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11/02/2011

Russia: Some BRICs Are Different


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Russia has always been different from the rest of the world. Even 20 years after the end of the Soviet Union and the Cold War, this author still finds it a little strange to find Russia grouped with other BRICs, or most emerging market countries. The others—China, India, and Brazil—all have very large portions of their populations struggling with poverty, and are characterized by historically limited, but now improving, access to technology. Not Russia.

RUSSIA IN COMPARATIVE PERSPECTIVE | THE 1990s: POST-SOVIET CRISIS AND ECONOMIC COLLAPSE | THE 2000s: VLADIMIR PUTIN, POLITICAL CONTROL, AND ECONOMIC TURNAROUND | THE 2010s: PUTIN'S SECOND DECADE

Other BRICs still have relatively low-quality human capital economically speaking, although it should be added that their elite performers, even if a tiny percentage of the population, are now as world class as anywhere. In most emerging markets, much of the recent economic productivity and output gains have come through the application of financial and technological capital to a low-wage workforce, combined with more open international trade rules permitting profit generation from exports. Russia is different.

Russia is essentially a collapsed empire, struggling with its past, trying to rise from its ashes, and—it should be added—with means to do so. Unlike other BRICs, and similar to emerging economies in Eastern Europe, Russia’s human capital is extremely flexible and capable, particularly in mathematics, computation, and the sciences: a legacy of Soviet education and habits that may have atrophied somewhat, but is still substantial. Russia also has a modern history of technological development and scientific innovation (Chinese and Indian achievements pre-1800 notwithstanding), although it is only in recent years that those advances have been at all directed at or benefited the ordinary consumer. Poverty in Russia is real, particularly east of the Ural Mountains, but it is not nearly as severe and pervasive as poverty in the other BRICs.

Russia is an emerging market not for its historical poverty or access to technology, but because it has made a transition from a centrally planned to a market-based economy. It is primarily the recent adoption of markets, the rules that govern them, and the population’s experience in operating with them—the institutional software, as Tom Friedman describes it—that marks Russia as an emerging market. The recent availability of foreign financial capital has made technological improvements easier to deploy, and Russia’s comfort with foreign investment is an issue in some circumstances.

RUSSIA IN COMPARATIVE PERSPECTIVE

Table 1: Comparative Economic and Demographic Statistics

Russia-Table1

Table 1 shows key economic and demographic statistics for Russia, other BRICs, Poland (a fellow former east-bloc transitional economy), the United States, and Germany. Sources: Economist Intelligence Unit, Transparency International, Heritage Foundation, World Federation of Exchanges, CIA World Factbook, accessed September 29, 2011; and Freedom House, accessed October 19, 2011.

Russia’s GDP now places it within the top 10 world economies. In 2010, the International Monetary Fund (IMF) ranked Russia the sixth largest economy on a purchasing power parity basis, just behind Germany and ahead of the UK. Its long-term real growth rate, while less spectacular than many other emerging markets, has been comfortably above most of Western Europe and the US for the last decade. In per capita terms, Russia is the wealthiest of the BRIC countries by a wide margin, roughly on par with Chile and the US territory of Puerto Rico, but still behind the westward sections of Eastern Europe.

In population, Russia is the ninth largest country in the world, ranked just behind Nigeria and ahead of Japan by 2010 estimates. Its median population age is older than most emerging markets, older even than the US’. Literacy rates are at Western levels, especially in urban areas. Income inequality is less frequently measured, but the United Nations Development program’s R/P20% ratio (of national income going to the top 20% v. the bottom 20% of earners) shows Russia having inequality levels greater than most of Western Europe, but not substantially different from the US.

All of this shows that the challenges Russia faces are about access to technology or the productive capacity of its workforce; it is about the effectiveness of Friedman’s “social software,” or the ability of businesses to operate. This shows up clearly in the comparative statistics on institutional factors such as corruption, economic, civil, and political freedoms. Russia’s corruption rating is the lowest in the table by a fair margin, ranking it at levels similar to Congo and Venezuela. The Heritage Foundation’s Index of Economic Freedom puts Russia lower than any of the countries in the table, comparable to Syria and Argentina. Finally, the Freedom House’s index of civil and political liberties—commonly interpreted as a “democracy index”—ranks Russia as “Not Free,” with a combined average score of 5.5 on a scale of 1-7, ranking it closer to China (6.5) than to India (2.5) or Brazil (2.0) or even Poland (1.0).

For a country with Russia’s wealth, human capital, advanced technological capacity, and population, the institutional scores are surprisingly low by international standards. These make Russia more similar to oil-rich Gulf countries than traditional BRICs, except that its economy is even less open, and corruption levels are even higher.

THE 1990s: POST-SOVIET CRISIS AND ECONOMIC COLLAPSE

From 1991 to 1998, the Russian economy contracted by one-third to one-half in real terms. The exact figure is difficult to determine because data from the Soviet period are less reliable, but the contraction was nonetheless dramatic. The largest single segment of the contraction came from substantially lower fixed investments, but even ordinary consumption dropped by one-third, illustrating the pressures felt by the average consumer.

Figure 1: Growth of the Russian Economy in 2005 USD, 1990-2010

Russia-Figure1

Source: Economist Intelligence Unit, accessed September 25, 2011.

Figure 1 shows the contraction and growth of the Russian economy in real terms from 1990 to 2010. It reveals much and helps explain both the Russian institutional environment and public attitudes which create the permissive setting for corruption and increasingly authoritarian rule. Given that Soviet economic growth was driven more by increasing scale and throughput than by capturing productivity gains, and that much Soviet spending was military-focused, the true damage to Russia’s productive base from this contraction was likely low, and the drop likely set the stage for shifts to more productive investments later. But the effects on employment and wealth distribution were stark, and left large numbers of people brutally exposed.

Figure 2: GDP Growth, Inflation, and Interest Rates (2000-2010)

Russia-Figure2

Source: Economist Intelligence Unit, accessed September 25, 2011.

On top of economic contraction, monetary policy in the early 1990s produced inflation as high as 2500%. This was driven in part by Russia having assumed all of the Soviet Union’s foreign debt, but—with Ukraine and Belarus now independent republics—now having only half of the previous tax base.

Large sectors of employment disappeared, savings were wiped out, pensions earned over a lifetime rendered meaningless by inflation. Survival for many depended on the informal economy, black markets, and maintaining links to corrupt officials. By 1998, the economic situation became completely untenable, leading to default on government debt and devaluation of the ruble, and the discrediting of the existing government and its policies in their entirety.

With much of Russia’s middle class wiped out by unemployment and hyperinflation, only those with connections to foreign sponsors or domestic political apparatchiks were truly able to benefit from the conversion from a centrally planned to a market economy.

Russian society became vastly more unequal in terms of wealth and income in the 1990s, and previous party bosses formed the seeds of a new oligarchy. The features that today mar the Russian business environment—corruption, difficulties enforcing contracts, and the risk of intimidation (or worse) by the politically powerful—are as much a holdover from 1990s survival tactics as they are patterns remaining from communist and even Tsarist times.

The backsliding during the 1990s was so dramatic that it can be seen in Russian life expectancy figures, which dropped from developed to developing country levels. Men’s life expectancy was hit particularly hard, falling from 64 to 57 years (a 10% decline) at its lowest and recovering only recently. This is another key way in which Russia differs from the other BRICs. Most emerging markets have seen a more-or-less steady improvement in health demographics during their market transformations. Russia has not.

Figure 3: Life Expectancy for Russia v. other BRICs

Russia-Figure3

Source: World Bank, World Development Indicators, accessed October 20, 2011

The depth of the 1990s turmoil leaves many Russians doubtful of value of democracy and “soft” issues such as transparency, civil liberties, and rule-of-law. Many believe that these concerns were contributors to the horrors, “humiliations,” and the sense that the country was out of control in the 1990s. Whether true or not, the current leadership has fully encouraged this interpretation.

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THE 2000s: VLADIMIR PUTIN, POLITICAL CONTROL, AND ECONOMIC TURNAROUND

Vladimir Putin is the personality that has dominated Russian politics since 1999, having assumed power as acting president on Boris Yeltsin’s New Year’s Eve resignation. A former Soviet KGB/Russian FSB operative, Putin had already distinguished himself as Yeltsin’s prime minister by bringing Russia’s first lasting successes in the Chechen separatist war and was thus popular with Russian voters.

In his first year, the explosion and sinking of the submarine Kursk, with the death of all aboard, caused international embarrassment for Russians, who widely saw it as a symbol of their decline in world stature. Putin publicly vowed to restore Russia to its former world prominence and redress the “humiliations” of the 1990s. These goals have guided Russian priorities, economic and political, ever since.

In practice, this focused Russian policy on the need to 1) rebuild Russia’s military and power projection capability, 2) crush separatist and other sizeable dissenting movements such as Chechnya’s, and 3) strengthen the state’s authority to act, while 4) ensuring the state has the fiscal means to execute the above.

These goals are popular with ordinary Russians, who tend to think that their proudest moments took place under strong centralized rulers and that Russia’s decade of democracy in the 1990s was a disaster. On balance, although they shy away a return of Communism, most Russians seem willing to tolerate significant restrictions on civil liberties, as long as they retain rights to travel and emigrate, if necessary. As a result, there is little drive for more democratic processes, and the environment is made fertile for corruption, populist leadership along Latin American patterns, and weak rule-of-law.

In this context, Russia’s effective nationalization of the oil and gas industry in the 2000s is more understandable. It is not a return to the communist doctrine of a state-run economy, or the even the random acquisition of profitable businesses. Rather, oil and gas nationalization is a mechanism to secure the solvency of the Russian state, fund rearmament, and provide international leverage over European consumers of Russian energy in order to orchestrate Russia’s reascendence as a great power. Creating, appeasing, and manipulating groups of oligarchs is the method of achieving these goals, but it is not the purpose of them.

Putin’s economic doctrine posits an important role for the state alongside the private sector for protecting, seeding, and promoting “strategic sectors,” defined as sectors key to Russian national security. In practice, these are industries connected to the military, natural resource extraction (mining, energy, and fisheries), and the media. Foreigners, in particular, are limited in their ability to obtain controlling stakes in those industries, and the state reserves the right to intervene readily.

The manner in which firms such as Yukos Oil were brought under state control makes investors think twice, and contributes to Russia’s low valuation ratios. In 2004, the government froze Yukos’ assets, reassessed their tax obligations to amounts larger than their revenues, placed the firm in bankruptcy, and then bought their assets at substantially reduced prices, convicting key officers of tax fraud and murder. Most Western observers have tended to believe that the charges were trumped up and politically motivated, particularly since the bankrupt company ended up squarely in the hands of the state.

Putin was able to nationalize companies in part by appealing to Russian nationalism and mistrust of foreign economic motivations, while still billing the acquisition as an anti-corruption, anti-oligarchy action. In reality, the move represented the elevation of one oligarchy—connected to the state—over others, typically connected to foreign capital.

Russian economic growth under Putin rocketed through most of the 2000s, averaging over 5% annually, and with several years in the 7.0–8.5% range. This is a massive improvement over the 1990s experience, strengthening Putin’s popularity and legitimacy among Russians, and ultimately his control. High global energy and commodity prices fueled much of this growth, but declining inflation, more stable fiscal balances, and an overall improved economic environment for investment and consumption also helped non-commodity industries to profit and grow. Luxury and real estate were particularly profitable sectors as ascendant oligarchs sought ways to spend their growing wealth.

Russia’s economy is widely known to be closely linked to commodity prices, making it prone to booms and busts. The 2008 commodity collapse and financial crisis definitely hit Russia harder than most emerging markets, but it recovered readily afterwards. Russia is diversifying its economy, particularly in areas such as high-end software services, nanotechnological materials, and biomedical research. The concentration of wealth impedes trickle-down effects, but the quantities are large enough that some profits are able to find their way across the economic spectrum.

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2010s: PUTIN'S SECOND DECADE?

Putin was constitutionally ineligible for a third consecutive term in 2008. Dmitry Medvedev ran for election in his place, promptly appointing Putin prime minister after taking office. Over the last three years, Medvedev has officially held the Presidency, but the two have ruled more or less with the same agenda, and Putin was widely seen as more-or-less the Russian “Godfather.”

With Medvedev’s recent announcement that he will not seek a second term, the path now is open for Putin to retake the presidency again, and his campaign has already started. As of now, there are no significant challengers, although Putin’s supporting party, United Russia, may well lose legislative seats, making it more difficult for him to control the legislative process. The stage is basically set for policy continuity, and the economic outlook is reasonably promising, given continued energy and materials demand from China. Recession in Europe remains a threat, but likely a manageable one.

Continuity, however, also means that government and corporate transparency will continue to be murky, and continued corruption creates many opportunities for surprises, risk, and company managements to take advantage of investors. Putin has said in his campaign that corruption and state waste is a discussable issue, but not a central one. Russia’s attitude towards foreign investors also appears inconsistent, even if it does appear to be gradually warming to foreigners again. It is also highly unclear how Russia might evolve should anything unfortunate happen to Mr. Putin; presumably, Mr. Medvedev would be the best suited to take up the mantle, but he would certainly not go unchallenged.

Russia is clearly different from the other BRICs. It has developed country human capital and developed country technology, but is also developing country institutions and developing country risks. Additionally, it is the one BRIC that seems to be steadily deliberalizing. Even China, more authoritarian in absolute terms, appears to be searching for ways to liberalize “safely.” Russia is the one BRIC that is clearly moving in the opposite direction.

For now, the state finances itself through its control of natural resources, particularly energy exports, and that has provided stability and independence of the sort seen in Persian Gulf countries. The society is more open than Gulf regimes, and recent economic performance has been good, and so the outlook is stable. But how might Russia react to an extended period of low commodity prices? Would the population be content to abide deep inequities and levels of corruption during periods of economic contraction? This is not our baseline scenario, but when institutions are highly personalized and the rule-of-law is shaky, it is still an important case to consider. Russia’s future is still bound up in the fate of its strongman, and—in historical Russian style—the hope that he governs well.

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–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Consulting, an independent consulting firm specializing in quantitative, emerging-market, and SRI research and strategy.

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