexibly and by political methods, all those who
achieve success through competition.

Second, the government must make the economic system flexible
and adaptive, while economic agents must be able to react to the
present challenges quickly and effectively. Adaptability must
replace the concentration of resources as a key benchmark of state
policy. The solution of this task is inseparable from the task of
building an effective system for the protection of ownership
rights.

Third, in the contemporary world a “catching-up” country must
have a lower budgetary load on its economy than the most advanced
countries in the world.
Fourth, the government and private entrepreneurs must give priority
to investment in human capital.

Fifth, the economy must be made sufficiently open. Foreign
economic policy must be oriented to the stimulation of the
development of new, high-tech sectors, and to the production of
high added value products from traditional Russian exports. At the
same time, negotiations on Russia’s accession to the World Trade
Organization must be aimed not at the primitive protection of
domestic producers but at a post-industrial breakthrough.

Energy price situation. It is generally
believed that high energy prices are exceptionally favorable for
the country. However, high energy prices over a long duration may
have negative consequences for the stability of the country’s
economic and political development in the future. This is due to
the degradation of the tax and budgetary systems, in which a high
level of revenues that do not stem from growth in labor
productivity substantially reduces the effectiveness of
decision-making.

The country’s political and economic dependence on petrodollars
increases annually as the boom in world energy prices continues.
Meanwhile, the political and economic risks of a decrease in oil
prices continue to grow. A fall in oil prices may provoke an
inappropriate reaction from the elite, which has become accustomed
to the exceptionally favorable budget situation. As a result, the
country may face a budgetary as well as a political crisis
characteristic of post-revolutionary development.

To cushion a possible crisis, the government must work out,
without delay, a plan of action in case the world economic
situation deteriorates. This plan must include various measures
concerning monetary, budgetary and tax policies, changes in foreign
economic regulation, and other measures that would help alleviate
the consequences of a hypothetical crisis. Without such a plan, the
likelihood that the situation may get out of control will be very
high. On the bright side, a decrease in oil prices and the
government’s reaction to it will be a maturity test for Russia’s
political elite and a gauge for determining the country’s real
devotion to a responsible economic policy.