#11 - JRL 7068
Moscow Times
February 19, 2003
Life at the Bottom of the Sandwich
By Christof Ruehl

Christof Ruehl, chief economist of the World Bank's Russia country department, contributed this comment to The Moscow Times. The report is available at www.worldbank.org.ru and www.cefir.ru

Although no one seems to expect any major disruptions in Russia, 2003 has started with an unusually wide range of growth forecasts. And, accompanying these forecasts, there has been everything from exuberant optimism, particularly in the private sector (often voiced by foreign analysts), to gloomy predictions from semipublic think tanks.

Why this disconnect? The optimists, claiming a "feel for the place," point out that official statistics are notoriously bad at measuring private-sector activities, particularly among new small and medium-sized firms (SMEs) and in the service sector. Add to this a sizeable shadow economy, and the claim that Goskomstat doesn't capture the most dynamic parts of the economy is hard to refute.

Pessimists also claim a "feel for the place" and cite the figures to support their case. These figures show a decline in the growth of investment, the leading indicator of things to come. They further show that capacity utilization is leveling out, while costs -- wages, domestic energy prices and the real exchange rate -- have all risen much faster than productivity. The conclusion is that the post-crisis recovery has run its course: Underutilized capacity translated ruble depreciation and high oil prices into high growth rates from 1998 on (and absorbed the whopping cost increases along the way). But once capacity is fully utilized, growth depends on investment again -- which has the skeptics worried.

The rift is deeper than one may think. Yegor Gaidar recently compared the current risks with the aftermath of Lenin's New Economic Policy and the unexpected, rapid economic recovery between 1923 and 1927. When this recovery ceased as unexpectedly as it had started, it led to the abandonment of any pretense of market mechanisms by the Bolsheviks. Others compare Russia -- oil rich and complacent -- to someone wandering outside and falling asleep in a snowdrift.

However, strolling down the main drag -- and not only in Moscow -- provides clear signs of economic boom. Even official statistics register a shortage of skilled labor, explosive growth of lending to the private sector and increased investment inflows from abroad, much of it repatriated capital flight. Plus, there is an increasing number of large signature deals, with the recent BP deal just the biggest example.

So who is right? Enter the "sandwich" theory, according to which three segments of enterprises in Russia overlap with one another. Judgment of economic performance will be clouded by which segment one is looking at.

On the top is a group of natural resource exporters, around which the financial industrial groups currently dominating Russia's economy are built. With current levels of oil, gas and other natural resource prices, this segment is doing well. It has the highest productivity improvements of any segment. And perhaps the biggest difference from the pre-crisis period is that an increasing amount of cash generated by core exporters finds its way back into the Russian economy.

On the bottom is a layer of de novo enterprises, created and growing up under competitive conditions. It is this segment that drives economic growth in other post-communist economies, but in Russia progress in this segment has been markedly slow. And the share of employment in new firms lags behind other transition economies.

In the middle, there is a large segment of old "Soviet" enterprises lacking technology, managerial skills and often simply the necessary cash flow. In Russia, for historical reasons, this segment is larger than in many Central European countries. It is in this middle segment that progress in economic development, or a lack thereof, is most visible. In part, the fate of this noncompetitive core depends on investment. For now, such investment can only come from the export earners or from investors abroad. Higher inflows have resulted in more mergers and acquisitions, and more successful turnarounds. Note, however, the risk that this mechanism will result in larger conglomerates further consolidating their stranglehold, generating problems for future growth.

But the problem companies should also be exposed to competition from new firms, and here progress has been slow. While the natural resource sector can compete internationally, attract investment and use offshore finance, the new SME sector suffers from red tape, lack of affordable finance and competition from large firms, which often enjoy the support of regional and local governments. While old enterprises may be unproductive, they tend to be key providers of jobs. And oligarchs, as a rule, are well-connected individuals. In the final analysis, both may have an interest in defending themselves against encroachment by new businesses, including by exerting influence on local bureaucrats.

Given this environment, it is welcome news that a recent survey conducted by the Center for Economic and Financial Research in collaboration with the World Bank shows improvements vis-a-vis the administrative burdens faced by small firms. The results square well with other survey evidence assembled by the World Bank and the EBRD. The CEFIR survey traces progress in the business environment by monitoring deregulation and liberalization. In particular, it tracks the implementation of a package of laws (introduced between August 2001 and January 2003) designed to simplify bureaucratic procedures and limit the scope for corruption.

The most important outcome of the recent survey is the message that reforms are starting to work for SMEs as well. Perceptions of the business environment have improved across the board, but progress has been significant in areas where new laws have had time to take effect and much less significant in those areas where debureaucratization laws came into effect only recently. This pattern points to the importance of targeted reforms. These reforms may be slow in coming and difficult to implement, but they have started to have an impact.

The survey also highlights a number of structural issues that are important for Russia's long-term development.

First, it confirms the privileged position of large enterprises. In locations where employment is highly concentrated, barriers to entry are higher and the administrative burden for those already "in business" is lower, indicating impediments to competition. It is not clear whether this applies more to old "dinosaurs" or new conglomerates, but preferential treatment in regions or municipalities with a high degree of industrial concentration is evident.

Second, deregulation has been more successful in regions with a larger share of small enterprises at the outset. Whether this is due to safety in numbers and the possibility of spreading the burden or an indication of the emergence of lobbying groups, the results do underline the importance of building a constituency for reform.

Third, the survey confirms the huge extent to which institutionalized corruption is still part of the system. Asked why they used the services of intermediaries or "consultants," generally with ties to the local administration, 20 percent of those who did responded that their applications for a license or certification would not have been considered otherwise.

So, clearly not everything is rosy. In fact, in most areas the business environment remains such that laws are being openly flouted: 77 percent of all licenses are valid for less than the five years prescribed by law; firms face multiple inspections in direct violation of the law; and fines are often not based on any official scale.

This gives an idea of how mixed the overall picture is. However, bad as the situation is, compared to the first survey conducted in spring 2002, small firms report an increase in fair competition as being the thing that changed most in making life difficult for them -- not an increase in any of the numerous government regulations confronting them.

Russia's business environment remains difficult, especially if one is a small and new firm. But the deregulation package has genuinely started to have an impact, and demonstrates just how important it is to continue going further down this road.