For a long time, Russia was seen as the land of opportunity for foreign investors. The allure of the country with a large population, vast natural resources, and more importantly, a large middle class willing to spend money, was irresistible. The burgeoning economy, however, held a few secrets which threatened to derail investors’ hopes.

Last week we started to discuss the ‘bear traps’ or structural inefficiencies built into the economic system in Russia. In particular, the rent management system in the Soviet Union centered around the idea of indirect resource transfers, whereby non-profitable enterprises would stay afloat through access to cheap energy, extra cash payments, and other forms of indirect subsidies.

Today we are trying to see what happened in the Russian economy after the dissolution of the USSR. How successful were the modernization efforts? What role does the Soviet economic legacy play in today’s economy?

PROMISE OF THE TRANSITION PERIOD

When Russia started the process of transition towards the market-based economy, one of the first steps was mass privatization of publicly owned enterprises. It seemed that the productivity and profitability of the enterprise were simply a matter of setting the incentives right. And yet, as Eteri Kvintradze (“Russian Output Collapse and Recovery: Evidence from the Post-Soviet Transition”) pointed out, productivity continued to plunge during the earlier stages of the transition period (before 1998).

There were several reasons for this: first, simply transferring the “ownership” of the existing firms to ordinary people with limited knowledge of entrepreneurship was certainly not going to increase productivity overnight. Secondly, as Gaddy and Ickes (“Prosperity in-depth: Russia. Caught in the Bear Trap”) argues, many industrial enterprises in the former USSR were not just inefficient. They were non-viable. They could not and would not survive outside the resource transfer system.

What followed next was predictable: the managers of the non-profitable enterprises (typically in ‘prestigious' industries, such as defense or machine building) started using their “relational capital” to lobby for the continuation of the resource transfer schemes. The owners of shares in resource sectors were compelled to comply or risk losing their newly privatized riches.

As a result, a version of the old rent management system was reestablished. From the economic perspective, the arguments for this scheme are similar to the “infant industry” argument often employed in the lobbying efforts throughout the world: the inefficient enterprises need some “breathing room” to restructure and modernize. Governments are often eager to support the “infant industries” out of concern for jobs and social stability. Unfortunately, as the world experience shows, the dependent ‘infants’ rarely become competitive, innovative adults, more so if they do not have a clear incentive to grow up.

Since the early 2000s, there were attempts to institute deeper structural changes in the Russian economy. Already in 2002, Bloomberg Businessweek Magazine was praising the government’s intent to slash bureaucracy, reduce the power of monopolies, institute flat income tax. However, insofar the reforms would have implied painful restructuring, the efforts did not take hold. Instead, the system of preferential resource transfers was largely preserved as the country continued to ride on the wave of increasing oil prices.

Of course, foreign investment did not dry up, but the Western resources and know-how could do nothing to fundamentally alter the system of resource transfer. The chart below shows the pattern of falling FDI to GDP ratio since 2008.

TROUBLES OF THE RUSSIAN ECONOMY TODAY

The signs of trouble became more pronounced already in 2012-2013.

During the last 2-3 years, the oil prices were stable and relatively high. However, the economic growth in Russia slowed down. According to the World Bank economic report on Russia (“Confidence Crisis Exposes Economic Weakness”, 2014), in 2013 the GDP growth rate slipped to 1.3%, from 3.4% in the previous year. This was well below the emerging economies’ growth rate, slightly below OECD high-income economies, and barely on the level with the troubled EU emerging economies.

The culprits were the slowdown of domestic demand and a negative, near-zero, capital investment growth. As the report points out, the end of the two large investment projects (Nord Stream Pipeline and Sochi Olympics) immediately lowered the investment baseline. Another worrying sign was that in the midst of a growth slowdown, the capacity utilization in Russian industries had reached its historical peak (near 80%) in 2013, while the unemployment level in the country was quite low (around 5-6%). This combination implies that the economy is facing structural productivity constraints, and further growth can be only achieved with the help of the new investment.

However, as the World Bank reports, investors’ confidence was falling in recent years, mainly due to the lack of comprehensive structural reforms in the economy. The Financial Times 2013 country report on Russia argued that privatization of large government enterprises in recent years was matched if not surpassed by the incidences of nationalization. The recent Rosneft purchase of TNK-BP, one of the largest private oil companies in Russia, showed that the government had no intention to weaken its presence in the economy.

The big promise of the Russian economy, the large share of the “middle class”, was a considerable source of hope for foreign investors, especially the ones trying to tap into the consumer goods market. Despite large wealth inequality, nearly 50% of the Russian population is classified as middle class (living on income at or above $10 per person per day). These people are not only consumers. They are also the producers: qualified workforce, potential entrepreneurs, engineers, and scientists. The human capital potential in Russia is undisputed. And yet, the recent cautionary tales of government interference in the start-up sector, the heart of the “smart economy”, is giving pause to both domestic and foreign investors. Among them, the decision of the Russian parliament to tighten the control of the country’s Internet space, the news of the recent shareholder dispute in Vkontakte, the analog to Facebook, which culminated in its founder fleeing the country.

The obvious government interference in the management and control of the sectors which flourish best under free marker rules keeps the domestic and foreign investors’ confidence down. It could also lead to the significant outflow of venture capital investments from Russia, if not the 1990s style brain drain. Last but not least, the Russian-Ukrainian conflict, along with the threat and the reality of economic sanctions could prove to be the breaking point even for the most enthusiastic foreign investors. While it may be tempting to claim that the country of this size could “go it alone” and do just fine without foreign investment, the example of the USSR shows much bleaker prospects for a large resource-dependent country standing on the path of economic isolationism.