TCS Daily

Putin's Real Reforms

By Constantin Gurdgiev - June 16, 2005 12:00 AM

Last week, after a half-year long absence, the daily tribulations of the economist's academic life brought me back to my birth-city, Moscow. Below the usual kitschy glitter of casinos, amid the torrents of Mercs and BMWs, framed by the reflections of the impossibly azure skies in the spotless windows of fashionable boutiques, in the everyday streets of the old city-centre there was something distinctively new in the air. A friend of mine, owner of a successful film production company -- a business built from scratch, not acquired in a shady deal of the Yeltsin's era privatizations, summed it up in a sentence. "You see", he said, "we are finally discovering what it means to own real property."

In his world -- the world of a Muscovite professional -- this meant that the city's middle class has finally broken through the cocoon of insecurity; it started earning and spending money. The results are impressive: a real estate boom, up until recently largely the domain of the wealthy, spread throughout the ranks of professionals. On the weekends, basking in the late May sunshine, Moscow appears nearly deserted with crowds of city-dwellers leaving for their dachas. Russian consumer markets are growing in strength in tandem with disposable income; last week the Russian advertising industry forecast an $8.5 billion budget for the adverts in 2005. Car sales are up 12 percent on the last year. All of this translates into Moscow finally becoming a warm, self-confident city after the years of turmoil and uncertainty.

Persistence of Myths

Vaclav Havel, playwright, philosopher and the first post-Communist president of the Czech Republic, once famously remarked that a country becomes a true democracy only when the foreign press is left with no news to report. By Havel's measure, Russia is far from completing its transition. Since the May 9th Victory Day celebrations, the country appears to be in the vortex of a journalistic maelstrom as Russian foreign and domestic politics are making front-page news around the world on a weekly basis. The latest stories focus on Messrs. Khodorkovsky and Lebedev, co-defendants in the Yukos trial. With all this attention, it is easy to confuse myths with facts.

Even professional analysts cannot agree in their assessments of the direction that Russia is taking both domestically and globally. A growing group of international observers subscribes to the idea that Russia is a model of middle-income country with strong economic growth and improving standards of living. These "believers" see Russian enterprises gaining in competitive strengths, the legal environment becoming normalized and a pluralist society attempting to reconcile the need for law and order with respect for human rights and freedoms. At the opposite side of the spectrum, a large number of "contrarians" claim that over the last four years reforms and privatization have slowed down, income inequality is rising and the economy is becoming more dependent on exports of oil, gas and other raw materials. The latter category includes most of the western press and political and social pundits.

These differences in opinion reflect divergent approaches to understanding Russian reality. While the believers tend to underestimate qualitative signals from Russia's political and social developments and overemphasize statistical data, the contrarians tend to romanticize Russian nature, seeking to find some trend in every event. Thus, the Yukos Affair becomes a prelude to a full-scale monopolization and nationalization of Russian businesses. The Kremlin's support for a pro-Russian presidential candidate in Ukraine becomes a sign of an unfolding Cold War II. Last month's stand off between Russia and Latvia on border disputes was immediately interpreted in Europe as a natural extension of the rekindled Soviet imperial ambition. President Putin's decision to end elections for the regional governors, replacing the polls with appointments from the Kremlin, is trumpeted as a sure sign of authoritarianism's return. Slower and less popular reforms in economic and social spheres are viewed as the power consolidation by the anti-reform ex-KGB apparatchiks. These are the main myths repeated ad nauseam in our press and policy circles, the myths that dominate the EU's approach to Russia.

Defiant Reality

Yet, Russian reality defies both the contrarians and the believers alike. Take for example financial markets. In 2004 the Russian balance of payments surplus was $60 billion, while the Central Bank Foreign Exchange reserves reached nearly $125 billion. Over the same year, the Russian economy grew at 7.1 percent, foreign direct investment doubled, foreign debt fell by 60 percent relative to 1998. Last week, Russian Finance Minister Aleksey Kudrin announced early repayment of $15 billion, or approximately 1/3 of total Russian debt to the Paris Club. According to Deputy Finance Minister Sergey Storchak, further repayment is expected by the end of 2005. Instead of rewarding Russia for exemplary fiscal and monetary performance, international markets saw a significant increase in the risk premium on government bonds (GKOs), although the risk premium on the GKOs was still approximately half of the average risk premium for the government bonds of the developing countries.

In terms of privatization, Vladimir Putin's administration auctioned off only a small share of economy, some 0.3 percent, or 100 times less than his predecessor. However, Putin's privatization netted the state nearly four times more in revenue - over $4 billion. Yukos was a sole example of the state reversing previous privatization results. But this reversal was incomplete: instead of merging the purchaser of Yukos' assets, Rosneft, with the state-controlled Gasprom monopoly, Kremlin left Rosneft alone. By the end of the year, according to Moscow plans, Rosneft will be floated at the stock exchange (with the state retaining majority share). Both, Rosneft and Gasprom will see lifting of restrictions on foreign ownership of their shares, forcing the two companies into direct competition with each other. State take-over, Russian-style, implies competition and independent management with foreign and domestic private participation.

It is equally wrong to regard Putin's administration as a supporter of entrenched state-owned monopolies. In fact, by the end of 2004, the last year of Vladimir Putin's first term in the office, the number of small businesses in Russia grew by 10 percent. Some of observers point to the fact that although numerous in numbers, Russian small businesses employ approximately 20 percent of the Russian labor force (as opposed to approximately 50-60 percent in the developed economies). However, the true numbers of employment in the cash-driven small business sector are hard to measure, given the widespread tax evasion. What is clear, however, is that the Kremlin is bent on pushing with the private sector reforms and the country's executive branch of government has fully embraced the need for protecting private property rights and reducing bureaucratic interference in economy.

Similarly, popular beliefs that Yukos trial was motivated by politics and/or a desire to reverse past privatizations are gross oversimplifications of reality. In fact, contrasting the Western near-hysteria that surrounded the auction of the former subsidiary of Yukos, Yuganskneftegas, labeled from the beginning a beginning of mass nationalization of Russian economy, Vladimir Putin consistently reiterated his belief in private sector-driven economic model. This belief was time and again tested during the last year. For example, in comprehensive review of Russian Privatization Policies, 1993-2003, the State Audit Chamber found multiple violations of laws by both the entrepreneurs and state officials. Despite this, the document explicitly states that such legal improprieties in acquisition should not be seen as a justification for re-nationalization of property.

Leaving Yukos Behind

Instead of triggering a wave of de-privatization, as predicted by the opponents of the Putin administration, hard data show that the Yukos affair had the intended effect of tightening tax compliance among the major oil producers. Year on year, effective corporate tax rates paid by Russia's five oil majors increased from 8.4 percent in 2003 to 33 percent in 2004. At the same time, foreign capital inflows went from around $23.5 billion in 2002 to $60 billion in 2004, while capital outflows averaging $20 billion per annum in 1998-2001 decreased to $6.6 billion on average per annum in 2002-2004. Strong growth in foreign direct investment (from $8 billion in 2003 to $13 billion expected in 2005) also indicates that both the global financial markets and domestic entrepreneurs have largely ignored the dire predictions made in the press over the Yukos affair.

Ironically, both supporters and opponents of Putin forget to mention that before Yukos other oil majors, such as LukOil, faced similar back-tax charges, which were settled by the companies. Last year, Sibneft - owned by Roman Abramovich - was audited by the Russian authorities. The audit found that the company used legal loopholes to obtain tax reductions amounting to hundreds of millions of dollars every year. Since the loopholes were legal, the auditors advised the state not to take action against Sibneft, but to address some of the unproductive parts of the tax code. Currently, in part as a result of Sibneft audit, Russian authorities are considering introduction of differentiated rates of taxation on oil producers, which will reflect various differences in oil fields' quality and technologies employed in production. A much-needed revision of the code to include tax incentives for secondary and tertiary extraction, a standard practice in the West, may finally become a reality in Russia.

Reforms Redux

Putin's record of reforms is equally misunderstood outside Russia. Under Boris Yeltsin, the Kremlin favored bombastic, larger-than-life projects -- wholesale, rushed through privatizations carried out in the context of lacking private resources for proper pricing and legal structures for ownership. In contrast, the current administration prefers a more pragmatic, managerial approach. Thus, in 2004 alone, Putin ushered in substantial changes in banking, introducing a comprehensive system of deposits insurance. Previously prohibitive tax on salaries was lowered to 26 percent, triggering an immediate increase in the state tax revenue due to improved compliance. New legal codes, drafted to ensure creation of the markets for long-term mortgages, economic stabilization fund financed by oil and gas export revenues and maligned, but timely and important reform of social welfare system - all were introduced in 2004-2005.

In addition to legal reforms there are changes in market regulation pertaining to the state monopolies. Starting on April 15, 2005, Siberia joined Moscow and St. Petersburg by deregulating electricity markets and it is expected that by 2005 some 5 percent of Siberian electricity will be freely traded. In fact, deregulation of Russian electricity markets precedes our own market liberalization by over a year.

Even more ambitious plans are set for the second half of the year. According to the latest information, Putin set September 1, 2005, as the date for introduction of ambitious new legislation that will see abolition of inheritance tax, normalization of tax inspections, streamlining currently Byzantine property rights for small holdings of private land and structures.

All of this warrants a simple conclusion. Despite the press obsession with finding trends and connections from Russian present into the Soviet past, modern Russia is a complex society with established and functioning political structures, markets and legal system. It is a society facing large challenges in the years ahead and in the need of continued reforms, but he cause of such reforms is unlikely to be well-served by a one-sided approach of seeing a shadow of the past in everything that Moscow does today.

The author is a Lecturer in Economics, Trinity College Dublin, and a Director of the Open Republic Institute, Dublin


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