2011 Review of the Russian Economy

By Alex Liao

The Russian economy has traditionally been focused on natural resources rather than innovation and entrepreneurship. During the global recession, oil prices hammered the Russian economy, prompting government stimulus, which similarly protected its financial sector. Nonetheless, the Russian economy has picked up slightly over the couple of years, achieving a modest though disappointing 4-5 percent growth. Although unemployment and currency rates are at pre-recession levels, inflation is rising and the budget deficit is expanding. Labor productivity is less than half of what workers in other OECD states achieve. Hence, the status quo is unsustainable.

Russia must, as a whole, become a more competitive economy. It is currently moving towards more efficient use of its resources, closing its capacity utilization gap by instituting new production processes, decreasing the amount of surplus labor, and having better organization of administrative tasks. A more competitive Russian economy is one that is attractive to foreign direct investment, one that is an attractive exporter of goods and services, and one that is has a productive manufacturing, pro-industrial base. There are several areas where economic reform will lead to a more competitive economy:

First, Russia must reform its administrative framework to be more conducive to business interests and foreign direct investment. Legal institutions must be able to protect intellectual property and drive investment and corporate development. Bureaucracy must be tamed, regulation must not stand in the way of innovation, and judicial transparency must create a secure economic environment where businesses can equitably settle disputes. A thorough review of all regulation, with the intention of making it comparable to international regulations, will send a clear message to foreign markets.

Nevertheless, the financial and banking industry must also be placed on a stable footing. Reforms implemented between 2002 and 2006 to increase transparency in financial reporting, privatization, and credit bureaus must be extended and furthered to cover weaknesses exposed during the global recession. For instance, recent proposals which will tighten capital requirements, or others which will strengthen the Central Bank of Russia’s regulatory powers, will be able to dampen business cycles and bring more stability to the financial framework for the Russian economy. An expansion of the financial industry will also be beneficial, as it will open up new avenues for capital.

Government itself, too, must reduce fiscal deficits to be able to effectually react to fluctuations in the business cycle. It must convey a readiness to keep inflation low, so companies can plan for the future. Corporate taxes must be kept lower to promote competition and increase incentives for productivity. Corporate taxation is relatively high in Russia, making it less competitive than many EU countries. Tariffs and other customs procedures similarly should be streamlined to make the economy more competitive, and make it easier and faster to start a new company. Currently, Russia’s high import tariffs and customs processes have created large barriers against trade. Changing these will reduce the amount of foreign competition while increasing foreign direct investment. Specifically, foreign direct investments would also improve if a 2008 law on protection of strategic sectors was reformed – the law limits foreign investments in the energy sector. Moreover, placing a priority on full accession to the WTO will enable Russia to access new markets and foreign investments.

In the past, corruption has run rampant amongst businesses and the judiciary, fomenting uncertain regulations and creating a rough business environment. Not only that, corruption stifles competition, giving many a reason to stay away from the economy. Corruption creates legal, financial, and reputational risks. Companies do not want to be involved in any allegations about corrupt dealings in Russia. Reform must also be focused on property rights, stable and protected access to land and resources, and intellectual property rights. These must be clearly defined to allow businesses to make clear investment decisions, as problematic administrative barriers will hinder growth. For intellectual property rights, Russia will need to solidly enforce the Trade Related Intellectual Property Rights agreement as per its obligations to the WTO.

Russian businesses that institute accountability standards to reduce fraud and corruption will also increase consumer confidence for economic stability. These may include collective action or zero-tolerance programs, where management takes the lead in anti-corruption measures. There are several private sector initiatives already in place, such as the Russian Initiative for Corporate Ethics and the Partnering Against Corruption Initiative. These programs aim at fostering a best-practice system to stem bribery and corruption between businesses, and should be publicized and further developed so that they become industry standards.
A clear governmental anti-corruption framework must include a sound corruption prosecution mechanism, grounded in legislation and a judiciary that can objectively and independently render decisions that are publicly respected. Moreover, these processes, as well as any other government contracts, must be transparent. Civil service codes should be more standardized to eliminate governmental corruption. Finally, citizens and the media should be able to contribute to these protections. Their voice must be protected, and whistle-blowers must be granted legal protections and incentives. These, combined with private sector efforts, will be seen as a large step towards reducing corruption.

Second, Russia must further develop its infrastructure and technology with innovation in mind. Companies who can access efficient infrastructure can expand with fewer costs to neighboring regions, and integration of infrastructure will increase both the quality and profits for businesses. Energy and transportation infrastructure will improve the density of the job market, while advanced communications systems can ensure that businesses make the soundest decisions in any given environment. To directly improve the job pool, investments must be made in education and healthcare. This will reduce economic inequality, opening up new potential workers and increasing their productivity. Those who have more advanced educations and training can more easily adapt to changing job markets and innovation in a particular sector. The private sector should also contribute to better training of workers, training them from within and providing them the skills to continue to thrive in their sector.

In particular, Russia’s educational system has not seen significant reform in the past few years relative to those of its peers. A brain drain has been observed, where the educated population has elected to leave Russia rather than stay and benefit the economy. Emphasis must be placed on math and science skills, as well as management skills, to shape the next generation of Russian business leaders. A transition to more highly trained management through an expansion of Russian business schools will create a more dynamic economy.

Third, technological innovation must be emphasized. More advanced business practices, as well as access to new products and processes will contribute to a more vibrant private sector. For example, businesses should form clusters to increase efficiency and make it easier for new companies or entrepreneurs to be established. Research and development must be supplemented by research from educational and scientific institutions. An innovation hub, named Skolkovo, has recently been established, and has been compared to the United States’ Silicon Valley. Stimulus measures should be focused on developing these areas. Relationships should be cemented to ensure collaboration between each partner to create homegrown, innovative systems. To this end, market inefficiencies must also be closely monitored. The government must break down monopolies and should write a tougher competition law than the one it wrote in October of 2006, which established a Federal Antimonopoly Service.
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Economic reform in these areas must be supplemented with leverage from Russia’s economic strengths. Natural resources will continue to fuel economic growth, though the byproduct – appreciation of the exchange rate – must be tempered to maintain a competitive manufacturing base. Moreover, while natural resources remains important, government investments should focus more on the manufacturing and services industries, which will make the economy more diverse. This, combined with anti-corruption and smart resource management, will allow the Russian economy to continue to grow despite the global financial liquidity difficulties. Russia must use the revenues it can still draw in from natural resources to invest for its future – one with energy efficiency and renewable energies in mind.
Another strength Russia must leverage is its location and broad population. It must use these to attract foreign direct investment, while also entering into agreements with its neighboring countries. Working with the EU, as well as working with CIS states, will prove to be beneficial looking forward. It should also look to establish more Common Economic Zones, like the one it has joined with Kazakhstan, Belarus, and Ukraine. These agreements will enable Russia to lower its tariffs and trade barriers, bringing in more foreign direct investment. Furthermore, Russia’s population ranks among the most educated in the world. It must focus on retaining the population in Russia and avoiding the brain drain. In order to do this, the government must invest in new, attractive jobs in the domestic market.
Thus, in the wake of the global recession, Russia should focus on streamlining its administrative framework to provide incentives for foreign investment, and investing in higher-level management and science education. This will enable the economy to become more competitive and attract innovators. Along the way, Russia should also push for full accession to the WTO, which will provide greater investment opportunities as well as buttress confidence in the Russian economy’s future.
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1 World Economic Forum. “Russia Competitiveness Report 2011,” World Economic Forum, 2011.