Not what the doctor ordered

Two major reports on the Russian economy were published in November by the EBRD and the World Bank. Both reports make similar diagnoses and offer the same prescriptions for Russia’s ills.

Russia has not escaped the worldwide financial crisis. The stock market collapse saw $1 trillion wiped of the value of Russian companies. The non-oil external current account deficit increased to almost $62 billion in third quarter 2008. Gross capital inflows declined by 40 per cent over the last year. The global and domestic liquidity crisis and tumbling commodity prices have led the World Bank to revise down its growth forecasts for Russia in 2009 from 6.5 per cent to 3 percent. This calculation was based on an average oil price of $100 barrel for next year. Today, the price stands at $50 barrel. So Russia will almost certainly experience negative growth next year.

There is a chain reaction. The general meltdown in capital markets has reduced capital inflows which have dried up syndicate lending and the bond market just as the fall in commodity prices, which has resulted in a drop in export receipts, has increased external refinancing needs. Higher risk and slower growth feed back into the financial sector lowering confidence further.

Russia’s performance has not been too bad relative to other transition economies, including recently-joined EU members like Poland. The World Bank contends that Russia’s short-term macroeconomic fundamentals are strong. It applauds the Russian government’s response to the crisis as ‘swift, comprehensive, and coordinated’, and argues that the crisis presents an opportunity to combine short term policy responses with long term measures that ‘would ensure that Russia emerges from this global crisis with a stronger basis for dynamic, productivity-led growth.’

This is the problem. The main ingredients of economic growth are high investment in education, and a high level of competition. Further, countries successful in export markets, especially in non-commodities, tend to grow faster than others.

Unfortunately, Russia has not yet succeeded in developing new, higher-value manufacturing industries and is still deeply reliant on fuels and raw materials. There are, as there have always been, two choices for its industrial policy. The first is a horizontal policy, based on state intervention directed at the environment in which firms operate: investment in education and human capital, better access to finance for SMEs, support for innovation, and improving government services and legal frameworks. The second is a vertical policy where state intervention is used to promote particular sectors and firms. The two reports naturally favour the second strategy.

They provide the typical prescriptions which modern economics think suitable for any developing economy. They rarely ask why Russia has been so slow to adopt their policies. Economics is a science of incentives, but economists offering policy advice often conveniently forget about incentives for governments to act the way they suggest. The crisis will concentrate minds in the Kremlin, but there is no guarantee that this focus will be in the direction favoured by the World Bank and the EBRD. The Russian government largely failed to use the good times to diversify the economy, clean up banking system, reform capital markets, strengthen property rights and establish rule of law. Why should it start now?

Russia is a country with a turbulent past, entrenched local elites, huge territory, grand political ambitions, and a government that is often dysfunctional. What economists call ‘governance’ is its major problem. Until progress is made in this area the two reports will be so much more hot air.