A “SOVIET SANDWICH” FOR MR. PUTIN?

By Stefan Hedlund

At long last, the Russian economy appears to have emerged out of the red. We are presently looking at a fifth straight year of positive growth in GDP, at a fourth of surplus in the federal budget, and at a third of immaculate performance on debt service. To some, this is conclusive evidence that Russia has indeed finally turned the corner, and that we may now look forward to sustained growth and a broad integration into the world economy. Others would contest that view, pointing at serious risks of a growth slowdown.

What is really at stake here, however, is not whether economic growth in this and the coming years will be in the 4-5 percent range that the Russian government can reasonably expect–still less the 8 percent that President Vladimir Putin called for in his recent state of the nation address. The real cause for concern is related not to growth rates over the next few years, but to a set of negative structural features that are presently emerging–even as the economy “recovers,” as measured by GDP growth rates–and that may prove hard indeed to remedy in the future.

Since the link between the present and the future will proceed via investment, that is where we must start looking for signs of long-term trouble. Given that fixed capital investment had dropped by more than four-fifths during the Yeltsin years, once the post-crash recovery set in there was one crucial question to be asked. Would the rebound also be accompanied by serious levels of new capital formation?

In 1999 and 2000, with fixed capital investment increasing by, respectively, 5.3 and 17.4 percent, the answer seemed to be encouraging. In 2001, however, the rate of increase dropped off to 8.7 percent, and for 2002 it fell back to 2.6 percent. The latter numbers are particularly discouraging if viewed against the background of the boom in the energy sector, and it is not much comfort that early developments in 2003 indicate a renewed upturn.

Following a protracted period of stagnation, with output levels hovering around 6 million barrels per day (bpd), Russian oil production has now been rising for five straight years in a row. It presently stands at 8.2 million bpd, and the outlook is for 10.8 million bpd by the end of the decade. Add to this expansion in output that global oil prices have also been unusually high, thanks to the Iraq war, and we have the makings of a real bonanza.

Over the past five years, the Russian economy has generated an accumulated trade surplus that comes to US$208 billion. This has caused the Central Bank’s currency reserves to balloon from US$11 billion in 2000 to US$61 billion today. While this helps explain why there has been no further trouble with foreign debt service, it makes the absence of a boom in investment even more puzzling.

A closer look at the numbers will tell us that in recent years the energy complex and the transport sector, the latter being mainly pipeline construction, have absorbed close to half of all investment in the Russian economy. The main reason is that Russian capital markets remain incapable of providing serious finance for productive investment in the real sector of the economy. Enterprises’ own funds provide close to half of all fixed capital investment, leaving bank credit to account for an insignificant proportion (4.3 percent in 2002).

Since it is in the energy sector that we will find the serious profits, it is hardly surprising that this also has been where we find serious investment. The main problem with such development is that it forms a vicious spiral, making for a steadily growing dominance of the energy complex, and of its dynamic young executives.

Among Moscow brokers and financial analysts it has become fashionable recently to speak of the Russian economy as a “Soviet Sandwich,” the consumption of which may seriously damage your financial health. The logic is that we have two pieces of fresh and appetizing bread. The top one is the energy complex, and the bottom one is the equally vibrant private sector of small start-ups, which has attracted a good deal of justifiable attention. Wedged in between, however, we may find a decaying filling of Soviet-era manufacturing industries that nobody wants to touch.

As is often the case with striking metaphors, it contains a strong element of truth. In order to illustrate, we may bring in some concepts from the work of political economist Oliver Williamson, who studied the evolution of capitalism in the West. He suggests three different ways in which economic transactions can be structured–spot-market trading, long-term contracting, and a permanent hierarchy (such as business corporations, or state agencies). He argues that neither spot-market nor hierarchical transactions will need much support from an independent rule of law: “Disappointed spot-market traders can easily limit their exposure and can seek relief by terminating and turning to other traders. And internal organization is its own court of ultimate appeal. By contrast, transactions in the middle range can be difficult to stabilize.” [1]

Williamson’s main point is that a failure to organize the judiciary in “an informed and uncorrupted manner” will lead transactions in the middle range to gravitate towards one or the other of the polar extremes: “The upshot is that the quality of a judiciary can be inferred indirectly: A high-performance economy (expressed in governance terms) will support more transactions in the middle range than will an economy with a problematic judiciary. Put differently, in a low-performance economy the distribution of transactions will be more bimodal – with more spot-market and hierarchical transactions and fewer middle-range transactions.” [2] Williamson’s work echoes that of U.S. economist Mancur Olson, who stressed “the crucial role of enforceable rights” in facilitating business transactions in this middle range between spot markets and hierarchies. [3]

The logic of the argument is that increasing gravitation towards the extremes of the bimodal distribution will be associated with a reduced pressure for structural reforms that support what Olson called “property-rights intensive” production. As a result, the economy risks being trapped in a low-performance equilibrium, with no societal pressure to produce a system of rule of law with a truly independent and effective judiciary.

The applicability to Russian realities is not perfect, but still suggestive. While parts of the energy complex are indeed moving toward contraction, it is overwhelmingly hierarchical in terms of providing its own finance from sources internal to each organization, and in securing government patronage. Above all, the barons of the energy complex are quite capable of handling their own contract enforcement, if need be with the assistance of “Comrade Kalashnikov.”

The “filling” in the Russian sandwich–that is, the vast majority of farms and industrial plants–also remains strongly hierarchical, as was all Soviet industry. If it is to win success in a functioning market environment it must move towards property-rights-intensity, but the prospects for this look rather grim. The managers of the small start-ups, finally, will be left to fight their own battles, without benefit of either long-term contracts or hierarchies, which reduces their prospects for growth and the long-term investment that would enable them to reap economies of scale.

In a comment on the “sandwich” theory, Peter Lavelle captures what is perhaps its most important implication, namely that “the filling is the state and most of the politically homeless electorate from the Soviet period.” As the wealthiest stratum of society derives its vast income from the natural-resources sector it does not have much of a need for the rest of society. Its “primary concern is manipulation of the state to get on with its business and, even, political concerns. It can stand on its own and is quite content with the status quo.” [4]

There are two sets of conclusions to be drawn from these observations, one relating to the economy and the other to the sphere of politics. Beginning with the former, we are presently witnessing a Russian economy that is becoming ever more dependent on energy exports, and which will thus also become increasingly vulnerable to recurrent bouts of “Dutch Disease.”

During periods of high oil prices, the currency will appreciate in real terms, which in turn will cause a great deal of damage to non-energy exporters and to domestic import-competing producers. When oil prices come down, the latter, representing the “filling” of the “sandwich,” and having been starved of investment, are able to rebound only up to previous capacity levels. This is why the current rebound is so fragile, and so intimately linked to fluctuations in the price of oil.

In the realm of politics, we must question the frequently expressed view that the oligarchs of old have now been transformed into benign “magnates,” bent on lobbying for better corporate governance and investor protection.

It may certainly be the case, as proven by Mikhail Khodorkovsky and his Yukos concern, that some of them presently find it to be in their own best interests to deal more honestly with foreign investors. If that laudable change in attitude were to gain in prominence it would surely be all for the better. It would not, however, remove the fact that they remain quite capable of doing without a functioning public judiciary.

The growing might of the energy complex, and the growing dependence of the government on raising taxes from that quarter, will make for a continued symbiosis of power and money. And that will leave the bulk of the population and the remaining sectors of the economy to fend for themselves.

As the “sandwich” continues to rot from within, the plight of those who depend on its increasingly putrid filling will also continue to deteriorate. Unless the Russian government moves decisively to break this trend, it will in the end be up to demography, in the most brutal fashion, to absorb the consequences.

Stefan Hedlund is a professor of economics at Uppsala University in Sweden and the author most recently of Russia’s Market Economy: A Bad Case of Predatory Capitalism (London: UCL Press, 2000).

1. Williamson, Oliver E. (1995), “The Institutions and Governance of Economic Development,” Proceedings of the World Bank Annual Conference on Development Economics 1994, Washington, DC: The World Bank, p. 181.

2. Ibid., pp. 181-82.

3. Olson, Mancur (2000), Power and Prosperity: Outgrowing Communist and Capitalist Dictatorships, New York: Basic Books, p. 186.

4. Lavelle, Peter (2003), “Can the ‘Soviet Sandwich’ Really be Edible?,” The Russia Journal, February 14-20, 2003 (cited from Johnson’s Russia List, #7065, February 17, p. 2).