Until very recently Russia was considered by many foreign companies a somewhat difficult but promising country for investment, a “land of opportunity” that perhaps necessarily came with a hefty dose of a “riddle wrapped in a mystery inside of an enigma”. The difficulty was stemming primarily from Russia’s heavy-handed bureaucracy. Stories of corrupt practices, politically motivated court decisions, and questionable tax authorities’ tactics abounded. While this may have scared off smaller investors, the large companies are typically no strangers to such challenges. Heartened by the rise of the Russian middle class, which was seen both as a source of profits and an engine for change, the West had hoped that the Russian state would in time transform into a modern, innovative, and competition-driven economy.

Yet, the events of just a month ago, when Russia carried out the occupation and annexation of the Crimean peninsula under the claim of defending the life of Russians in Ukraine, and the current threats of military invasion in Eastern Ukraine seem to be putting these hopes on hold. What do military ambitions have to do with economic policy? The link is more direct than seems at first.

In this two-part article, we will explore the evolution of the Russian economy from Soviet times until the present day. We will try to pinpoint the specific complex challenges facing the Russian economy, and how much the country’s economy is still bound by its Soviet legacy.

MAIN ECONOMIC AND SOCIAL INDICATORS

Just how well do Russian people live? With a GDP of $2.6 trillion, the Russian economy stands in 6^th place in the world ranking. Taking into account a huge population (146 million) of the world’s biggest country, with a GDP per capita of $17.884, Russia’s standing drops to 58^th place.

According to World Bank estimates, the shadow economy accounts for about 40 % of GDP (World Bank, 2007). In addition, Transparency International’s corruption perception index ranks Russia as 127 out of 177 countries, in between Pakistan and Bangladesh. Russia is also in 61^st place (out of 142) by the 2013 Legatum Prosperity Index. As the index also suggests, 78.6% of people believe that corruption in business and government is widespread.

Some other indicators of living standards are not very encouraging either. In terms of income inequality, Russia is doing worse than nearly all OECD countries except Mexico and the United States.  As far as wealth inequality, the discrepancy between the rich and the poor in Russia looks quite dismal. Currently, Russia stands in 3^rd place worldwide by the number of billionaires in the country, and these billionaires, 110 people, all in all, control 35% of the nation’s wealth. To compare, billionaires worldwide account for only 1-2% of household wealth. In the US, a country characterized by a relatively large wealth gap, 40% of the country’s wealth is controlled by 3.17 million people.

Still, despite all these problems, Russian is the largest country in the world, extremely rich in natural resources. It accounts for about 20 percent of the world's production of oil and natural gas and has significant reserves of both. Moreover, Russia has reserves of almost all industrially important non-fuel minerals. With such large potential at hand, can Russia be doing better economically? If yes, why is the country not better off? Why, for example, the number of people dissatisfied with the status quo kept growing in recent years, necessitating the very tough anti-protest laws in Russia?

Some experts named “Dutch disease” as one of the main problems of the Russian economy today. The oil and gas sectors account for around 70% of export and 50% of government revenues. The currency appreciation from oil and gas sector expansion made the country’s other exports too expensive to compete on the global market.

Yet, some argue the “Dutch disease” may not be Russia’s most pressing problem. Recent economic literature and reports on this subject, such as the paper “Russian Output Collapse and Recovery: Evidence from the Post-Soviet Transition” by Eteri Kvintradze and “Prosperity in-depth: Russia. Caught in the Bear Trap” by Clifford G. Gaddy and Barry W. Ickes, suggest that the roots of the mystery of Russian economy go far back into the Soviet days. Russia’s story is a classic “resource curse” story. The case of the country, where economic inefficiencies are stemming from the overwhelming dependence on natural resources, with consequences more far-reaching than the Dutch disease.

THE SOVIET ECONOMIC LEGACY

Inefficiency. The Soviet Union tried to develop a fully-fledged industrial system largely or completely independent from the West. This independence, however, came at a price. Gaddy and Ickes claim that the first indicator of the system’s inefficiency was a totally inappropriate allocation of factors. In order not to leave any piece of land without use, the Soviet central planners built whole cities, with factories and all the necessary infrastructure, in remote and often extremely cold locations. To compare, in Canada and in Alaska, where climates are similar to Russia’s the Far East, the population density in severely cold areas is much lower. The main problem with such allocation was the cost of transporting products and inputs between the factories. This was one of the artificially created extra burdens for the economic system of the Soviet Union – a “bear trap” that continued to affect negatively the development of the modern economic system in Russia.

Another ‘bear trap’ was the Soviet price system.  In the absence of a market-based price mechanism, the economic exchange was built around the industrial networking among the inter-dependent enterprises. The value of the final goods produced was very often lower than the cost of production implied by the free market economy.  When the revenues from production were negative, the state kept the enterprises afloat by subsidizing them. The sizeable resource rents (profits from sales of natural resources) were used to support the inefficient industries.

Rent management system. The system of distributing the resource rents did not function in terms of direct subsidies – i.e. not taken directly from the revenues of profitable sectors. The system, as Eteri Kvintradze explains, was much more opaque with the elements of non-monetary inter-enterprise transactions (NMTs). Under NMTs firms would sell oil and gas as inputs to enterprises at below the market price; they would transfer extra payments for certain orders or deliver services to the inefficient enterprises through intermediaries.

Clearly, the main problem of the Soviet economy was the dependence on the resource transfer to inefficient enterprises, and the consequent “rent addiction” or high dependence of the economy on the profitability of the natural resource sector.

Rent addiction. Indeed, the fluctuations in the resource rent value very much affected the development and the sustainability of the resource-dependent industrial system in the Soviet Union.  A few crises during the 1970-1990s were related to the decline of world oil/gas prices and the gradual decline of the resource rents. The recent (pre-transition period) decline of resource rents started in 1980 and culminated eventually in the collapse of the Soviet Union in 1989.

The collapse clearly showed that the planned economy with such an inefficient rent management system was not viable. After the dissolution of the USSR, Russia started the process of transition towards a market-based economy. How successful were these efforts? Has Russia been close to developing a modern knowledge and innovation-based economic system, or is it still laboring under the burden of the Soviet economic legacy? Find out in our follow-up article next week.