An investment wonderland? Reality checks

(www.opendemocracy.net – Pavel Usanov – January 11, 2013)

Pavel Usanov is head of the Hayek Institute for Economy and Law in St. Petersburg and Reader at the Higher School of Economics.

Since the collapse of the USSR investors have flocked to Russia, tempted by the high rates of return and the Alice in Wonderland atmosphere in Moscow, where everything seems possible. But the Russian business community has rather less faith in the future promised them by their government, says Pavel Usanov

The aphorism ‘Russia will never be as weak ­ or as strong ­ as she appears’ has been attributed to Talleyrand.

In the 90s the state of Russia’s economy seemed very woeful indeed, especially in the light of what was happening at the time in the economies of Europe and the USA. Now Russia’s reinstated imperial ambitions and the rapid growth of her economy look like a breakthrough to scaling new heights, especially in the context of the global problems in the EU countries. At times it seems to observers that the current situation in Russia is characterized by a strong leader who ensures continuing growth in the prosperity of his citizens, while at the same time maintaining political stability and the standing of the country in the world.

A spending nation

But if observers previously underrated Russia, the likelihood is that now they will over-rate it. Nowhere is this more true than in matters of the economy and investment environment.

Russia is a country with a very young market economy, only just over 20 years old. Western countries, unlike Russia, have a much longer history of functioning capitalist institutions. They have learnt enough from their mistakes to develop rules which allow for the preservation of a stable and prosperous society. In Russia, it’s another story. She still not managed to establish the institutions of a market economy, mainly because the policy of liberalization at the time of transition to the market was not carried through with any consistence. An additional point is that the low growth rates are a function of the anti-capitalist mentality so typical of many Russians.

The situation is paradoxical: Russians have become considerably better off than they were in Soviet times and have many more opportunities, but the market economy continues to be regarded unfavourably, which generates continuing reliance on a strong leader and a demand for paternalism.

In Europe, the concept of the Welfare State has existed since Bismarck’s time, and in the US, since Roosevelt. This model was unknown in Russia, but now she is trying to copy what is already disintegrating in Europe. The Russian version of the Welfare State sees the government’s role in the economy increasing, archaic institutions being preserved and no strong rule of law.

It is well known that in the international rankings Russia is very far from first as regards her public institutions. The World Economic Forum’s Global Competitiveness Index, for instance, ranks Russia in 122nd place for independence within the judiciary, 124th for political transparency, 133rd for protection of the rights of the individual and 133rd for trust in the police. In the West the Welfare State is linked to the strong rule of law, but increasing government interference in the economy in Russia has not been conducive to the strengthening of public institutions.

In recent years the Russian government has developed plans for considerably increased expenditure in all the significant areas of the economy: from re-arming the army to conquering Space, from holding the World Football Championship in 2018 to increased pensions and public sector salaries. This will all mean a ballooning of the bureaucracy, and the various influence groups will redouble their efforts to devise ways of extracting (unearned) income from any situation. Data for Russia show that for every 1000 people there are 110 officials; in OECD countries the average figure is 75, in Brazil it’s 45 and in South Korea only 29.

Europe is currently investigating new ways of reducing expenditure by cutting public sector salaries and privatizing state property, but Russia is going the other way.

The EU is tightening belts, but Russia is encouraging ever more consumption, and of the most expensive goods too. Not many people from developed countries could afford such purchases. Does this mean that Russia’s level of development and the quality of her public institutions have outstripped Western countries? That the investment climate in Russia is extremely favourable for both foreign and domestic investors?

It doesn’t, because investment remains Russia’s biggest problem. Since 2008 the capital outflows have amounted to more than $380 billion and are still continuing, in spite of the extremely high oil prices. One of the reasons for this is the increasing tax and administrative burdens being laid on small and medium businesses. The tariffs are going up because the government needs funds to pay for its colossally expensive projects, and taxes are its main source of revenue. Tariffs for the natural monopolies have also been raised considerably and there are plans to increase duty on alcohol to 36%.

The future of business in Russia

Sociological research by PwC shows that 57% of owners of businesses in Russia intend eventually to sell their companies; for the rest of the world the average figure is 17%.  Only 10% of respondents are intending to pass their business on to their children, whereas the average figure for the rest of the world is 25%. This is an indication of the Russian business community’s uncertainty that they will be able to protect their property in the future. They are also disturbed by changes in the pension system. The accumulated benefits system, which was introduced some time ago, has all but collapsed, resulting in a return to the system of pay-as-you-go pensions.

The government is trying to get salary levels nearer to world standards, not by increased productivity, which is only 32% of US productivity rates, but by adjusting the minimum wage down to a minimum. The minimum wage in Russia is currently $197, in the USA it’s $1256.70 and in the Netherlands $1622.10, or 8 times more than in Russia. If the minimum wage is increased at the expense of capital and the business community, the economy will not grow, but unemployment and capital outflows will.

Another factor making investments in Russia less attractive is the State Anti-Monopoly Service (SAMS). There have been 3197 cases charges brought for abuse of a dominant market position, which is more than in all the countries included in the rankings of anti-monopoly services. The annual figure for the USA is 7 and for the UK 3, so the SAMS is not protecting the consumer from monopoly prices so much as damaging business prospects.

Civil servants initiate new Cyclopean projects, relying on the stability of the favourable market conditions to enable them to go on stealing money from the budget under the pretext of making important investments. But Russia does not have enough reserves of capital for hugely expensive projects, so one day it will become all too clear that the economy has insufficient resources to complete all the projects that have been started, that the investments were a mistake and no benefits can possibly accrue to society from them. The revelation of which investments were erroneous is only a matter of time, but the bigger the gap between ambitious plans and real resources, the nearer the end of the mega-projects.

What next?

Russia is country with a falling birth-rate, so the amount per head of the population that the infrastructure is swallowing up just to replenish its capital is permanently on the increase. If funds are used for production, which will only provide consumer opportunities in the distant future, rather than for consumption today, the existing infrastructure will simply collapse in the very near future. In actual fact, it’s already happening with the heating system for housing in St Petersburg, where there are regular large-scale accidents when the underground pipes that bring hot water to the buildings burst.

This trend is unlikely to change because the Russian elites are only interested in the budget being used for their purposes. They will never voluntarily renounce their privileges; financial discipline will deteriorate, state investments will continue to displace private money, and the public sector contributions to GDP will only increase. The only thing that could bounce the system out of this situation would be an external shock, which would force attention on to the economy. Until this happens, the consumer boom, stimulated by expanded credit facilities, will continue to convince the elites and the people of the wisdom of the Welfare State model à la Russe.

Article also appeared at http://www.opendemocracy.net/od-russia/pavel-usanov/investment-wonderland-reality-checks bearing the following notice:

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