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Tuesday, November 16, 1999 copyright The St. Petersburg Times 1999 Official: Reforms in Post-Soviet Russia Failed, Says Report After a dramatic and often murky decade of attempts at change, Russia is a long way away from becoming a market economy, according to a survey just out. Melissa Akin reports. RUSSIAS various attempts at reform have resulted in a poorly-governed, inegalitarian, corrupt and economically backward country, one where a growing proportion of the population lives below the poverty line. Thats the grim picture that emerges from a report just released by the European Bank for Reconstruction and Development, "Transition Report 1999." Over the 10 years since the Berlin Wall came down, Russias Gini coefficient - a standard measure of inequality - grew faster than almost every other country in the former Soviet bloc. And on the EBRDs transition indicators index, Russia is one of just five countries - along with Kyrgyzstan, Uzbekistan, Kazakhstan and recidivist Belarus - to have regressed. These countries recorded a negative change in transition indicators, a measure of progress in core aspects of reform - markets and trade, enterprises and financial institutions. In the early 1990s, a plan for swift liberalization and mass voucher privatization programs looked to be taking Moscow in the right direction, according to the EBRD report. However, the EBRD - which was set up by European governments to boost private investment in transition economies of Eastern Europe - says that the reforms were hijacked by self-serving individuals at the very start. The consequences have been disastrous. While the patchy nature of Russias reforms presented a small elite with the opportunity to make millions of dollars, the rest of the population have seen their standard of living plummet. "Before the transition began, the centrally planned economies enjoyed a relatively egalitarian distribution of income, compared with developing economies," the report says. "During the transition, however, income differentials have widened considerably. This is most notably the case in Russia, where inequality is now comparable to that in some of the most unequal Latin American countries." FRACTURED MARKET Russia now has some of the trappings of a market economy thanks to the privatization process and several other reforms. Indeed, 70 percent of Russias Gross Domestic Product is produced by the private sector. Thats a greater level of privatization than exists in some potential members of the European Union, including Poland. But the problem is that simple headline figures such as these tell only part of the story. In any country, the private sector does not function in a vacuum. It depends on a legislative and economic framework whose parameters are to a large extent set by the government sector. And in Russia, the government has done an appallingly bad job at fostering an attractive business environment. The country had the fourth-worst governance rating in the EBRD report, ahead of only Romania, Kyrgyzstan and Moldova. The EBRD rating was compiled from a poll conducted by the EBRD and the World Bank of 3,000 businesses in 20 countries across the former Soviet bloc. The firms were asked to rate the states performance within the country where they were based according to four areas - macroeconomic performance, microeconomic performance, infrastructure and legal framework. In many ways, Russia had ended up with the worst of both worlds, according to the report. For example, Belarus is rated significantly above Russia. While that might surprise many observers familiar with the capricious authoritarianism of Belarus President Alexander Lukashenko, the EBRD explained the better rating by saying that Minsks unreformed state controls are at least capable of keeping the lid on vested interests. In contrast, Russia went halfway, removing state controls but failing to institute and enforce clear regulations to take their place. Countries such as Russia, "that have introduced partial reforms have begun the process of dismantling the states capacity to govern the economy according to the requirements of the command system without developing the new institutions on which a market based form of governance could be established," the report says. STUMBLING IN Drawing a direct contrast to Poland, which has begun to emerge as the new powerhouse of Eastern Europe, the EBRD says that the so-called shock therapy approaches of acting Prime Minister Yegor Gaidar in 1992 and of Privatization Minister Anatoly Chubais in 1993 through 1995 acted to hobble Russias chances of economic growth. Sold at the time as bold, radical programs, liberalization - and later, the loans-for-shares privatization scheme of 1995 - were in fact deeply compromised from the start. l In Russia, the early liberalization of prices was patchy and inconsistent and offered scope for enrichment by the few who had access to the levers of power, the reports introduction reads. The privatization process, and particularly the notorious loans for shares scheme of 1995, offered scope for further concentration of wealth and income through manipulation by those who had benefitted from the defects of the liberalization earlier in the decade. Together, flawed liberalization and privatization left enormous power in the hands of a few oligarchs. Neither Gaidar nor Chubais responded to repeated requests for comment on the report. However, several economists defended the pairs actions, saying that their principles were sound. The reformers "faced a choice of privatization or no privatization," said Paul Reynolds of the Adam Smith Institute in London. "No privatization at all would concentrate more and more wealth in the hands of a few. At least this held out prospects of some dispersal of ownership." But the new elite - little more than the old elite in capitalist disguise - had little interest in institution building and sound business practices, the EBRD says. Instead, they played by their own rules, championing reform when it suited them and using their influence however they could to hold it up when it threatened them, the bank said. l These vested interests had little incentive to press for reforms which could establish a level playing field for competitors, which could lower barriers to entry and to new initiatives, and which could improve corporate governance, the report said. As a result, earlier expectations that market institutions, macroeconomic stabilization and sound business practices would naturally develop in response to demand from profit seeking players on the new market were not borne out. The lack of planning was understandable - to be fair, no one knew quite what to plan for, said Ben Slay, chief economist at PlanEcon consultancy in Washington. "Its a lot easier to liberalize prices than it is to create a well-functioning legal environment," Slay said. "And its really hard to design regulations for economic behavior that doesnt exist yet." "Its sort of hard to blame the people that were in early on, even in the first government, to be aware of what would actually happen," said Peter Westin, an analyst with the Russian European Center for Economic Policy in Moscow. He pointed to the influence of Western advisers fresh from the Polish experience, where concentration on macroeconomics paid off but dawdling on privatization led to asset-stripping by some managers. BEHAVIORAL ECONOMICS Usually, critics of Russias troubles tend to point to structural difficulties that could have been solved through better policies. A classic example is the banking sector, which never saw reform in time to stave off the effects of the Aug. 17, 1998 debt default and devaluation. However, the EBRD says it is now focusing on more subjective factors - the "social capital" or behavior patterns that it now believes made the difference between success and failure for the reform programs carried out by different regimes. And for businesses operating here, despite some outward signs of progress such as new company laws, firms polled by the EBRD say the behavior factor is still a crucial negative in their day to day operations. Rule of law is still sketchy, and what is still needed to get ahead, they say, are old-fashioned political connections and bribes. A poll by the EBRD and the World Bank of 3,000 businesses in 20 countries found a telling statistic: Businesses in Russia were paying heavy tolls in bribes and time just to get business done, shelling out a bribe tax to the tune of 4.1 percent of revenues. Nearly 30 percent of Russian businesses polled said that unofficial payouts were made frequently. The burden appears to lie heaviest on smaller firms - especially startups - across the region, especially in the Commonwealth of Independent States, where they tend to pay larger and more frequent bribes. In addition, senior managers said they were paying a heavy "time tax" in Russia, spending nearly 15 percent of their time dealing with public officials. A key indicator of trust in the governments ability to govern, the report says, is companies faith in the security of property and contract rights. Asked whether they agreed that the legal system would uphold their contract and property rights in business disputes, nearly 75 percent of businesses polled said they strongly disagreed. Analysts say Russias dismal levels of foreign investment, which fell further in 1999 after the August crisis, can be blamed in part on poor defense of their rights. Indeed, in "advanced transition" countries such as tiny Estonia, where more companies appear to trust the government to defend their property and contract rights, per capita foreign direct investment stood at $241 compared to Russias $20. Analysts point out that corruption is endemic to many emerging markets and some say Russia should not be singled out. In Russia, however, mere influence peddling is just the tip of the iceberg. The bank says that undue influence by vested interests - in Russias case, the oligarchy - on the governments relationship with business that allows to manipulate policy to the benefit of their businesses and the detriment of the overall business climate. To show the degree to which "state capture" is affecting businesses here, 40 percent of Russian firms polled by the EBRD said the sale of parliamentary votes and presidential decrees had an impact on their business. The only countries where influence buying was worse, the poll said, was in former Soviet republics Moldova, Ukraine, and oil-rich Azerbaijan. By contrast, only about 5 percent of businesses polled said they could influence the content of new federal laws, rules, regulations or decrees that could affect their businesses, and nearly 10 percent said they influenced similar decisions made by local governments. In economies like Russias, the EBRD says, high state capture has a dismal correlation with dismal corporate governance - a list of basic state provided services required for the market to function: law and order, infrastructure, macroeconomic stability, and a transparent tax and regulatory structure. GROUND ZERO So strongly has the state in Russia fallen under the sway of vested interests, that many observers now feel that real change can only come through a grass-roots desire for change similar to the surprising wave of revolutionary fervor that helped to sweep away the Berlin Wall and then the Soviet Union. There is a growing consensus that sweeping, top-down efforts at reform have proven to be Russias undoing. Arnab Das, a sovereign credit strategist at JP Morgan who studies emerging markets, says the absence of a ground-up political consensus was one factor that put Russias reforms at the mercy of individual whims in the first place. The haphazard enforcement of the rules and corruption that now plague Russia are "symptoms of a deeper malaise. That is a lack of political consensus about making Russia a modern market economy." The privatization and liberalization programs that marked Russias first transition efforts "can be done at the wave of a hand - the things more important for the long run, the more involved, micro-level reforms - they require a lot of political changes and huge cost in terms of welfare." "For that it turned out the political backing was not there - to make changes that would be economically better in the long run, but politically difficult in the short run." The EBRD believes that the fewer political holdovers to the old Communist regime, the better. The report pictures Russia, however, at the center of a camp of reform laggards whose leaders are almost always drawn from the former leaders of the old Communist nomenklatura. "You have to remember there was no popular revolution in Russia," said Reynolds of the Adam Smith Institute. For now, the bank - which lost millions of dollars invested in failed banks and has scaled back lending to Russia - is taking a wait-and-see approach to Russian reforms, saying radical changes were unlikely in the runup to December parliamentary elections and June presidential elections. Instead, the bank says Russias near-term "key challenges" are limiting political disruption during the election season and the achievement of a new constitutional arrangement that would cut economic dependence on President Boris Yeltsin and his power of decree and shift authority to other branches of power. That would limit the ability of one powerful individual to wield influence over the economy. A more difficult question is how to put a leash on the vested interests that exert more furtive control over the economy. Analysts agree it will be difficult to legislate market players behavior - though some say distilled regulation might help. "The most important thing is to have a clear conception of the rule of law," said Westin of RECEP. "A lot of the corruption is systemic, and so the system needs strengthening." Slay of PlanEcon suggested a policy move that could restart reforms the way they began in 1992: From the top down. "If instead of thinking the war in Chechnya is going to solve all of Russias problems the government were instead arresting people who had absconded with millions of dollars of peoples money - two or three incidences and that would have an impact. But that is not what politicians in Russia are concerned about. They are concerned about parliamentary elections, they are concerned about presidential elections, they are concerned about feathering their nests - their concerns are not with policies to change peoples behavior."
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