Felix Goryunov is a Russian journalist who has been observing the world economy for over 30 years. Now he runs an English language website www.rusbizconf.com covering Russia's economy and investment opportunities.

People change times; times change people. Both assertions might be equally true if the second was not so slow in its impact. People adapt to changes in their economic and political environment with a time lag, especially when they are burdened with inherited ideological prejudice, as is the case in Russia. Thus, it is worth remembering a wise observation made by David Rockefeller, one of the founders of the Trilateral Commission, as quoted in The New York Times: "The greatest strength of capitalism is probably its adaptability. Having the virtue of relative freedom, it is able to respond to changing circumstances more readily than tightly controlled systems."

The adherence to statism is to blame for Russia's slow adaptation to a market economy more than any other reason, either political or economic. This Soviet legacy shaped Russian government policies at the start of market reforms and is vividly traceable in the Kremlin's behavior now. The history of Russia's transition to market economics proves that this mental rigidity is a major constraint to capitalizing on the country's exceptionally favorable position in the global economy.

The state-led Bolshevik style of Russia's transition to a market economy almost overnight resulted in a contraction in economic activity - and not only because economic leaders had to adjust their thinking towards making a profit rather than meeting planned targets. The contraction was also an after-effect of the Yeltsin administration's neglect of the economic and social impacts of the transition, including high inflation. The combination of a contraction in business with inflation in a market economy is called stagflation, but in Russia's case, stagflation was only partly the result of market forces. It became prolonged and unnecessarily destructive due to the government's failure to apply adequate macroeconomic measures.

Attempts to stabilize the economy and contain inflation by piling up treasury liabilities eventually resulted in Russia's default on sovereign debt in August 1998. Paradoxically, the default, which at first seemed to a disaster for Russia's economy, became its salvation. This rescue operation was not manned, but rather managed by the invisible hand of the market.

In a very short time, the default resulted in a four-fold depreciation of the ruble against the dollar and made Russian products domestically and internationally competitive. The devaluation boosted the price advantages of Russian merchandise while the spare capacity created by the contraction in industry conditioned the potential for recovery.

The impact of devaluation on macroeconomic performance was exhausted by the beginning of 2003 as the ruble strengthened. But by that time, another market factor started to drive the growth as the price of the Urals brand of oil rose from $8 per barrel to over $60. Since Russia's primary export commodities are crude oil and natural gas, this windfall of revenues created budget surpluses and began to boost consumer demand. Again, it was not government policies but external market factors - in this case, the dynamics of world energy prices - that allowed the Russian economy to remain stable.

From 1999 to 2006, Russia's GDP grew at an average annual rate of 6.7 percent of industrial production. Considering persistent world demand for oil and gas, this bonanza will continue indefinitely - hopefully until the time that local living standards rise enough to make consumer spending a major driver of Russia's economy.

It never looked so good

There is little doubt among economists that Russia is now enjoying a consumption-driven growth cycle, which feeds on domestic stimulants to increase business activity. Unlike world energy prices, this stimulant can be fine-tuned by government regulation. This regulation improved noticeably after reforms in business legislation enacted after 2000 aligned Russia's regulatory and legislative framework to WTO requirements. No less encouraging were new tax and customs codes as well as laws on currency regulation, foreign trade, investment activities and property rights. Though enforcement of many of the new laws leaves a lot to be desired, they have proved beneficial to both domestic and foreign businesses.

Since the market for consumer services is far from saturated, consumer demand can only grow as a driving force behind business activity. Consumer credit and retail banking are still in the nascent stages of development in Russia and will increasingly offer more options to consumers, so despite persistent inflation, real disposable incomes rose last year by 10.2 percent and, judging by available estimates, this year may exceed 12 percent.

Thanks to the confluence of market forces in recent years, Russia can also boast of a robust equity market capitalization (above $1 trillion), the world's third largest foreign currency reserves (above $400 billion) as well as persistent current account surpluses ($77 billion over the past 12 months). The sustainable final demand has led to sizable increases of overall investment in fixed capital (by 22.3 percent in the first half of 2007) and in foreign direct investment (more than $28 billion in the first half of this year). Although most domestic and foreign capital has so far been concentrated in sectors with quick return on investment - extracting industries, retail trade, services and real estate - the effects have been felt in manufacturing industries as well.

After the Russian government abandoned its macroeconomic stabilization stance in favor of proactive industrial policies earlier this year, another market growth factor has been in development. The funding of national priority and regional projects as well as plans to kick-start the "knowledge economy" have become the order of the day. Huge government spending on these projects is supposed to make investment-driven growth an even more forceful accelerator of the Russian economy. International experience shows that an increase in domestic capital outlays is a good multiplier for foreign direct investment.

On the surface, it seems that Russia has completed the transition from a controlled economy to a market-driven one. Unfortunately, this is no more than wishful thinking. Actually, Russia's radiant macroeconomic performance exists in the midst of severe deficiencies, which give the country no competitive leverage in the global economy. Most of these deficiencies are legacies of the Soviet era, which were aggravated during the stagflation of the 1990s.

Planning Deficiencies

The core deficiency is the poor state of Russia's manufacturing base, which badly needs restructuring and renovation. Machine-building and other high-tech industries in developed economies account for 40-50 percent of total industrial production. Between 1993-2006, the share of the high tech sector in the Chinese industrial economy increased from 10 percent to over 30 percent. In Russia, the share of these industries is less than 20 percent. Russian industry still suffers from the Soviet legacy: a unit of manufacturing production in Russia consumes twice as much energy as a similar unit in China or India, and seven times more than in Finland or the United States. According to the World Bank, the average level of productivity in Russian manufacturing is about 40 percent that of Brazil, one-third of that of South Africa and half that of Poland. Although the manufacturing value added per worker in Russia is about the same as that in China and a bit higher than in India, Russian labor costs are twice as high.

The deficiencies can be remedied in a relatively short time if the Russian government were to follow a coherent economic policy. According to a survey conducted by the consultancy Droege & Company in cooperation with the Association of European Businesses in Russia, the installation of modern production facilities has already led to a convergence of Western and Russian productivity levels at manufacturing plants run by European companies. Whereas in 2001, labor productivity in Russian production plants compared with their Western counterparts was 23.5 percent, by 2007, it had reached 73.9 percent. Russian manufacturers, including machine-builders, are happy to re-equip production facilities with efficient technologies or build new plants, and there are domestic investors ready to fund feasible projects in manufacturing, but there is a significant lack of targeted government policies aimed to provide cheaper credit, tax breaks and tax havens for specific industry sectors as well as to encourage competition. The current lag in overall competitiveness cannot be overcome unless the small and medium enterprises (SMEs) engaged in industrial production enjoy a favored level of treatment. The inadequate level of competition and the far too modest role of SMEs in Russia's economy are among its other severe deficiencies.

International experience has proven that innovation and knowledge industries cannot be created without a vigorous expansion of the role of SMEs in the economy. Small businesses account for only 10-12 percent of Russia's GDP and provide jobs for about 15 million people - only 13 percent of the working-age population). As a comparison, the 19 million small businesses in the United States account for over 50 percent of GDP, employ over 70 million people and have long become the country's major incubator of new products and technologies. By some estimates, Chinese SME contribution to GDP growth exceeds 70 percent. Still more important, it was not state-owned enterprises but private small businesses that have converted China's centrally controlled economic system into an innovation economy.

It would seem logical that the recent change of heart among Russian decision makers in favor of the innovation economy would follow a similar economic strategy pattern, but the Soviet mental legacy points in the opposite direction. In July, First Deputy Prime Minister Sergei Ivanov described the government's industrial strategy. In his assessment, a series of government measures is required in order to stimulate and modernize production facilities because Russian businessmen are too inert and wary of taking risks. As a result, the state must take these risks. In order to encourage the development of new products and technologies, by 2015 the government will create about 40 holding companies similar to those recently formed in the aircraft and shipbuilding industries. Along with nanotechnologies, which are to be developed and marketed by a state-run concern, the R&D potential accumulated in the defense industry will be activated to improve competitive leverage of the Russian economy.

There is little doubt that the planned state-owned holding companies will be clones of the existing ones - Gazprom, Rosneft or United Energy Systems (UES), to name just a few. These monopolies have thrived and have grown thanks to exceptionally favorable market conditions, but so far they have not been known for breakthroughs in development. However, their low corporate efficiency and non-transparent governance remains the talk of the town. With the Soviet legacy of economic mismanagement still fresh, the proclaimed strategy of creating a knowledge economy from the top town seems suspicious.

Going topsy-turvy?

The merits of the strategy are doubtful not only in terms of its ability to create an economy that will be competitive in today's globalized environment; it also lacks relevance to the realities of Russia's current economic growth, which is driven not by state-owned monopolies - no matter how vast their control over resources - but by market forces, both domestic and external. The strategy contradicts the age-old that it's impossible to beat the market. The best way to generate gains in a market economy is to adapt to prevailing trends or try to influence market conditions in a desirable manner. Instead of capitalizing on the market forces already at work, top Russian politicians are trying to construct a centrally-controlled economy with very familiar political birthmarks.

Although it seems funny, the Russian powers-that-be are refuting the Marxian dogma that a nation's superstructure depend on its economic basis - on who owns profit-making property. Not counting household property, Russia's economy is now 65 percent privately owned, but despite this fact, the state's dominant role in the economy is undoubted. Thus, it is not Russia's private economic structures, but its political superstructure that rules the roost. This topsy-turvy structure might seem a revolutionary innovation if it did not smell of the old Soviet concept of how economies should be run. The idea that a strong state can be built on state property and by tight control of business is now penetrating all levels of the Russian administration, breeding red tape, graft and endemic corruption. At the top of the system is a small group of high-ranking bureaucrats and government nominees managing state-owned concerns and a few Kremlin-friendly business tycoons. These groups' vested interests coincide so far as preservation of the political regime is concerned, but differ in areas of economic strategy, since these may create hazards to the status quo and strengthen one group at the expense of others. Hence, it should hardly be taken for granted that the proposed innovation strategy will be unanimously approved by the political establishment.

It remains to be seen when the most powerful driver of Russia's economy - the sectors of its domestic market that are already integrated into the global economy - will overturn these new attempts to switch into reverse, but it is already becoming clear that the mentality of the Russian capitalist establishment has to be able to adapt to international changes. After 15 years of market-oriented development, the moment for Russia's economic leaders to catch up with times is well overdue.