A Testing Ground for Modernization and a Showcase of Success

8 march 2009

Mikhail Delyagin

Resume: 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.

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.


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.


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.


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.


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.


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.

Last updated 8 march 2009, 14:56

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