[JPRT 107-50]
[From the U.S. Government Publishing Office]


107th Congress 
 1st Session             JOINT COMMITTEE PRINT                  S. Prt.
                                                                 107-50
_______________________________________________________________________
 
                      RUSSIA'S UNCERTAIN ECONOMIC
                                 FUTURE

                               __________

                          COMPENDIUM OF PAPERS

                            SUBMITTED TO THE

                        JOINT ECONOMIC COMMITTEE

                     CONGRESS OF THE UNITED STATES


[GRAPHIC] [TIFF OMITTED] TONGRESS.#13


                             DECEMBER 2001





          Printed for the use of the Joint Economic Committee


                     U.S. GOVERNMENT PRINTING OFFICE
76-171                       WASHINGTON : 2002








                                FOREWORD


                      By Senator Robert F. Bennett

                              ----------                              

    Russia's economy has rebounded significantly since the 
crisis of 1998. Economic growth has resumed, unemployment has 
fallen, and production, consumption, and investment have all 
expanded. At the same time, Russia has initiated a series of 
promising economic reforms, including strengthening its banking 
system and enacting fundamental tax reform.
    These improvements illustrate Russia's potential for a 
strong economic future. At the same time, memories of past 
economic difficulties demonstrate the risks that Russia faces 
if its reforms do not succeed.
    Russia's economic future is of great importance to the 
United States. To assist American citizens and policymakers in 
thinking about that future, I asked the Congressional Research 
Service to commission a collection of expert reports on the 
Russian economy. The resulting reports review the recent 
history of the Russian economy, analyze current policy issues, 
and consider possible futures.
    The reports were prepared by experts--in academia, the 
private sector, and government--who represent a wide diversity 
of professional perspectives on the Russian economy. The 
reports thus reflect a broad range of opinions on the 
challenges and opportunities before Russia. The views and 
conclusions in these reports are those of their authors, not 
those of the Joint Economic Committee or any of its individual 
members.
    I hope that these reports will contribute to our ongoing 
efforts to understand the Russian economy. I thank the 
Congressional Research Service for its efforts and the authors 
for sharing their expertise.









                            C O N T E N T S

                              ----------                              

                                                                   Page

Foreword, by Senator Robert F. Bennett...........................   iii
Historical Note..................................................   vii
Highlights, by John Hardt........................................    ix
Overview, by John Hardt..........................................    xi

      Past Economic Performance and Insights for Future Prospects

Russia's Economic Performance: Entering the 21st Century, by 
  William H. Cooper..............................................     3

                      Russia's Economic Challenges

Removing Barriers and Providing an Incentive System..............    25
The Russian Economy: How Far from Sustainable Growth?, by Ben 
  Slay...........................................................    25
Unlocking Economic Growth in Russia, by Vincent Palmeda and Bill 
  Lewis..........................................................    47
Administration and Reform of the Russian Economy, by Paul Gregory 
  and Wolfram Schrettl...........................................    81
Russian Crime and Corruption in an Era of Globalization: 
  Implications for the United States, by Jonathan M. Winer and 
  Phil Williams..................................................    97

Financial Reform: Taxes, Budgets and Banks.......................   125
Tax Reform in Russia, by Z. Blake Marshall.......................   125
Putin's Dilemma: Austere Budgeting in a Poor State, by James A. 
  Duran, Jr......................................................   141
Russian Defense Spending, by Christopher J. Hill.................   161
Russian Financial Transition: The Development of Institutions and 
  Markets for Growth, by David M. Kemme..........................   183

Breakup of Monopolies: Energy, Transportation and Agriculture....   213
The Russian Energy Sector: Current Conditions and Long-Term 
  Outlook, by Matthew J. Sagers..................................   213
Agricultural Reform: Major Commodity Restructuring but Little 
  Institutional Change, by William Liefert.......................   253

Human Capital and the Social Contract............................   283
Russia's Demographic and Health Meltdown, by Murray Feshbach.....   283
Social Welfare: A Social Contract, by Judyth L. Twigg............   307

          Long-term Prospects for Russia's Economic Governance

Long-run Prospects for the Russian Economy, James R. Millar......   329
Russia's Evolution as a Predatory State, by Peter J. Stavrakis...   347

              Russia's Economic Future and U.S. Interests

U.S. Bilateral Assistance to Russia, 1992-2001, by Curt Tarnoff..   369
Arms Exports and Russia's Defense Industries: Issues for the U.S. 
  Congress, by Kevin P. O'Prey...................................   385
U.S.-Russian Trade and Investment: Policy and Performance, by 
  Inga Litvinsky, Matt London, and Tanya Shuster.................   411
Russia and the International Financial Institutions: From Special 
  Case to a Normal Country, by Jonathan E. Sanford...............   425










                            HISTORICAL NOTE

                              ----------                              

    This study belongs to the series of committee prints for 
the Joint Economic Committee by the Congressional Research 
Service and its predecessor, the Legislative Reference Service, 
dating back to the 1950s, on the economies of the Soviet Union 
and successor states, the People's Republic of China, and 
Central Eastern Europe. In November 1959, the Joint Economic 
Committee held a week of hearings that highlighted the 
publication entitled Comparisons of the United States and 
Soviet Economies. These hearings were a continuation of the 
committee's past interest in this subject that had resulted in 
the publication of two studies prepared for the committee by 
the Legislative Reference Service of the Library of Congress--
one, in 1955, entitled Trends in Economic Growth: A Comparison 
of the Western Powers and the Soviet Bloc, and the other, in 
1957, entitled Soviet Economic Growth: A Comparison with the 
United States.
    The first study on the People's Republic of China, An 
Economic Profile of Mainland China, was released in 1966, after 
the initiation of the Cultural Revolution. The first volume on 
Central Eastern Europe, Economic Development in Countries of 
Eastern Europe, was released in 1970, following the Soviet 
invasion of Czechoslovakia. Other studies followed at regular 
intervals.
    The most recent study in this long series was China's 
Economic Future: Challenges to the U.S. Policy, released in 
1996. The most recent study on Eastern Europe was East-Central 
European Economies in Transition, released in 1994, which was 
preceded by a two-volume study, The Former Soviet Economies in 
Transition, released in 1993.










                               HIGHLIGHTS

                           By John Hardt \1\

                              ----------                              

    The authors in this volume analyze the present state of the 
Russian economy and its future possibilities. Vladimir Putin 
has committed himself to economic reform in his 2 years as 
Russia's president. The opportunity for a transition to a 
democratic market economy is more likely now than at any 
previous time in Russian history. This volume explores the 
opportunities offered by this transition and the obstacles it 
faces, with particular reference to Putin's reform agenda. The 
main findings of the volume are as follows:
---------------------------------------------------------------------------
    \1\ John P. Hardt, Senior Specialist in Post-Soviet Economics at 
the Congressional Research Service, is author of the Highlights, the 
Overview and coordinator of the volume.

   Sustained economic growth will be crucial to all 
        reform efforts. Russia's recent performance since its 
        financial crisis in 1998 has been positive in terms of 
        both its annual growth of gross domestic product (GDP) 
        and its balance of payments. Whether this recent 
        performance represents a new trend line of sustained 
        growth or is a part of a cyclical pattern of prosperity 
        and crisis remains unknown.
   Putin's unfinished reform agenda features changes 
        critical to the development of a pluralistic market 
        system under the rule of law, such as the establishment 
        of market-friendly administrative and judicial systems 
        and the introduction of an effective banking system. 
        Bureaucratic inertia and lingering corruption continue 
        to hinder these reform efforts.
   Putin's reform policies will be decisive only if 
        they result in redistribution of political power that 
        controls economic decision-making along with revision 
        of budgetary priorities. Restructuring the power of 
        Russian financial and governmental elites and reducing 
        populist subsidies will prove difficult, however, 
        because that may erode Putin's power and popularity.
   Russia's economic competitiveness and growth 
        potential would be greatly enhanced by the breakup of 
        monopolies in three key sectors: energy, transportation 
        and agriculture. Such reforms are underway, but they 
        have not been completed.
   Russia's human capital has become a depreciating 
        asset. Without appropriate legislation and budgets, 
        Russia is facing a ``demographic and health meltdown.'' 
        Russia is not yet living up to Putin's commitments to 
        the Russian people; welfare entitlements, pension funds 
        and education needs are all underfunded.

    The path of Russia's economic development will make a 
significant difference to the United States. U.S. policy, in 
turn, will play an important role in Russia's future economic 
development.

   Russia may become a major trading and investment 
        partner with the United States in spite of its modest 
        bilateral trade and investment in the past.
   The United States may benefit from reduced Russian 
        sale of arms to countries who may be a threat to U.S. 
        security interests.
   U.S. support could facilitate Russia's integration 
        into the global economy and its eventual accession to 
        the World Trade Organization in spite of the 
        noncompetitive nature of most Russian enterprises and 
        strong protectionist sentiments.
   The United States may take an effective lead in 
        helping Russia manage its external debt burden, even 
        though the majority of its external debt is held by 
        other countries.








                                OVERVIEW

                           By John Hardt \1\

                              ----------                              

    Russia's uncertain economic future is of special concern to 
U.S. as well as Russian policymakers. This was highlighted by 
the Bush/Putin Summit in Washington, DC, and Crawford, Texas, 
November 13-15, 2001, as Putin moved to align Russia more 
closely with the western market economies.\2\ The range of 
possible economic developments in Russia is greater now than in 
the past.
---------------------------------------------------------------------------
    \1\ John P. Hardt is a Senior Specialist in Post-Soviet Economics 
at the Congressional Research Service. References to authors from the 
volume are made in the text of the Overview. References to authors not 
in the volume are made in footnotes.
    \2\ Communiques of Washington/Crawford Summit, Washington File, 
State Department.
---------------------------------------------------------------------------
    This volume includes articles that present four approaches 
to the overarching question: Where is the Russian economy 
going?

   A discussion of Russia's past performance and 
        insights for future growth. Is extrapolation of Russian 
        past economic performance useful for projecting 
        Russia's economic future? Will current opportunities 
        for improved growth lead instead, as in the past, to 
        economic crises?
   A discussion of the reform policy issues that 
        challenge the leadership of President Vladimir Putin to 
        make choices that may determine economic governance in 
        Russia. What policy decisions would best advance the 
        reform agenda and the necessary redistribution of power 
        and financial resources? Will Putin prove to be an 
        effective democratic reformer or yet another promoter 
        of strong state power?
   A discussion of the range of possible outcomes for 
        long-term development of Russia's political and 
        economic system. Is Russia likely to abandon its 
        historical pattern of autocratic governance in favor of 
        the western model of democracy and market economy? Is 
        either of these antithetical outcomes inevitable or 
        subject to change?
   An assessment of U.S.-Russian economic issues that 
        materially affect U.S. interests. Does it make a 
        significant difference to the United States how Russia 
        develops economically? Can and should the United States 
        influence or effectively manage the outcome?


     This volume is divided into four sections: past 
performance and insights for future prospects; Russia's 
economic challenges; long-term prospects for Russia's economic 
governance; and Russia's economic future and U.S. interests. 
What follows is a summary of the authors' responses to the 
above questions, supplemented by commentary provided by the 
volume's coordinator. The contributors to this volume offer 
contrasting perspectives on these questions. They consider that 
Putin turning out to be an effective reformer rather than an 
authoritarian leader to be crucial to the development of 
Russia's economic future. While these contributions do not 
represent the views of the Congressional Research Service 
(which does not take positions on public issues), nor 
necessarily of the Joint Economic Committee of the U.S. 
Congress, they do reflect schools of thought in the 
professional community in the United States and abroad.

      Past Economic Performance and Insights for Future Prospects

     Past performance in quantitative terms is useful but not 
definitive in understanding the past and in forecasting its 
future. While progress in reform made in the early 1990s 
provided some expectation of improved growth, Russia suffered a 
severe recession from 1992 through 1998. By 1998 gross domestic 
product (GDP) was 70 percent that of 1992. After the financial 
crisis in 1998, Russia experienced unprecedented short-term 
economic growth, with real GDP growth expected to reach 5 
percent in 2001.
    William Cooper, in his performance assessment, finds that 
making accurate projections of Russia's economic future is 
difficult: ``The current economic growth could be short lived 
but it has generated political support and thus presents 
President Putin and his team with a `window of opportunity' to 
promote economic reform. The current upswing in economic growth 
is favorable but not sufficient to assure sustained growth.''

                      Russia's Economic Challenges

    Ben Slay reports: ``Huge current account surpluses and 
unprecedented growth and reserves are welcome developments in 
the last 3 years. However, capital flight has not abated and 
foreign direct investment that would help modernize and 
recapitalize Russian industry is conspicuously absent in 
Russia.'' Ben Slay adds that large capital flight and minuscule 
foreign direct investment mirror each other as symptoms of 
failure of institutional reform in Russia.\3\ In this context 
it may be just as difficult to substantiate that Russia has 
``turned the corner'' toward sustained economic growth and is 
now a market economy as it was earlier to document that Russia 
was a failing transitional economy.
---------------------------------------------------------------------------
    \3\ European Bank for Reconstruction and Development (EBRD), 
``Cross-Border Capital Flows,'' Transition Report Update, April 2001; 
John P. Hardt, Russia's Economic Policy Dilemma and U.S. Interests, CRS 
Report RL30266, January 23, 1999; Alexander Boulatov and Mark Silveira, 
``Capital Flight and Foreign Direct Investment,'' Working Paper, 
Washington, DC, August 2001.
---------------------------------------------------------------------------
    Past performance shortfalls provide a road map for the 
difficult reform path ahead. Future reform requires development 
of an incentive system, a working financial system, competitive 
enterprises, and adequate attention to the quality of life.
    Russia's current economic challenges are summarized in 
Putin's ``unfinished agenda.'' Slay argues, along with many 
other specialists, that only the radical reforms in the Putin 
agenda will be sufficient to create a market-friendly system. 
While a turning point toward development of a market system may 
be more likely than at any time in Russian history, 
implementation of reform policies on the Putin agenda can be 
decisive only if they result in redistribution of the political 
power that controls economic decisionmaking, along with a 
revision of budgetary priorities.
    Central to reform implementation, in the view of this 
report's contributors, will be the character of President Putin 
as a reformer. President Putin has used his vision of Russia's 
economic future as the theoretical basis for his reform agenda. 
Putin's vision is for ``rapid and comprehensive'' institutional 
reform, to ensure that Russia will not fall further behind the 
developed countries in economic performance. Putin, as an 
advocate of reform, has prescribed the reform medicine favored 
by western economic specialists, but it remains to be seen 
whether Putin, as President, administers this medicine. By 
restructuring the power of Russian financial and government 
elites and reducing populist subsidies, Putin may erode his own 
popularity and power. While many reforms may have an immediate 
impact, the full benefits from successful reform may accrue to 
Putin's successors. If Putin is unable or unwilling to be 
proactive on his reform agenda, then, in the view of Jonathan 
Winer and Phil Williams, political elites will continue to 
dominate the political and economic future of Russia.
    Putin's difficulty in supporting reform may be 
characterized as a twofold dilemma arising from the necessity 
to bring about a redistribution of power and a change in 
budgetary priorities. On the redistribution of power that is a 
prerequisite for reform, Putin has the classic Machiavellian 
constraint that he must utilize the full force of his 
leadership against the wishes of strong, entrenched opponents 
because the proponents of change are weaker and less ardent.
    Budgetary priorities need to promote the market system 
rather than cater to the state and political elites. Winer and 
Williams consider the political elites satisfied that the 
fruits of reform and their preferential share can be retained 
through the use of state power.
    Putin, as a reformer, may have to effectively use his 
leadership role to maintain both the elite and popular support 
needed for implementing reform. For example, in restructuring 
Gazprom, the energy conglomerate, Putin may have to convince 
its administrators and stockholders that being a global 
enterprise, and conforming to the requirements of the world 
marketplace, would protect their wealth and assure their future 
income, more than would retaining their privileged domestic 
position under an autocratic model of governance. Were Gazprom 
to become a model of corporate governance, the likely increase 
in wealth and profit for its shareholders might influence other 
oligarchs to support infrastructure monopoly reforms.
    There are some recent indications that other enterprises 
may be seeking profits instead of rents. Ben Slay notes that 
the consolidation trend in industry has recently led many cash-
rich enterprises to raise the level of corporate governance in 
lossmaking enterprises they have acquired. Responsiveness to 
market forces may thus be seen as beneficial to some Russian 
industrial elites by assuring protection of their wealth and 
prospects for profitability. Profit seeking beneficial to the 
Russian economy as a whole may prove more favorable 
economically to some industrial elites than rent seeking that 
only feathers their own nests.
    In reducing subsidies to housing and utilities, Putin may 
need to design a support program that does not sink Russian 
urban dwellers further into poverty and generate opposition to 
reform but that, instead, offers prospects for future 
improvement in the quality of citizens' lives. By developing a 
new social contract supporting education and a meaningful 
social safety net, as suggested by Judyth Twigg, Putin might 
generate more reform support from the developing middle class 
and the populace. Some need-based income maintenance programs 
may be both economically and politically more successful than 
traditional subsidies.
    Without a proactive policy, the benefits of market 
transition toward sustained economic growth are unlikely to be 
forthcoming. There is uncertainty about implementation of 
reform in Russia because Putin must face difficult decisions 
that will involve political risks and economic costs. Reform 
would reduce the direct political and economic power of the 
financial and governmental elites, including the Putin 
presidency. The marketplace, foreign investors and government 
regulators would take over important economic decisionmaking 
functions and change the basis for wealth accumulation from 
political to economic criteria.
    Even with more revenue in a growing economy, relative 
shares of the budget would need to shift away from national 
security, politically popular or populist subsidies, and debt 
servicing. A market-friendly budget would need to fund 
necessary reforms: a new civil service, a working financial 
system, infrastructure improvement, and social welfare. These 
are both very costly and inimical to the interests of the 
entrenched elites. Budget priorities that favor the interests 
of the middle class and the populace as a whole may gain broad 
support for reform over time, but reduction of populist 
subsidies and uncertainty of future growth may lead to short-
term popular sentiments against reform.

          removing barriers and providing an incentive system

    The authors in this section stress the importance of 
removing barriers inherited from the previous Soviet system in 
order to assure development of a market-based incentive system. 
In the in-depth studies of Russian economic performance in the 
1990s, Vincent Palmeda and Bill Lewis conclude that the 
productivity potential of key sectors and the economy as a 
whole have been constrained by the lack of an incentive 
system.\4\ Palmeda and Lewis, in updating their assessment to 
2001, conclude that with market-oriented changes in economic 
institutions, Russia's economy might expect to sustain a GDP 
growth rate of 8 percent per annum.
---------------------------------------------------------------------------
    \4\ McKinsey Global Institute, Unlocking Economic Growth in Russia, 
October 1999.
---------------------------------------------------------------------------
    In their essay, Paul Gregory and Wolfram Schrettl note that 
the Russian economy denies itself the benefits of its full 
productive potential by the lack of a market-friendly 
administrative system that incorporates rule-of-law concepts, 
establishes property rights, and enforces laws through a 
competent judicial system. Such an administrative reform would 
require a professional civil service. Gregory and Schrettl 
opine that economic rationality should lead Putin to give 
priority to administrative restructuring and adequately 
rewarding a new civil service in Russia as a condition for 
effective reform. However, they are not optimistic that Putin 
will overcome the political barriers to implementing these 
administrative reforms. Winer and Williams are even more 
doubtful that the current administrative system based on 
cronyism, crime and corruption will change. The necessary 
reforms, they argue, ``require Russia to undertake steps that 
threaten those whose power depends on discouraging rule-of-law, 
including criminals, exploitative business persons and corrupt 
bureaucrats.''

               financial reform: taxes, budgets and banks

    An efficient monetized economy is essential for operation 
of a market economy. To promote these objectives, a variety of 
financial reforms are required:

   Generation of sufficient tax revenue that may be 
        used to fund reform programs;
   A shift of budget priorities sufficient to promote 
        market reform initiatives; and
   Creation of banks that are attractive to savers and 
        banks that efficiently convert savings to investment.

    According to Z. Blake Marshall, tax reform currently under 
way will remove the onerous taxes of the past authoritarian 
command economy and replace them with taxes that do not place 
undue burdens on domestic and foreign enterprises. The new tax 
code, if fully implemented, will go far toward encouraging a 
market-friendly system.
    Budgets have recently become important instruments of 
Putin's policymaking, according to James Duran. The current 
priority budgetary outlays, however, do not support effective 
reform. Three appropriations are scheduled to absorb the major 
share of the 2002 budget: external debt servicing, subsidies 
for holding down apartment rents and utility fees, and defense 
spending. Duran says reform may not be implemented effectively 
without a radical change in these budget priorities. Even if 
adequate expenditures for reform are mandated, there may 
continue to be unfunded mandates because of the likely over-
commitment of future budgets and the continuing pressures 
toward funding traditional claimants.
    On the issue of debt servicing, Putin accepted in 2001 the 
foreign creditors' requirement that debt be fully serviced. 
External debt servicing will peak in 2003 and continue at a 
high level thereafter unless Russia receives major debt relief.
    Closing down popular subsidies for holding down rents and 
utility fees is proving to be politically difficult, as 
indicated by current parliamentary debates. Putin's civilian 
budget policy may be doomed to a robbing Peter to pay Paul 
policy of partially funding reform-related programs.
    In the area of defense spending, Russia continues to 
allocate a higher percentage of GDP than any NATO countries, 
and spends more in absolute terms than all NATO countries 
except the United States, according to Christopher Hill. Under 
current defense plans, maintaining and developing some new 
weapon systems and downscaling military manpower will require 
additional spending. Hill states that in order to re-emerge as 
a modern and powerful presence on the world scene by 2010, 
total defense spending needs to increase by about 3.5 percent 
per annum in terms of real increase in GDP. Other Russian 
defense economic specialists say that fulfilling Putin's 
defense policy requirements for the decade will require defense 
spending increases that exceed the rate of GDP growth.\5\ Still 
other analysts do not see that increasing defense spending 
necessarily reduces civilian allocations to meet reform needs. 
They believe that Russia can establish market conditions in its 
civilian economy that would attract foreign investment and 
generate increased growth that could permit increased defense 
spending and also generate funds for necessary reform.\6\
---------------------------------------------------------------------------
    \5\ Christopher Davis, ``Defense Sector in the Economy of a 
Declining Superpower: Soviet Union and Russia, 1965-2001,'' Defense and 
Peace Economics, Overseas Publishers Association, 2001.
    \6\ Steven Rosefielde, ``Back To The Future: Prospects for Russia's 
Military Industrial Revival,'' Conference on Eurasia's Future Landpower 
Environment, Washington, DC, July 10-11, 2001.
---------------------------------------------------------------------------
    On the issue of financial reform, David Kemme considers 
development of a functioning banking system the key to Putin's 
plan to generate increased investment in order to promote 
sustained growth. ``While the number of financial institutions 
has increased dramatically, the state structure still dominates 
the financial sector,'' reports Kemme. Because of a lack of 
legal and regulatory development in banks, savers do not trust 
banks, banks do not convert savings to investment, and 
conflicts of interest are rampant throughout the banking 
system. At this stage of Russian development, banks are far 
more critical than stock and bond markets for assuring economic 
growth, according to Kemme. The best indicator for success in 
banking reform, according to Slay, would be purchase and 
control of some major Russian banks by large western banks, 
such as Deutsche Bank or Citibank. Only multinational banks 
possess the resources and the size needed to resist political 
pressures to lend, Slay asserts.

     breakup of monopolies: energy, transportation and agriculture

    There are three major monopolistic sectors Putin's reform 
policies seek to break up: energy, transportation and 
agriculture. Enhanced competitiveness in these sectors would 
facilitate increased economic growth.
    Opening the energy industry by restructuring Gazprom and 
the Unified Energy System (UES) would provide the benefits of 
globalization, larger markets, more foreign direct investment 
and better corporate governance. The energy sector accounted 
for about 16 percent of GDP, 48 percent of federal budget 
revenue and 54 percent of foreign exchange earnings in 2000, 
according to Matthew Sagers. Energy, especially gas and oil, 
may be the primary engine of future Russian growth. Long-term 
investment necessary for growth in the energy sector is largely 
dependent on comprehensive reform, according to Sagers. A major 
increase in foreign direct investment (FDI) may be channeled 
early on to the oil and gas sectors if current reforms lead to 
one or more foreign investment success stories, e.g., joint oil 
and gas developments in Sakhalin, expansion of the Caspian 
pipeline consortia, or increased foreign investment in a 
reformed Gazprom and UES.
    Overall, the saying ``As Gazprom goes, so goes the economic 
reform of Russia'' has some merit. If domestic and foreign 
shareholders have a larger say in decisionmaking and corporate 
governance improves, Gazprom may become a global enterprise and 
a major spur to overall reform. Gazprom, as a competitive 
global enterprise, might be the largest industry or sector 
contributor to future Russian GDP, revenue, and export 
earnings.\7\ Increased revenue from gas and oil sales might 
then serve to loosen budget constraints that limit funding for 
reform programs.
---------------------------------------------------------------------------
    \7\ Boris Fyodorov, Interviews and Correspondence.
---------------------------------------------------------------------------
     Putin wants the railroad system to follow the same reform 
pattern projected for Gazprom and UES. The current partially 
privatized rail transport system is inefficient and a burden on 
the Russian economy as a whole.
    Although not directly bracketed in Putin's reform agenda 
with energy and transportation monopolies, Russian agriculture 
is another key monopolistic system from farm to market. 
Agriculture is ticketed for restructuring and clarification of 
property rights through a new Land Code for agricultural land. 
Only 5 percent of agriculture is privatized. While the Russian 
Parliament has passed a Land Code providing for property rights 
for urban centers, legislation has not yet extended the Land 
Code to include agricultural land. Providing for secure land 
ownership for Russian farmers would permit equity financing in 
the agriculture sector. Some vertical consolidation, ``joint 
stock companies,'' may hold promise for more efficient farm-to-
market agriculture, according to William Liefert.
    Overall, demonopolization in the Russian economy may serve 
to shift the structure of the Russian economy toward value-
added manufacturing and processing enterprises, according to 
Palmeda and Lewis. Oil, gas and other commodity output might 
substantially increase in absolute terms. Sectors such as 
general merchandising, food processing and distribution would 
then likely increase their relative share of GDP, moving Russia 
over time toward a developed economy structure and away from 
the commodity-based pattern of a developing economy.

                 human capital and the social contract

    Russia's large, literate and skilled labor force has 
traditionally been considered a strong asset for improving 
productivity. As Murray Feshbach and Judyth Twigg graphically 
demonstrated, Russia's human capital has become a seriously 
depreciating asset. Population decreases caused by the ``burden 
of decades of destructive practices that have had a direct, 
harmful impact on public health'' make addressing demographic 
and health concerns a national priority, according to Feshbach. 
With a projected escalation of HIV/AIDS and tuberculosis, 
infectious diseases may reach calamitous proportions in Russia. 
However, there has been no appropriate legislation addressing 
what Feshbach calls the ``demographic and health meltdown.''
    The quality of human capital, such as skilled workers and 
scientists, also has been sharply deteriorating due to lack of 
social security measures. In the Soviet era, workers had some 
degree of stability through a social safety net that provided 
minimal but predictable benefits. This represented an implicit 
social contract between the state and the citizenry. In post-
Soviet Russia, this minimal commitment of the state to the 
citizens has not been fulfilled. Twigg notes the deleterious 
effect this has had on the development of human capital: 
``Sudden withdrawal of meager but comprehensive programs 
covering health care, pensions, employment, housing and other 
services has resulted in widespread poverty and disillusion.''
    Putin has introduced ambitious and, if funded, expensive 
programs for social welfare entitlements, pension funds, and 
education to meet human capital needs. Duran notes that Putin 
also supports expensive legal reform that would stimulate 
enterprise efficiency and protect workers' rights. Unless there 
is more revenue and a change in budgetary priorities, these 
mandates will be underfunded.

          Long-term Prospects for Russia's Economic Governance

    Many Russian specialists subscribe to one of two differing 
schools of thought on Russia's future beyond 2010. One 
envisions a market economy, the other foresees rule by a 
predatory elite. James Millar sees an ``inexorable trend'' 
toward a complete market economy and away from the past 
autocratic economic governance model, especially the Soviet 
development pattern. This judgment is based on Russia's 
commitment to attain sustained economic growth that can only 
come from transition to a market system. Peter Stavrakis, on 
the other hand, projects a predatory model for Russia that 
rejects liberal democracy and postulates retention of only a 
patina of a democratic market system. ``Free markets and civil 
society,'' Stavrakis claims, ``are thus hostage to political 
elites who are free to intervene whenever and wherever this 
appears financially profitable and politically useful.'' In his 
view, Russian state leadership would continue to support the 
powerful predatory elites.
    Russia's predatory elites favor a continued state role in 
governing the economy. The ``directive economy'' plan supported 
by Viktor Ishayev, governor of Khabarovsk, calls for continued 
state control of economic decisionmaking in investment and 
allocation of resources.\8\ Through state control of economic 
decisions on investment and production, Ishayev's group 
promises results comparable to those projected for Putin's 
unfinished reform agenda without reducing the direct economic 
power of the state and the political elites. The Ishayev 
program also promises to increase the size and influence of the 
middle class. Some members of Putin's state apparatus appear to 
be inclined toward supporting the Ishayev plan. There is 
concern that adoption of the Ishayev plan would support the 
views of Stavrakis that Russia's future governance will be 
based on a predatory, political elite system.
---------------------------------------------------------------------------
    \8\ Strategy for the Development of the State to the Year 2010, 
Moscow, 2000. Cf. John Hardt, CRS Report RL30266, op. cit.
---------------------------------------------------------------------------
    The authors in this volume consider it necessary that Putin 
take a strong leadership role in reform and make the necessary 
decisions reducing the role of the state in economic 
decisionmaking. Whether Putin is able to fulfil this strategic 
role is still to be demonstrated.
    Proponents of these contrasting views expect Russia's 
future to be determined by long-term historical processes 
without major policy changes in the short run up to 2010. Both 
Millar and Stavrakis consider that the choices of Russia's 
future economic governance are at this point largely pre-
ordained. Millar cites ``reform fatigue'' as a reason for not 
expecting effective reform soon. Moreover, a functioning market 
system would require across-the-board comprehensive reform that 
would not come quickly even if Russia adhered to the accession 
process of the European Union (EU). Effective compliance with 
the transition requirements of the EU would be a lengthy 
process for Russia.
    Stavrakis finds the autocratic trend resistant to reform. 
He sees the entrenched ``financial oligarchy now competing with 
the state elites using standard Russia-style methods: 
corruption and cronyism dominate and society has withdrawn from 
the political and economic arena.'' Moreover, he argues that 
the autocratic model is more consonant with Russia's imperial 
legacy. Stavrakis sees a pattern of historical crises, ``times 
of trouble,'' characterized by recurring resistance of Russia 
to western democratic market models accompanied by increasingly 
authoritarian, inward-directed governance.

              Russia's Economic Future and U.S. Interests

    In considering Russia's economic future, U.S. policymakers 
may recognize not only the diverse possible outcomes for 
Russia, but also the varying effects those outcomes may have on 
U.S. interests. Russian success and U.S. interests may not 
converge, but they are not necessarily opposed. Curt Tarnoff 
notes that ``three overarching interests are involved: 
security, stability and humanitarian concerns.'' Successful 
reforms may provide considerable reduction in the threats to 
U.S. security if reform leads to decreased defense spending, 
reduced weapons inventories, non-proliferation of weapons of 
mass destruction, and reduced arm sales. However, a stronger 
economy may also permit re-establishment of military forces in 
Russia that might be considered a threat to U.S. security. 
Market reform may lead to a stable and profitable commercial 
relationship with Russia. However, a reformed Russia may be a 
stronger competitor in the world market and an increased threat 
to U.S. national security interests. The rule of law needed for 
effective market reform may contribute to development of a more 
civil, humane Russian society. However, the absence of 
effective reform may have negative effects on the human rights 
interests of the United States.

                            security issues

    The United States has tried to discourage Russia from 
making foreign arms sales, especially to states that are 
perceived to be threats to U.S. security. The current expansion 
of Russian arms sales appears troublesome to the United States, 
as Kevin O'Prey notes, because ``more sophisticated weapon 
systems have been supplied to countries that may be a threat to 
U.S. interests.''
    U.S. policymakers may also be concerned that the income 
from arms sales might be used to revive and expand Russia's 
military industrial base. While 1,600 defense enterprises 
continue to operate at minimum production levels, only 6 to 10 
of these enterprises benefit from cash sale of arms. Moreover, 
even with more arms sales and increased defense spending, 
O'Prey doubts that Moscow could resume the cold war arms race 
with the United States. Russia's military complex does not have 
the capability to compete in high-technology weapons, 
especially because of backwardness in electronics. Even in the 
worst-case scenario, Russia could return only to manufacturing 
large quantities of older generation weapons, according to 
O'Prey. Others consider it possible for Russia to fund reform 
and increase defense spending, thereby having the resources to 
rebuild its war mobilization base sufficient to compete with 
the United States.\9\
---------------------------------------------------------------------------
    \9\ Steven Rosefielde, op. cit.; and Vitaly Shlykov in Voennyi 
Vestnik (Military Herald) #8, Moscow, April 2001.
---------------------------------------------------------------------------
    Promotion of nuclear and chemical non-proliferation has 
also been a centerpiece of U.S. security relations with Russia. 
If the United States felt assured that Russian budget 
priorities would shift to funding reform, some mutually 
beneficial debt swaps might be in order.\10\ Security and 
stability interests of the United States and Russia may be 
linked by debt for non-proliferation swaps that might dampen 
the proliferation threat and reduce the heavy debt service 
burden from Soviet-era debt. U.S. leadership in debt management 
negotiations might influence other creditors to follow 
suit.\11\ Germany has been considering debt for assets swaps in 
negotiating some inherited Russian Paris Club debt since the 
Schroeder-Putin summit in April 2000. The European Bank for 
Reconstruction and Development (EBRD) has offered to support 
debt swaps that might encourage nuclear power plant safety and 
discourage weapons proliferation in the former states of the 
Soviet Union.\12\
---------------------------------------------------------------------------
    \10\ John P. Hardt, Russia's Paris Club Debt and U.S. Interests, 
CRS Report RL30617, updated June 6, 2001; John P. Hardt, Putin's 
Economic Strategy and U.S. Interests, CRS Report RL31023, June 19, 
2001.
    \11\ The Biden-Lugar-Helms S-1803, Russian Federation Debt 
Reduction for Nonproliferation Act of 2001. James Fuller, Debt-for-
Nonproliferation, Pacific Northwest Center for Gloval Security and 
Defense Nonproliferation Programs. Paper delivered in Moscow, Russia, 
December 10, 2001.
    \12\ EBRD, Transition Report Update, April 2001.
---------------------------------------------------------------------------

                            stability issues

    Programs favoring development of a democratic market system 
may support domestic stability in Russia and its integration 
into the global marketplace and international institutions. In 
the Department of Commerce paper in this volume, Inga Litvinsky 
and Matt London note, ``The U.S. administration would like to 
see business become the bedrock of U.S.-Russian relations . . . 
Thus, U.S. and Russian interests are in alignment to commence a 
new bilateral commercial era.'' Bilateral trade and investment 
ties in the past have been small and concentrated in a limited 
number of sectors, according to Tanya Shuster. Were Russia to 
reform and enter the process of accession to the World Trade 
Organization (WTO), U.S. commercial relations with Russia might 
substantially expand in volume and scope. The Economic 
Dialogue, with its private sector initiative, undertaken after 
the Bush/Putin June 2001 Summit may encourage favorable trade 
and investment developments. Successful energy investments 
might top the bilateral commercial agenda. Litvinsky and London 
further note, ``As Russia moves closer to WTO membership, the 
United States will need to re-examine our domestic trade 
laws.'' Permanent normal trade relations (PNTR), more access of 
Russian steel and other commodities to the U.S. market, and 
greater Export/Import Bank financing might then be placed on 
the U.S. legislative agenda.
    Favorable developments in the bilateral commercial 
environment are contingent on Russia completing Putin's 
unfinished agenda. Thus, reform may have to be the horse 
leading the bilateral commercial cart.

                          humanitarian issues

    Human and civil rights in Russia have been of continuing 
concern to the United States. The conduct of the war in 
Chechnya violates many of the humanitarian principles of the 
United States. Threats to freedom of religion in Russia have 
drawn continuous U.S. monitoring and concern. Freedom of 
speech, imperiled by state intervention and control over 
television, radio and print media, has troubled U.S. 
policymakers. Human and civil rights and stability interests 
have been adversely affected by persistent crime and corruption 
in Russia.
    Russian crime, corruption and money laundering have all 
plagued U.S.-Russian relations and deterred market reform. 
Capital flight and money laundering have had a disruptive 
effect on the U.S. banking system and encouraged international 
crime and terrorism, in the view of Winer and Williams. A 
peaceful, prosperous, market-oriented Russia might become more 
democratic and more sensitive to civil and human rights, but 
the record to date is mixed.
    Thus, in summary, policymakers in Russia and the United 
States face prospective benefits and costs as well as the 
uncertainty inherent in Russian policy options. The current 
policy of renewed dialogue and engagement adopted by both sides 
at the Bush-Putin Summits of 2001 may generate a forum within 
which prospective Russian economic reform measures may be 
influenced by the interaction of Russian and U.S. policymakers. 
The analyses in this volume do not provide definitive answers 
to the questions posed at the outset of this overview or to the 
overarching question, where is the Russian economy going, but 
they may offer a carefully reasoned range of U.S. policy 
choices.
    The United States, in concert with other western countries, 
may influence the direction that Putin pursues in economic 
reform. Policies needed for the reform process pose difficult 
decisions for the Russian leadership, some of which could lead 
to a different distribution of power and resources in Russia, 
contrary to the vested interests of powerful elites. These 
decisions may be influenced by U.S. policymakers and western 
allies of the United States. The United States and Germany may 
encourage or discourage Russian reform measures by use of 
leverage from debt management policy. By engaging in debt 
restructuring the United States may be able to use its leverage 
to push Russia toward more effective non-proliferation 
measures. Germany, as Russia's leading western trading partner 
and creditor, may play a leading role in economic policy with 
Russia, if it chooses to take the initiative. An economic 
dialog between the Bush and Putin Administrations could be an 
important stimulus for broader agreements that would enhance 
our mutual national interests. Similarly, WTO accession 
discussions might benefit both countries. However, caution may 
be required to assure that the Russian economic reform process 
leads to concrete developments rather than promises that remain 
unfulfilled.
    The IMF, World Bank, EBRD and other international 
institutions may play a continuing but less critical role in 
Russian economic development. If debt rescheduling is put on 
the policy agenda, the IMF would need to be involved. Jonathan 
Sanford notes that after a decade of programs from 
international financial institutions (IFIs) treating Russia as 
a special case for aid and advice, the IFIs now plan to treat 
Russia as a normal country.
      

=======================================================================




      PAST ECONOMIC PERFORMANCE AND INSIGHTS FOR FUTURE PROSPECTS

=======================================================================









        RUSSIA'S ECONOMIC PERFORMANCE: ENTERING THE 21ST CENTURY



                        By William H. Cooper \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................     3
Introduction.....................................................     4
Macro-economic Performance.......................................     5
    Output.......................................................     5
    Inflation....................................................     7
Structural Economic Performance..................................     7
    Dominance of large unrestructured enterprises................     7
    Structural problems in the banking sector....................     8
Living Conditions................................................     9
    Real income..................................................     9
    Unemployment rate............................................    10
    Poverty......................................................    11
    Life expectancy..............................................    12
    Income disparity.............................................    12
External Economic Performance....................................    13
    Foreign trade................................................    13
    Foreign investments..........................................    14
    Foreign debt.................................................    16
Analyzing Russia's Economic Performance..........................    17
Policy Implications for Russia...................................    19
Implications for the United States...............................    20
Appendix A: Notes on the Data....................................    21
Appendix B: The 1998 Financial Crisis............................    21
    Symptoms.....................................................    21
    Causes.......................................................    22
                                Summary

     Russia enters the 21st century potentially in better shape 
economically than it was during the last decade of the 20th 
century. It has not only survived several financial crises, 
including its most severe crisis in 1998, but has also enjoyed 
3 straight years of economic growth and rising income for the 
average Russian citizen. But the improvement comes after more 
than 7 years of severe economic contraction that left many 
Russians worse off than they had been during the Soviet era, at 
least in economic terms. The economy and its people have been 
the victims of the lingering Soviet legacy of central planning 
and of misdirected and incomplete economic reforms of post-
Soviet Russian leaders.
---------------------------------------------------------------------------
    \1\ William H. Cooper is a Specialist in International Trade and 
Finance from the Foreign Affairs, National Defense, and Trade Division 
of the Congressional Research Service (CRS).
---------------------------------------------------------------------------
    Some analysts have suggested that recent economic growth 
indicates that the Russian economy is on the road to sustained 
economic growth. However, the recent growth may be fragile and 
short term. An examination of Russia's recent economic 
performance suggests that one might be cautious about 
predicting Russia's long-term economic prospects based on the 
past 3 years. The factors that have generated growth--high 
world commodity prices and ruble devaluation--are by nature 
ephemeral and subject to the vagaries of world markets. 
Furthermore, the economic growth has run neither deep nor wide. 
Some regions have benefited much more than others, and the 
disparity in income distribution within the Russian population 
has widened over the years.
    Whether short term or more sustainable, Russia's economic 
growth presents President Putin and his policy team a ``window 
of opportunity'' to address the structural problems of the 
Russian economy by completing the reform process to help ensure 
long-term growth. In addition, Putin and his team must preserve 
the ``accomplishments'' attained during the past 10 years. For 
example, maintaining macro-economic stability, a crucial 
condition for gaining investor confidence and attaining 
sustainable economic growth, remains a challenge for Russia. 
The recent 20 percent inflation rates, while moderate by post-
Soviet standards, are still high by conventional standards.

                              Introduction

    By the end of the 1980s, the Soviet Union was declining 
economically, rapidly falling behind the industrialized West 
and even slipping behind some of the advanced developing 
countries of East Asia. The Communist system of central 
planning, under which the Soviet Union undertook rapid 
industrialization during and after World War II generated high 
economic growth rates through the 1960s. Eventually, however, 
the system led the Soviet Union into a period of economic 
stagnation in the 1970s and decline in the 1980s with few 
prospects of improvement. This dismal outlook was a factor in 
Mikhail Gorbachev's decision to undertake perestroika to try to 
save the Soviet system through reform. The system proved beyond 
reform, and Gorbachev's perestroika led to the collapse of the 
Soviet Union by the end of 1991. For the next 10 years, Russian 
leaders, Presidents Boris Yeltsin and Vladimir Putin, and their 
respective governments, have had to lead Russia through the 
transition from a central planned economy to what many hope and 
expect to be a market economy. The transition remains a work in 
progress and not always linear.
    The 10 year economic performance of post-Soviet Russia has 
been mixed at best. For most of the decade, the Russian economy 
shrank and, with it, the standard of living of the average 
Russian citizen. The economy has been burdened by the legacies 
of central planning and by misdirected and incomplete 
government reform efforts of its leadership. But Russia enters 
the 21st century potentially in better shape economically than 
it had been during the last 7 years of the 20th century. It has 
not only survived several financial crises, including its most 
severe crisis in 1998, but also has enjoyed 3 straight years of 
economic growth and rising income for the average Russia 
citizen. However, the Russian economic recovery may not be long 
term under present conditions.
    Russia's record of economic performance suggests that 
Russian leaders face a formidable challenge in turning Russia 
into a modern industrialized economy. The performance has 
critical implications for the Russian leadership and for U.S. 
policymakers as well.

                       Macro-economic Performance

    Russia's economic performance during the past decade has 
largely been disappointing at best and destabilizing at worst. 
This is evident in examining the output of the Russian economy 
measured by real gross domestic product (GDP) and Russian 
inflation rates. It has also been uneven with some regions of 
the country hit harder than others. Yet, the performance during 
the last 3 years has shown tentative signs of recovery.

                                 output

    GDP is one of the most comprehensive measures of a nation's 
economic activity and health. An economy must grow in order to 
improve, or at least maintain, the living standards of the 
population. A contracting economy, especially over an extended 
period of time, can threaten a nation's political as well as 
its economic foundation.
    The Russian economy, measured in real (adjusted for 
inflation) GDP, has contracted since the collapse of the Soviet 
Union (1992-2000). The level of real GDP in 2000 was less than 
80 percent of what it was in 1992 (see Figure 1). The sharpest 
decline occurred early in the transition, between 1992 and 
1996, when the economy shrank 27 percent, before the economy 
grew modestly (1 percent) in 1997.
    The economic contraction affected sectors across the 
economy, some much harder than others. On the production side, 
industrial production declined 28 percent between 1992 and 2000 
and agricultural production declined 29 percent. On the 
expenditure side, fixed investment, a crucial factor for future 
growth, declined 49 percent between 1992 and 2000.\2\
---------------------------------------------------------------------------
    \2\ These calculations are based on CRS-constructed production 
indices of Goskomstat data.
---------------------------------------------------------------------------
    The economic slide, especially in the early years of the 
transition, was not entirely unexpected. An economy, like 
Russia's, that is going through a wrenching transition will 
certainly contract. Much of Russian economic output during the 
Soviet period was of little economic value. It was directed 
toward heavy industry to supply the military and military-
related industries. Soviet production in the consumer sector, 
for example, clothing, prepared foods, and passenger cars, was 
of poor quality as Soviet producers faced no competition. Once 
the Russian economy opened its borders to trade, domestic 
producers were unable to meet the foreign competition, and 
production collapsed. Therefore, the decline was inevitable as 
market forces began to take hold and rationalize investment and 
production. But if the decline was inevitable, it was longer 
than in other economies going through post-Communist 
transitions in East and Central Europe.
    In 1997 real GDP increased 1 percent. However, the positive 
news proved not only modest but ephemeral. In 1998, a financial 
crisis hit. (See note in appendix B for background on the 
crisis). As a result of the crisis, GDP plunged 4.9 percent. 
The downturn hit all sectors of the economy, setting back 
economic progress. Many analysts speculated that 1998 would be 
just the beginning of a new phase of Russian economic decline 
because Russia would be cut off from capital markets and the 
weaker ruble would discourage consumption. Instead, Russia 
experienced growth in 1999 (3.2 percent) and in 2000 (7.7 
percent). The Russian economy continued to grow in 2001 in 
terms of real GDP at an estimated rate of 5.1. percent.\3\
---------------------------------------------------------------------------
    \3\ As of June 2001. Russian Economic Trends. October 2001. p. 14.

             FIGURE 1._INDEX OF REAL RUSSIAN GDP, 1992-2000

                              [1992 = 100]
[GRAPHIC] [TIFF OMITTED] T6171.023


  Index constructed by CRS based on Goskomstat data.

    Despite the recent growth, the 10 year record of economic 
performance suggests that the Russian economy still has much 
room to grow. In 2000, Russian real GDP was less than 80 
percent of its level in 1992, just after the collapse of the 
Soviet Union. Its level of fixed investment was only 51 percent 
of the 1992 level. Similar gaps are prevalent throughout the 
economy.\4\
---------------------------------------------------------------------------
    \4\ Ibid.
---------------------------------------------------------------------------
    Russian economic growth has been unevenly distributed among 
the regions of the country. In 1999, the per capita nominal GDP 
for the entire Russian Federation was 15.81 thousand rubles. In 
the oil-rich Tyumen region, per capita GDP was 64.49 thousand 
rubles and was 37.49 in the Moscow region. In contrast, the per 
capital GDP for North Ossetia in the Caucasus was only 5.66 
thousand rubles.\5\
---------------------------------------------------------------------------
    \5\ Goskomstat.
---------------------------------------------------------------------------

                               inflation

    Compounding the problem of declining growth were very high 
inflation rates. In 1992 alone, Russian consumer prices rose 
2,509 percent and 840 percent in 1993. Inflation robs 
individuals of their savings and lowers their standard of 
living. Hyperinflation, accompanied by declines in output, can 
create political and social unrest. Fortunately, except for an 
increase in workers' strikes, Russia avoided massive social 
upheaval. But the Russian people began to lose faith in their 
transition to the market economy. By 1997, inflation rates 
declined to 11 percent, but rose to 84 percent in 1998 as a 
symptom of the financial crisis. By 2000 they had declined to 
20 percent, a manageable, but still unstable rate. As Russia 
enters the 21st century, inflation remains a persistent problem 
for the economy, although much less so than at the beginning of 
the economic transition.

                                  TABLE 1.--RUSSIAN INFLATION RATES, 1992-2001
                                  [Annual percentage change in consumer prices]
----------------------------------------------------------------------------------------------------------------
                                                   Inflation
                      Year                           rate                     Year                Inflation rate
----------------------------------------------------------------------------------------------------------------
1992...........................................       2,508.8  1997.............................           11.0
1993...........................................         839.9  1998.............................           84.4
1994...........................................         215.1  1999.............................           36.5
1995...........................................         175.0  2000.............................           20.2
1996...........................................          21.8   2001 \1\........................           20.0
----------------------------------------------------------------------------------------------------------------
\1\ As of September 2001.
 Source: Goskomstat data in Russian Economic Trends.


                    Structural Economic Performance

    Underlying the weak macro-economic performance in Russia 
during the 10 years of the transition have been structural 
economic problems. Many of the problems affect the efficiency 
of the economy, that is, the productivity of its labor and 
capital. These inefficiencies make it difficult, if not 
impossible, for the economy to achieve long-term growth. They 
also affect the distribution of income among regions and within 
the population. Two critical areas of the economy that suffer 
from structural problems are the business sector and the 
banking sector. The problems in these sectors are symptomatic 
of structural problems throughout the economy.

             dominance of large unrestructured enterprises

    The Russian Government privatized most of the state 
enterprises in several phases. Nevertheless, the current 
profile of Russian business suggests that while Russia has made 
some progress in restructuring, it remains incomplete. Large 
enterprises that are legacies of the Soviet period continue to 
dominate the Russian economy. The top 20 Russian companies 
accounted for 30 to 35 percent of Russian GDP and for 70 
percent of Russian exports in 1999. These companies are largely 
in the natural resources and infrastructure sectors (energy, 
transportation, etc.).\6\ Small- and medium-sized enterprises 
accounted for only 30 percent of the total number of 
enterprises and 10 percent of the workforce. In contrast, 
small- and medium-sized companies accounted for 50 percent of 
the employment in the transition economies in Central and 
Eastern Europe and for 65 percent of the employment in the 
European Union. Furthermore, the number of small- and medium-
sized Russian firms has remained constant since 1995 indicating 
little progress in business restructuring and development.\7\ 
The stalled restructuring impedes productivity as it signifies 
barriers to the exit of inefficient firms and the entry of new 
firms to the market. These barriers prevent the efficient use 
of resources and diminish productivity.
---------------------------------------------------------------------------
    \6\ European Bank for Reconstruction and Development (EBRD). 
Strategy for the Russian Federation. Paris. October 2000. p. 15.
    \7\ Ibid. p. 47.
---------------------------------------------------------------------------

               structural problems in the banking sector

    A viable banking sector is critical to an economy. Its 
primary function is to operate as an intermediary funneling 
capital between savers (households) and borrowers (businesses, 
consumers, etc.) thereby facilitating the efficient use of 
financial resources. Without banks, businesses and others would 
be hard pressed to raise funds to finance investment to replace 
outdated equipment and technology or to expand production 
capacity. Banks also allow individuals to take out mortgages to 
invest in housing and to purchase big-ticket consumer goods. A 
weak banking sector can impede economic growth. An important 
principle for a banking sector to be credible is to maintain an 
``arm's-length'' relationship with borrowers so that loans are 
extended at market-determined rates and that borrowers are 
deemed acceptable risks.
    A number of private Russian banks emerged just prior to the 
collapse of the Soviet Union in response to the Gorbachev 
reforms. The number accelerated during the Yeltsin period. 
However, the ownership of the vast majority of these banks was 
closely tied to emerging private enterprises and functioned as 
conduits of soft credits from the government to those 
enterprises. Some of the larger banks belong to the financial 
conglomerates controlled by the so-called oligarchs. Such a 
conglomerate may consist not only of a bank, but a major 
enterprise, usually a raw material producer (nickel, diamonds, 
oil), or a news media outlet (television, newspaper). Most of 
the banks survived because of subsidies from the government or 
because they were part of an oligarch's conglomerate. In 
addition, some of the oligarch-owned banks made money by 
holding deposits for the Russian Government and investing the 
funds. They were not operating as financial intermediaries.
    In the mid-1990s, many banks, including the larger ones, 
sought returns by heavily investing in Russian Government 
treasury bills (GKOs) that were paying high interest rates; 
they were not making money lending funds.\8\ Households have 
placed most of their savings deposits in the state-owned and -
operated Sberbank, which is the only institution whose deposits 
are insured by the state.\9\ The weakness of the banking sector 
was exposed when the government was forced to default on the 
GKOs in August 1998 forcing most of the banks into virtual 
bankruptcy. As a result, the Russian Government under Vladimir 
Putin has ostensibly made restructuring the banking industry a 
major priority. The government established the Agency for 
Restructuring Credit Organizations (ARCO). Its job was to 
ensure that those banks that had no hope of surviving would 
disappear while recapitalizing potentially viable banks under 
conditions that would make them profitable.
---------------------------------------------------------------------------
    \8\ One report estimates that 80 percent of household deposits are 
held by Sberbank. Talskaya, Marina. Russia Misled Western Creditors. 
Vremya. September 13, 2000.
    \9\ EBRD. Strategy for the Russian Federation. Paris. October 2000. 
p. 16.
---------------------------------------------------------------------------
    However, few banks have closed. At the end of the third 
quarter of 1998, the height of the financial crisis, there were 
2,473 commercial banks in Russia. By the end of the second 
quarter 2001, only 398 banks had been closed.\10\ Most of the 
remaining banks are not viable, and the sector remains under-
capitalized.\11\ Unless the banking sector is restructured and 
banks are in a position to lend, the expansion of the business 
sector, and consequently of the economy as a whole, is stymied. 
Russian enterprises have relied on retained earnings as a 
source of investment, rather than banks, thereby severely 
limiting industrial expansion.
---------------------------------------------------------------------------
    \10\ Central Bank of the Russian Federation (Central Bank of Russia 
or CBR). Bulletin of Banking Statistics. No. 7. 2001. p. 64.
    \11\ Economist Intelligence Unit. September 2000. p. 31.
---------------------------------------------------------------------------

                           Living Conditions

    The macro-economic performance and the structural economic 
problems in Russia have had a direct impact on living 
conditions for the average Russian. These conditions have 
deteriorated during the past 10 years. The conventional 
measures of living standards--real disposable income, 
unemployment, poverty, and life expectancy--indicate that the 
transition has adversely affected the average Russian, although 
here, too, experts differ on the significance and accuracy of 
the data.

                              real income

    Russian real disposable income, a basic measure of economic 
welfare or purchasing power, has fluctuated during the 10 year 
period, but has declined appreciably overall. According to 
official government data, from 1992 through 1994, the level of 
real income increased. Between 1994 and 1996, real income 
declined substantially (16 percent) before recovering modestly 
in 1997, mirroring the upturn that year in real GDP. However, 
the data in Figure 2 indicate that the 1998 financial crisis 
had a major impact on the buying power of the average Russian. 
Between the end of 1997 and the end of 1999, the level of real 
disposable income declined 27 percent and rose only modestly (9 
percent) in 2000. The data suggest that despite the recovery in 
the last 2 years, Russian real disposable income was still 21 
percent below its level in 1997, before the financial crisis, 
and remained slightly below its level when the transition began 
in 1992. Preliminary figures show that during the first 6 
months of 2001, real disposable income rose 4.4 percent.\12\
---------------------------------------------------------------------------
    \12\ Jamestown Foundation Monitor. August 6, 2001.

      FIGURE 2._INDEX OF REAL RUSSIAN DISPOSABLE INCOME, 1992-2000

                              [1992 = 100]
[GRAPHIC] [TIFF OMITTED] T6171.022


  Index constructed by CRS based on Goskomstat data.

                           unemployment rate

    Russia has had to confront the phenomenon of unemployment 
in the post-Soviet period. Under the Soviet system, everyone 
had a job, although much of that labor was redundant. Economic 
changes in the last 10 years have forced Russian firms to 
rationalize their business practices, in order to compete. They 
have had to layoff workers or, in some cases, firms have had to 
close down thereby eliminating jobs. The unemployment rate has 
risen, accordingly, although some specialists argue that 
standard indicators do not accurately measure the magnitude of 
Russian unemployment. In some cases, the unemployment rate may 
not take into account redundant labor as some firms are forced 
to retain workers because the firms remain the primary 
distributor of housing, food, and other necessities, even 
though the employees may not be actually working. In other 
cases, the unemployment rate may not take into account laborers 
who work in ``the shadow economy,'' in jobs not captured by 
official statistics.
    The data in Table 2 show that the economic transition has 
taken a toll on workers. The rate of unemployment had risen 
since the beginning of the economic transition period in 1992, 
peaking at 12.6 percent in 1999. As a result of the recent 
economic expansion, the unemployment rate has declined since 
1999 but is still above the rates of the early 1990s and is 
almost double the rate in 1992. The increase in unemployment 
may prove beneficial to the Russian economy, if the economy is 
shedding unproductive labor. While painful to the individual 
worker in the short run, the process can improve overall labor 
productivity in the economy. The economy then can create more 
employment through growth, which seems to be the case in the 
recent drop in the unemployment rate. But the process also 
draws on government resources to provide unemployment insurance 
and other safety net benefits to assist unemployed workers 
through the transition.

                                 TABLE 2.--RUSSIAN UNEMPLOYMENT RATE, 1992-2001
                     [Percentage of workforce, International Labor Organization definition]
----------------------------------------------------------------------------------------------------------------
                      Year                           Rate                     Year                     Rate
----------------------------------------------------------------------------------------------------------------
1992...........................................           4.7  1997.............................           10.8
1993...........................................           5.5  1998.............................           11.9
1994...........................................           7.4  1999.............................           12.6
1995...........................................           8.5  2000.............................           10.4
1996...........................................           9.6   2001 \1\........................            8.2
----------------------------------------------------------------------------------------------------------------
\1\ As of August 2001.
 Source: For the 1992-1994 data--Goskomstat. For 1995-2001--Russian Economic Trends, October 2001.


                                poverty

    The Russian statistical committee measures poverty as the 
percentage of the population that lives below an officially 
established subsistence level. The government calculates the 
subsistence as the cost of purchasing a set basket of goods and 
adjusts that level annually.\13\ The Russian Government has 
also revised its methodologies for calculating the poverty 
rate, at times making the construction of a consistent data 
series somewhat difficult.\14\ The Russian Government changed 
the methodology in 1994 and 2000, partially accounting for some 
of the abrupt downward shifts in the poverty rates in those 
years.
---------------------------------------------------------------------------
    \13\ At the end of 2000, the official subsistence level was around 
1,285 rubles, or about $44, per month.
    \14\ For example, the methodology was changed in 1994 which biased 
the rate downward. The change accounts for some of the step drop in the 
poverty rate that year. One study estimates that the poverty rate would 
have risen to around 34 percent if the methodology had not been 
changed. Similarly, the government changed it again that added an 
upward bias. Ovtcharova, Lilia. What Kind of Poverty Alleviation Policy 
Does Russia Need. Russian-European Center for Economic Policy. Research 
Paper. May 2001. pp. 4-5.
---------------------------------------------------------------------------
    The data indicate, however, that the poverty rate declined 
somewhat between 1994 and 1997, but that the financial crisis 
in 1998 eliminated these gains as the poverty rate increased 
markedly by 1999. This trend is in line with the dramatic 
decrease in real disposable income and the rise in the 
unemployment rates in those years as noted in Figure 2 and 
Table 2. The growth of poverty is another sign of deteriorating 
living conditions in Russia. The Russian people are well known 
for managing to survive with little income through subsistence 
farming on private plots and through barter. Nevertheless, the 
low officially-determined level of subsistence means that a 
significant number of individuals may be living well below what 
would be considered subsistence in many other countries. Other 
data indicate among those that are considered living in poverty 
are a number of people who live substantially below the 
official poverty level.

                               TABLE 3.--RUSSIAN ANNUAL RATE OF POVERTY, 1992-2000
                                           [Percentage of population]
----------------------------------------------------------------------------------------------------------------
                      Year                           Rate                     Year                     Rate
----------------------------------------------------------------------------------------------------------------
1992...........................................          33.5  1997.............................           21.2
1993...........................................          31.5  1998.............................           24.6
1994...........................................          22.4  1999.............................           39.1
1995...........................................          26.2  2000.............................           33.7
1996...........................................          21.4   2001 \1\........................           31.3
----------------------------------------------------------------------------------------------------------------
\1\ As of June 2001.
 Source: Goskomstat, Russian Economic Trends.


                            life expectancy

    A significant indicator of the deterioration of living 
conditions in Russia has been the decline in the life 
expectancy of the average Russian, especially the Russian male. 
In 1991, life expectancy for males was 64 years and 74 years 
for females. By 1999, it had declined to 59 years for males and 
72 years for females placing Russia among developing countries 
in that category. Increases in alcoholism and other diseases, 
some of which like tuberculosis have been nearly eradicated in 
developed countries, have contributed to the decline. It is 
also explained by the poor and deteriorating health system 
which has been slow to adjust to the transition from central 
planning. A World Health Organization (WHO) report ranks the 
Russian health care system 130th in the world, below that of 
even many developing countries.\15\
---------------------------------------------------------------------------
    \15\ WHO. World Health Report 2000. http://www.who.org.
---------------------------------------------------------------------------

                            income disparity

    The distribution of income within Russia has become 
increasingly unequal during the post-Soviet period. A standard 
measure of income distribution is the Gini coefficient (or 
index) which is on a 0.00 to 1.00 scale. The lower the number 
the more equal the income distribution. Thus, 0.00 is perfectly 
equal income distribution, while 1.00 is totally unequal.
    According to Table 4, the Gini coefficient for the Russian 
population has increased. This conclusion is underscored by a 
second measure of income distribution, which shows how income 
has been distributed at various income levels of Russian 
society. These data show that in 1991, before the collapse of 
the Soviet Union, the richest 20 percent of Russian the Russian 
population accounted for 30.7 percent of Russian income while 
the poorest 20 percent accounted for 11.90 percent. By early 
2000, the richest 20 percent held 48.6 percent of the income 
while the poorest 20 percent's share had declined to 5.9 
percent. The middle 60 percent of the population's share had 
declined from 57.4 percent in 1992 to 45.4 percent by early 
2000.\16\ The two sets of income distribution indicators mean 
that some segments of the Russian population have suffered more 
than others as living conditions in Russia have deteriorated 
during the past decade.
---------------------------------------------------------------------------
    \16\ Goskomstat.

                                      TABLE 4.--RUSSIAN INCOME DISTRIBUTION
                                               [Gini coefficient]
----------------------------------------------------------------------------------------------------------------
                      Year                           Rate                     Year                     Rate
----------------------------------------------------------------------------------------------------------------
1992...........................................         0.289  1997.............................          0.375
1993...........................................         0.398  1998.............................          0.379
1994...........................................         0.409  1999.............................          0.394
1995...........................................         0.381  2000.............................      \1\ 0.401
1996...........................................        0.375
----------------------------------------------------------------------------------------------------------------
\1\ Estimate.
 Source: Goskomstat.


                     External Economic Performance

    Russia's foreign economic has driven recent economic 
growth. However, Russia has also proved vulnerable to the 
vagaries of foreign markets, which could eventually undermine 
the growth.

                             foreign trade

    The role of foreign trade in the Russian economy has 
increased since Russia embarked on its transition. According to 
some rough estimates in 1994 (the earliest data available) 
exports were equivalent to 24 percent of Russian GDP. By 2000, 
the percentage had grown to 42 percent. Russian imports were 
equivalent to 18 percent of Russian GDP in 1994 and in 
2000.\17\ Furthermore, Russian trade is largely conducted 
outside of the former Soviet Union. By 2000, only 14 percent of 
Russian exports and 30 percent of Russian imports were with 
former Soviet republics. In 2000, Russian exports were split 
50-50 between the industrialized countries (Canada, the United 
States, Europe, Japan, Australia, and New Zealand) and 
developing countries. Developing countries accounted for 
approximately two-thirds of Russian imports and industrialized 
countries account for the remaining one-third.\18\ These 
figures indicate that the Russian economy has changed from one 
that operated under the closed system during the Soviet period 
where most trade was conducted within the Soviet bloc, 
including Central and Eastern Europe, to one where trade has 
become geographically diverse.
---------------------------------------------------------------------------
    \17\ Calculations based on International Monetary Fund (IMF) data 
in International Financial Statistics. July 2001. pp. 702, 704, 706. 
Trade data are expressed in dollars, while GDP data are in rubles. The 
ruble figures were converted into dollars using an exchange rate of 
2.19 rubles per dollar for 1994 and 28.1 rubles per dollar for 2000.
    \18\ IMF. Direction of Trade Statistics. June 2001. p. 214.
---------------------------------------------------------------------------
    However, Russian trade particularly Russian exports, is 
highly concentrated in a narrow group of commodities. In 2000, 
50 percent of Russian exports were in oil and oil products and 
natural gas. The share of commodities increases to over 65 
percent, when exports of other raw materials, such as metals, 
are included.\19\ These figures suggest that Russian trade is 
highly vulnerable to the often volatile world market prices for 
energy and raw materials. They also indicate that after 10 
years of transition, the manufacturing sector of the Russian 
economy remains uncompetitive.
---------------------------------------------------------------------------
    \19\ Russian Economic Trends. June 2001. p. 22.
---------------------------------------------------------------------------
    In 2000, the Russian current account (trade in goods and 
services, plus investment income, and unilateral transfers) had 
a surplus of $46.3 billion, soaring from $24.6 billion in 1999 
and from $0.7 billion in 1998. The surplus has allowed the 
Central Bank of the Russian Federation (Central Bank of Russia 
or CBR) to build up foreign reserves to $24 billion by the end 
of 2000 (not including gold reserves).\20\
---------------------------------------------------------------------------
    \20\ IMF. International Financial Statistics. July 2001. pp. 704, 
706.
---------------------------------------------------------------------------

                          foreign investments

    With outdated infrastructure and other modernization 
requirements the Russian economy needs financial capital. Other 
economies in transition, such as Hungary and Poland, have 
proved ripe targets of foreign investors. Yet, Russia has run 
up large capital account deficits indicating minimal confidence 
of foreign investors in the long-term prospects of the Russian 
economy.
    Both the Yeltsin and Putin governments have promoted 
foreign direct investment (FDI). Loosely defined, FDI is long-
term investment in plants and real estate. Through FDI, foreign 
investors establish a presence in the economy that often 
includes transfers of technology, management skills, and other 
intangible assets. The Russian economy so far has failed to 
attract much foreign investment during the post-Soviet 
transition.
    From 1992 to 1999, total FDI flows into Russia were $19.8 
billion (see Table 5), one-third of which occurred in one year, 
1997. In comparison, total FDI flows into Poland were $31.0 
billion. The Russian FDI level was more comparable to that of 
Hungary ($17.8 billion), an economy that is much smaller than 
Russia. Moreover, the trends are not improving despite economic 
growth. In 2000, $2.7 billion in FDI flowed into Russia, down 
from $3.2 billion in 1999. In fact, FDI outflows from Russia in 
2000 exceeded inflows by about $500 million. During the first 
half of 2001, $1.2 billion in FDI flowed into Russia, while 
$1.5 billion flowed out of Russia.\21\ (These recent numbers 
are preliminary and subject to revision.)
---------------------------------------------------------------------------
    \21\ Central Bank of Russia. Balance of Payments Data. http://
www.cbr.ru.
---------------------------------------------------------------------------
    The regional distribution of FDI into Russia has been 
highly uneven. According to Goskomstat data reproduced by the 
Organization for Economic Cooperation and Development, as of 
January 1, 2000, Moscow and its environs accounted for 48.9 
percent of the stock of FDI in Russia. Sakhalin region was next 
with 5.1 percent.\22\
---------------------------------------------------------------------------
    \22\ OECD. The Investment Environment of the Russian Federation-
Laws, Policies, and Institutions. p. 194. Paris. 2001.
---------------------------------------------------------------------------
    Portfolio investments are all other foreign investments 
besides direct investments--government bonds, corporate stocks 
and bonds, treasury bills, etc. By their nature portfolio 
investments do not represent as firm a commitment and are an 
indicator of short-term investors' outlook for an economy. 
Russia has not done well in attracting portfolio investments, 
either, especially since the 1998 crisis. Table 6 shows that 
portfolio investments surged, in 1997 to $46 billion. In 1998, 
the year of the crisis, $8.9 billion still flowed to Russia. 
But in 1999 and 2000, Russia incurred a disinvestment of 
foreign portfolio assets, $1.3 billion and $9.9 billion, 
respectively. During the first half of 2001, portfolio 
investments into Russia were only slightly negative.

                         TABLE 5.--FOREIGN DIRECT INVESTMENT (FDI) IN RUSSIA, 1992-2000
                                            [In billions of dollars]
----------------------------------------------------------------------------------------------------------------
                      Year                           Rate                     Year                     Rate
----------------------------------------------------------------------------------------------------------------
1992...........................................          $0.7  1997.............................           $6.6
1993...........................................           1.2  1998.............................            2.8
1994...........................................           0.6  1999.............................            3.3
1995...........................................           2.0  2000.............................            2.7
1996...........................................           2.5  1992-2000........................           19.8
----------------------------------------------------------------------------------------------------------------
Source: Central Bank of the Russian Federation (Central Bank of Russia or CBR).



                           TABLE 6.--PORTFOLIO INVESTMENT FLOWS INTO RUSSIA, 1994-2000
                                            [In billions of dollars]
----------------------------------------------------------------------------------------------------------------
                      Year                           Rate                     Year                     Rate
----------------------------------------------------------------------------------------------------------------
1994...........................................         -$0.1  1998.............................           $8.9
1995...........................................          -0.7  1999.............................           -1.3
1996...........................................           4.6  2000.............................           -9.9
1997...........................................         46.0
----------------------------------------------------------------------------------------------------------------
Source: Central Bank of Russia.


    The trends in foreign direct and portfolio investments in 
Russia indicate that investor confidence in the Russian economy 
weakened rather than strengthened. This conclusion is 
reinforced by the problem that Russia has had with ``capital 
flight.'' Capital flight is an abnormal flow of funds whose 
holders seek safe havens from financial uncertainty and 
taxation or to launder proceeds from illegal activities. 
Russian capital flight is a longstanding problem with very 
negative consequences for the Russian economy. It deprives the 
Russian economy of critical investment and tax revenues that 
might be used for restructuring the pension system and other 
social security programs. More importantly, capital flight 
indicates a lack of confidence by Russian and foreign investors 
in the Russian ruble, in the Russian financial system, and more 
generally, in the Russian economy. Capital flight signifies 
that Russia's transition to a market economy continues to be 
incomplete and far from sustainable.
    Estimates of the amount of Russian capital flight vary 
according to definition and context. Most estimates suggest 
that between 1992 and 1999, $150 billion of capital left Russia 
as capital flight. Furthermore, the problem of capital flight 
has remained the same or may have worsened. According to one 
estimate, Russian capital flight was $28 to $29 billion in 
2000, an increase from $24 billion in 1999.\23\
---------------------------------------------------------------------------
    \23\ This estimate is from the Ministry of Finance's Economic 
Experts Group and is cited in the Economist Intelligence Unit. Country 
Report: Russia. March 2001. p. 39.
---------------------------------------------------------------------------

                              foreign debt

    The Russian Government carries a rather heavy burden of 
foreign debt. Much of this debt was inherited from the Soviet 
Union. As part of an arrangement with the other former Soviet 
states, Russia agreed to accept the obligations of servicing 
the Soviet debt in exchange for control over Soviet official 
assets abroad, such as embassy facilities. As Table 7 below 
shows, much of the Soviet debt was in the form of credits 
extended or guaranteed by foreign governments to finance Soviet 
Government purchases of equipment for major projects. Since the 
Soviet Union's collapse, Russia has incurred its own foreign 
debt obligations particularly in the form of loans from the 
International Monetary Fund (IMF), the World Bank, and the 
European Bank for Reconstruction and Development (EBRD).

                  TABLE 7.--RUSSIAN FOREIGN DEBT, 2000
                        [In billions of dollars]
------------------------------------------------------------------------
 ------------------------------------------------------------------------
Post-Soviet Russian debt...................................       $44.5
Debt inherited from the Soviet Union.......................        97.7
                                                            ------------
    Total federal government...............................      $142.2
                                                            ============
Russian regional authorities...............................         2.0
Central Bank of Russia.....................................         3.4
Russian private sector debt................................        27.9
                                                            ------------
        Total..............................................       175.6
------------------------------------------------------------------------
Source: Central Bank of Russia, Economist Intelligence Unit.


    Various measures are used to determine the burden of 
foreign debt on a nation's economy. It is not the absolute size 
of the debt that is critical but its term structure, 
composition, and size relative to the economy's ability to meet 
the servicing obligations.
    IMF data (see Table 8) show the level of Russia's long-term 
debt-service payments and the ratio of these payments to the 
level of Russia's exports for the years 1997 to 2005.\24\ Data 
for the years 2000 through 2005 are projections. Although debt 
service payments are projected to remain roughly stable between 
2001 and 2002, they are projected to rise in 2003 to $23.3 
billion, equal to 20.6 percent of goods and service exports, 
the highest percentage share since 1999, when they stood at 
23.9 percent.
---------------------------------------------------------------------------
    \24\ This analysis of the Russian debt burden is drawn from work by 
Patricia Wertman, Specialist in International Trade and Finance, CRS, 
and various IMF reports.

        TABLE 8.--RUSSIA'S FOREIGN DEBT SERVICE BURDEN, 1997-2005
------------------------------------------------------------------------
                                           Debt-service
                                           payments (in    Debt service/
                  Year                      billions of     exports (in
                                             dollars)        percent)
------------------------------------------------------------------------
1997....................................           $15.4            24.9
1998....................................            17.5            20.0
1999....................................            20.3            23.9
2000....................................            15.7            13.8
2001....................................            18.2            15.8
2002....................................            18.2            16.1
2003....................................            23.3            20.6
2004....................................            17.4            14.9
2005....................................            19.2            15.7
------------------------------------------------------------------------
Data for 2001 through 2005 are projections.
 Source: IMF, Russian Federation: Post-Program Monitoring Discussions--
  Staff Report and Public Information on the Executive Board Discussion.
  IMF Country Report no. 01/02. July 2001.


    Russia is projected to face a debt servicing burden 
ballooning in 2003. Nevertheless the IMF projects that Russia 
should be able to service the burden from its own resources. 
The IMF forecast assumes that declining oil prices will be 
offset by an improved domestic economic climate that will 
encourage foreign investment and the return of capital. In 
addition, the structural reforms, the IMF assumes, will allow 
Russia to boost non-energy exports cutting its dependence on 
oil and natural gas exports. Any dramatic negative shifts in 
these assumptions would affect Russia's debt forecast, and 
therefore the projections are subject to revision.\25\ The 
trends in foreign investment and capital flight for 2000 and 
2001 noted above would indicate that Russia's international 
financial situation may be deteriorating rather than improving.
---------------------------------------------------------------------------
    \25\ IMF Country Report: Russian Federation. No. 01/102. July 2001. 
pp. 17, 25, 26.
---------------------------------------------------------------------------

                Analyzing Russia's Economic Performance

    The decade of economic transition has taken a large toll on 
the Russian economy and its people. Individual Russian data 
series may not accurately measure the economic performance. 
However, by examining the economic performance from a variety 
of perspectives, it is accurate to conclude that the Russian 
standard of living has declined considerably over the last 10 
years. In some respects, the average Russian citizen is worse 
off now than he or she was prior to the end of the Soviet 
Union, and the depth of economic decline will require Russia to 
generate high growth rates over a significant period of time in 
order to regain what its people have lost. The data on Russian 
poverty levels, life expectancy, shrinking population, and 
health-related conditions point to an economic decline that has 
left deep roots and long-term problems.
    Furthermore, the burden of the economic contraction has 
fallen disproportionately on some segments of Russian society 
and on some regions of the Russian Federation. The income gap 
between the richest and poorest segments of the Russian 
population has widened significantly in the last 10 years. In 
addition, the available wealth in the Russian economy has been 
concentrated in the larger, more politically influential 
regions of Moscow and St. Petersburg and in those regions 
naturally endowed with oil and other commodities. Other 
regions, such as those in the Caucasus, are much poorer and 
have been hit much harder by the effects of the transition.
    Russia has shown signs of economic recovery since 1999, and 
that recovery appears to be generated in most sectors on the 
demand and supply sides of the GDP equation. Of particular 
importance has been the surge in investment in equipment and 
machinery. Russia's infrastructure in both the public and 
private sectors is sorely outdated, so new investment is a 
welcomed and necessary trend. Russian living standards have 
also shown signs of improving in the last 3 years with modest 
increases in real income and consumption.
    Furthermore, Russian terms of trade have improved 
significantly boosting current account surpluses and Russian 
foreign currency reserves. This trend has allowed Russia's to 
meet its immediate foreign debt service obligations without 
incurring more debt. However, the large and increasing outflows 
of capital, especially in the form capital flight, strongly 
suggest that investors, both foreign and Russian, are skeptical 
about the depth of Russia's economic recovery.
    What lies behind Russia's economic performance? In general, 
as many observers have pointed out, Russia's transition away 
from central planning was bound to be more difficult and longer 
than that of the Central and East European states. The 
Communist system was much more entrenched in the Soviet Union 
than it was in the rest of the Soviet bloc. Furthermore, Russia 
does not have a legacy of market economy to draw on as is the 
case with some of the Central and East European states. Russia 
has had to deal with the legacy of a Soviet economy that was 
administered to meet the needs of the military while civilian 
production and investment were given low priority.
    However, the Soviet legacy aside, Russia's economic 
problems were also grounded in policy failures during the 
transition. These failures included loose monetary and fiscal 
policies early in the transition period. They have also 
included structural problems such as poorly developed and 
executed privatization programs that have left many potentially 
productive assets in the control of enterprise mangers from the 
Soviet period or in the hands of a few politically-connected 
individuals (oligarchs) who extracted the value from many of 
these assets rather than making them commercially viable for 
the long run. In addition, an inefficient banking system, the 
lack of private land ownership protection, the absence of a 
adequate system of commercial laws, and an inefficient and 
corrupt government bureaucracy inhibited economic growth and 
development.
    Despite the setbacks and the challenges for Russian 
policymakers, it is important to keep in mind what Russia has 
accomplished in terms of economic reforms during the last 
decade:

   The government has eliminated price controls on most 
        goods and services. This reform has been important 
        because it allows the market forces of supply and 
        demand to guide producers and consumers on purchasing, 
        production and investment making the economy more 
        efficient. Controls have remained on some important 
        items, such as energy, housing, and transportation, but 
        these, too, are scheduled for removal.
   Russia has opened its economy to foreign trade and 
        investment.
   The structure of Russian production more closely 
        resembles that of an open economy than of a militarized 
        economy. For example, the service sector accounts for a 
        much larger share of national output than does the 
        goods sector.
   The ruble is convertible, and Russian residents may 
        hold hard currency assets which can be a hedge against 
        inflation and help protect Russian savings.
   The private sector accounts for roughly three-
        fourths of national output.

    The economic growth that Russia has experienced since 1999 
has been largely driven by favorable trends in the Russian 
balance of payments. The sharp depreciation of the ruble in 
1998 cut demand for imports and encouraged domestic production 
of goods. A rapid increase in world oil prices boosted revenues 
from Russian exports. Those factors are by nature ephemeral, 
subject to sudden changes. Indeed, the ruble has recently been 
appreciating in real terms causing imports to increase and 
reducing the price competitiveness of Russian goods. 
Nevertheless, the Russian economy in terms of real GDP 
continues to grow in 2001 at an estimated 5.5 percent rate 
suggesting that domestic demand may be driving some of the 
growth. It is difficult to estimate how long this trend will 
continue.

                     Policy Implications for Russia

    Sustainable economic growth is critical to Russia. Among 
other things, it is necessary in order to improve the standard 
of living of the average Russian, and, as the above analysis 
has indicated, the standard of living needs improvement. In 
addition, sustainable economic growth is necessary in order to 
generate tax revenues to meet growing pressures on the 
government sector.
    The question of whether Russia's current economic growth is 
sustainable over the long term or just short term has 
significant policy implications for Russia. If the answer is 
the former, then Putin and his team could give the economy 
lower policy priority and delay undertaking politically 
challenging structural reforms.
    Some specialists have suggested that Russia's period of 
economic growth indicates that the Russian economy has turned 
the corner and is on the road to sustained economic growth.\26\ 
However, the above analysis suggests that one must be cautious 
in extrapolating long-term trends from the record of the past 3 
years. The analysis, instead, indicates that the economic 
growth is fragile and that without continued economic reforms 
it may not be sustainable. Many of these reforms would be aimed 
at increasing investor confidence in the Russian economy. They 
would include, banking reform, tax reform, land policy reform 
and the protection of property rights, government regulatory 
reform, and legal reform.\27\ The Putin government and the 
Russian Duma have proceeded with introducing and passing some 
of these reforms which are part of the Putin team's economic 
strategy for the next decade. Some of these reforms are 
difficult because they will entail fundamental changes in the 
way of life for Russians. At the same time, the Putin 
leadership will have to preserve the ``accomplishments'' of 
past years. For example, macro-economic stability, that is low 
inflation and a stable exchange rate, is critical to gaining 
investor confidence and ensuring an environment conducive to 
sustainable economic growth.
---------------------------------------------------------------------------
    \26\ See, for example, Aslund, Anders. The Bear Turns Bullish. 
World Link. July-August 2000. pp. 49, 51, 53-54. (Available on the 
Carnegie Endowment for International Peace Web site: http://
www.ceip.org/files/Publications/aslund/). Another expert who subscribes 
to this point of view is Yegor Gaidar, the former Russian Prime 
Minister. The Political and Economic Situation in Russia. Remarks to 
the Carnegie Endowment for International Peace. January 29, 2001. 
http://www.ceip.org/files/events/.
    \27\ OECD. The Investment Environment in the Russian Federation: 
Laws, Policies, and Institutions. Paris. 2001. pp. 36-37.
---------------------------------------------------------------------------
    Economic reforms will require political support. The 
current period of economic growth is a ``window of 
opportunity'' for the Putin leadership to undertake these 
reforms because it has provided Russians with some relief from 
the adverse impact of the transition and has generated popular 
support for Putin.

                   Implications for the United States

     Russia's economic performance has significant implications 
for U.S. interests. How Members of Congress and other 
policymakers view Russia's economic performance in relation to 
U.S. national interests is a function of their views of the 
fundamental nature of the U.S.-Russian relationship.
    In some respects, an economically weakened Russia has 
benefited the United States by greatly reducing it as a 
military threat. Some might argue, therefore, that a weak 
Russian economy will help to prevent the threat from 
reemerging. The military sector will have to compete with other 
domestic needs for limited resources helping to keep military 
spending down. In addition, Western creditors could maintain 
some financial leverage over Russia which might help to manage 
any threat to U.S. interests. This view is held by many of 
those who still see Russia as primarily a security threat, 
albeit a weakened one.
    On the other hand, others believe an economically strong 
Russia better would serve U.S. interests. Many in the business 
and financial communities and those who analyze the U.S.-
Russian relationship within an economic framework hold this 
view. It can be argued, for example, that an economically 
efficient and expanding Russia enhances U.S. and global 
economic welfare. Russia is viewed by many as a trade partner 
and target for U.S. investments, and these opportunities will 
grow as Russia becomes healthier economically. Furthermore, an 
economically strong Russia would be less likely to have to 
export arms to states whose policies are adverse to U.S. 
national interests. Some also hold that an economically stable 
Russia would mean a politically stable Russia which would 
benefit the United States, its allies, and the countries 
surrounding Russia.

                     Appendix A: Notes on the Data

    This survey of Russia's economic performance relies on 
official Russian Government data published by the Russian 
Government State Committee on Statistics (Goskomstat), the 
Russian Ministry of Finance, the Central Bank of Russia, and 
the Russian Economic and Trade Ministry. These data are derived 
directly from these agencies through their online sites or 
through secondary sources, such as Russian Economic Trends. 
Russian economic data, as with the Russian economy, has been 
going through a major transition since the collapse of the 
Soviet Union. Soviet data and early versions of Russian 
official data were notoriously unreliable.
    Russian Government data-collection methodologies have 
improved over time and with them so has the quality of data. 
Russia's participation in international organizations, such as 
the IMF and the World Bank, and its bid to join the World Trade 
Organization (WTO), have required Russian data collectors to 
conform to international standards. As many analysts continue 
to point out, the current versions of economic data still 
suffer shortcomings, for example, under-reporting of some 
activity in the ``grey economy.'' Nevertheless, the data do 
allow analysts to measure trends and changes in magnitude and 
thus to construct an informative survey Russia's economic 
performance over the last decade. Possible shortcomings in the 
official data will be noted in the survey.

                 Appendix B: The 1998 Financial Crisis

    The 1998 financial crisis proved to be a pivotal event in 
Russia's transition to a market economy. It exposed many of the 
weaknesses of Russian economic policies and the need for 
economic reform.\28\
---------------------------------------------------------------------------
    \28\ This is a brief discussion. For more analysis of the financial 
crisis see CRS Report 98-578, The Russian Financial Crisis: An Analysis 
of Trends, Causes, and Implications, by William H. Cooper.
---------------------------------------------------------------------------

                                symptoms

    The crisis culminated in August 1998, when the government 
of then-Prime Minister Sergei Kiriyenko abandoned its defense 
of a strong ruble. It also defaulted on official domestic debt 
forcing its restructuring and imposed a 90 day moratorium on 
commercial external debt payments. The crisis led to the demise 
of many Russian banks, owned by oligarchs, which had held 
government debt. The crisis also led to Kiriyenko's firing by 
Russian President Yeltsin who replaced him with Prime Minister 
Primakov.
    Symptoms of the crisis developed months before August.

   Interest rates soared.--Yields on GKOs rose sharply 
        in a matter of months--to 135.3 percent by the end of 
        August 1998. The CBR refinancing rate skyrocketed from 
        30 percent at the end of April to 150 percent by the 
        end of May. The CBR's overnight interbank lending rate 
        increased from an average of 45.3 percent in August to 
        135.3 percent in September 1998.\29\
---------------------------------------------------------------------------
    \29\ Central Bank of Russia data published in Russian Economic 
Trends. September 15, 2000. p. 29.
---------------------------------------------------------------------------
   Stock market values plummeted.--The Moscow Times 
        (MT) index of stock prices declined 79 percent from the 
        end of April to the end of August 1998.\30\
---------------------------------------------------------------------------
    \30\ Ibid. p. 30.
---------------------------------------------------------------------------
   The value of the Russian ruble sank.--Between the 
        end of July 1998 and the end of September 1998, the 
        ruble lost 60 percent of its (nominal) value in terms 
        of the dollar.\31\
---------------------------------------------------------------------------
    \31\ Furthermore, the ruble continued to decline losing 71 percent 
of its value from April to the end of 1998. Measured on a real 
effective exchange rate basis (adjusted for inflation), the ruble 
depreciated 41 percent between April and December 1998. CRS 
calculations based on data in Ibid.
---------------------------------------------------------------------------
   Foreign reserves declined sharply.--Between the end 
        of July 1998 and August 1998, the reserves, including 
        gold, dropped from $18.4 billion to $12.5 billion.\32\
---------------------------------------------------------------------------
    \32\ Ibid.
---------------------------------------------------------------------------
   Real GDP dropped 4.9 percent in 1998 after a modest 
        increase in 1997 and inflation soared to 84.4 percent 
        from 11.0 percent the year before.\33\
---------------------------------------------------------------------------
    \33\ Ibid. p. 22.
---------------------------------------------------------------------------

                                 causes

    The immediate cause of the crisis was the accumulation of 
Russian Government short-term debt in the form of GKOs and 
bonds (OFZs), to finance burgeoning budget deficits. As long as 
the Russian Government could service the debt, it managed to 
maintain large budget deficits without incurring inflation and 
was able to keep the ruble stable.
    But beginning in 1997 and into 1998, a number of forces 
came into play that placed Russia in a financially vulnerable 
position:

   World prices for oil and other commodities, on which 
        Russian depends for much of its foreign currency 
        earnings, plummeted, putting downward pressure on 
        foreign currency reserves and making it more difficult 
        to service the debt and defend the ruble.
   The Asian financial crisis made investors much more 
        wary of holding risky short-term securities such as 
        GKOs.
   The decline in demand for Russian debt and declining 
        world commodity prices put downward pressure on the 
        Russian ruble, making foreign debt servicing much more 
        expensive.

    Foreign economic shocks that hit a financially vulnerable 
Russia largely explain the suddenness of the 1998 financial 
crisis. The effects of the crisis are still being felt. But 
analysts explain how Russia got to this point of vulnerability 
by citing more fundamental problems with Russian economic 
policy and economic structure. These included the failure to 
institute tax reform, property rights, and bankruptcy laws and 
procedures.
      

=======================================================================




                      RUSSIA'S ECONOMIC CHALLENGES

=======================================================================







          Removing Barriers and Providing an Incentive System


         THE RUSSIAN ECONOMY: HOW FAR FROM SUSTAINABLE GROWTH?


                            By Ben Slay \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................    25
Introduction.....................................................    25
Russian Macro-economic and Political Economy Trends, 1991-2001...    27
Russia's External Trends.........................................    33
Russia's Unfinished Reform Agenda................................    37
    Reform of infrastructure sectors.............................    38
    Financial system.............................................    39
Leading Indicators for the Future of Russia's Transition.........    44
    Business formation...........................................    44
    Labor force participation rates..............................    45
    Commodity composition of exports.............................    45
    FDI levels and composition...................................    45
    The ``Putin factor''.........................................    45
                                Summary

    The consolidation of capitalism in Russia during the 1990s 
was difficult, but reform initiatives ultimately succeeded in 
stabilizing prices and restoring economic growth. Most markets 
have undergone significant liberalization, and the bulk of the 
enterprise sector is in private hands. But the consolidation of 
these changes is likely to require important structural reforms 
that comprise Russia's ``unfinished reform agenda.'' In the 
short run by 2010, institutional reform, particularly in the 
infrastructure and financial sectors, would be necessary to 
establish a well-functioning market economy with sustained 
growth. If reform is not completed by 2010, Russian leadership 
could still finish the unfinished agenda.
---------------------------------------------------------------------------
    \1\ Ben Slay is Director, Regional Support Centre, United Nations 
Development Programme's Regional Bureau for Europe and the CIS, 
Bratislava. The views in this paper do not necessarily reflect those of 
the United Nations. Much of this paper was written while the author 
worked as senior economist at PlanEcon, Inc., the Washington-based 
economics consultancy. The author acknowledges his gratitude for the 
PlanEcon data and analyses that underpin this paper.
---------------------------------------------------------------------------

                              Introduction

    Russia has had a capitalist economy since the mid-1990s. 
\2\ Market forces set most prices, and the bulk of Russian 
enterprises are privately owned. International economic 
integration has proceeded apace: exports of energy, metals, and 
raw materials play a key role in determining Russia's external 
creditworthiness and growth prospects. The imperative of fiscal 
balance has played a key role in federal budget policy since 
1999, while monetary and exchange rate policies reflect the 
tradeoffs between price stability and exchange rate 
competitiveness faced by central banks everywhere. Although 
elite commitment to democracy remains an open question, the 
inevitability of capitalism is widely accepted across Russia's 
political spectrum. And after years of sharp reported declines 
in output and incomes, the Russian economy has recorded growth 
in 4 of the past 5 years. The 14 percent cumulative expansion 
in gross domestic product (GDP) reported in 1999-2000 was 
Russia's best growth performance since the 1970s.\3\
---------------------------------------------------------------------------
    \2\ Aaslund, A., How Russia Became a Market Economy, Washington, 
DC, 1995, The Brookings Institution.
    \3\ All data are taken from the official monthly and annual 
publications for the Russian State Statistical Office and the Central 
Bank of the Russian Federation (Central Bank of Russia or CBR) (or from 
their Web sites) unless otherwise indicated. Indicators on poverty and 
inequality trends are taken from Human Development Report 2000: Russian 
Federation, UNDP, Moscow, 2001.
---------------------------------------------------------------------------
    But if Russian capitalism is here to stay, it is far from 
well-functioning. The creation of efficient markets supervised 
by regulatory institutions applying best international 
practices remains years (if not decades) away in many sectors. 
Most enterprises have passed out of full state ownership, but 
problems of corporate governance, the judicial system, and land 
ownership continue to distort property rights. Market forces 
determine prices, but administrative decisions keep key tariffs 
for energy, transport, and communal services well below market 
levels. Although the federal government reported an impressive 
fiscal adjustment during 1999-2001, sub-national fiscal policy 
leaves much to be desired. Unaddressed consequences of the 
August 1998 financial collapse continue to plague Russia's 
banking system, and foreign capital inflows remain minuscule. 
While Russia is fully servicing its sovereign external debt in 
2001, this is only the second year (after 1997) since the 
Soviet collapse in which Moscow has not stiffed its creditors. 
The strong economic growth reported during 1999-2000 was due in 
part to such transitory factors as high world prices for key 
energy exports, and the temporary effects of the ruble's sharp 
devaluation after August 1998. The signs of a slowdown were 
apparent in the first half of 2001, when industrial and GDP 
growth slowed to around 5 percent. And despite the strong 
growth recorded during 1999-2000, much of the country still 
lives in poverty.
    Like most transition economies, the Russian economy has 
markets, private enterprise, and is growing. But in contrast to 
the leading Central European and Baltic transition economies, 
Russia's development prospects remain constrained by sharp 
institutional divergences from best international practices. As 
the Russian Government itself has admitted,\4\ the economy is 
unlikely to find a sustainable development path unless these 
divergences are narrowed significantly. Russia also faces some 
worrisome demographic, public health, and infrastructure trends 
that raise troubling longer-term questions.\5\ While the 
economic development program for 2000-2020 promulgated by 
Economics Minister German Gref and approved by President 
Vladimir Putin acknowledges these problems, prospects for their 
effective resolution are far from certain.
---------------------------------------------------------------------------
    \4\ Osnovnye napravleniya sotsial'no-ekonomicheskogo razvitiya 
Rossii na dolgosrochnuyu perspektivu (Gref program), Ministry of 
Economy and Trade, Moscow, 2000 (http://www.economy.gov.ru/program/
soderzanie.html).
    \5\ See Russia's Physical and Social Infrastructure: Implications 
for Future Development, National Intelligence Council, Washington, DC, 
December 2000.
---------------------------------------------------------------------------
    This paper addresses these issues in the following manner. 
First is a brief narrative of key macro-economic and political 
economy trends since the Soviet collapse. Special emphasis is 
placed on the causes and implications of the August 1998 
financial crisis, and the drivers of the economic expansion 
that followed. Next is an investigation of external trends, 
paying particular attention to developments in the commodity 
composition of Russian trade, the balance of payments, foreign 
investment, capital flight, and relations with the country's 
creditors. Following that is an examination of key issues in 
the unfinished reform agenda, with particular emphasis on the 
infrastructure monopolies and the financial system. Last are 
some concluding remarks and some leading indicators on 
prospects for sustainable growth in Russia.

     Russian Macro-economic and Political Economy Trends, 1991-2001

    The official data in Table 1 show that Russian macro-
economic trends during the 1990s closely resembled patterns 
apparent in other transition economies. An initial period 
(1991-1994) of systemic collapse and deep structural changes 
was accompanied by triple- and quadruple-digit inflation and 
sharp declines in reported output and employment.\6\ This was 
the period in which many prices and commercial activities were 
liberalized (although not with Central European decisiveness), 
and ownership of thousands of state enterprises passed into 
private hands.\7\ It was also the period of deep political 
transformation (if not necessarily democratization), in which 
President Boris Yeltsin forcibly suppressed an insurrection in 
October 1993 orchestrated by the Communist and Nationalist 
opposition. A constitution was approved (in highly inauspicious 
circumstances) by plebiscite shortly thereafter, codifying the 
basic outlines of electoral democracy and a federal system.
---------------------------------------------------------------------------
    \6\ For a provocative investigation of the differences between 
actual and reported declines in output in Russia and other transition 
economies during this time, see Aaslund, A., ``The Myth of Output 
Collapse After Communism,'' Carnegie Endowment Working Paper 18, 2001, 
Washington, DC, Carnegie Endowment. (http://www.ceip.org/files/
Publications/wp18.asp?from=pubauthor) 2001
    \7\ Blasi, J.R., M. Kroumova, and D. Kruse, Kremlin Capitalism: 
Privatizing the Russian Economy, Cornell University Press, 1997, Ithaca 
and London.
---------------------------------------------------------------------------
    The introduction of a quasi-fixed exchange rate mechanism 
(the currency corridor) in July 1995 marked the end of the 
chronic macro-economic instability that characterized the first 
period of the Russian transition. The exchange rate's nominal 
peg and growing financial assistance from the International 
Monetary Fund (IMF) and World Bank helped inflation rates to 
fall sharply after mid-1995. Reduced financial instability 
helped attenuate the reported contraction in economic activity: 
annual declines in GDP fell to 3 to 4 percent during 1995-1996, 
and stopped in 1997. Slowing inflation, the appearance of 
economic growth, better relations with its creditors, Yeltsin's 
re-election in 1996, and propitious conditions on international 
capital markets caused the Russian stock market to boom.

                                                       TABLE 1.--MACRO-ECONOMIC TRENDS, 1991-2000
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                1991     1992      1993     1994      1995     1996     1997     1998     1999     2000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Dollar GDP (at purchasing power parity exchange rates,\1\ in   $1,063      $909     $830      $726     $696     $672     $678     $645     $680     $736
 billions)..................................................
Per-capita dollar GDP \2\...................................    7,200     6,100    5,600     4,900    4,700    4,500    4,600    4,400    4,700    5,100
Real GDP growth (in percent)................................     -5.0     -14.5     -8.7     -12.7     -4.1     -3.4      0.9     -4.9      5.4      8.3
Growth in personal consumption (in percent).................       -5        -3        0        -3       -7       -5        5       -3       -4        9
Growth in gross fixed investment (in percent)...............      -16       -40      -12       -24      -10      -18       -5      -10        5       16
Federal budget balance (percent of GDP).....................       NA        -3       -1        -5       -3       -4       -5       -3       -1        3
Consolidated budget balance (percent of GDP)................       NA        -4       -5       -10       -3       -4       -7       -4       -1        3
Consumer price inflation (annual average, in percent).......       96      1533      881       322      196       48       15       27       93       21
Unemployment rate (by ILO standards, in percent)............       NA       4.9      5.5       7.5      8.2     10.1     12.2     13.3     12.2      9.6
Gini coefficient (income inequality)........................     0.26      0.29     0.40      0.41     0.38     0.38     0.38     0.40     0.40     0.39
Population with below-subsistence incomes (in percent)......       NA        34       32        22       25       22       21       24       39      34
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ PlanEcon estimates.
\2\ Ibid.
 NA--Not available.


    Some $50 billion in foreign direct and portfolio investment 
poured into the country in 1997, as emerging market investors 
increasingly saw Russia as a transition economy on the verge of 
``turning the corner.'' After years of deterioration, social 
indicators of poverty and inequality also began to improve in 
the mid-1990s. After rising from 0.26 in 1991 to 0.41 in 1994, 
Russia's Gini coefficient of income inequality dropped to 
around 0.38 during 1995-1997. And the share of the population 
with incomes classified as below the poverty line dropped from 
around 33 percent during 1992-1993 to about 20 percent in 1997.
    The calumnious events that led to the currency, debt, and 
banking crisis of August 1998 brought an end to the second 
phase of the Russian transition, and revealed the optimism 
engendered by developments in 1996-1997 to have been premature. 
The federal government in that month defaulted on its domestic 
debt and began accumulating arrears on its rescheduled external 
debt obligations inherited from the Soviet period. The 
government and the Central Bank of the Russian Federation 
(Central Bank of Russia or CBR) halted their defense of the 
quasi-fixed exchange rate, permitting the nominal exchange rate 
to collapse from 6.2 rubles per dollar to 21.1 rubles per 
dollar by the end of the year. The ruble's collapse led to 
renewed price pressures: year-on-year consumer price inflation 
rates had returned to triple-digit levels by mid-1999. Almost 
all of Russia's private banks collapsed after the devaluation, 
leaving the state savings bank, Sberbank, the only domestic 
financial institution of any consequence. The ``reformist'' 
Western-oriented governments that had ruled Russia since 1992 
were replaced in September 1998 by a cabinet that drew its 
support from the Communist Party of the Russian Federation, the 
largest party in the parliament.\8\
---------------------------------------------------------------------------
    \8\ For more on August 1998, see Komulainen, T., and I. Korhonen, 
eds., Russian Crisis and Its Effects, Helsinki, 2000, Kikimora 
Publishers.
---------------------------------------------------------------------------
    The shock waves generated by the ``Russian crisis'' were 
felt throughout the world. Investment bankers hawking the 
``Russian boom'' gave way to pundits claiming that Russia's 
economic and political transitions had failed, or that Russia 
was a failed state. In Washington, opponents of the policies 
pursued by the Clinton administration and the IMF and World 
Bank vis-a-vis Russia explained the Russian crisis as the 
inevitable result of ideological orthodoxy and/or political 
opportunism.\9\ Coming on the heals of the East Asian crisis 
that began in mid-1997, Russia's financial crisis contributed 
to the global emerging market rout that led the Federal Reserve 
to sharply cut interest rates in order to avoid a global 
liquidity squeeze in late 1998. It also added new urgency to 
the search for a ``new international financial infrastructure'' 
to deal with such problems as financial contagion and money 
laundering.
---------------------------------------------------------------------------
    \9\ Stiglitz, J., ``Whither Reform? Ten Years of Transition,'' 
Washington, DC, The World Bank, 1999.
---------------------------------------------------------------------------
    Rather than marking the inevitable failure of the Russian 
transition, the August 1998 financial crisis reflected a 
confluence of unfortunate domestic and external factors. Some 
of these were avoidable, others of which not. Moreover, the 
storm clouds generated by August 1998 also weakened or removed 
many of the causes of the crisis, which helped pave the way for 
the strong GDP growth that took hold in 1999-2000. The recovery 
of 1999-2001 marks the third phase of Russia's economic 
transition, which is marked by the challenge of transforming 
the growth that took hold since August 1998 into sustainable 
economic and social development.
    Two domestic causes of August 1998 were paramount. First, 
Russia's macro-economic policy framework was plagued by 
inconsistencies between the quasi-fixed exchange rate regime 
and large fiscal deficits that were financed by foreign 
borrowing. Russia's consolidated government budget (i.e., the 
balance on the federal, regional, and municipal government 
budgets) reported deficits of 5 to 7 percent of GDP during 
1996-1997, and through mid-1998. The borrowing required to 
finance these deficits created increasingly unstable foreign- 
and domestic-debt dynamics that by mid-1998 undermined the 
credibility of the monetary and exchange rate policies.
    Second, the implementation pace of Russia's market reform 
agenda slowed noticeably after 1995. Virtually no major 
improvements in economic policy or institutions were introduced 
during 1995-1998. This resulted in part from a lack of 
leadership at the top, due first to the 1996 presidential 
election campaign and then to President Yeltsin's growing 
infirmity that culminated in his surprise December 1999 
resignation. But the stagnating market reform agenda also 
reflected the political economy of transition, which has 
produced what the World Bank's Joel Hellman has termed ``low-
level, partial reform equilibria'' in many transition 
economies. As Hellman points out, the successes of the initial 
stages of the economic transition--the partial liberalization 
of prices and commerce, the first waves of rapid privatization, 
and the devolution of power from the central to regional 
authorities--create new interest groups who are opposed to 
further market reforms.\10\ In Russia, the ``oligarchs'' who 
benefited from the rent-seeking opportunities created by the 
incomplete liberalization of prices and trade, and then from 
quick and dirty privatizations of key state companies, were 
instrumental in securing Yeltsin's re-election in 1996. 
Yeltsin's reliance on Russia's regional leaders in his battles 
against the Communist opposition allowed the regions to pursue 
policies that balkanized Russia's large domestic market and 
weakened Russia's fiscal coherence. Measures to strengthen the 
financial system, improve regulation of infrastructure 
monopolies, or provide a level playing field across Russia's 
economic space, generally went nowhere after 1995.
---------------------------------------------------------------------------
    \10\ Hellman, J., ``Winners Take All: The Politics of Partial 
Reform in Postcommunist Transitions,'' World Politics, 50 (January 
1998), pp. 203-234.
---------------------------------------------------------------------------
    The Russian economy in 1998 was also hit by three highly 
unfavorable developments over which it had no control: a bad 
harvest, an oil price shock, and financial contagion from East 
Asia. Bad weather in various parts of the country caused a 19 
percent reduction in value added contributed by the 
agricultural sector in 1998. The dollar prices of Russian 
exports dropped 15 percent in that year, as oil exports were 
selling for only $7 per barrel in December 1998 (according to 
official data). Export prices dropped another 4 percent in 1999 
as well. This terms-of-trade shock pushed overall exports down 
from $88 billion during 1996-1997 to $74 to $76 billion in 
1998-1999. Russia's current account balance, which registered 
surpluses of 2 to 3 percent of GDP during 1995-1997, had fallen 
into deficit by mid-1998. At the same time, foreign investors 
who were burned by the East Asian financial crises in 1997 
became increasingly unwilling to risk investing in Russian 
securities in 1998. This ``repricing of Russian risk'' combined 
with the collapse of Russia's current account surplus would 
have posed daunting policy challenges even for a country with a 
robustly pro-reform political elite.
    The August 1998 crisis did significant damage to Russia's 
financial system, to the country's external creditworthiness, 
and to living standards. Financial intermediation by private 
banks essentially stopped in August 1998, and has not been 
renewed since. With only a handful of exceptions, private- and 
public-sector borrowers in Russia effectively lost access to 
international capital markets and have not regained it since. 
After years of small improvements, Russian indicators of 
poverty, inequality, and social hardship deteriorated anew 
during 1999-2000.
    But August 1998 also made possible the rapid GDP growth 
that was reported in 1999-2000. The ruble's sharp devaluation 
set the stage for an import-substituting industrial recovery 
led by privatized firms in the metallurgical, light industrial, 
and machine building sectors. The banking collapse and the low 
oil prices of 1998-1999 weakened the oligarchs, while the 
collapse of the domestic debt market deprived the federal and 
regional governments of sources of borrowing. Russia therefore 
got fiscal religion: regional governments were forced to start 
running budget surpluses in 1999, and the federal budget has 
been in surplus since early 2000. While these surpluses were 
due in part to reductions in debt servicing, they also 
reflected improvements in tax collection. The share of GDP 
collected as consolidated government tax revenues, which had 
dropped below 20 percent in 1998, rose to 21 percent in 1999 
and 24 percent in 2000. And in contrast to 1998, when as much 
as a third of federal and half of regional tax revenues were 
collected in non-monetary forms, all federal tax revenues since 
early 2000 have been collected in cash. The crisis of arrears, 
barter, and monetary surrogates that seemed to be choking the 
Russian economy in 1998 has largely melted away.
    Other factors besides the bounce from August 1998 
facilitated Russia's recovery during 1999-2000. High oil prices 
were obviously one of these: thanks to 65 percent growth in the 
prices of export crude and refined oil products, Russia's 
dollar export prices rose by 26 percent in 2000. But high world 
prices for energy and other exports do not explain the strength 
of Russia's recovery during 1999-2000. For one thing, 5.4 
percent GDP growth was reported in 1999, even though Russia's 
export prices fell 4 percent overall in that year. Sharply 
lower relative prices for energy and transport services also 
played an important role in promoting the Russian recovery. 
Thanks to regulatory decisions that held energy and transport 
prices in check in the aftermath of the August 1998 financial 
crisis, the relative prices of gas, transport, and electricity 
dropped by 20, 23, and 39 percent respectively (calculated vis-
a-vis the industrial producer price index on an end-year basis) 
during 1998-2000. Energy-intensive companies in chemicals, 
ferrous metallurgy, and other manufacturing branches were able 
to re-export this cheap energy in the form of highly price-
competitive exports. The economy also benefited from Boris 
Yeltsin's relatively painless departure from the Russian 
presidency in December 1999, and from the rapid consolidation 
of power by his successor Vladimir Putin.\11\
---------------------------------------------------------------------------
    \11\ See Rutland, P., ``Putin's Path to Power,'' Post-Soviet 
Affairs, Vol. 16, No. 4 (December 2000), pp. 313-354.
---------------------------------------------------------------------------
    Russia's growth in 1999 was driven largely by foreign 
demand. Whereas exports in volume terms rose by some 7 percent 
in that year, import volumes dropped by nearly a third. This 
sharp growth in net exports compensated for a decline in 
domestic demand, as personal consumption dropped 4 percent. In 
sector-of-origin terms, growth in 1999 was powered by the 
industrial sector (an 11 percent increase was reported in 
industrial value added) and agriculture (which, recovering from 
the poor harvest of 1998, reported a 17 percent increase in 
value added in 1999). By contrast, the declines in imports and 
personal consumption kept growth in the service sector flat, as 
value added generated by the trade sector dropped 3 percent in 
1999. In 2000, on the other hand, domestic demand became the 
driver of the 8.3 percent GDP growth reported for that year. 
Personal consumption was reported up 9 percent, while fixed 
investment rose 16 percent. Russia's recovery in 2000 was also 
more balanced sectorally: the 12 percent growth in value added 
reported for the industrial sector was complemented by 11 
percent growth in construction and 10 percent growth in the 
trade sector. While export volumes reported healthy 11 percent 
growth in 2000, import volume grew by some 20 percent. Average 
inflation rates also dropped sharply in 2000, while the 
unemployment rate at the end of the year had fallen to 9.6 
percent, down from 13.3 percent at the end of 1998.
    With a few exceptions, these trends continued into 2001. 
While growth in production volumes in the industrial and 
construction sectors slowed to 6 percent during the first half 
of the year, retail trade turnover continued to surge, with 10 
percent growth was reported during the first half. Consumer 
price inflation stopped falling, however, and averaged nearly 
25 percent in year-on-year terms during the first half of the 
year. This inflation was due primarily to very loose monetary 
policies. Inflows of foreign exchange produced by the 
continuing large current account surpluses, combined with 
unsterilized CBR intervention, kept growth in the monetary base 
and M2 in the 50 to 60 percent ever since the second half of 
1999. While the demand for rubles grew strongly during 1999-
2000 thanks to Russia's strong output growth and sharp 
reductions in the use of monetary surrogates, the supply of 
rubles in 2001 had clearly begun to outpace demand. Inflation 
in the 25 percent range combined with an essentially stable 
nominal exchange rate to further boost the value of the ruble 
in real effective terms; and the firmer ruble in turn helped 
boost imports and slow growth in the manufacturing sector. A 
long-delayed correction in the relative prices for energy and 
transport services also took hold in 2001, further slowing 
industrial growth.
    Despite these problems, 4.9 percent GDP growth was reported 
for the first quarter of 2001, and gross output trends 
suggested a similar or slightly higher rate of growth for the 
second quarter as well. These are hopeful signs for Russia's 
economic prospects. But Russia's development during the 1990s 
suggested that a return to growth was at some point inevitable. 
Output trends in virtually all Eurasian transition economies--
ranging from success stories like Poland and Estonia to 
laggards like Belarus and Tajikistan--show that a third, 
``recovery'' phase eventually follows an initial period of 
macro-economic disorganization and contraction, and then a 
second period of stabilization and austerity. Russia's great 
misfortune was that the first two phases lasted nearly 10 
years, whereas Poland managed to get through the first two 
phases of its economic transition in only 2 to 3 years.\12\ The 
challenge now facing policymakers in Russia--as in many other 
Commonwealth of Independent States (CIS) economies--is to 
transform the recovery of 1999-2000 into sustainable economic 
and human development.
---------------------------------------------------------------------------
    \12\ Slay, B., ``The Polish Economic Transition: Outcome and 
Lessons,'' Communist and Post-Communist Studies 33 (2000), pp. 49-70.
---------------------------------------------------------------------------

                        Russia's External Trends

    The dramatic improvement of Russia's external position 
during 1999-2000 is among the most hopeful post-August 1998 
changes. The current account deficit reported at mid-1998 gave 
way to a surplus of nearly $46 billion--nearly 19 percent of 
GDP--in 2000. Official reserves tripled from $11 billion in 
March 1999 to $35 billion as of mid-2001--more than double 
their previous high recorded in late 1997. Russia in 2001 
returned to fully covering its external sovereign debt after 
rescheduling a portion of its Soviet-era obligations to the 
London Club of commercial creditors in 2000. In contrast to the 
1990s, Moscow is not dependent on credits from multi-lateral or 
private lenders, and in contrast to 1997-1998 there is very 
little ``hot money'' in the country. If prior to August 1998 
Russia was on IMF life support, Moscow was able to reduce its 
obligations to the Fund from $19 billion in 1998 to around $10 
billion as of mid-2001.
    To be sure, these improvements came at a high cost. The 
sharp reductions in household incomes and personal consumption 
recorded during 1998-1999, coupled with sharply higher 
unemployment, were the price Russian households paid for the 
restoration of external balance. Serendipity has also helped 
strengthen Russia's external position, in the form of sharply 
higher export prices in 2000 (when Russian received an 
estimated 33 percent terms of trade windfall). The extent of 
this improvement could face a sharp test in 2003, when Russia's 
sovereign foreign debt obligations are slated to rise from $9 
billion in 2000 to some $19 billion.
    Still, the unprecedented growth in reserves, the huge 
current account surplus, and the shift in Moscow's fiscal 
priorities in 2001 to allow for full coverage of external debt 
obligations, suggest that Russia's external position can weaken 
but still remain quite strong compared to pre-1998 levels. The 
risks associated with the debt spike in 2003 are being 
addressed by a host of policy measures, and others can be 
employed in the future. Moscow in late 2000 and the first half 
of 2001 used undisclosed amounts of surplus budget revenues to 
repurchase its heavily discounted sovereign debt. These pre-
payments reduce Russia's debt burden and make full coverage of 
future obligations less burdensome. Despite the sharp increase 
in debt-service payments in 2001, the CBR's foreign exchange 
reserves rose from $28 billion at the end of 2000 to $34 
billion as of mid-2001. A joint government/CBR declaration on 
economic policy through 2004 released in May 2001 calls for 
reserves to grow to $37 billion by the end of this year. This 
target seems eminently feasible--especially since reserves in 
mid-July had climbed close to $36 billion. The CBR's target of 
$45 billion in official reserves by the end of 2002 therefore 
seems quite attainable.
    Russia's sovereign domestic debt at the end of 2000 stood 
at only $20 billion, less than 10 percent of GDP. Strong ruble 
liquidity in the Russian financial system should allow Moscow 
to borrow domestically to repay foreign debt during 2001-2002. 
The Finance Ministry in June 2001 auctioned off 5 billion 
rubles' ($175 million) worth of 3 year domestic debt 
instruments. This issue, which was snapped up by cash-rich 
Russian banks, marked the largest such sale of government debt 
since the August 1998 financial crisis. Should Russia's 
external position deteriorate due to a terms-of-trade shock, 
the Paris Club of sovereign creditors has declared its 
willingness to consider restructuring Russia's obligations. The 
IMF ostensibly stands ready to provide financing during 2002-
2003 through a precautionary framework, should this prove 
necessary--and if Moscow can meet its conditions. Additional 
revenues for foreign debt repayment can be raised from sales of 
precious metals, from issuing new eurobonds, or by arranging 
non-securitized loans.
    But protection against a balance-of-payments crisis is not 
the same as sustainable growth. The commodity composition of 
Russian exports, Russia's problematic record with foreign 
investment, and continued large capital outflows are 
particularly worrisome in this respect. As Table 2 shows, fuels 
made up half of Russia's export basket in 2000--a higher share 
than in 1993. By contrast, machinery and equipment comprised 
only 11 percent of total exports in 2000, down from 14 percent 
in 1993. Attempts to parley Russia's comparative advantages in 
metallurgy, armaments, aerospace, and IT into a more 
competitive engineering sector have not achieved spectacular 
results. This contrasts sharply with the export-driven 
industrial restructuring that occurred in the leading Central 
European transition economies during the late 1990s.
    The foreign direct investment (FDI) that has driven Central 
Europe's industrial modernization is conspicuously absent in 
Russia. Russia through 2000 had attracted $23.5 billion in 
cumulative inward FDI, or $160 on a per-capita basis. By way of 
comparison, per-capita inward FDI in Hungary--the leader among 
transition economies--was nearly $2,500. The Czech Republic 
reported $2,000 in per-capita FDI, Estonia registered $1,500, 
and Poland had $780. Among CIS countries, Russia's per-capita 
FDI compares quite unfavorably with Azerbaijan's $620 and 
Kazakhstan's $580. Even Armenia--a country with virtually no 
energy reserves, and which has faced an economic blockade for 
more than 10 years--reported higher per-capita cumulative FDI 
($170) through 2000 than Russia.\13\
---------------------------------------------------------------------------
    \13\ These data come from national bank publications or Web sites 
for the countries in question.

                                      TABLE 2.--EXTERNAL TRENDS, 1993-2000
----------------------------------------------------------------------------------------------------------------
                                                             1993  1994  1995  1996  1997   1998    1999    2000
----------------------------------------------------------------------------------------------------------------
Exports (in billions of dollars)...........................   $59   $68   $81   $89   $88     $74     $76   $106
  Percent share of fuel exports in total...................    40    42    38    43    44      38      41     50
Imports (in billions of dollars)...........................    44    51    61    69    73      59      40     45
Trade balance (in billions of dollars).....................    15    17    20    20    15      15      36     61
  Percent share of GDP.....................................     8     6     6     5     4       6      19     24
Current account balance (in billions of dollars)...........    13     8     7    12     2       1      25     46
  Percent share of GDP.....................................     7     3     2     3     1       0      13     19
Percent change in terms of trade...........................     3     7     3     7    -3     -14      -4     33
Inward FDI (in billions of dollars)........................     1     1     2     3     5       3       3      3
Net portfolio investment (in billions of dollars)..........     0     0     2     4    46       9      -1     -1
``Capital flight'' (in billions of dollars) \1\............    10     9    13    24    30      17      11     15
  Percent share of GDP.....................................     5     3     4     6     7       6       6      6
Gross foreign debt (in billions of dollars)................   121   132   143   152   167     191     181    172
  Percent share of GDP.....................................    65    48    42    36    39      70      95     68
Official reserves, end year (in billions of dollars).......     8     7    14    15    18      12      12     28
  Import coverage (months).................................     2     2     3     3     3       3       4      8
Percent change in real effective exchange rate \2\.........   169    79    40    39     8     -32     -29    22
----------------------------------------------------------------------------------------------------------------
\1\ Calculated as the sum of: (1) Russian purchases of foreign exchange; (2) export contracts that have been
  concluded but for which revenues have not been received; (3) import contracts that have been concluded but for
  which payment has not been made; and (4) net errors and omissions.
\2\ Unweighted average of annual changes in real effective exchange rates vis-a-vis domestic, euroland, and
  dollar consumer and industrial producer price trends.


    Russia's energy and non-ferrous metallurgical bounty 
suggests that industry, and energy and metals in particular, 
should have attracted the bulk of the country's inward FDI. 
This has not been the case. Only $3.6 billion--one-sixth of 
Russia's inward FDI--went into the energy sector during 1993-
2000. Virtually all of this went into crude oil extraction. 
Ferrous and non-ferrous metallurgy combined accounted for less 
than 2 percent of total FDI during this time, while virtually 
no FDI went into natural gas or electric power. The industrial 
sector as a whole attracted 47 percent of total FDI, with 
manufacturing accounting for 31 percent. The food processing 
branch was manufacturing's leading recipient, with 18 percent 
($4 billion) of total FDI. Since food processing accounts for 
at most 3 percent of Russian GDP, the sector's strong FDI 
performance is somewhat surprising. The explanation is largely 
political: foreign investment in food processing generally 
remains ``below the radar screen.'' By contrast, Russian elites 
are generally unwilling to permit significant amounts of 
foreign capital into ``strategic'' sectors such as oil, gas, 
electric power, diamonds, nickel, and aluminum.
    Rather than attracting foreign investment, Russia is 
instead becoming an important source of FDI for other CIS 
countries. The CBR registered some $3.1 in outward FDI in 2000, 
which exceeded the $2.7 billion in inward FDI reported. Cash-
rich Russian oil companies took control of three of Ukraine's 
six major oil refineries during 1999-2000, while the Russian 
Aluminum conglomerate acquired Ukraine's Mykolayivsky 
Hlynozemny Zavod, Europe's largest alumina maker. Russian 
acquisitions were not limited to the CIS, however: Lukoil in 
late 2000 spent $70 million to acquire Getty Oil's retail 
outlets in the United States. After recording large inflows 
during 1997-1998, net outflows were reported on Russia's 
portfolio investment balance during 1999-2000 as well.
    Russia's strong economic recovery during 1999-2000 was 
paradoxically accompanied by a steep acceleration in capital 
outflows. After posting positive balances during 1995, 1997 and 
1998, Russia's financial account swing heavily into deficit, 
posting net outflows of $17 billion in 1999 and $48 billion in 
2000. But in many respects, trends on Russia's financial 
account offer a misleading guide to capital flows. For one 
thing, substantial negative sums are reported every year on 
``net errors and omissions.'' During 1995-2000, this balance 
was fairly stable, averaging--$7 billion annually. These large 
negative balances are commonly viewed as indicators of illicit 
capital flight and as such they should be considered part of 
Russia's net outflows. But not all transactions reported as net 
outflows on the financial account reflect transfers of assets 
from Russia to other countries. Some reflect portfolio 
management choices by Russian households and companies. 
Decisions to increase dollar cash holdings (for savings or 
working capital) in the informal sector, at the expense of 
ruble assets in official bank accounts, boost net outflows 
reported on the financial account even though these funds do 
not leave Russia. Likewise, export receipts that are left in 
off-shore accounts in order to finance imports may appear on 
the balance of payments as a capital outflow, even though they 
function as working capital.
    Russia's external accounts do not distinguish ``capital 
flight'' that reflects illicit, speculative, or hedging 
purposes from ``normal,'' transactions-based capital outflows 
reflecting the liquidation of Russian assets held by non-
residents. A commonly used measure of capital flight in the 
Russian case is the sum of: (1) Russian purchases of foreign 
exchange; (2) export contracts that have been concluded but for 
which revenues have not been received; (3) import contracts 
that have been concluded but for which payment has not been 
made; and (4) net errors and omissions. This measure shows 
Russian capital flight falling from $30 billion in 1997 to $11 
billion during 1999, before rising to $15 billion in 2000. As a 
share of dollar GDP, this measure of capital flight has 
remained at 6 to 7 percent ever since 1996.
    An alternative perspective on Russian capital flight comes 
from comparing gross capital inflows (changes in the gross 
liabilities recorded on the capital and financial accounts) and 
outflows (changes in the gross assets in Russia's capital and 
financial accounts, plus net errors and omissions). Gross 
outflows as a share of GDP rose from 9 percent during 1996-1997 
to 13 percent in 1999, before dropping back to 12 percent in 
2000. By contrast, gross capital inflows essentially dried up 
after August 1998, falling from 9 percent of GDP in 1997 to 
below 1 percent in 1999-2000. This suggests that the sharp 
acceleration in net outflows on the financial account during 
1999-2000 were not due primarily to capital outflows per se, 
but rather to foreign investors' post-1998 aversion to Russia.
    Russia's poor track record on attracting FDI may not last. 
Foreign investment in transition economies typically lags a few 
years behind recoveries in GDP and domestic investment. Still, 
a comparative assessment of Russia's FDI performance to date 
can not help but cast a shadow over future prospects for 
sustainable growth. Making Russia more attractive to 
investors--foreign and domestic alike--requires significant 
reforms in the financial and legal systems.

                   Russia's Unfinished Reform Agenda

    Arguments about links between growth and market reform in 
transition economies--particularly in Russia--often reflect two 
implicit propositions: (1) the far-reaching institutional 
reforms needed to create a well-functioning market economy are 
necessary and sufficient conditions for growth; and (2) 
transition economies' short-term growth prospects are closely 
tied to progress in market reform. The record of the 1990s 
shows that both assertions are at the very least exaggerations. 
Instead, the liberalization of prices and commerce, the 
creation of stable monetary, fiscal, and exchange rate 
environments, and some measure of privatization, are generally 
sufficient to create the ``critical mass'' of institutional and 
policy changes needed to end the transition recession.\14\ 
Albania, for example, recorded annual GDP growth during 1993-
1996 and 1998-2000 of 8 percent or above, despite a large 
unfinished reform agenda. Azerbaijan's growth performance 
during the second half of the 1990s was far superior to the 
Czech Republic's, despite the fact that market reforms were 
much farther advanced in the latter country than in the former. 
Many factors besides the extent and pace of market reforms--
including location, size, resource endowment, political 
stability, economic policies, and state capacity--have an 
important impact on growth in economies--transition or 
otherwise.
---------------------------------------------------------------------------
    \14\ Balcerowicz, L., ``The Interplay Between Economic and 
Political Transition,'' in Zecchini, S., ed., Lessons From Economic 
Transition: Central and Eastern Europe in the 1990s, 1995, pp. 153-167.
---------------------------------------------------------------------------
    Still, there can be little doubt that progress in market 
reform--understood as measures to remove barriers or threats to 
growth that were inherited from the Soviet-type system, or 
which appeared during the course of transition--has a key 
influence on prospects for sustainable growth and development 
in transition economies. If banks do not become effective 
financial intermediaries, capital will continue to be poorly 
mobilized and allocated. If infrastructure monopolies do not 
face competition or charge prices that cover their costs, the 
provision of basic public services can come under threat. If 
investors can not rely on courts to protect and clarify 
property rights, some investments will not be made. If 
bureaucratic connections are more important for entrepreneurs 
than competitive advantage, companies will continue to invest 
in ``relational capital'' rather than in fixed assets. All of 
these problems stand in the way of sustainable growth, and--as 
the Gref program acknowledges--Russia suffers from all of them.
    During Boris Yeltsin's second term, initiatives to address 
these problems made little headway. Upon becoming president, 
Vladimir Putin promised rapid and decisive steps in these 
areas. Some progress was made in Putin's first year, and as of 
mid-2001 the government had succeeded in pushing a raft of 
market reform initiatives through parliament. Still, much 
remained to be done, and many of the salient results 
anticipated from these changes will take decades to 
materialize.

                    reform of infrastructure sectors

    Thousands of urban dwellers in Siberia and the Far East 
spent much of winter 2000-2001 without adequate supplies of 
heat and electricity. In many places Russia's infrastructure 
for heat, power, and communal services simply buckled. The 
sharp declines in human welfare stemming from these problems 
prevented many Russians from experiencing the benefits of the 
strong economic growth recorded in 2000. While a number of 
factors--including a particularly cold winter and ineptitude on 
the part of the local authorities--contributed to the deep 
freeze, years of below-cost pricing and mismanagement by the 
Unified Energy Systems (UES) national electricity company and 
its subsidiaries played a critical role in this debacle. 
Although Russia's gas infrastructure remains relatively free of 
such problems, production at Gazprom--Russia's gas monopoly--
dropped some 5 percent during 1999-2000, and the company had to 
import significant quantities of gas from Turkmenistan in order 
to meet its supply commitments. UES and Gazprom management 
argue that tens of billions of dollars must be invested in 
these sectors in order to maintain and expand output levels in 
the future. This seems to particularly be the case for UES, 
since fixed investment in the electricity sector dropped by 
some 30 percent during 1997-2000. Similar claims are made by 
municipal administrations, who point out that household charges 
for rent, sewer, and water cover less than half of the costs of 
providing these services. And Railroad Ministry officials argue 
that billions more must be invested in Russia's rail 
infrastructure, in order to prevent the further 
decapitalization of Russia's largest and most important 
transport network.
    According to the Gref program, the government intends to 
deal with these problems by further marketizing these sectors, 
by: (1) reducing administrative barriers, so as to promote 
increased competition and entry by new suppliers; (2) 
increasing relative prices in these sectors, in order to bring 
tariffs closer to full cost-recovery levels; (3) selling off 
state monopoly assets to private (and potentially foreign) 
investors; (4) introducing compensating payments for those 
households (and other users) whose welfare is most threatened 
by step (2); and (5) introducing tighter controls over those 
monopolistic activities remaining under state control, via: (a) 
better regulation of monopoly pricing; and (b) more active 
control by federal bodies--acting in their capacity as owners--
over management in these sectors.
    As of mid-2001, measures embodying these themes had been 
approved for implementation in the electricity, gas, rail, 
housing, and communal service sectors. To the surprise of many 
observers, Rem Vyakhirev was replaced as Gazprom CEO by Putin 
loyalist Aleksei Miller in May. Miller promised to halt the 
large-scale asset stripping at Gazprom that allegedly occurred 
during Vyakhirev's tenure. He also promised to afford 
independent gas producers access to Gazprom's domestic pipeline 
network, thereby increasing other companies' abilities to bring 
gas to market. After nearly a year of haggling, UES CEO Anatoly 
Chubais in July 2001 struck a deal with minority shareholders 
that cleared away some obstacles to the sale of UES assets as 
part of the company's competitive restructuring. Economics 
Minister Gref and Railroad Minister Nikolai Aksyonenko by mid-
year seemed to have agreed on a compromise rail restructuring 
program that would divest the Railroad Ministry of most of its 
commercial assets (i.e., rolling stock) and liberalize the 
determination of rail tariffs and route structures. And the 
government in August approved legislation to create an omnibus 
regulatory agency, in which the regulation of monopoly price 
setting would be centralized and (presumably) depoliticized.
    These developments, combined with concurrent parliamentary 
approval of other measures--including passage of legislation on 
pension reform, the liberalization of the sale of non-
agricultural land, reductions in the number of burdensome 
licenses needed for entrepreneurial activity, and banking 
reform--amounted to Russia's most impressive flurry of market 
reform activity in nearly a decade. If implemented as planned, 
these measures could significantly improve prospects for 
sustainable economic growth. But political and economic factors 
are likely to constrain the government's ability to implement 
these measures as planned. For one thing, the sharp increases 
needed to quickly bring tariffs up to cost-recovery levels are 
seen as too painful socially, particularly in light of Russia's 
still-high (20 percent and above) inflation rates and the 
parliamentary and presidential elections scheduled for 2003 and 
2004, respectively. The bulk of these tariff hikes are 
therefore slated to be postponed until after 2004. But new 
suppliers are unlikely to enter these markets in significant 
numbers as long as (relatively) low prices are maintained. 
Sales of assets in firms whose prices are set below costs can 
be rightly seen as a asset stripping--as UES minority 
shareholders frequently pointed out when explaining their 
opposition to CEO Chubais' competitive restructuring program. 
In the meanwhile, the continued absence of competition from new 
suppliers is likely to result in higher costs and tariff hikes 
than would otherwise be the case. Finally, the difficulties 
Russia's ponderous social welfare bureaucracies would face in 
identifying and subsidizing those households most at risk from 
the tariff hikes are unlikely to be anything short of immense.

                            financial system

    Russia's financial system has recovered from the crash of 
August 1998--after a fashion. Economic growth, tighter fiscal 
policies, and improved enterprise liquidity have reduced 
arrears and the use of monetary surrogates. More retained 
earnings helped finance investment growth. A consolidation wave 
based in the oil and metallurgical sectors that began in 1999 
suggests that some of Russia's largest companies are becoming 
more interested in corporate governance. On the other hand, the 
government and CBR have done little to restructure commercial 
banks or improve the foreign investment environment. Financial 
sector privatization faces stiff opposition from political and 
business elites. And the restructuring driven by oil and 
metallurgical companies may do little more than create a new 
class of oligarchs that do not differ fundamentally from their 
predecessors.
    The best news in the financial sector lies in the shrinkage 
of Russia's ``virtual economy.'' \15\ After soaring in 1998, 
total arrears (measured as the sum of wage and general 
government tax arrears plus overdue enterprise payables to 
banks and other enterprises) dropped by 55 percent during 1999-
2000. In real terms, arrears fell by three quarters during this 
time. The ratio of total arrears to nominal GDP, which averaged 
0.33 during 1998, fell to 0.07 in 2000. Most of this progress 
came from sharp reductions in wage arrears, which constitute 
more than 90 percent of the total. Wage arrears shrank 77 
percent in real terms during 1999-2000, as public-sector wage 
arrears (which are now less than a fifth of total wage arrears) 
fell 80 percent. While overdue enterprise payables to other 
companies rose in nominal terms during 1999-2000, their real 
value dropped some 38 percent. Similar trends are apparent in 
the use of monetary surrogates--barter, promissory notes, and 
mutual offsets of liabilities--accepted as ``payment'' by 
companies. Only 31 percent of total payments collected by 
Russia's largest companies were settled via these surrogates in 
2000, down from 51 percent in 1999 and 63 percent in 1998. The 
8 percent increase in the real value of the stock of tax 
arrears to the general government in 2000 was the only 
significant exception to this trend.
---------------------------------------------------------------------------
    \15\ For more on the ``virtual economy,'' see Gaddy, C. and B.W. 
Ickes, ``An Accounting Model of the Virtual Economy in Russia,'' Post-
Soviet Geography and Economics, Vol. 40, No. 2, 1999, pp. 79-97; and 
Slay, B., ``A Comment on the Virtual Economy,'' Post-Soviet Geography 
and Economics, Vol. 40, No. 2, 1999, pp. 110-113.
---------------------------------------------------------------------------
    Positive developments occurred in terms of corporate 
governance as well. Minority shareholders, led by former 
Finance Minister Boris Fyodorov who represents minority 
shareholders on the UES, Gazprom, and Sberbank boards of 
directors, are increasingly well-organized, and their demands 
for corporate transparency and accountability are increasingly 
difficult to dismiss. Minority shareholders in UES ultimately 
forced management to adopt a more investor-friendly version of 
the company's original competitive restructuring program. 
Fyodorov's campaign against Gazprom management helped 
precipitate Vyakhirev's removal, and tipped the balance toward 
removing some of the controls over foreign purchases of Gazprom 
shares. Although the legal framework (especially Russia's 
under-capitalized court system) continues to prevent effective 
capital market regulation, the Federal Securities Commission 
(FSC) intervened on behalf of minority shareholders against the 
managements of UES, Gazprom, and Norilsk Nickel. The FSC also 
promoted discussion and (in some cases) the adoption of 
corporate governance codes in some of Russia's largest 
companies.
    More important corporate governance changes could be 
occurring as a result of consolidation trends within Russian 
industry. Cash-rich oil, metallurgical, and other companies are 
increasingly investing big money in productive assets, and are 
increasingly worried about getting their money's worth from 
their investments. Lukoil's 1999 $300 million acquisition of 
Komitek, and the Tyumen Oil Company's (TNK's) $1 billion 
purchase of Onako in September 2000, are the most visible 
results of this trend. In food processing, Wimm Bill Dann is 
using cash generated from dairy products to diversify into 
breweries. Severstal, Russia's largest and one of its best-run 
ferrous metallurgical companies, has acquired stakes in a 
number of automotive producers. Open-market purchases last year 
by Siberian Aluminium (Sibal) of equity in Nizhny Novgorod's 
Gorkovsky Avtomobilny Zavod (GAZ)--Russia's second largest 
automobile company--set off a bidding war for GAZ stock and 
ended with Sibal's acquisition of a controlling stake in the 
company.
    These acquisitions have an international dimension as well. 
By the end of last year, Russian companies had taken control of 
three of Ukraine's six major oil refineries: Lukoil owned the 
Odessa refinery; Tatneft was running the UkrTatnafta joint 
venture at Kremenchug; while TNK owned the Lisichansk refinery. 
Thanks to these investments, Russian companies supplied half of 
Ukraine's refined oil products last year. The Ukrainian 
subsidiary of the Russian Aluminum conglomerate (Rusal--which 
is itself the product of consolidation trends within the 
industry) spent at least $130 million during 2000 to acquire a 
controlling stake in Ukraine's Mykolayivsky Hlynozemny Zavod, 
Europe's largest alumina maker. Russian acquisitions were not 
limited to the CIS, however: Lukoil in late 2000 spent $70 
million to acquire Getty Oil's retail outlets in the United 
States.
    This corporate shopping spree has many desirable 
properties. First, acquirers like Severstal and Rusal now have 
an interest in better corporate governance, in order to protect 
the value of their purchases. Second, in contrast to the 
consolidation that followed Russia's first privatization wave 
in the early 1990s, the role of state agencies and Russian 
banks in these acquisitions is very small. These purchases are 
the result of hardheaded business calculations, and do not 
represent the misappropriation of other people's money. Third, 
poorly managed companies and assets are generally being 
acquired by better-managed companies. This should ultimately 
boost efficiency. On the other hand, much of this consolidation 
violates the spirit (if not the letter) of Russian competition 
and securities law. Political considerations may be less 
important than in previous consolidation waves, but well-
connected oligarchs like Roman Abramovich (oil, aluminum), 
Anatoly Chubais (electricity), and Oleg Deripasko (aluminum) 
continue to use their influence in the government, the courts, 
and the media to advance their corporate and personal 
interests. Russia's commercial playing field may be 
globalizing, but it is not necessarily becoming more level.
    The August 1998 financial crash left most of Russia's 
large, privately owned banks insolvent. Their owners took 
advantage of Russia's unclear regulatory framework and 
transferred assets to other ``bridge'' banks, in the process 
defrauding creditors, depositors, and minority shareholders. 
Rather than seeking their prosecution, the CBR was more likely 
to refinance the oligarchs' new bridge banks. Since then, the 
CBR, the courts, and parliament have generally been 
uninterested in closing the regulatory loopholes that 
facilitated these scams. Russian households and companies 
therefore use the banks as a payments system, but continue to 
save and hold working capital elsewhere.
    The banking system has in some respects recovered from 
August 1998. Bank exposure to foreign-exchange risk continues 
to fall: the ratio of commercial bank foreign-currency assets 
to liabilities rose from 0.8 during 1997-1998 to 2.0 in 2000. 
Total commercial banking assets rose from a low of $49.1 
billion in December 1998 to $83.3 billion as of December 2000. 
``Overdue'' bank credits at the end of 2000 represented only 4 
percent of total bank credits, down from 11 percent in early 
1999. Banks are now lending to companies: credits to 
enterprises grew by some 11 percent in real terms in 2000, and 
this growth has continued into 2001. The authorities in mid-
2001 also succeeded in passing bank reform legislation that had 
been long sought by the IMF, directed at tightening banking 
supervision and cracking down on money laundering.
    But there is little else to cheer about in the Russian 
banking sector. Despite the growth in total banking assets, the 
0.34 ratio of banking assets to nominal GDP at the end of 2000 
was actually below 1998's end-year ratio of 0.38. The absence 
of significant improvement in commercial bank transparency and 
supervision makes reported improvements in the quality of loan 
portfolios difficult to interpret. Key perpetrators of the 
August 1998 developments continue to play important roles in 
the Russian banking system. The Sberbank state savings bank 
seems to be the sole institution to enjoy minimal confidence on 
the part of the population. Thanks to the fact that its savings 
accounts are guaranteed by the federal government, Sberbank at 
the end of 2000 held some 40 million household savings accounts 
(87 percent of the total deposit base).
    These circumstances make it difficult to be optimistic 
about the consequences of the rapid growth in bank lending to 
enterprises that took hold during 2000-2001. This growth was 
extremely rapid after mid-2000, averaging 72 percent in nominal 
terms and 25 percent in real terms. Much of this lending is now 
being done by Sberbank--its share of total bank credits to 
enterprises rose to 37 percent in 2000--and is occurring at 
negative real interest rates. When adjusted for changes in the 
industrial producer price index, the interest rate on 12 month 
commercial credits averaged--24 percent in 2000, and--19 
percent in 1999.
    Since 60 percent of Sberbank's equity is held by the CBR, 
and since neither institution is a paragon of transparency, it 
is difficult to assess the consequences of Sberbank's lending 
offensive. (The CBR's latest target date for completing the 
commercial banks' transition to international accounting 
standards is 2006.) Its monopsonistic position on the household 
savings market (which affords Sberbank a healthy spread on its 
commercial loans) and the reported declines in non-performing 
loans suggest that Sberbank's cash flow and profitability 
should be strong and improving. The bank's preliminary 2000 
financial statement, which was computed under Russian 
accounting standards and released in February 2001, seems to 
confirm this: profits were reported up 63 percent from a year 
earlier. But Sberbank's management also announced in February 
that the bank's capital-adequacy ratio had dropped below the 
legally mandated 10 percent, necessitating a new share issue.
    While its political and economic moxie make Sberbank's 
bankruptcy highly unlikely, pressures on bank managers to 
``lend to the real sector'' combined with its opaque regulatory 
and ownership framework make Sberbank a strong candidate for a 
future financial crisis. Since its 40 million savings deposits 
are de facto liabilities of the Russian Government, a run on 
Sberbank could be tantamount to a run on the federal budget. 
Experience in other transition economies shows that poorly 
regulated state-owned banking systems are prodigious generators 
of financial crises. While the timing and magnitude of Russia's 
next banking crisis can not be predicted, the probability of 
its occurrence is high.
    The experience of other transition economies shows that the 
sale of leading commercial banks to strategic investors is the 
only viable solution to the problems. Only multinational banks 
possess the resources needed to straighten out messes like 
Russia's and the size needed to resist political pressures to 
lend. The banking reform programs announced by the government 
and CBR during 2000-2001 generally ignore these lessons, 
however, and instead emphasize continued state ownership over 
Sberbank and Russia's other large commercial banks (the 
Vneshekonom and Vneshtorg foreign trade banks, and the 
Industrial, Agricultural, and Regional Development Banks). 
Federal government control over these institutions is to be 
attained through the acquisition of 75 percent equity stakes, 
large enough to prevent minority owners from assembling 
blocking (25 percent plus one) stakes. Funds to purchase these 
stakes are to be raised by selling off the state's minority 
shareholdings in up to 500 smaller banks.
    In contrast to the dramatic post-1998 changes apparent in 
fiscal policy and foreign debt management, or the (perhaps 
excessively) ambitious market reform agenda apparent in the 
infrastructure sectors, Russian policies toward the financial 
sector are characterized by benign neglect. The lending 
campaign conducted by state banks, the continued sorry state of 
bank supervision, the official disinterest in improving 
corporate disclosure and transparency--all this has two 
strongly negative implications for Russia's growth prospects. 
First, it ensures that fixed investment must continue to be 
financed primarily by retained earnings. In part for this 
reason, investment growth had already begun to slow in 2001, as 
enterprise profits (reported under Russian accounting 
standards) actually fell in real terms during the first half of 
2001. After soaring 18 percent in 2000, year-on-year growth in 
gross fixed investment had dropped to around 5 percent by mid-
2001. Second, the surging growth in lending to companies by 
state-owned banks during 2000-2001 suggests that Russia's next 
banking crisis--if and when it occurs--will have a significant 
fiscal dimension. In light of Russia's heavy debt-service 
burden during 2003 and beyond, the implications of such a 
crisis can not be easily dismissed. The contingent fiscal 
liabilities implied by such a banking crisis could undo much of 
the post-1998 progress made in achieving fiscal balance, and 
could lead to heightened capital outflows as well. And the 
unwillingness to open up the financial sector (and other 
sectors) to foreign investment and competition constitutes a 
major obstacle to Russia's timely accession to the World Trade 
Organization.
    Russia's unfinished reform agenda extends well beyond the 
financial sector and the infrastructure monopolies. The 
creation of an appropriate legal framework for the long-delayed 
restructuring of the agricultural sector (including passage of 
legislation to protect and standardize agricultural land 
ownership, and to govern the bankruptcy of Soviet-era state and 
collective farms), the modernization of Russia's judicial 
system, the rationalization of Russia's quasi-dysfunctional 
fiscal federalism--these are all multi-year undertakings 
fraught with grave political, economic, and social risks. To 
its credit, the government has pledged to address these 
barriers to growth. But should these attempts fail--or should 
the implementation of its reform programs stretch out 
indefinitely--its divergences from best international practices 
will continue to burden Russia's economic prospects.

        Leading Indicators for the Future of Russia's Transition

    Russian ``exceptionalists'' often reject the utility of 
comparisons with other countries, claiming that Russia is 
``different.'' While such claims can of course be made for all 
countries, Russia as a transition economy does stand out in a 
number of respects. Its immense size and ethno-regional 
diversity, its scientific potential, its energy/natural 
resource base, the legacy of the large Soviet-era military-
industrial complex, Russia's uncertain Eurasian geopolitical 
status, its federal nature, and (since 1998) its relative 
insulation from the international capital markets--the 
combination of these features does give Russia a somewhat 
unique profile among transition economies.
    This combination suggests that not every lesson from the 
more successful Central European and Baltic transition 
economies is relevant for Russia. For example, membership in 
the European Union--the prospects for which have been a driving 
force behind the leading transition economies' success in 
introducing best international economic practices--is most 
unlikely to be an option for Russia in the foreseeable future. 
As such, the justification for introducing these changes must 
be sought elsewhere. Its characteristics as a transition 
economy--particularly the commodity composition of its 
exports--also suggest that Russia's short-term economic 
performance is likely to be less directly correlated with 
economic policies and reforms than other countries. Movements 
in world energy, metals, and raw materials prices in particular 
are likely to have a much greater short-term effect on economic 
performance in Russia than in most other transition economies--
despite Russia's larger size and nominally smaller 
``openness.''
    Trends in a number of key indicators (besides movement in 
real output and incomes) are likely to be particularly 
revealing in demonstrating whether Russia is making progress 
toward sustainable growth. These include the following:

                           business formation

    The number of registered Russian companies per thousand 
inhabitants rose to 23 in 2000, compared to 1995's 15 per 
thousand figure. While this remains well below Central European 
levels, it also shows the extent to which Russian businesses 
and households continue to operate below the authorities' radar 
screens. Moreover, while the numbers of large and medium-sized 
firms continued to grow in 2000, the creation of small 
enterprises seemed to come to a standstill. Continuing this 
growth--which requires reducing the administrative and tax 
burden on enterprises and households--will be an important 
indicator (and source) of sustainable growth. Continuing 
stagnation in small business formation by contrast would be a 
very bad sign.

                    labor force participation rates

    During 1998-2000 Russia was able to offset accelerating 
population declines by boosting crude labor force participation 
rates (the labor force divided by the population) from 49.4 
percent to above 50 percent. Along with the sharp declines in 
unemployment recorded during this time (from a high of 14.1 
percent in February 1999 to around 9.5 percent during the first 
half of 2001), rising participation rates made possible the 
employment growth needed to fuel Russia's expansion. Since 
Russia's population is expected to shrink significantly during 
the next 15 years, prolonging the economic expansion will 
require continued increases in participation rates. This need 
not prove impossible: the crude labor force participation rate 
was close to 51 percent in 1993, and was much higher during the 
Soviet period. But boosting labor force participation will 
require further reductions in the tax and regulatory burden on 
enterprises and households, in order to strengthen incentives 
to move out of the grey sector.

                    commodity composition of exports

    The dominant role of energy, metals, and raw materials in 
Russia's export basket makes Russia's short-term economic 
prospects hostage to world price trends. The leading transition 
economies have succeeded in reducing this vulnerability by 
significantly increasing the share of engineering products--
particularly machinery and equipment--in total exports. 
Sustainable growth in Russia is unlikely to occur if the share 
of primary products in total exports does not shrink. A ``petro 
state'' afflicted with Dutch disease and a dual economy would 
instead be the more likely outcome.

                       fdi levels and composition

    Industrial restructuring in the leading transition 
economies has been driven by FDI into their manufacturing 
sectors. Long-term improvements in Russia's industrial and 
export competitiveness are unlikely if FDI continues to remain 
at its anemic levels, and remains concentrated in oil 
extraction and food processing.

                          the ``putin factor''

    President Vladimir Putin's robust support for market reform 
initiatives is one of the most pleasant surprises of the past 2 
years. But this support--coupled as it is with his initiatives 
to strengthen the role of the Kremlin and security apparatus in 
Russian politics--is a double-edged sword. The successful 
economic transitions in Central Europe and the Baltics 
correlate unambiguously with democratization, demilitarization, 
the flowering of non-governmental organizations (NGOs), and 
through this progress in establishing the rule of law. The 
creation of the rule of law in Russia that Putin's Kremlin 
claims to seek is inconsistent with the authorities' 
hostility--if not outright persecution--of NGOs, and with their 
profound suspicion of independent media and environmental 
activism. The perilous state of Russia's environmental and 
demographic balance, as well as attempts at reducing excessive 
administrative discretion and increasing public accountability, 
are poorly served by such hostility. The same can be said for 
Putin's bloody military solution to Russia's ``Chechen 
problem''--a problem that ultimately does not have a military 
solution, short of a genocide directed against a people (the 
Chechens) that also happen to be citizens of the Russian 
Federation.
    Putin's rule represents an attempt at strengthening order 
and markets at the expense of freedom. This combination is 
troubling, and not only because it contains strongly 
conflicting elements. Despite his support for market reform to 
date, Putin is not an economist, and as such he does not seem 
to value market reforms per se. Putin instead sees them as a 
means to achieving certain ends: namely, the rebuilding of 
Russia's position on the world stage, and sustained 
improvements in Russians' living standards. Should Putin become 
convinced that other economic policies are more conducive to 
meeting these ends, he could attempt to supplement or replace 
them with policies that deepen, rather than narrow, the gaps 
between Russian and best international economic practices. In 
this sense, Vladimir Putin's continuing evolution is itself a 
key indicator of Russia's progress toward sustainable growth.





                  UNLOCKING ECONOMIC GROWTH IN RUSSIA



                 By Vincent Palmeda and Bill Lewis \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................    47
Introduction.....................................................    49
    The productivity problem.....................................    50
How Does Low Productivity Lead to Low Standards of Living........    50
Low Productivity Performance in All Parts of the Russian Economy.    51
Main Operational Reasons for Persistent Low Productivity.........    54
The Direct Cause: Unequal Competitive Conditions.................    56
Immediate Impact of Unequal Competitive Conditions...............    56
    Steel and cement.............................................    57
    Oil..........................................................    58
    Confectionery................................................    59
    Residential construction.....................................    59
    Food and general merchandise retailing.......................    60
    Software.....................................................    60
Indirect Impact of Unequal Competitive Conditions................    61
    Dairy........................................................    61
    Software.....................................................    62
Secondary Causes.................................................    63
Russia's Growth Potential with Key Economic Reforms..............    64
Sectors with the Highest Growth Potential........................    64
Large Amounts of Potentially Viable Spare Industrial Capacity....    65
Benefits from Foreign Direct Investments (FDIs)..................    65
Fundamental Barriers to Economic Reforms.........................    66
Social Concerns..................................................    68
Corruption.......................................................    68
Lack of Information..............................................    69
Appendix: Summaries of Sector Case Studies.......................    70
                                Summary

    Russia is in a dire economic situation. Unlike some other 
reformed ex-Communist economies--Poland or Hungary--where 
economic performance sagged in the early years of the reform, 
but surged as reforms took hold, Russia experienced only 
decline to 1999. Gross domestic product (GDP) per capita has 
fallen by as much as 40 percent since 1992 and is now at only 
15 percent of the U.S. level. Unemployment topped 12 percent, 
and many more people are now engaged in subsistence forms of 
employment.
---------------------------------------------------------------------------
    \1\ Vincent Palmeda is the principal author of the McKinsey Global 
Institute study on Russia. Vincent Palmeda holds an engineering degree 
from Ecole Nationale des Ponts et Chaussees and an MBA from 
Northwestern University (Kellogg) in Chicago. Dr. Bill Lewis is the 
Director of the McKinsey Global Institute. His doctorate is in 
theoretical physics from Oxford.
---------------------------------------------------------------------------
    In an attempt to understand why economic reform has failed 
in Russia, we looked at the performance of ten representative 
sectors--software, steel, general merchandise and food 
retailing, hotels, oil, housing construction, cement, 
confectionery, and dairy-- and related their performance to 
that of the overall Russian economy. We also gauged the 
productivity of those industries against best practices around 
the world, determined why Russian companies lagged best 
practice, and identified what the government should do in 
priority to provide them with the means and incentives to 
improve their operational performance and expand. We believe 
that this micro-economic analysis is the only way to build a 
firm foundation for future economic policies and economic 
growth.
    Our primary findings are:
    Overall labor productivity is indeed very low. Our ten 
industries averaged only 19 percent of U.S. productivity 
levels, with software leading the group at 38 percent and 
cement at only 7 percent.
    Soviet legacy assets--which were roughly 30 percent as 
productive as U.S. assets in 1992--have had their productivity 
halved. This precipitous drop results from the fact that 
industries have not restructured despite sharp drops in demand 
from Russian consumers who now have access to products from 
around the world. Roughly 25 percent of Russia industrial 
capacity is currently in sub-scale or obsolete assets, which 
are still operating and fully staffed, but should be shut down.
    Assets added since 1992 are surprisingly unproductive. 
Almost no new capacity is being added in the oil and consumer 
goods industries, the sectors of the economy with the greatest 
potential for fast performance improvement. New assets are 
either well below efficient scale--as in housing construction 
and software, or undercapitalized--as in open-air markets.
    Despite high competitive intensity, the competition is 
unequal and it causes low productivity. Price decontrol and 
privatization did successfully stimulate competition. 
Paradoxically, however, in Russia the more productive companies 
are often the least profitable. Thus, more productive companies 
are not gaining market share and not pushing less productive 
firms out.
    In nine out of the ten sectors, the direct cause of low 
economic performance is market distortions that prevent equal 
competition. The distortions come from attempts to address 
social concerns, corrupt practices, and lack of information.
    In the manufacturing sectors, regional governments channel 
implicit federal subsidies to unproductive companies. Such 
subsidies take the form of lower tax and energy payments, and 
are allegedly intended to prevent companies from shutting down 
and laying off employees. This puts potentially productive 
companies at a cost disadvantage, blocking investments and 
growth on their part.
    In the service sectors, where employment should grow, 
investments by efficient companies are discouraged by the 
presence of well connected unproductive incumbents who benefit 
from favorable regulations, weak law enforcement, and 
privileged access to land or government procurements.
    Furthermore, these sector level market distortions are key 
contributors to macro-economic instability, because they reduce 
government revenues and increase its expenditures. Macro-
economic instability itself is another important deterrent to 
investments.
    We found the other often mentioned reasons for Russia's 
economic problems to play a much smaller role (e.g., poor 
corporate governance and lack of a transport infrastructure).
    There are no natural or economic obstacles to high economic 
growth in Russia, and the current situation need not be 
tolerated. Russia can rely on a skilled and inexpensive labor 
force, large and economically attractive energy reserves, and 
surprisingly, much spare capacity in potentially productive 
industrial assets. Explicit and targeted social policies 
combined with balanced and enforceable regulations (mostly at 
the sector level, involving taxes, energy, land and red tape) 
would remove the most important market distortions. The payoff 
would be strong economic growth in Russia.
    The findings and conclusions of this report have been 
largely published by the Russian and international media, as 
well as extensively discussed with the current Russian 
Government.
    Although economic reforms have accelerated in the last year 
in Russia and economic performance has been markedly better 
since the publication of our report in October 1999, we believe 
that its main findings and conclusions still hold true.\2\
---------------------------------------------------------------------------
    \2\ Bill Lewis, Director of the McKinsey Global Institute, reviewed 
the earlier detailed report and concluded that in June 2001 the main 
findings and conclusions still remain.
---------------------------------------------------------------------------
    First, Russia's strong economic performance in 2000 can be 
largely attributed to a rebound following the 1998 financial 
crisis and subsequent devaluation of the ruble. Good economic 
performance was further helped by the rapid rise in oil and gas 
prices. Furthermore, productivity growth (once adjusted for the 
cyclical increase in capacity utilization) and business 
investments, notably from foreign companies, are still at 
levels way below Russia's potential.
    Second, despite a sound economic plan, most of the key 
necessary economic reforms outlined in our report have yet to 
be drafted, passed through the Duma and/or enforced. 
Nevertheless, there have been some promising starts with the 
tax and land codes as well as with the reform plans of some 
crucial sectors such as telecom, railways and electricity.
    The U.S. Congress has a crucial role to play in helping 
Russia to quickly join the ranks of the advanced democracies, 
and we hope that it will find our report to be a useful 
contribution to that aim.
    These findings are discussed in greater detail in the 
following sections.

                              Introduction

    This paper is the executive summary of a year-long project 
by the McKinsey Global Institute, working closely with members 
of the McKinsey's Moscow office, on the economic performance of 
Russia.\3\ This report was first published In October 1999, but 
we believe that its main findings and conclusions still apply 
to the Russian economy of the year 2001.
---------------------------------------------------------------------------
    \3\ The full report (more than 400 pages) can be accessed on the 
Internet (www.mckinsey.com) or obtained by faxing request to the 
Institute in Washington, DC (1-202-662-3218).
---------------------------------------------------------------------------
    McKinsey undertook this project as an important step in 
developing our understanding of how the global economy is 
working. The failure of the reforms undertaken in Russia in the 
early 1990s to generate good economic performance is one of the 
highest priority problems in the global economy. We wanted to 
find out whether the reforms were causing change at the micro-
level that would eventually yield good economic performance. If 
not, we wanted to find out why reforms had failed and how to 
improve the situation. We have undertaken this work as an 
investment by McKinsey in knowledge building, we would 
emphasize that the work is independent and has not been 
commissioned or sponsored in any way by any business, 
governmental or other institution.
    This project builds upon the previous work of the McKinsey 
Global Institute in assessing economic performance among the 
leading economies of the world. Our earlier reports addressed 
separately labor and capital productivity and employment, the 
fundamental components of economic performance. Later, we 
combined these components to address the overall performance of 
Sweden, Australia, France, Germany, The Netherlands, Brazil, 
Korea, the United Kingdom, Poland, Japan and India.
    As before the core of our work is conducting sector case 
studies to measure differences in productivity, output and 
employment performance across countries and to determine the 
reasons for the differences. We studied in detail ten 
representative economic sectors. Specifically, we examined why 
Russian companies are not restructuring and expanding faster, 
and why foreign companies are not investing more in Russia. 
This comprehensive micro-economic approach reveals the relative 
importance of the various problems, which plague the Russian 
economy and thus helps set priorities among the long list of 
economic policy changes recommended from all directions.
    In conducting the project, we have drawn on the counsel of 
an external Advisory Committee. Chaired by Professor Robert 
Solow of the Massachusetts Institute of Technology, it included 
Professor Olivier Blanchard, also from the Massachusetts 
Institute of Technology, Professor Richard Cooper of Harvard 
University and Ted Hall, Chairman of the McKinsey Global 
Institute Advisory Board.

                        the productivity problem

    Market reforms so far have failed to improve Russia's 
economic performance. Although the efficiency (productivity) 
with which companies produced goods and services in the Soviet 
era was already low compared to the best practice in the world, 
it has gotten worse since the reforms started. By understanding 
the underlying operational sources of the productivity gaps 
between Russian companies and global best practice, we are able 
to better understand which factors in the external (regulatory) 
environment are causing managers and investors not to make 
progress toward closing the gaps.
    The size and nature of the productivity gaps are discussed 
below in this section, the main external factors stopping 
productivity growth, and consequently economic growth, are 
discussed in the next section.

       How Does Low Productivity Lead to Low Standards of Living

    The material standard of living in a country is determined 
by the amount of goods and services produced by the economy, 
referred to as GDP. Russia's GDP per capita is only at 15 
percent of the U.S. level. It is also falling behind many of 
the ex-Communist countries, notably Poland, which, unlike 
Russia, has been rebounding economically since 1992 (Figure 1).
    The GDP (output) level is determined by the combination of 
two factors: the amount of hours worked by the people (labor 
inputs) multiplied by the amount of goods and services produced 
by an average hour of work (labor productivity). Because people 
in all countries work to make ends meet, labor inputs tend to 
be at similar levels. In Russia, for example, despite high 
unemployment, labor inputs per capita are still at more than 80 
percent of the U.S. level. Thus, labor productivity ultimately 
becomes the determinant of economic performance. Russia's labor 
productivity is very low at only 19 percent of the U.S. level 
in 1997, down from around 30 percent in 1991 (Figure 2).

          FIGURE 1._GDP PER CAPITA AT PURCHASING POWER PARITY

                     [United States = 100 in 1995]

[GRAPHIC] [TIFF OMITTED] T6171.019



  Source: Goskomstat, Polish Central Statistical Office; 
Organization for Economic Cooperation and Development (OECD), 
Economist Intelligence Unit (EIU).

    Low Productivity Performance in All Parts of the Russian Economy

    In this study, we have examined in detail ten economic 
sectors which cut across manufacturing and services and 
together represent over 15 percent of total employment in 
Russia: steel, cement, oil, dairy, confectionery, residential 
construction, food retailing, general merchandising, hotels, 
and software. Agriculture and government sectors, like defense, 
were not included in the scope of the project. Our cases cover 
both heavy and light manufacturing, the large core domestic 
sectors of construction and retailing, and software, the 
largest of the new, high technology service sectors.

                   FIGURE 2._RUSSIA'S GDP PER CAPITA

                     [United States = 100 in 1995]

[GRAPHIC] [TIFF OMITTED] T6171.018


  * Based on hours worked per capita.
  ** Fifteen percent in 1998.

  Source: Goskomstat; EIU; Bureau of Economic Analysis; 
McKinsey analysis.

    In each of these selected sectors we have compared the 
performance of companies operating in Russia (both Russian and 
foreign) with those in the United States, selected as the 
benchmark country.
    Our study reveals huge productivity gaps in all sectors of 
the Russian economy, whose productivity ranges from 7 percent 
of the U.S. level in cement to 38 percent in the new software 
sector (Figure 3). Moreover, in the sectors we studied, a long 
tail of unproductive enterprises co-existed with a few 
relatively productive ones, dragging down the overall 
productivity (Figure 4).
    Over the last 8 years, labor productivity in the old assets 
(put in place before 1992) fell from 30 percent to 17 percent 
of the U.S. level. This decline was not compensated for by a 
rapid growth of a new and productive economy. New assets (put 
in place since 1992) employ less than 10 percent of the Russian 
workforce and, surprisingly, achieve only 30 percent of the 
U.S. productivity level on average (Figure 5).

      FIGURE 3._AVERAGE LABOR PRODUCTIVITY BY SECTOR, RUSSIA 1997

                     [United States = 100 in 1995]

[GRAPHIC] [TIFF OMITTED] T6171.016


  * Russia's actual labor productivity is 25, but only 15 if 
measured on a geology-comparable basis.
  ** Weighted by employment share.

  Source: McKinsey analysis.

FIGURE 4._EMPLOYMENT AND LABOR PRODUCTIVITY IN FOOD RETAILING IN MOSCOW
[GRAPHIC] [TIFF OMITTED] T6171.017


  Source: Case studies.

                  FIGURE 5._THE OLD AND NEW ECONOMY *

                     [United States = 100 in 1995]
[GRAPHIC] [TIFF OMITTED] T6171.014


  * Estimates based on sector case studies.

  Source: Goskomstat; EIU; McKinsey analysis.

        Main Operational Reasons for Persistent Low Productivity

    We found three main operational reasons for persistent low 
productivity in Russia:

   Excess workers maintained in the old assets.--
        Customers turned away from low quality products and 
        services offered by the old companies once they had to 
        pay the full cash price for them. The resulting 50 
        percent fall in the output of these companies was not 
        matched by a similar reduction in employment, which 
        fell by ``only'' 20 percent. We estimate that 10 
        percent of workers on average are redundant, while 
        another 20 percent are currently stranded in non-viable 
        operations.
   Inefficient organization still prevailing in the old 
        assets.--Although most of the former Soviet companies 
        have been privatized. They remain plagued by antiquated 
        modes of organization: absence of marketing and sales 
        skills, poor quality control, lack of basic profit 
        incentives and teamwork. Below are three examples from 
        the studied sectors:
     In steel, breakdowns or defects often go 
            unreported because workers fear being blamed for 
            them.
     Sales and marketing departments at many 
            confectionery plants have extended their product 
            portfolios well beyond an efficient scope.
     In hotels, a team of receptionists could absorb 
            the functions currently performed by the 
            dezhurnayas on each floor (e.g., key handling and 
            surveillance).

   Potentially profitable investments not made.--We 
        discovered that managers and investors forego 
        investment opportunities in covered upgrading existing 
        assets and in developing new ones. In markets covered 
        with equal conditions of competition, such investments 
        would bring financial return in excess of 30 percent.
     Our sector studies show that almost three-fourths 
            of the old assets are still economically viable and 
            could achieve up to 65 percent of the U.S. 
            productivity with limited upgrade investments 
            combined with modern forms of organization (Figure 
            6). The investments are primarily required to 
            improve the quality of output and/or energy 
            efficiency. Examples include upgrading the wet/gas 
            technology in cement, more hydrofracturing in oil, 
            more flexible production lines in panel housing and 
            conversion of gastronoms into mini-markets.

 FIGURE 6._LABOR PRODUCTIVITY POTENTIAL OF VIABLE OLD OPERATING ASSETS

                     [United States = 100 in 1995]

[GRAPHIC] [TIFF OMITTED] T6171.015


  * Impact from favorable geology included.

  Source: McKinsey analysis.

     Potentially high return and substantial 
            investments in). The developing new productive 
            assets are also not made. For example, new oil 
            fields should be developed in the economically 
            attractive proven reserves of Western Siberia. And, 
            unlike in Poland, very little new capacity has been 
            developed in the consumer goods industries. In 
            these sectors, the demand for quality goods is 
            still being met largely through imports. In food 
            retail, there is strong evidence of unmet demand 
            for high service (relative to open-air wholesale 
            markets) formats like supermarkets. These modern 
            high productivity formats are still almost entirely 
            absent from Russia with less than 1 percent market 
            share, against already 18 percent in Poland 
            (growing fast) and 36 percent in Brazil.

    We will now explain why managers and investors are not 
scrambling to seize these operational improvement 
opportunities, which should, in a market economy with equal 
competition, lead to higher profits.

            The Direct Cause: Unequal Competitive Conditions

    Unequal conditions of competition at the sector level, 
caused by the existing economic policies, are the most 
important reason for the lack of restructuring and productive 
investment in Russia. These inequalities tend to favor low 
productivity incumbents, protecting them from takeovers and 
productive new entrants. These policies are often put in place 
to achieve social objectives, namely protecting existing jobs, 
but in many cases, the suspicion is that they also serve the 
personal financial interests of government officials in 
collusion with businessmen.
    We show below how these distortions have both direct and 
indirect negative impacts on the economy.

           Immediate Impact of Unequal Competitive Conditions

    In open markets with equal conditions of competition, the 
most efficient (productive) company should be the most 
profitable. Being more productive means that the company either 
uses less inputs for the same output (i.e., it has lower costs) 
or produces better output with the same inputs (i.e., it makes 
superior products that command higher prices). Higher 
profitability should enable productive companies to invest and 
grow at the expense of less productive ones, which should be 
eventually forced to either improve their operations or shut 
down.
    Studying the sectors of the Russian economy, we found that 
while competitive intensity is usually high, the rules of the 
game are different for different competitors. The rules are 
seriously distorted in favor of less productive companies. 
Often the regulatory environment in which companies operate 
makes it difficult for the productive companies to crowd out or 
take over their unproductive competitors. As a result of 
unfavorable differential treatment, more productive companies 
often struggle financially, while their less efficient 
competitors thrive.
    These distortions tend to be sector-specific; they can take 
many different forms such as:

   Different effective tax rates paid by the companies 
        within one sector
   Preferential access to land and government 
        procurements
   Different effective energy prices paid by different 
        players in the same industry
   Variable degrees of red tape imposed on companies at 
        the discretion of authorities
   Differential law enforcement, e.g., in the area of 
        intellectual property rights or import tariffs
   Differential access to government-controlled export 
        infrastructure.

    Below are examples of the impact these market distortions 
have on the development of the sectors covered by our study.

                            steel and cement

    Obsolete (sub-scale and/or inefficient in their use of 
energy) steel and cement plants are avoiding shutdowns by 
paying for only a fraction of their energy bills--their largest 
cost component. Because these companies are often the major 
employers in a town, municipal and regional officials go to 
great lengths to keep them operating (Figure 7). Regional 
governments channel implicit federal energy subsidies to these 
companies by letting arrears to federal suppliers (Gazprom and 
Unified Energy Systems (UES)) accumulate at the local gas and 
electricity distribution companies. These energy distribution 
companies are often under effective control of the regional 
governments; laws make their bankruptcy practically impossible. 
These subsidies slow down recovery in many manufacturing 
sectors by preventing upgrading investments and industry 
consolidation in and around the viable industrial assets.

                     FIGURE 7._COMPANY STEEL TOWNS

       [Steel plant workforce as a percentage of town employment]

[GRAPHIC] [TIFF OMITTED] T6171.013


   = Major social issue.

  Source: Goskomstat.

    Serving as a means of reallocation of resources to 
unproductive enterprises, these subsidies may also be viewed as 
fines imposed on healthy firms. As a result of the subsidies, 
financially sound companies end up paying taxes and energy 
bills ``for themselves and the other guy.''

                                  oil

    Russia has large and economically attractive proven 
reserves which can become a source of additional export and tax 
revenues. Unpredictable economic policies impede investments 
into the development of new oil fields. Oil companies are 
reluctant to commit to large long-term investments without 
stable and workable tax policies (the recently passed law on 
the production sharing agreement is far from being operational) 
and without fully liberalized domestic oil prices. But here 
again, the social objectives are pursued inefficiently. Policy 
makers deliberately limit oil exports to secure supply of cheap 
oil to ``strategic'' customers like the agriculture and defense 
sectors. Combined with the current rate of depletion in the 
existing oil fields, the export-limiting regulations may make 
Russia a net importer of oil by 2009. Providing the necessary 
assurances to investors, notably well financed foreigners, 
could enable oil production to double in 10 years (Figure 8). 
Such an increase would be sufficient to meet the demand of a 
fast growing economy and to increase oil exports by at least 50 
percent. In addition, it would provide additional tax revenues, 
which would be more than enough to compensate strategic 
customers for higher oil prices.

         FIGURE 8._POSSIBLE SCENARIOS FOR FUTURE OIL PRODUCTION

                     [Millions of barrels per day]

[GRAPHIC] [TIFF OMITTED] T6171.012


  Source: Mckinsey analysis.

                             confectionery

    Investments into existing confectionery plants are also 
discouraged. Regional and municipal governments may effectively 
ban the best practice companies from laying off excess workers 
and reaping the productivity benefits of their investments. 
Local authorities have the means to discipline disobedient 
managers by, for example, subjecting them to troublesome fire, 
safety, health and other inspections, the number of which can 
reach 400 in a year for a single company.
    Regional governments, as in the steel and cement 
industries, can support unproductive confectionery plants by 
effectively waiving their local tax obligations and helping 
them to pay less federal taxes. As a result, the few law 
abiding best practice foreign companies are less profitable 
(after taxes) than their inefficient domestic competitors 
(Figure 9).

               FIGURE 9._CONFECTIONERY INDUSTRY DYNAMICS

[GRAPHIC] [TIFF OMITTED] T6171.011


  * Excludes brownfield plants operated by multinationals (13 
percent market share).

  Source: Goskomstat; Institute for confectionery industry.

                        residential construction

    More than half of residential construction in Russia is 
still financed by the government. Although government contracts 
are officially submitted to open tenders, they almost 
invariably end up going to the same ex-Soviet companies closely 
affiliated with the local authorities. As a result, these 
companies have no incentives to increase their very low 
productivity (which they could quadruple with almost no 
investments). On the contrary, one of their implicit deals with 
the local government is to get the contracts in exchange for no 
layoffs.

                 food and general merchandise retailing

    Productivity in the retail sector in Russia is low mainly 
due to a very low penetration of modern formats: supermarkets, 
hypermarkets, malls and convenience store chains. 
Supermarkets--the most productive format in food retailing--
have less than a 1 percent market share in Russia.
    The share of supermarkets is low because productive modern 
formats are treated unfavorably and, as a result, have a 
significant cost disadvantage vis-a-vis the much less 
productive sub-scale formats like open-air wholesale market 
stands and kiosks. The latter benefit from much lower tax 
liabilities, less control on the origin of their goods (which 
are often illegal imports or counterfeits), and cheaper access 
to prime locations (Figure 10). Here again the official 
rationale for such distortions is social: many jobs are at 
stake in small format operations, and open-air wholesale 
markets are the way to get cheap food to the poor.

FIGURE 10._ESTIMATED EFFECTS OF UNEQUAL TAX AND LAW ENFORCEMENT ACROSS 
                             RETAIL FORMATS

                 [Indexed to price in gastronoms = 100]

[GRAPHIC] [TIFF OMITTED] T6171.010


  Source: McKinsey price survey; McKinsey productivity survey; 
Gubernia, expert interviews.

                                software

    Because the products of Russian packaged software companies 
are systematically pirated, they lack the resources to invest 
into the development of innovative products. This consequently 
limits their productivity and growth potential (Figure 11).
    The other sub-sector in the software industry, project 
services, proves by reaching 72 percent of the U.S. 
productivity level that, with equal conditions of competition, 
a whole economic sector can reach high productivity. There are 
no market distortions in this sector for two reasons; first, it 
is completely new, with no incumbents to be protected, and 
second, its customized nature makes it immune to piracy.

         FIGURE 11._EFFECTS OF SOFTWARE PIRACY ON PRODUCTIVITY

[GRAPHIC] [TIFF OMITTED] T6171.009


  * Indicates total worth of software.
  ** Russia, 1998; other countries, 1996.

  Source: Bureau of Statistical Analysis; International 
Development Corporation; ``Russian Shield'' Association; 
financial reporting; McKinsey analysis.

           Indirect Impact of Unequal Competitive Conditions

    Negative effects of market distortions are not limited to 
the sectors where they appear. Barriers to higher economic 
performance in key sectors of the economy block the growth of 
productivity, and consequently output, in related industries 
via negative spillover effects, and fundamentally lead to 
macro-economic instability.
    Negative spillover effects from problems in related sectors 
are important in explaining the lack of productivity and 
investment growth in four out of the ten studied sectors. Below 
are two examples:

                                 dairy

    Negative spillover effects plague the all-important food 
chain. The absence of large modern retail formats leads to the 
dominance of monopolistic wholesalers who squeeze retailers and 
dairy plants. The cash-poor milk processors can neither invest 
in new equipment, nor pay the ailing dairy farmers. In 
response, farmers set up their own dramatically sub-scale dairy 
plants and then distribute the milk (including a large 
proportion of raw milk) directly to retailers and consumers.
    Recent development in Poland shows that the modern best 
practice supermarkets are interested in helping the local food 
industry to improve efficiency and grow. They establish direct 
purchasing agreements to leverage their scale and bypass 
monopolistic wholesalers. In turn, increasingly sophisticated 
Polish food processors have, due to supermarkets, the financial 
resources to help develop efficient farmers through contract 
growing agreements.

                                software

    The growth of software companies in Russia depends on the 
growth of their local business customers. In markets with equal 
and intense competition, the largest software consumers (like 
banks, supermarkets and telecommunication companies) constantly 
require productivity enhancing software tools to help them beat 
their competitors. Naturally, when productivity improvement is 
not the primary way to financial success, as is the case in 
Russia, software services are in low demand. Russian companies 
spend only 0.1 percent of their output on purchasing software, 
against more than 1 percent in the United States (Figure 12). 
The much smaller size of output of Russian companies confounds 
the situation.

  FIGURE 12._ESTIMATED CONSUMPTION OF SOFTWARE BY SOME SECTORS OF THE 
                               ECONOMY *

         [Software spending as percent of output of the sector]

[GRAPHIC] [TIFF OMITTED] T6171.008


  * Russia, 1997; other countries, 1996.

  Source: International Development Corporation; OECD; EIU; 
interviews.

    Barter transactions, which are prevalent in half of 
Russia's economy, are fundamentally a result of these market 
distortions. Tax evasion, energy subsidies and directed 
government procurements are most often carried out through 
complex barter deals. The government and government-related 
companies conceal these subsidies under unfavorable (if real 
market prices are applied) barter deals, which also provide 
ample personal enrichment opportunities because they are put in 
place through short-lived and hugely profitable trading 
companies.
    Macro-economic instability in Russia has been directly 
caused by the fiscal deficit, which results from the fact that 
the government spends more than the taxes it manages to 
collect. This deficit has to be financed by either printing 
money or by paying high real interest rates to attract private 
investors. Both ways of financing the deficit introduce macro-
economic instability: inflation becomes a hidden tax on all 
holders of Russian currency, and high real interest rates paid 
on government debt lures private investment away from the rest 
of the economy. The negative effects of macro-economic 
instability could be seen in all the studied sectors, and most 
notably in oil and hotels, where a long time is needed to 
recuperate large initial investments.
    Unequal rules of competition are a fundamental cause of the 
chronic budget deficit. Government expenditures are increased 
by large implicit federal subsidies to inefficient enterprises 
in the traditional declining sectors (e.g., heavy manufacturing 
and construction), while tax collection from the unproductive 
but well-connected firms in the new growing sectors (e.g., 
retail) is very poor.
    The recent progress made toward balancing the budget should 
be little cause for comfort. Around 40 percent of budget 
revenues still depend on extremely volatile oil and gas prices, 
which have fortunately soared in 1999. Key government 
expenditures, like the wages of law enforcement officials, are 
still grossly inadequate. Capital flight, rational when 
economic policies discourage investment within Russia, 
continues. Finally, the rise in industrial production, which 
followed the August 1998 devaluation, should be seen as a one-
time adjustment due to a sudden increase in prices of imports, 
rather than the start of a prolonged economic recovery.
    Overall, the facts show that inequalities in the rules of 
competition at the sector level are the main roadblocks on the 
path of economic growth in Russia. Notwithstanding corrupt 
practices or plain disbelief in the market economy, many of 
these distortions have been put in place by the government to 
meet social objectives. Unfortunately, they keep Russia at a 
very low level of economic performance and thus damage the 
social provisions they were intended to improve.
    We discuss in the last section which policies and dynamics 
could unlock the current system of intertwined social, 
political and financial interests.

                            Secondary Causes

    We found the other most often cited reasons for lack of 
growth in Russia to be much less important than the sector 
level market distortions described above.
    Problems in the area of corporate governance, resulting 
from a combination of privatization to insiders and the lack of 
shareholders' rights, are often mentioned as key to Russia's 
economic under-performance. The existing governance environment 
gives the current managers more incentives to divert the 
company cash flows to their own trading firms, than to 
restructure or invest. Such cash diversions have been commonly 
mentioned in the steel, cement and oil sectors. However, in 
these industries, battles for corporate control are now coming 
to an end in most of the viable assets, allowing management to 
focus on increasing long-term value of the company.
    Restrictions on labor mobility may lead to social tensions 
in company towns, but do not limit the abilities of growing 
companies to recruit workers. For example in Moscow, where the 
labor market is allegedly tight, a large share of workers 
engaged in government-financed housing construction could be 
easily made available for re-employment. Facilitating labor 
mobility, notably in the non-viable company towns, would 
nevertheless help release the current pressure on regional and 
municipal governments to oppose restructuring of enterprises.
    Lack of legal infrastructure to enforce commercial 
agreements.--While the lack of a strong and independent 
judiciary does make it difficult for productive companies to 
appeal against the inequalities of competition, private parties 
are now finding ways to work out secured transaction 
arrangements (e.g., cash on delivery and employment of private 
third party negotiators).
    Lack of an effective banking system.--Lack of trust in both 
the ruble and the banks (especially following the August 1998 
debacle) leads people not to make their savings available for 
subsequent lending by the banks (savings are mostly kept at 
home in dollar notes, or outside of the country). Although this 
is certainly bad news for Russia, it should be noted that the 
virtual absence of bank lending in Poland did not prevent it 
from achieving a strong economic growth due to foreign direct 
investment (FDI) and retained earnings, the main source of 
business investments in the West.
    Poor transport and communications infrastructure, even with 
the great Russian distances, did not emerge as an important 
barrier. Most of the population and production facilities are 
located west of the Urals, where distances are not as huge as 
in the Eastern part of the country, and most of the European 
part of Russia can be reached fairly quickly and inexpensively 
by truck or train.

          Russia's Growth Potential with Key Economic Reforms

    As described in the previous section, our investigation of 
sectors of the Russian economy helped us identify the relative 
importance of the reforms now being discussed. We concluded 
that the main barriers to economic growth, unequal conditions 
of competition, tend to be industry-specific. Thus, they have 
to be removed on a sector-by-sector basis. Given the political 
difficulty of reform, this process probably should start with 
the high growth potential sectors identified below.
    Removing the market distortions, especially in the sectors 
with high growth potential, could enable Russia to achieve and 
sustain rapid economic growth. Eight percent per annum would be 
within reach, allowing standards of living to double in less 
than 10 years. This performance could be achieved due to a 
significant share of potentially viable spare capacity, a 
sizeable pool of skilled and inexpensive labor, and crucially, 
a large inflow of FDI into Russia, which can be expected once 
the inequalities are eliminated from the conditions of 
competition.

               Sectors with the Highest Growth Potential

    We have estimated the relative potential of output growth 
in Russia's economic sectors based on the experience of other 
countries, Russia's starting point and sources of comparative 
advantage (Figure 13). This analysis shows that in addition to 
oil, where exports could sharply increase, output in light 
manufacturing (food processing, consumer goods and automotive 
industries) should grow to replace the current high share of 
imports. Demand for new services, like supermarkets, should 
also continue to increase. These are the sectors where the 
market distortions should be removed first.

    FIGURE 13._RELATIVE OUTPUT GROWTH POTENTIAL OF RUSSIA'S SECTORS

           [Percentage points of U.S. GDP in 1995 per capita]
[GRAPHIC] [TIFF OMITTED] T6171.006


  * Oil expected to grow faster than gas and mining.
  ** Commercial and infrastructure construction to grow faster 
than housing construction.

  Source: OECD; McKinsey analysis.

     Large Amounts of Potentially Viable Spare Industrial Capacity

    Our sector analyses have shown that about 75 percent of 
Russia's inherited assets (put in place before 1992) would 
still be viable if upgraded and managed according to modern 
principles. Generalizing from the sectors we studied and 
assuming equal market conditions, this upgrade would allow 
production in these assets to increase by 40 percent on average 
for a relatively small investment, only around 5 percent of GDP 
per annum, for 5 years (Figure 14).

            Benefits from Foreign Direct Investments (FDIs)

    FDI could be attracted en masse into the high growth 
sectors and potentially viable assets, provided that the market 
distortions are removed. Foreign companies would bring not only 
the dollars necessary to finance imports of machinery, but also 
the best practice managerial skills indispensable to achieving 
high productivity.

                FIGURE 14._SIZE OF UPGRADING INVESTMENTS
[GRAPHIC] [TIFF OMITTED] T6171.007


  Source: Interviews.

    In oil alone, foreign investment could amount to $80 
billion over the next 10 years, the equivalent of 3 percent of 
Russia's GDP every year. Foreign oil companies would also bring 
the expertise and technologies, that would double drilling 
efficiency in new fields.
    In Poland, which has no oil, direct foreign investment 
already amounts to 7 percent of GDP, against less than 1 
percent today in Russia. FDI in Poland is concentrated in light 
manufacturing and services, and in light manufacturing accounts 
for 60 percent of total investment (Figure 15). Large inflows 
of FDI have been the secret of Poland's ``economic miracle.'' 
The Polish experience also shows that if exposed to intense 
competition on an equal basis, foreign companies do not 
``milk'' the country, but rather keep reinvesting profits and 
develop a pool of local management talent.
    The Novgorod region of Russia is a rare positive example of 
what can be done in today's Russia by regional governments. It 
managed to attract more FDI than almost any other Russian 
region, including nearby St. Petersburg, by removing red tape, 
facilitating access to land and offering tax holidays to 
investors. As a result, the region has enjoyed economic growth 
since 1995, and over half of industrial output is now coming 
from productive foreign companies (Figure 16).

                Fundamental Barriers to Economic Reforms

    The drive toward establishing a market economy based on 
equal opportunities for all competitors has essentially stopped 
in Russia since 1995. Why has this happened? There are three 
fundamental explanations for this: social concerns, corruption 
and lack of information. We discuss below how these factors 
interplay to lock Russia at the current low level of economic 
performance and what could be the ways to unlock it.

          FIGURE 15._POTENTIAL INCREASE IN BUSINESS INVESTMENT

                            [Percent of GDP]
[GRAPHIC] [TIFF OMITTED] T6171.005


  * Includes automotive.
  ** Transport, communication, business and personal services.

  Source: Goskomstat; Polish Analysis of Industrial Enterprises 
(PAIZ); McKinsey analysis.

        FIGURE 16._SUCCESS OF MARKET REFORMS IN NOVGOROD REGION
[GRAPHIC] [TIFF OMITTED] T6171.004


  * Median of cumulative 1995-1997 FDI per capita of all 
regions.
  ** First quarter 1998.

  Source: Goskomstat; interviews; Bureau of Economic Analysis; 
Institute of East-West Studies (IEWS); press reports.

                            Social Concerns

    Many of the market distortions are kept in place in the 
name of preserving existing employment. When justified, these 
social concerns would be better addressed with a system of 
explicit direct subsidies to the workers, rather than through 
the current mechanism of implicit subsidies to companies, which 
also serves to enrich government officials and company 
managers.

   Ill-founded social concerns.--Based on the 
        experience of other countries further ahead in their 
        economic development, notably Poland, and our 
        understanding of labor productivity gaps in Russia, we 
        have estimated how employment would evolve by sector if 
        the barriers to economic growth were removed. We found 
        that employment should continue to grow in services and 
        remain roughly stable in light manufacturing and 
        construction. Thus, workers who would loose their jobs 
        as a result of strong productivity growth or shutdowns 
        in these sectors should be able to find new jobs of 
        similar profile, especially if they are around large 
        urban areas. As a result there are no social reasons to 
        keep in place the following barriers which have been 
        identified in the cases:
     Red tape limiting the restructuring of potentially 
            viable dairy and confectionery plants
     Directed housing contracts to preserve employment 
            levels in the traditional (panel type) housing 
            construction companies
     Tax and other advantages given to open-air 
            wholesale markets, kiosks and pavilions
     Government ownership of hotels.
   Alternative for addressing well founded social 
        concerns. In the heavy manufacturing sectors, 
        productivity would grow faster than output, leading to 
        substantial employment losses. This prospect does raise 
        serious social issues, especially in doomed company 
        towns, because workers' mobility is restricted by the 
        registration (propiska) system. In such cases, direct 
        subsidies, given to the workers to help them relocate 
        would be much more efficient than the current barter-
        based corrupt system of implicit federal subsidies to 
        unproductive companies. Doing this would allow the 
        removal of the following distortions:
     Unequal energy and tax payments slowing down 
            modernization of viable industrial assets
     Limits on oil exports to force cheap oil to be 
            supplied to agriculture and defense, discouraging 
            investment into new oil production.

                               Corruption

    Our interviews with companies confirmed the common view 
that pursuit of personal financial gains within the government 
and government-related agencies or companies is pervasive in 
Russia. Like in many other developing countries, the 
combination of arcane laws, government control over key assets, 
low salaries of state employees and weak enforcement and 
control mechanisms provides the means and incentives for 
corrupt practices. In Russia, virtually every business is in 
violation of laws (primarily tax laws) and hence the potential 
target of public or private shakedowns (primarily at the local 
level). We believe that in many cases corruption, together with 
social concerns, is the main reason for the rules of 
competition to be kept unequal.

   The conventional wisdom on how to fix corruption 
        suggests that the highest level of government, 
        remaining untarnished, should initiate the crackdown: 
        ``the fish rots from the head.'' The salary level of 
        key officials needs to be increased, laws against 
        conflict of interest passed and strong independent 
        controls need to be put in place together with credible 
        punishment.
   Based on our case studies, we believe that a 
        potentially more effective way to reduce corruption in 
        Russia would be to remove the numerous means by which 
        the federal and local governments can interfere with 
        the markets to extract economic rent. This would entail 
        lower and simpler taxes, streamlined red tape, reduced 
        scope for government procurements (e.g., social 
        housing) and privatization of remaining government 
        assets (e.g., land and hotels).

    This suggests that corruption is not only a cause of 
Russia's current economic problems but also a consequence of 
incomplete market reforms.

                          Lack of Information

    Such vicious dynamics have been broken in other countries 
through the democratic process on the basis of fact-based 
policy debates. Facts about the Russian economy are difficult 
to obtain. We hope to contribute a useful fact base to policy 
debates, as we show with micro-economic analysis:

   The extent of the performance gaps for both the old 
        and new economy
   The absence of fundamental natural or economic 
        obstacles to high economic growth in Russia
   The economic sectors with the highest growth 
        potential
   The often underestimated importance of services in 
        stimulating overall economic growth (e.g., supermarkets 
        triggering positive spillover effects down the whole 
        food chain)
   The key role that could be played by FDIs, 
        especially in a ``strategic'' sector like oil
   The most important economic reforms, to be pursued 
        with priority in the high growth potential sectors
   How these economic reforms can be made compatible 
        with the pursuit of social objectives
   How these economic reforms would help reduce the 
        scope for corrupt practices
   The key role and responsibility of regional 
        governments in fostering economic growth.

    The changes described above require painstaking efforts in 
the political process to overcome conflicts of interest and 
reach compromises. Today's advanced democracies have taken 
decades to achieve good economic policy, both at the macro-
economic and sector levels. However, the result has been that 
they have achieved the highest levels of economic performance 
in the world. Russia can benefit from the hard lessons learned 
by others, but for historical reasons, the obstacles in Russia 
are more difficult. How to lead a democratic political process 
to overcome these obstacles is beyond the scope of this project 
and beyond McKinsey's experience and expertise. However, we 
have found no structural constraints on the economic side that 
would prevent Russia from quickly joining the ranks of the 
advanced economies.

               Appendix: Summaries of Sector Case Studies

    Below we present summaries of each of the ten sector case 
studies. Each summary covers five topics: industry overview, 
productivity performance, reasons for productivity gap at the 
operational level, external barriers to productivity and output 
growth, and to conclude, policy implications and future 
outlook.

                                 steel

Industry overview
    In 1990 the Soviet Union was the largest steel producer in 
the world. Following a 60 percent drop in domestic steel 
consumption, not compensated for by an increase in exports, 
steel production fell by 40 percent in Russia since the 1990 
production peak. The more than 100 Russian steel plants can be 
divided between the ``Big Three'' integrated steel plants 
(mainly flat products), the ``Medium Six'' (long products) and 
``Small Others.'' Each group employs around one third of the 
almost 400,000 steelworkers.
Productivity performance
    With no shutdowns or layoffs, productivity fell by 40 
percent to 28 percent of the U.S. level between 1990 and 1997. 
The Big Three achieve around 45 percent of the U.S. 
productivity level, the Medium Six 25 percent and the Small 
Others only 10 percent of the U.S. level.
    The main reasons for the productivity gap at the 
operational level for the Big Three and Medium Six are low 
capacity utilization, excess workers in logistics and overhead 
functions, and low yields on energy and raw materials. These 
plants could achieve more than 80 percent of the U.S. 
productivity level with very little upgrading investments. Most 
of the Small Others, however, are not viable because they use 
the outdated open hearth furnace and ingot casting process, 
wasting energy and representing major environmental hazards.
    The most important external barrier to productivity and 
output growth is the implicit federal energy subsidy given, in 
the form of arrears or advantageous barter deals, to many non-
viable Small Others, allowing them to remain in operation. 
There have been virtually no layoffs in the viable steel plants 
because wages are free to adjust downward, as the prevailing 
registration (propiska) system curbs the ability of workers to 
travel in search of better jobs. Poor corporate governance was 
a key barrier to growth soon after the privatization (1993-
1996) as managers concentrated their efforts on gaining 
control. Today, with the end of most shareholder battles at the 
large productive plants, it is of secondary importance.
Policy implications and future outlook
    With adequate technology in most of its production 
capacity, and relatively low labor and energy costs, Russia has 
a clear competitive advantage in steel. To allow the industry 
to realize its full potential, local governments should stop 
channeling implicit subsidies to doomed plants in exchange for 
appropriate mobility provisions and social safety nets to be 
provided by the federal government. At the same time, a good 
way for the West to help Russia would be to remove the current 
restrictions on Russian steel imports.

                                 cement

Industry overview
    There are 50 cement plants in Russia employing around 
40,000 workers. Cement production collapsed by more than 60 
percent since the 1990 peak; it is now at half the Polish level 
on a per capita basis. The industry has remained extremely 
fragmented since privatization, and the three foreign global 
players present in Russia have yet to commit to significant 
investment.
Productivity performance
    Despite the production collapse, there have been virtually 
no plant shut downs or layoffs. Productivity has thus dropped 
from 20 percent of the U.S. level in 1990 to 7 percent in 1997. 
The best Russian plant achieves 30 percent of the U.S. 
productivity level, while many plants stand at 1 percent.
    The main reasons for the productivity gap at the 
operational level are very low capacity utilization, lack of 
multi-tasking, less automation in packaging and delivery and 
inferior wet/gas technology leading to much higher energy 
consumption and lower cement quality. More than half of the 
cement plants could achieve 50 percent of the U.S. productivity 
level at full utilization, with best practice modes of 
organization and a few targeted investments like converting to 
semi-wet/gas technology.
    The most important external barrier to productivity and 
output growth is the flow of implicit federal subsidies in the 
form of cheap energy, tax arrears and/or directed government 
procurements channeled to the weakest players by local 
governments anxious to prevent shut-downs. These subsidies and 
political constraints are also preventing best practice 
companies from buying up excess capacity to shut it down in 
order to increase capacity utilization and make the necessary 
upgrading investments that are worthwhile in the viable 
capacity. These subsidies do not only serve a social cause, 
since allegedly, part of the subsidy flow is being diverted, 
via complex barter deals, to short lived and well-connected 
trading companies.
Policy implications and future outlook
    A strong federal government could force the rapid 
restructuring of the sector by cutting the flow of energy and 
tax subsidies and replacing them with direct help to the 
workers wherever deemed necessary. This would make more higher 
quality and cheaper cement available to major downstream 
industries, such as construction and oil.

                                  Oil

Industry overview
    While its employees accounted for only 1 percent of the 
Russian workforce, the oil sector \3\ sales represented 6 
percent of GDP, 16 percent of exports and 22 percent of budget 
revenues in 1998 (despite relatively low oil prices). Oil 
production has halved since the peak of 1988, with the fall in 
domestic demand and exports to countries of the ex-Communist 
block. The industry has been privatized to insiders with very 
little foreign involvement.
---------------------------------------------------------------------------
    \3\ Including refining and transportation of crude and petroleum 
products.
---------------------------------------------------------------------------
Productivity performance
    The actual total factor productivity (the combined measure 
of labor and capital productivity) of the Russian oil industry 
is 55 percent of that of Texas on-shore. Once adjusted for 
favorable geology and younger oil fields in Russia, the 
productivity level falls to about 30 percent.
    The main reasons for the productivity gap at the 
operational level are lower oil recovery due mostly to less 
hydrofracturing and poor reservoir management techniques, and 
inefficient drilling because of low quality drill bits, 
cleaning muds and cement being used. There are also more than 
35 percent excess workers and a large amount of idle drilling 
equipment resulting from the stoppage of new field developments 
since 1991, despite attractive proven reserves in Western 
Siberia. The total production cost in these new fields would be 
as low as $6 a barrel (against $20 a barrel for current world 
oil prices) with best practice operations.
    The most important external barriers to productivity and 
output growth are the lack of workable tax laws (the recently 
passed production sharing agreement is not yet operational) and 
distorted domestic oil markets with limits on oil exports. 
These limitations, which discourage any significant 
investments, force the supply of cheap oil to ``strategic 
sectors'' such as defense and agriculture. Other, less 
important, factors include unresolved shareholder battles with 
weak minority shareholder rights protection, and widespread 
barriers to layoffs put in place by local governments in oil 
company towns.
Policy implications and future outlook
    If the main barriers to investment are not removed, Russia 
could, with the current rate of depletion in the existing 
fields, end up being a net importer of oil in 10 years. The 
social objectives and national interest would be better served 
if further assurances were given to investors, notably deep 
pocket foreigners who could pour in 80 billion dollars' worth 
of investment over the next 10 years. Such assurances should 
include workable taxes as well as a fully liberalized domestic 
oil market with open access to an enlarged export 
infrastructure. As a result production could double in 10 
years, thus meeting demand of a (hopefully) fast growing 
economy and increasing exports by more than 50 percent (keeping 
Russia's market share of world oil exports constant given 
current expectations of increasing future demand). Also, the 
additional tax revenues would suffice to keep subsidizing (if 
deemed necessary) the oil purchases for agriculture and defense 
customers and help relocate stranded oil workers.

                                 dairy

Industry overview
    The industry consists of four functions: raw milk 
receiving, fluid and non-fluid milk processing, and packaging. 
Dairy farming and distribution are excluded from our study. The 
major processed dairy products are fluid milk (the largest 
category), cream, butter, cheese and milk powder. In 1997, 
199,000 people were employed in the Russian dairy industry 
across 1,753 plants.
Productivity performance
    Labor productivity in dairy is at 8 percent of the U.S. 
level. Russian dairy plants produce one-fifth of U.S. output 
per capita using more than twice as many people. Since 1990, 
labor productivity has almost halved. Productivity differs by 
size of plant, since large economies of scale are present in 
this industry: 72 large plants (capacity of 55,000 tons a year 
or more) employ about 20 percent of the industry workforce and 
have 12 percent of the U.S. level of productivity; 1,681 small 
plants employ the rest, and operate at 7 percent of U.S. 
productivity level.
    The main reasons for the productivity gap at the 
operational level differ between small and large plants. Large 
plants (43 percent of industry capacity) could raise their 
productivity from 12 percent to more than 60 percent of the 
U.S. level without major investments, since the present gap is 
mainly due to low capacity utilization and inefficient 
organization of functions and tasks. The remainder of the gap 
comes from lack of automation and inefficient relations with 
suppliers. These large plants, if utilized at 80 percent, could 
produce all current output of the industry by themselves. Small 
processors need major investments to reach minimum efficient 
scale--an investment that will not be economical.
    The most important external barriers to productivity and 
output growth are problems in up- and down-stream industries, 
macro-economic instability and local government interventions. 
Problems in up- and down-stream industries hinge on 
monopolistic wholesalers, who force arrears onto dairy plants 
and set off a chain of events leading to inefficient dairy 
farming and the emergence of sub-scale mini-plants which do 
their own distribution. Macro-economic instability manifests 
itself via a high cost of capital (discouraging investments 
into larger scale plants, and into shelf-life enhancing 
technologies that could give dairy plants more bargaining power 
over wholesalers) and a low level of demand (leading to reduced 
consumption of processed milk and lower capacity utilization of 
dairy plants). Local governments shield wholesalers from 
competition from supermarkets by taxing the latter ones out, 
and directly hamper restructuring of the dairy sector by 
deterring layoffs and bankruptcies of inefficient plants, thus 
creating unequal conditions of competition in the industry.
Policy implications and future outlook
    For Russia to increase its productivity in the dairy 
sector, large plants should expand, while small ones should 
exit. For this to happen, barriers to growth of supermarkets 
need to be lifted (see the summary of the Food Retailing 
industry), regulatory interventions against layoffs must be 
stopped, and bankruptcies of small plants should not be 
artificially prevented. With these policies, the sector would 
be able to achieve more than 60 percent of the U.S. 
productivity level with limited investments.

                             confectionery

Industry overview
    The confectionery industry consists of four functions: raw 
material receiving: mixing; processing; and packaging. Farming 
and distribution are excluded from this study. Following the 
official Russian industry definition, biscuits and crackers are 
included in addition to regular confectionery. In 1997, 120,000 
people were employed in the industry across 925 plants. This 
sector has been relatively successful in attracting best 
practice foreign companies, although these investments are 
still too small to make any significant difference to the 
overall sector's performance.
Productivity performance
    Labor productivity in the Russian confectionery industry is 
at 10 percent of the U.S. level, down from 13 percent in 1990. 
Productivity differs between large (capacity of 35,000 tons per 
year or more) and small plants: 11 large plants achieve 
productivity of 22 percent, using 20 percent of total 
employment in the sector. The productivity of 914 small plants 
is 7 percent, using 80 percent of total employment.
    The main reasons for the productivity gap at the 
operational level are low scale and capital intensity. Even the 
large plants that have minimum efficient scale have to rebuild 
their multi-storied structures in order to use new equipment. 
Large confectionery plants already have a high capacity 
utilization and thus the potential for improvements is smaller 
than in the large dairy plants. The productivity potential for 
large plants and small plants without major investment-fixing 
capacity utilization, organization of functions and tasks and 
product proliferation/value added within category--is around 50 
percent of the U.S. level for the large plants and less than 30 
percent for the small plants.
    The most important external barriers to productivity and 
output growth are low labor cost, an unfavorable tax structure, 
unequal tax enforcement, and an inefficient wholesaling 
industry. The low labor cost renders automation uneconomical 
even for multinationals with a low cost of capital. 
Deductibility of advertising expenses for tax purposes is very 
limited, and advertising expenses can be taxed in some regions. 
This discourages expansion of best practice firms through brand 
building. The playing field is further distorted when local 
governments deter layoffs by best-practice firms by subjecting 
them to numerous inspections, and condone tax arrears from 
unproductive companies, which end up being more profitable than 
their global best practice competitors. Rights of brand 
ownership are not enforced, further hampering investment into 
branding and expansion, and the procedure for approving shelf-
life claims can be very slow and subject to undue influence. 
Due to the large number of wholesalers in the confectionery 
distribution chain, wholesale margins in Russia are twice the 
U.S. level, which protects local players by making cross-
regional expansion more difficult for productive players.
Policy implications and future outlook
     In order for the industry to increase its overall 
productivity restrictions on layoffs must be removed, taxes 
from all firms collected equally, tax disincentives to 
advertising removed, brand property rights enforced, and shelf-
life approval process streamlined. Under such conditions, the 
industry overall would be able to reach 30 percent of the U.S. 
productivity level (without major investments) and compete more 
successfully against imports.

                             food retailing

Industry overview
     The food retailing industry employs 4 percent of the 
Russian workforce and is one of the largest sectors in the 
economy. Since food constitutes 45 percent of Russian household 
spending and food retailing accounts for 20 percent of that 
cost, the sector affects 9 percent of total household spending. 
The sector has experienced a dramatic transformation in recent 
years. Open-air wholesale market stands, kiosks, pavilions and 
agricultural markets have taken shares away from Soviet-era 
formats (whose shares have declined from 90 percent in 1990 to 
41 percent in 1997).
Productivity performance
     The Russian labor productivity is at 23 percent of the 
U.S. level. Street vendors are at 9 percent, traditional 
Soviet-era formats (the smaller gastronoms) at 24 percent, 
open-air wholesale markets at 24 percent, kiosks and pavilions 
at 26 percent, and supermarkets at 78 percent of the average 
U.S. productivity.
    The main reasons for the productivity gap at the 
operational level can be grouped into two. First, Russia lacks 
modern productive formats such as supermarkets and 
hypermarkets. The market share of modern formats is less than 1 
percent in Russia compared to over 70 percent in the United 
States. Second, format-to-format, Russian stores suffer from 
over-manning, low scale of chains and stores, and low capital 
intensity compared to their U.S. counterparts.
    The most important external barriers to productivity and 
output growth are those that prevent the penetration of modern 
formats. Modern formats cannot gain share against the less 
productive open-air wholesale market stands, kiosks and 
pavilions because the latter benefit from lower tax 
liabilities, less control on the origin of their goods (which 
are often illegal imports or counterfeits), and cheaper access 
to prime locations. Inefficient Russian food processors also 
impede the entry of modern formats since best practice firms 
will not invest in a country unless they can source quality 
products domestically.
Policy implications and future outlook
     If the main barriers are removed, modern formats should 
gain substantial market share. For example, in the city of 
Obninsk in Central Russia, supermarkets gained 15 to 20 percent 
market share (compared to less than 1 percent for all of 
Russia) after the local government provided equal opportunities 
(for supermarkets and open-air wholesale market stands) in 
terms of land allocation and tax/tariff/counterfeit 
enforcement. As another example, Polish supermarkets and 
hypermarkets gained 18 percent market share in less than 5 
years--having started from a similar format mix as Russia--
after the government put into place equal tax legislation and 
clear land allocation procedures.

                     general merchandise retailing

Industry overview
     The general merchandising industry employs 2 percent of 
the workforce and generates 2.5 percent of GDP in Russia. 
Between 1990 and 1997, general merchandising turnover dropped 
by 40 percent and the share of imports rose from 15 percent to 
80 percent. The share of Soviet-era formats declined from 100 
percent to 20 percent, they were replaced by new more 
convenient or cheaper formats, especially open-air wholesale 
markets, which captured 65 percent market share.
Productivity performance
     The Russian labor productivity is at 26 percent of the 
U.S. level. Soviet-era multi-product stores are at 10 percent, 
Soviet-era single-product stores at 24 percent, open-air 
wholesale markets at 27 percent, kiosks and pavilions at 28 
percent, and the few modern chains (mostly in electronics) at 
less than 80 percent of the productivity level of their U.S. 
equivalent.
    The main reasons for the productivity gap on the 
operational level can be grouped into two. First, Russia lacks 
modern chains that are more productive than non-chains. The 
market share of modern chains is at 8 percent in Russia 
compared to 70 percent in the United States. Nearly all the 
modern chains are consumer electronics chains. Second, open-air 
wholesale markets stands have low productivity because they are 
both sub-scale and under-capitalized. Finally, and much less 
importantly, Russian (consumer electronics) chains have lower 
productivity than their U.S. counterparts because they do not 
use part-time workers to match demand fluctuations, and enjoy 
less economies of scale.
    The most important external barriers to productivity and 
output growth are those that prevent the penetration of modern 
chains. Modern chains cannot gain share against the less 
productive open-air wholesale market stands, kiosks and 
pavilions because the latter benefit from lower tax 
liabilities, less control on the origin of their goods (which 
are often illegal imports or counterfeits), and cheaper access 
to prime locations. In addition, the high cost of capital 
deters domestic investors from financing capital-intensive 
hypermarkets or malls.
Policy implications and future outlook
     If the main barriers are removed, modern chains should 
gain substantial market share. Foreign multinationals can 
overcome financing limitations and are thus attractive 
candidates for investment. Such multinationals invested only 
$0.1 billion in Russian retailing (both food and general 
merchandise) compared to $2.1 billion in Poland (with another 
$2.7 billion in the pipeline), where the playing field is much 
more level with serious law enforcement. As a result, Poland 
enjoys a 22 percent market share for chains, while bazaars (the 
equivalent of Russian wholesale markets) are in marked decline, 
with only 10 percent market share in 1999.

                                 hotels

Industry overview
     Approximately 100,000 people are employed in about 5,000 
hotels located in Russia. Unlike most Russian sectors that have 
been privatized, over 80 percent of hotels remain in the hands 
of municipal, regional or federal government. Recently four- 
and five-star hotel foreign chain operators have entered the 
high-end segment of the market; they currently account for 15 
percent of turnover.
Productivity performance
     Russian labor productivity in the hotel sector (for 
lodging only, excluding food and beverage) is at 18 percent of 
the U.S. level. Russian chains (exclusively the four- and five-
star hotels) are at 60 percent of the productivity of U.S. 
chains while Russian non-chains are at 19 percent of the 
productivity of U.S. non-chains.
    The main reasons for the productivity gap at the 
operational level can be separated into three groups. First, 
comparing Russian non-chains to U.S. non-chains, Russian hotels 
are less utilized, do not implement multi-tasking of personnel, 
have lower value-added rooms, and are more sub-scale. Second, 
comparing Russian chains (managed by Western operators) to U.S. 
chains, Russian hotels are penalized by the need to train their 
personnel (e.g., cleaning ladies). Third, Russia lacks chains, 
which are more productive than non-chains (e.g., central 
booking leading to higher utilization); chains account for only 
15 percent of turnover in Russia compared to 40 percent in 
Poland and 70 percent in the United States.
    The most important external barriers to productivity and 
output growth are also separated into three groups. For non-
chains, government ownership stifles managerial incentives for 
improving efficiencies. Also, the collapse in demand has 
reduced capacity utilization, while low income has limited the 
demand for higher value added rooms. For chains, lack of multi-
tasking should be resolved over time as a skilled labor pool is 
developed. Last, for chain penetration, collapse in demand, 
high cost of capital and country risk, under-developed tourist 
attractions, high construction costs, and red tape/corruption 
involved in land allocation have been the main barriers.
Policy implications and future outlook
     If the main barriers are removed, the Russian hotel 
industry could achieve productivity of up to 60 to 65 percent 
of U.S. levels. International experience shows that demand for 
hotels increases rapidly as income per capita grows. Removing 
the barriers is likely to increase investment in new hotels, 
especially in chains. Besides the improvements in the format 
mix, this higher chain penetration will also foster 
productivity in non-chains by increasing the industry's 
competitive intensity.

                        residential construction

Industry overview
     Residential construction is one of the largest economic 
sectors in Russia accounting for about 5 percent of total 
employment and 3 percent of GDP. Output in the sector has 
declined by 25 percent since 1990. Growth in the construction 
of privately financed brick houses and apartments has not 
compensated for the 50 percent decline in the construction of 
government-financed traditional pre-fabricated apartment 
buildings.
Productivity performance
     The overall productivity of the sector is estimated at 
around 10 percent of the U.S. level. Productivity fell to 10 
percent of the U.S. level in the traditional segment, as many 
companies did not adjust their staffing levels to the fall in 
output. New entrants only achieve 20 percent of the U.S. 
productivity level, and furthermore, around one-fourth of all 
construction is now being carried out ``brick by brick'' by 
individuals (5 percent productivity level) as financing becomes 
available.
    The main reasons for the productivity gap at the 
operational level for the traditional companies are very low 
capacity utilization at both the panel factories and 
construction sites, and complete lack of incentives for workers 
to improve efficiency or quality levels. The new companies are 
mostly affected by both the lack of special trade companies and 
the small scale of privately financed housing programs.
    The most important external barrier to productivity and 
output growth is the fact that local governments systematically 
allocate housing programs to the same (ex-Soviet) companies in 
exchange for no layoffs. New private companies are also 
penalized by the fact that large single family housing programs 
(the most productive form of housing construction) are 
virtually impossible in the absence of an operational land code 
and mortgage financing.
Policy implications and future outlook
     Government-financed housing programs should be limited to 
the most urgent social needs (e.g., relocation of stranded 
industrial workers) and carried out through open and equal 
tenders. The following would also help stimulate the demand for 
private housing, appropriate legislation in the areas of land 
property and usage rights, tenant rights, a mortgage system 
(with macro-economic stability as a prerequisite), removal of 
administrative barriers to labor mobility (propiska system), 
and accelerated phasing out of the utility and maintenance 
subsidies in the existing housing stock.

                                software

Industry overview
     We address two distinct sub-sectors in our software case: 
packaged software and project services, in total employing 
about 8,000 people in Russia (compared to more than 600,000 in 
the United States).
Productivity performance
     The overall labor productivity in the sector is 38 percent 
of the U.S. level, an average of 13 percent for packaged 
software and 72 percent for project services (consulting, 
implementation and training in the information technology 
area). This latter sub-sector is the most productive of all the 
industries we have studied in Russia.
    The main reasons for the productivity gap at the 
operational level for packaged software, a high fixed 
(development) cost business, are low scale (on average, Russian 
packaged software companies are 100 times smaller than their 
U.S. counterparts), and a low value-added product mix. This 
latter factor is also responsible for the (small) productivity 
gap in project services.
    The most important external barriers to productivity and 
output growth differ between sub-sectors. In packaged software, 
the causes are the prevalence of software piracy and lack of 
leading-edge demand from business customers. The piracy rate is 
90 percent in Russia--one of the world's highest, so Russian 
software firms lose most of their resources to pirates and can 
not invest in research and development of better products. 
Software-consuming sectors, whose demand drives development of 
software firms, are both very small in Russia and less 
interested in productivity-enhancing software tools than their 
Western counterparts. For example, banks, important software 
consumers elsewhere, in Russia depend on relationships with 
authorities, rather than cost control or good service. Kiosks, 
unlike supermarkets, do not consume software.
    The customized nature of project services makes this sub-
sector immune to piracy. The low value-added service mix of 
Russian project services firms, the main culprit of the (small) 
productivity gap, comes from the low level of customer demand. 
The low level of domestic demand can be partially overcome by 
serving overseas customers via offshore programming. The 
Russian business of offshore programming is growing at 50 to 60 
percent per year, although from a very small base. With time, 
this industry should be able to obtain the requisite track 
record and international certification, and become a force in 
the world offshore programming market along with India.
Policy implications and future outlook
     The following four policy measures should improve the 
economic prospects for the software sector in Russia: removal 
of barriers to productivity and output growth in the other 
(software-consuming) sectors (see all other sector case 
studies), stepping up enforcement of anti-piracy laws (which 
are already in place), support to ISO- and SEI-certification 
initiatives (e.g., through setting up a number of specialized 
certification centers to ease the process for Russian 
companies), and removal of red tape in software export 
procedures. The future of the domestically oriented packaged 
software and project services sub-sectors will depend on growth 
of the whole economy. Offshore programming can be expected to 
continue growing output and employment at the current rate of 
50 to 60 percent per year.







            ADMINISTRATION AND REFORM OF THE RUSSIAN ECONOMY



                By Paul Gregory and Wolfram Schrettl \1\

                              ----------                              


                                contents
                                                                   Page

Objectives of Russian Administrative Reform......................    81
Soviet Administration............................................    82
The Administration of the Russian Federation.....................    84
Federalism.......................................................    89
Liberalization, De-Bureaucratization, and Corruption.............    90
Civil Service Reform.............................................    93
Are Putin's Reforms Too Good To Be True?.........................    94
    The goal of Russian administrative reform is to create a 
``rule of law'' that encourages domestic entrepreneurship, 
foreign investment, and economic growth. Old planning 
institutions must be replaced by new state institutions that a 
market economy requires. After more than 10 years of 
transformation, the major administrative changes have been the 
replacement of the executive, legislative, and judicial 
Communist Party monopoly with a strong presidency and a to-date 
weak legislature. Destatized large enterprises have replaced 
the industrial ministries, and they represent a new source of 
independent power. New agencies have been created but they have 
not taken firm hold in the new administrative system. President 
Putin has presented a comprehensive program of administrative 
reform. His regional reform has passed the legislature and 
decides the federalism issue by centralizing power. His de-
bureaucratization reforms seek to improve Russia's business and 
investment climate by reducing bureaucratic interference and 
arbitrary official behavior. Significant reforms remain to be 
implemented; namely, judicial reform and civil service reform. 
A key question is whether these reforms are successfully 
resisted, as have been earlier reforms, by those parts of the 
bureaucracy that stand to lose income and power.
---------------------------------------------------------------------------
    \1\ Paul Gregory is Professor of Economics, University of Houston. 
Wolfram Schrettl is Head, Department of International Economics, German 
Institute for Economic Research, DIW Berlin. The authors wish to thank 
Henning Schroeder for comments and suggestions on an earlier draft of 
this paper and Carina Schulz for able research assistance. Wolfram 
Schrettl is grateful to the KfW-managed TRANSFORM program of the German 
Government for financial support to GLOROS (``Global Economy and 
Russia. A Russian-German Dialogue''), a project of DIW Berlin (German 
Institute for Economic Research) and HSE Moscow (State University 
Higher School of Economics).
---------------------------------------------------------------------------

              Objectives of Russian Administrative Reform

     A significant part of the transformation process is the 
creation of a structure for the administration of a market 
economy to replace the administrative structure of the planned 
economy. Such a transformation requires the government's 
credible commitment to firm legal ``rules of the game,'' a non-
corrupt bureaucracy that enforces and interprets these rules 
impartially, and a judiciary that independently interprets 
these rules and punishes violations. The term administrative 
reform means different things to different people in 
contemporary Russia. Changes in center-periphery relations, 
anti-bureaucratic legislation, and civil service reform all 
fall under the category of administrative reform. In this 
paper, we interpret progressive administrative reform as any 
reform that creates new legal rules of the game that will 
administered fairly and efficiently by the bureaucracy. We 
describe the current Russian administrative system in terms of 
this general goal, and we use the Soviet legacy, which has left 
a strong imprint on the current system, as our starting point.

                         Soviet Administration

    Figure 1 provides a schematic sketch of the Soviet-type 
administrative structure from which that of the Russian 
Federation evolved. It shows that the legislative rules of the 
game were set by the top leadership of the Communist Party in 
the Central Committee and Politburo. Formal decrees and orders 
were issued by the state administration (called the Soviet 
order), but the top administration of both state and party 
comprised an interlocking directorate of key political figures 
that blurred distinctions between the party and state at the 
highest level. This was a decree-based system in which national 
laws and instructions were issued by the Council of Ministers, 
with the most important decrees issued jointly by the state and 
party. Decrees and orders were typically quite specific, 
instructing some subordinate agency to fulfill a designated 
task.
    The Soviet Government was the Council of Ministers in which 
the most important ministries and state committees were 
represented. Ministries consisted of two types: Industrial 
ministries which supervised productive enterprises and 
functional ministries that carried out the normal state 
functions, such as education, defense, internal security, 
justice, and public finance. State committees typically 
attended to functions specific to a planned economy and usually 
not found in market economies. Gosplan drew up national plans, 
Gossnab prepared supply plans, Goskomtsen set prices, 
Goskomtekhnika supervised research and development, and 
Gosstroi planned construction. A monopoly state bank assumed 
all functions of banking, and carried out, in particular, 
central banking and allocations of credit. Its monetary and 
credit policies were subordinated to the plans prepared by 
other state committees, and its main job was the distribution 
of credits according to plan.
    This central administrative structure was replicated in the 
15 republics, of which the Russian Republic was one, with 
Republican governments answering to the Council of Ministers 
and Communist Party. These Republican Party and state 
organizations supervised local industries, they did not play 
independent roles, and their influence on national policy was 
felt primarily through the Republican leader's influence within 
the party apparatus.

                    FIGURE 1._SOVIET ADMINISTRATION

                          [Schematic version]

[GRAPHIC] [TIFF OMITTED] T6171.021


    The plan was ``the law.'' Given that there were a large 
number of plans, many conflicting, the administration engaged 
in considerable negotiating, coercion, and compromising in the 
absence of overall rules of the game. The party was the 
``leading institution'' which gave it the primary role of 
negotiator, compromisor, and facilitator. Administrators with 
authority to make resource allocation decisions (party, 
planners, ministers, etc.) were the distributors of the 
economic rents associated with the monopolistic structure of 
Soviet industry. Contemporary writers even argue that the 
party's main role was to distribute economic rents among 
society's players. \2\ Those with power to distribute and use 
resources were called fundholders. They actively traded 
resources among themselves by barter, plan instructions, and 
outright sales in a manner that is still poorly understood.
---------------------------------------------------------------------------
    \2\ Boettke, Peter. Calculation and Coordination (London: 
Routledge, 2001).
---------------------------------------------------------------------------
    The Soviet system used a nomenklatura system for 
administrative appointments, promotions and firings, which was 
managed at the top by the party personnel department. The 
nomenklatura system had rather clearly stated rules concerning 
which agency (state or party) was authorized to make personnel 
decisions. We do not know to what extent the nomenklatura 
system was merit based. Some appointments were made on merit; 
others through connections or family relations. The operations 
of the nomenklatura system were opaque and unlike the Western-
style ideal of a transparent civil service. The notion of free 
access to administrative careers in the state or party through 
a well-defined set of rules was totally foreign. In a society 
that lived drably, membership in the nomenklatura meant access 
to goods, perks, and services beyond the reach of ordinary 
citizens. These perks and benefits could not be purchased; they 
were linked to specific positions in the nomenklatura.

              The Administration of the Russian Federation

    The Soviet administrative system collapsed along with the 
Communist Party monopoly in late 1991, which had been its 
foundation. The administrative-command economy collapsed with 
Gorbachev's withdrawal of administrative power from the branch 
ministries in the late 1980s. Once Yeltsin and his reform team 
determined to abandon the Soviet command system, administration 
had to change to meet the new circumstances of an economy that 
was no longer centrally planned, in which there was 
considerable market allocation, and significant privatization 
(or destatization) of property. Conceptually, such an economy 
required creation of a rule of law based upon a legislative 
framework to which the state was ``credibly committed'' as 
opposed to ad hoc decrees, which could change with the whims of 
leaders. Also required was a well-defined distribution of power 
among the executive, legislative, and judicial branches with 
the legislature making law, the executive executing that law, 
and the judiciary interpreting law and resolving conflicts. The 
distribution of power, tax revenues and government 
expenditures, and property between the central government and 
regional and municipal governments had to be agreed upon with 
non-contradictory and non-overlapping rules and regulations. 
Without such ``federalism'' agreements, state property could 
not be managed and disposed of and businesses could not operate 
in a uniform market with a level playingfield.
    A series of new or improved government institutions was 
also required, including ``normal'' institutions for monetary 
and fiscal policy, such as a two-tiered banking system (with a 
quasi-independent Central Bank of the Russian Federation 
(Central Bank of Russia or CBR)) to replace the monopoly state 
bank and a system for orderly fiscal budgeting. Also new 
agencies required by a market economy had to be created and 
agencies associated with planning and administrative price 
setting had to be eliminated. Agencies had to be appointed that 
would effectively manage property, either fully or partially 
owned by the state, in the public interest.
    In place of the party-directed nomenklatura, which was 
designed to issue orders and distribute resources in an opaque 
fashion, a Western-style civil service had to be installed. 
This civil service should be appointed according to merit, be 
inculcated with a notion of service to the public, and 
administer rules and regulations impartially.
    Figure 2 provides a schematic sketch of the current Russian 
administrative structure. When compared with Figure 1, it shows 
the substantive changes that have taken place over the past 
decade but underscores the reforms that have yet to be made. 
The lack of full resolution of the general objectives of 
administrative reform listed above after more than 10 years is 
not at all surprising. A complete restructuring of a society's 
administrative structures and power relations requires 
considerable time, especially in the face of substantial and 
mostly concealed opposition.

             FIGURE 2._ADMINISTRATION OF RUSSIAN GOVERNMENT

                          [Schematic version]

[GRAPHIC] [TIFF OMITTED] T6171.020


     The most significant changes are the disappearance of the 
Communist Party as the leading institution and the conversion 
of former industrial ministries into semi-independent 
corporations. Although the Communist Party remains the largest 
single faction in the legislature, it lacks the power to 
``order.'' Earlier it had the power to block, a power 
apparently lost under Putin. In the Soviet era, the party was 
the ultimate source of legislative power and was the ultimate 
enforcer of executive power, although most legislative decrees 
were formally issued by state power; namely, by the Soviet 
Council of Ministers. Given that all responsible positions were 
held by party officials through the nomenklatura, the party 
also had the power to punish and thus acted as well as a 
judiciary.
    Figure 2 shows that the ``legislative-executive-judicial'' 
party has been replaced by a President, who serves as the 
ultimate source of executive power, but also can serve as a 
source of legislative power through the use of presidential 
decrees--a device used frequently during the Yeltsin 
presidency. The President has the power to nominate the Prime 
Minister and hence oversees the top appointments to the 
executive branch, subject to approval of the legislature, the 
Duma, which can be forced to dissolve itself if the President's 
nominee is not accepted. These procedures were put in place in 
the 1993 Yeltsin Constitution, which affords the President 
considerable power in naming the government (pravitelstvo). 
Given the strong presidency, a massive presidential 
administration of officials, advisors, and bureaucrats is 
associated with the office of the President.
    The appointment, confirmation, staffing, and 
responsibilities of the government are defined in the 
constitutional law approved in December 1997.\3\ The government 
is headed by a Prime Minister and a number of Deputy Prime 
Ministers with specific obligations, who preside over the 
various governmental agencies and ministries. The government, 
like its former Soviet variant the Council of Ministers, 
continues to have a massive administrative apparat, which 
competes in influence and size with the presidential 
administration.
---------------------------------------------------------------------------
    \3\ Federalny konstitutsionny zakon o pravitelstve Rossiiskoi 
Federatsii. 31.12.97 N 3-FKZ.
---------------------------------------------------------------------------
    Figure 2 shows that there have been major changes in the 
makeup of the Russian Government which consists of slightly 
less than 50 ministries, agencies, and committees.\4\ 
Previously powerful planning committees have been converted 
primarily into regulatory agencies and agencies for devising 
economic policies and strategies. Gosplan has become the 
Ministry of Economic Development and Trade, which drafts 
industrial policy and regulations rather than issuing 
directives. Some former industrial ministries have become 
regulatory and licensing agencies such as the fuel and energy 
ministry and the geology ministry. Most significantly, most 
``production'' ministries have been converted into non-state 
(at least partially privatized) enterprises in which the state 
continues to own significant shares, such as Gazprom, Lukoil, 
and Unified Energy System (UES). The conversion of industrial 
ministries from direct controllers of branch enterprises into 
``destatized'' companies has been a significant change in 
Russian administration. The state's dealings with these 
companies remains in flux. It is unclear in whose interests 
these enterprises are being run and whether the state is able 
or willing to properly exercise its role as the largest single 
shareholder.\5\ Other agencies of the Russian Government are 
ministries common to all countries--education, defense, trade, 
labor, ecology, justice, and internal security, although the 
power of the Federal Security Service (FSB) may now be 
exceptional under Putin, insofar as Putin himself was trained 
in the FSB's predecessor organization, the State Security 
Committee (KGB).
---------------------------------------------------------------------------
    \4\ Spravochnik: Federal'naia vlast' v Rossii.
    \5\ Putin's replacement of Gazprom Chairman Vyakhirev with his own 
man, Miller, in June 2001, represents perhaps a watershed in the 
state's relation with large destatized corporations.
---------------------------------------------------------------------------
    Figure 2 also shows that new agencies required by a market 
economy have been created. Of the 49 ministries, committees, 
and agencies of the Russian Government, 6 are ``new'' agencies 
required by a market economy.\6\ Skeptics note that these new 
agencies were not part of the traditional power structure of 
the Soviet Union, and they have not become credible centers of 
authority. Another feature of the new Russian structure is the 
substantial overlap among agencies, with several agencies 
responsible for taxes, security, construction, and 
technology.\7\ This overlap and duplication will presumably be 
a prime issue of contention in future administrative reforms.
---------------------------------------------------------------------------
    \6\ Pravitelstvo Rossiiskoi Federatsii, Struktura federalnykh 
organov ispolnitelnoi vlasti (www.pravitelstvo.gov.ru). They are the 
anti-monopoly ministry, the property ministry, the tariff committee, 
the securities commission, the bankruptcy commission, and the land 
registry committee.
    \7\ Parison, Neil. ``Russia: Public Administration Reform: Issues 
and Options,'' mimeo; a Russian version appeared in E.G. Yasin (ed.), 
Investitsionny klimat i perspektivy ekonomicheskogo rosta v Rossii 
(Moscow: Vyshaia shkola ekonomiki, 2001), pp. 202-213.
---------------------------------------------------------------------------
    The Russian legislature consists of two houses, the state 
Duma and the Federation Council. The lower-house Duma is 
comprised of elected deputies, while the upper house, the 
Federation Council, is comprised of regional leaders or, more 
recently, of their representatives.\8\ Of the two, the Duma is 
the dominant legislative body. Unlike the Soviet system where 
power clearly derived from the Communist Party, Figure 2 shows 
the basic power conflict in the new Russian administration--the 
potential of stalemate between legislative and executive power. 
The legislative branch has been dominated by the Communist 
Party, which has shared virtually no common goals with either 
Russian President. Legislation was passed slowly in the 
Communist dominated Duma, if at all, and Yeltsin sought to 
legislate by presidential decree--a poor substitute for 
legislation approved by the legislature. With the recent 
decline in Communist Party power and Putin's relatively easy 
election and personal popularity, it appears that the 
legislative logjam is breaking and movement toward a 
legislative rule of law is gathering steam.\9\
---------------------------------------------------------------------------
    \8\ Putin's regional reforms, discussed below, phase out membership 
of governors in the Federation Council. But selected regional leaders 
will be members of the resurrected State Council under the Putin plan.
    \9\ During its Spring 2001 session, for example, the Duma adopted 4 
federal constitutional laws, 155 federal laws, ratified 27 
international treaties, and considered 58 of 83 priority draft laws 
scheduled for discussion. See RFE/RL Newsline, 16 July, 2001.
---------------------------------------------------------------------------
    A second point of conflict is between the powerful 
administration of the President and the official bureaucracy of 
the country; namely, the apparat of the government. Such 
conflicts are not uncommon in democracies, where officials 
close to the chief executive often wield more power in specific 
areas than does the responsible minister.
    A third source of potential conflict is between the Russian 
Government (as represented by the legislature or the President) 
and the quasi-independent large corporations, headed by former 
branch ministry officials (Gazprom, Lukoil) and the financial 
industrial groups headed by oligarchs who were not prominent 
members of the old elite (Berezovsky, Abramovich, Gusinsky). 
These large industrial, raw material, and financial companies 
represent a new source of power, whose relations with the state 
remain to be decided. Their predecessors, the industrial 
ministries, were indeed powerful, but they were reined in by 
Gosplan, the Council of Ministers, and the Communist Party 
leadership. As major employers, often the most substantial tax 
payers, and sources of liquidity, these destatized corporations 
hold considerable unofficial power. They can make campaign 
contributions, bribe regulatory officials, acquire vast media 
empires, or ``buy'' their own members of the legislature. The 
balance of power between these large corporations and the 
official holders of power (the legislature, the President and 
the bureaucracy) is in flux and remains to be defined. The 
issue of unofficial state power has become so acute in some 
transition economies, including Russia, that experts question 
to what extent the state has been ``captured'' by these 
unofficial interests.\10\
---------------------------------------------------------------------------
    \10\ The European Bank for Reconstruction and Development (EBRD) 
even compiles ``state capture'' indexes for the transition economies in 
their various transition reports.
---------------------------------------------------------------------------
    In many cases, the state continues to own substantial 
shares in the destatized corporations, not only of the 
prominent companies such as Gazprom and Lukoil but also of 
regional and local destatized companies. The ``state'' 
therefore has a natural means of controlling such companies by 
exercising its rights as the largest single shareholder. 
Putin's recent replacement of Gazprom's general director with a 
trusted subordinate provides a model. In less prominent cases, 
such as smaller regional destatized companies, management 
appears to have ``captured'' state officials who are supposed 
to represent the state's interests, and they escape effective 
state control. For example, at about the same time that Putin 
was replacing the management of Gazprom, the GOK Combinat was 
being ``auctioned'' to insiders for $20 million instead of its 
``expected'' price of $100 million. Accordingly, the state 
budget seems to have lost $80 million through this insider 
transaction.\11\
---------------------------------------------------------------------------
    \11\ ``Ochen' spetsialny auktsion,'' Moskovskie novosti, 12-18 
June, 2001.
---------------------------------------------------------------------------
    Some agencies have grown in power and others have lost 
power compared to the Soviet period. Previously dominant 
agencies, such as Gosplan, have been converted into a less-
powerful Ministry of Economic Development and Trade.\12\ The 
Soviet Ministry of Oil and Gas Industry, which ran the 
U.S.S.R.'s vast energy complex, has become a regulator and 
issuer of licenses as the Russian Ministry of Fuel and Energy. 
The various tax collection agencies have grown in importance 
now that taxes are collected from more independent units rather 
than semi-automatically by the state banking system from state 
enterprises. The property committee has been a powerful agency, 
particularly during periods of active privatization. It had no 
predecessor in the Soviet period. The ``new'' ministries and 
agencies required for a market economy (such as the Federal 
Securities Agency, the Federal Service for Financial 
Rehabilitation and Bankruptcy) were grafted into the structure 
of government without gaining much influence in government 
circles. They have been unable to attract sufficient funding or 
secure cooperation from other ministries. Moreover, cuts in 
government agencies have been carried out uniformly, meaning 
that the new agencies, which tend to be understaffed, become 
more understaffed, while traditional ministries, which are 
overstaffed become less overstaffed.\13\
---------------------------------------------------------------------------
    \12\ The power of a particular agency depends upon proximity and 
trust of the President. For example, the Ministry of Economic 
Development and Trade has been very influential in the first 2 years of 
the Putin presidency and has spearheaded the reform process.
    \13\ Parisons, Neil. op. cit., pp. 202-213.
---------------------------------------------------------------------------
    Figure 2 lists one state agency, the State Bank, which by 
legislation of 1995, has become a quasi-independent agency. The 
Soviet structure also lacked independent agencies. The most 
obvious candidate for future independence, the judiciary 
branch, may become an independent branch of government if 
Putin's declared reform program is realized. Putin has made the 
creation of an independent judiciary a priority of his state 
program announced in 2001.\14\ Putin argues that the investment 
climate of Russia cannot improve without confidence in an 
impartial judiciary; hence an independent judiciary is being 
proposed for quite pragmatic reasons.
---------------------------------------------------------------------------
    \14\ BBC Monitoring Service, Russian President's Annual Address to 
Federal Assembly, April 3, 2001; translation of Vystuplenie presidenta 
RF V.V. Putina s poslaniem federalnomu sobraniiu RF, 3 April 2001 
(http://president.kremlin.ru/events/191.html).
---------------------------------------------------------------------------

                               Federalism

    In the Soviet period, there was no debate about 
federalism--who owned state property, how tax revenues were 
distributed, who regulated enterprises located in the region, 
etc.? Republics, provinces, regions, and cities were clearly 
subservient to the national government. The Soviet budget was a 
unified budget prepared by the Soviet finance ministry; taxes 
were collected and credits allocated by the state banking 
system; spending was allocated through the unified state 
budget. Nevertheless, the de facto owners of state property 
were known. The national ministries were the de facto owners of 
the most important industrial assets; Republican ministries and 
state agencies were the de facto owners of assets of lesser 
importance. Local governments were the de facto owners of 
enterprises that worked for local markets, such as gravel and 
local building materials. Regional, metropolitan, and local 
governments' claims to resources were largely dictated by the 
political position of the regional leader (whether or not the 
regional leader was in the Politburo or Central Committee). 
Appointments to republican, regional, and local positions were 
made from Moscow through the nomenklatura list. The best and 
most promising people were transferred to Moscow.
    The federalism issue--how are power and resources to be 
divided between the center and the periphery--has been one of 
the most difficult tasks of Russian administrative reform. The 
lack of resolution of this issue should come as no surprise. 
Even highly stable countries, like the United States, still 
argue bitterly over issues like states' rights more than 250 
years after their founding.
    Federalism asks whether power is to be decentralized to the 
regions or centralized in Moscow? Different countries have 
arrived at different solutions that work well in practice. On a 
theoretical level, a decentralized system encourages diversity, 
offers citizens different choices, and allows for 
experimentation. On a practical level, a well-defined rule of 
law requires sufficiently uniform and consistent laws and 
regulations. Excessive divergences of regional laws from 
national laws, or even contradictions of one by the other, 
cause the national political space to subdivide into different 
markets, operating according to substantially different rules 
of the game. Founding constitutions usually address rights of 
regions vis-a-vis the center, but the 1993 Russian Constitution 
left many of these issues to be resolved in practice.
    Upon achieving independence, the Russian periphery 
consisted of 89 regions, each headed by a governor or 
equivalent. The governor was elected, often with rigged 
elections, and could not be dismissed by the President. 
President Yeltsin's attempts to remove a regional governor 
failed. Each region passed its own laws and regulations and 
made claims to assets, such as oil fields or industrial assets 
that were located on its territories. Taxes were collected 
mostly at the local level, and the distribution of tax proceeds 
was a constant source of conflict. Many regional laws and 
regulations were passed chaotically without reference to the 
Constitution of the Russian Federation, and a number of regions 
made claims to complete independence (including Chechnya, which 
led to a war between the center and this periphery).
    Putin's legislation creating seven federal districts was 
passed by the Duma and even by a compliant Federation Council 
(which the measure emasculated) in spring 2000. Putin's 
regional reform goes a long way toward resolving Russia's 
federalism issue in favor of the centralized variant. Putin has 
called the passage of this measure ``one of the most important 
decisions taken in 2000.'' \15\ This legislation inserted seven 
federal regions, headed by a plenipotentiary regional 
representative appointed by the President, between the federal 
government and the regional governors. This reform enables the 
Russian President to appoint all representatives of federal 
power within the district, control regional legislation, 
monitor the carrying out of federal decrees, and increase 
control over regional governors (even allowing the President to 
dismiss governors under certain conditions).
---------------------------------------------------------------------------
    \15\ BBC, op. cit., April 3, 2001.
---------------------------------------------------------------------------
    Putin's regional reform also redistributes tax revenue from 
55 percent for the center to 70 percent for the center and 
makes the region's primary source of revenue the uncertain 
profits tax on enterprises on the theory that regional 
authorities can better gauge enterprise profits than some 
national tax authority.\16\ A key feature of the reform is the 
harmonization of regional laws and regulations with national 
laws and the Russian Constitution. According to Putin, more 
than 3,500 laws of the regions conflicted either with the 
constitution or with federal laws.\17\ In the year 2000, 
prosecutors and Presidential envoys brought 90 percent of the 
regional laws into compliance with federal laws,\18\ but the 
harmonization work continues, especially on joint jurisdiction 
issues. The negotiation of 42 power-sharing agreements is still 
required, on which more than 250 existing agreements are 
based.\19\
---------------------------------------------------------------------------
    \16\ Petrov, Nikolai. ``Decentralization and Recentralization in 
Russia,'' Carnegie Endowment for International Peace, Russian and 
Eurasian Program, Vol. 2, October 25, 2000.
    \17\ BBC, op. cit.
    \18\ Kommersant, June 27, 2001.
    \19\ RFE/RL Russian Federation Report, Vol. 3, no. 20, July 2001.
---------------------------------------------------------------------------
    Putin's success in resolving, at least for the time being, 
the federalism issue relates to his first-round election in 
early 2000, his popularity associated with a rising economy, 
and his popular tough stand on Chechnya leading up to the 
Presidential election.

          Liberalization, De-Bureaucratization, and Corruption

    Russia receives low rankings from international 
organizations and agencies, such as European Bank for 
Reconstruction and Development (EBRD), Transparency 
International, and Heritage Foundation, concerning its high 
corruption and limited economic liberalization and economic 
freedom among the transition countries. Foreign investment is 
limited by the lack of a clear ``rule of law'' as is domestic 
entrepreneurship.\20\ Excessive bureaucracy also encourages 
businesses to operate in the shadow economy by making it too 
expensive to operate legally. Unclear or conflicting laws 
encourage bureaucratic intervention. Tax complexity allows more 
discretion by tax officials and hence encourages bribes to 
officials. A vague criminal justice system encourages the 
negotiation of sentences for fees.\21\
---------------------------------------------------------------------------
    \20\ See e.g., the two volume study by E.G. Yasin (ed.), op. cit.
    \21\ A new administrative code passed the Duma in October 2000. It 
constitutes a 500 page document that updates the 16 year old Soviet 
administrative code. This code requires, among a large number of 
regulations, Russian citizens to carry their passports, regulates fines 
for traffic violations and sets the rights of police to impound 
vehicles, and levies fines on officials for giving false information to 
citizens. It is unclear whether the new administrative code is an 
improvement in guaranteeing the civil rights of citizens. One of the 
fiercest debates in the Duma was a provision (subsequently dropped) 
that would have allowed the traffic police to impound vehicles. On 
this, see ``State Duma Lays Down the Law of the Land,'' Moscow Times, 
October 6, 2000.
---------------------------------------------------------------------------
    Russian writers depict endless inspections, certifications, 
and unnecessary restrictions on property rights. In many cases, 
the same licenses are required by different agencies, making 
the cost of licensing excessively high. Examples of excessive 
bureaucracy and corruption abound: The budget gets, for 
example, only 5 to 7 percent of the sum charged for licences. 
Regional administrations issue unlawful licences for 600 types 
of entrepreneurial activities. Licences serve as market 
barriers on the principle ``pay to enter the market and then do 
what you want.'' \22\ Expert calculations suggest that 
administrative barriers cost Russian families $18 a month in 
the form of higher retail prices.\23\ Because of confusing and 
contradictory laws, practically every businessman is obliged to 
break the rules and to pay bribes to get the exemptions 
required to operate the business.\24\
---------------------------------------------------------------------------
    \22\ Press Briefing By Minister for Economic Development and Trade 
German Gref, March 2, 2001 (www.fednews.ru/).
    \23\ ``Getting rid of bureaucrats will save $5.8 bln,'' March 2, 
2001 (www.strana.ru).
    \24\ Press Briefing By Minister for Economic Development and Trade 
German Gref, March 2, 2001, op. cit.
---------------------------------------------------------------------------
    Economic analysts, both within and outside of Russia, argue 
that the regulatory burden on Russian enterprises must be 
reduced significantly if the economy is to continue to grow and 
to attract foreign investment.\25\
---------------------------------------------------------------------------
    \25\ Yu. A. Tikhomirov, ``Rol gosudarstva i prava v formirovanii 
blagopriiatnogo investitsionnogo klimata,'' in E.G. Yasin (ed.), pp. 
213-218.
---------------------------------------------------------------------------
    The Putin government, as represented by the reform-minded 
Minister of Economic Development and Trade, German Gref, issued 
an ``anti-bureaucracy'' decree in June 2001 forming the 
``Commission of the Government of the Russian Federation for 
the Curtailment of Administrative Restrictions on 
Entrepreneurship and the Optimization of Expenditures of the 
Federal Budget on State administration.'' \26\ This commission 
is charged with reducing the amount of bureaucratic 
intervention in business affairs, ensuring that laws are 
applied to business consistently, and combating corruption of 
officials. The government's long-term development program 
assigns the anti-bureaucracy commission the following tasks, 
among others: \27\ The Commission must lower barriers to entry 
into markets, remove technical barriers to the process of 
production and trade, eliminate redundant administrative 
regulation of entrepreneurial activity, assure agreement 
between national and regional organs of authority, and 
eliminate redundant and ineffective regulation in the sphere of 
arbitration. There should be one system of licensing for the 
entire Russian Federation with a unified system of forms and 
documentation based on a ``one window'' registration procedure. 
Moreover, there should be a register of information on 
juridical persons that is available to all, and a sharp 
reduction in the number of licensed activities. The licensing 
of investment projects (such as major energy infrastructure 
projects) are also to have a ``one window'' licensing procedure 
and cannot be required to obtain licenses from multiple 
authorities. The Commission is also charged with reducing the 
number of certifications, the number of agencies that are 
allowed to make inspections; and the elimination of duplication 
of inspections. Moreover, it is recommended that more use be 
made of professional self-regulating organizations, rather than 
government agencies.\28\
---------------------------------------------------------------------------
    \26\ Postanovlenie pravitelstva rossiiskoi federatsii No. 452, June 
8, 2001.
    \27\ Kuzminov, Yaroslav. ``Rol gosudarstva i prava v formirovanii 
blagopriiatnogo investitsionnogo klimata v Rossii,'' in E.G. Yasin 
(ed.), pp. 213-218.
    \28\ Osnovnye napravleniia sotsial'no-ekonomicheskogo razvitiia 
rossiiskoi federatsii na dolgosrochnuiu perspektivu, Moscow, 2001, 
Section 1.2.3.
---------------------------------------------------------------------------
    These anti-bureaucracy measures have considerable popular 
appeal and the support of both domestic and foreign 
entrepreneurs, but they also face considerable opposition. The 
economic theory of corruption states that an economy that is 
``over-regulated'' with rules, licensing requirements and 
bureaucratic interventions encourages corruption.\29\ A highly 
regulated economy creates opportunities for government 
officials to ``sell'' monopoly rents, or even to charge 
businesspersons for carrying out their ``normal'' bureaucratic 
duties, like issuing a routine license. The more liberalized 
the economy, the fewer the opportunities for officials to earn 
income by selling valuable rights or by charging customers for 
carrying out their normal duties. If the regulated domestic 
price of oil is one half the foreign price, an oil export 
license provides the owner of the license an opportunity to 
double his money. In a liberalized economy, the two prices 
would be the same and the export license would not be valuable. 
If there were specific sentencing guidelines in the criminal 
code, prosecutors could not sell lenient sentences to 
criminals.\30\ If it did not take 6 months to obtain a business 
license, the situation would not exist where the license may 
officially cost 15,000 rubles but people actually pay 
$400,000.\31\
---------------------------------------------------------------------------
    \29\ Shleifer, A. and R. Vishny. ``Pervasive Shortages Under 
Socialism,'' Rand Journal of Economics, Vol. 23, 1992, pp. 237-246.
    \30\ Yasin, E.G. ``Modernization of the Russian Economy: Problems 
on the Agenda, Modernization of the Economy of Russia,'' Higher School 
of Economics, Moscow, April 30, 2001.
    \31\ Press Briefing By Minister for Economic Development and Trade 
German Gref, March 2, 2001, op. cit.
---------------------------------------------------------------------------
    The regional reform's harmonization of regional and 
national laws is intimately related to the anti-bureaucratic 
reform in that much of the redundancy and duplication in 
matters of licensing and certifications are related to 
conflicts between federal and regional statutes and 
regulations.
    Putin's anti-bureaucracy reforms, if implemented, attack 
the heart of official corruption. A lower bureaucratic and 
regulatory burden on businesses reduces the demand for official 
corruption. The more liberalized the economy's prices, 
international trade, banking institutions, licensing 
procedures, and the like, the less opportunity officials have 
to sell monopolies to rent seekers.
    Despite its popular appeal, these anti-bureaucracy measures 
face considerable open and hidden opposition for the very 
reason that they threaten the incomes of officials, who, more 
than likely, receive low nominal salaries for their official 
work. Any Russian official with the power to regulate, starting 
with a lowly traffic policeman to the distributor of oil export 
licenses, stands to lose considerable ``bribe'' income if the 
anti-bureaucracy commission is successful. As in Soviet times, 
economic reform stumbled over bureaucratic opposition; it 
remains to be seen whether Russia's bureaucrats can 
successfully block the current reform effort.

                          Civil Service Reform

    Russia's civil service administration is governed by the 
Civil Service Law of 1995. Moreover, the Federal Constitutional 
Law on the Government of the Russian Federation spells out 
rules of conduct for government officials, such as the conflict 
of interest rules in article 11. Putin included a basic outline 
of proposals for civil service reform in his 2001 agenda, but 
apparently no draft of the civil service reform has been 
released. Its basic objectives, however, were spelled out in 
Putin's state of the union address of April 2001.\32\ According 
to Putin, ``the efficiency of a state is determined not so much 
by the amount of property it has under its control but rather 
by the efficiency of the political and administrative 
mechanisms the state has to protect the public interest.'' \33\ 
In his address, Putin stated the following principles: The 
Russian administration is currently too large and needs to be 
trimmed. The federal administration employed 882,000 in 1993 
but employed more than one million in 2001. The number of 
bureaucrats at all levels has grown since Soviet days from 1.15 
million in 1980 to 2.6 million. In 2000 alone, the number of 
official chauffeur driven cars grew by 23,500 to 605,290.\34\
---------------------------------------------------------------------------
    \32\ BBC, op. cit.
    \33\ Ibid.
    \34\ Reuters, March 6, 2001.
---------------------------------------------------------------------------
    In line with the anti-bureaucracy measures, governmental 
agencies should be subjected to review to identify their 
functions and presumably reduce the amount of overlap. All 
relations between the state and business should be transparent, 
eliminating the possibility of arbitrary intervention and 
excessive regulation.
    In its essence, Putin's civil service reform outline aims 
to change the Russian bureaucracy from its petitioning and 
strong control structure of the Soviet past to a service 
culture.\35\ Position papers prepared in anticipation of an 
eventual civil service reform state the goal of creating a 
professional civil service based upon merit selection, civil 
service rules, and competitive salaries that reduce bribe 
taking and corruption. Low pay of civil servants discourages 
public service and limits the entry of young persons into 
public service (the average age of employees in the ministry of 
economics is over 50). The assumption is that Russian civil 
servants if properly compensated will reduce their intervention 
in the affairs of private businesses because they will no 
longer need bribes and other payoffs to make ends meet.
---------------------------------------------------------------------------
    \35\ Parison, op. cit., p. 362.
---------------------------------------------------------------------------
    Although not stated specifically, the need for higher 
salaries appears to be a reason why administrative reform is 
not scheduled for the immediate future. If an average salary 
of, say, $1,000 per month were agreed upon as one that would 
drastically limit graft and corruption, this figure alone would 
account for about one-third of all federal government spending 
or 20 percent of spending from the consolidated budget. 
Clearly, if salaries are to be raised to such levels, the size 
of the state bureaucracy has to be markedly reduced, which is a 
time consuming activity that goes against strong vested 
interests.
    In order for a public administration reform to be 
successful the remnants of the old nomenklatura mentality must 
be removed. The nomenklatura mentality was that public 
positions are to be obtained not through merit but through 
influence, connections, and perhaps even outright purchase.\36\ 
The nomenclature or bureaucratic mentality also assumed that 
membership in the nomenklatura brought with it perks and 
privileges not accessible to others. When perks and privileges 
associated with public service declined, graft and bribe taking 
took their place.
---------------------------------------------------------------------------
    \36\ In modern day Russia there are rumors and other evidence that 
high-level government positions an purchased. See Parison, op. cit., p. 
363.
---------------------------------------------------------------------------

                Are Putin's Reforms Too Good To Be True?

    The administrative reforms outlined in this paper are 
breathtaking in their rhetoric and scope. They surpass the 1992 
reform language of the Gaidar reform government. These measures 
appear to move the country in the right direction, although one 
can disagree with Putin's consolidation of power in the center. 
It could be argued that a rule of law can be imposed on a 
country in chaos only from the center and that regional 
experimentation and autonomy may have to be sacrificed in the 
process. Two significant issues remain: Will Putin remain 
steadfast in his support of liberalizing reforms or will he, 
like his predecessor, Yeltsin, vacillate between liberalizing 
and de-liberalizing reforms with the passage of time and 
fluctuations in his popularity. If Putin, as a relatively young 
man, intends to be President for the next decade, he would 
likely take a long-run view and realize that the Russian 
economy cannot prosper without a rule of law, without domestic 
and foreign private investment, and a reduction of corruption. 
Thus, Putin's interests and the interests of economic 
rationality would coincide. We, of course, cannot guess what 
Putin's personal objectives are, but we cannot rule out that 
they prominently include the long-term economic growth and 
development of the Russian economy. The second question is 
whether Putin, like decades of Russian and Soviet leaders 
before him, will be sabotaged in his reform efforts at the 
grassroots level. In attacking bureaucratic excesses, 
corruption, and barriers to entry, Putin is taking on powerful 
and largely unseen forces that have objectives inconsistent 
with the development of an efficient economic system. It should 
be noted that the current Russian nomenklatura is basically the 
old Soviet elite. During the first half of the reform decade, 
the survival rate among the regional administrative elite was 
82 percent and 65 to 75 percent of the former nomenklatura 
continued to occupy positions within the Russian post-Communist 
elite. Some have moved across institutional boundaries, but 
most have continued to occupy their old positions or similar 
positions.\37\ We cannot tell whether such vested interests 
still succeed in defeating these and subsequent administrative 
reforms. The thousands of administrative decisions that must be 
made monthly or quarterly, such as auctions of government 
shares in less visible companies or the implementation of de-
bureaucratization rules at the local level, will determine 
whether Russia operates by a rule of law or not. These 
decisions cannot be taken by the President. They must be taken 
by thousands of faceless officials, who must somehow be 
motivated to decide in the larger interests of the state. This 
is a daunting goal that only a few ``civilized'' countries have 
achieved. In this light, Russia faces an uphill battle in its 
struggle for rational administrative reform.
---------------------------------------------------------------------------
    \37\ These figures are from Stephen White and Olga Kryshtanovskaya, 
``Russia: Elite Continuity and Change,'' in Mattei Dogan and John 
Higley (eds.), Elite, Crises, and the Origins of Regimes (Lanham: 
Rowman and Littlefield, 1998).









 RUSSIAN CRIME AND CORRUPTION IN AN ERA OF GLOBALIZATION: IMPLICATIONS 
---------------------------------------------------------------------------
                         FOR THE UNITED STATES








               By Jonathan M. Winer and Phil Williams \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................    97
Russian Organized Crime: Economic Impact and Characteristics.....    99
    Historical and cultural elements.............................   101
    The element of violence in Russian organized crime and Mafiya 
      businesses.................................................   106
    Typologies of Russian organized crime........................   109
Differences from Organized Crime Elsewhere.......................   110
The Scope and Impact of Russian Organized Crime Activities 
  Outside Russia.................................................   111
    Where is Russian organized crime?............................   111
    What kinds of presence and how developed?....................   112
The Impact of Russian Organized Crime on Russia's Evolution......   113
Money Laundering and Financial Crime.............................   116
    The gray economy, Russia's tax system and capital flight.....   117
    Poor accounting, auditing, and documentation requirements....   118
    Prominence and connection of organized crime to officials and 
      official structures........................................   118
    Rent-seeking activity by government officials................   118
    Ease of moving funds offshore................................   119
    Inadequate knowledge base, training, government capacity.....   119
Options for Reform in Russia.....................................   119
    Anti-corruption measures.....................................   120
    Increased press freedom......................................   120
    Improving tax system.........................................   120
    Financial sector regulatory reforms..........................   120
    Legal reforms................................................   120
    Money laundering legislation.................................   121
Policy Options for the United States.............................   121
                                Summary

    While globalization and privatization have clearly fueled 
Russian organized crime, organized crime has a lengthy history 
in Russia. Among the most important elements of today's 
organized crime are liaisons between the nomenklatura, ethnic 
traders, and Russian criminals. Important elements of these 
groups colluded during Russia's transition to convert the 
resources of the Soviet Union's command economy to their 
personal ownership and control. The mechanisms by which they 
accomplished this included ruble to dollar credit manipulation, 
theft of natural resources owned by the government through 
false documentation, the exploitation of the state to secure 
exemption from taxation and from oversight, bribery, extortion, 
contract killings, and money laundering. Triangular 
relationships between criminals, business persons, and 
officials exploit the lack of clear distinctions in Russia 
between what is legal and what is illegal; what is public and 
what is private; and what is permissible and what is 
prohibited. Closely linked to Russia's organized crime is 
Russian money laundering, whose infrastructure serves not only 
criminals but facilitates large-scale capital flight, depriving 
Russia of fiscal resources, and fueling Russia's shadow 
economy.
---------------------------------------------------------------------------
    \1\ Jonathan M. Winer, formerly U.S. Deputy Assistant Secretary of 
State for International Enforcement, is currently counsel at Alston & 
Bird, L.L.P. Dr. Phil Williams is a Professor in the Graduate School of 
Public and International Affairs at the University of Pittsburgh and 
formerly Director of the University's Ridgway Center for International 
Security Studies. Certain elements of this paper were originally 
prepared for the National Intelligence Council in spring 2001 in 
separate presentations by each of the authors.
---------------------------------------------------------------------------
    The transformation of Russia to a country where free 
markets and democracy are realities requires Russia to 
undertake steps that threaten those whose power depends on 
discouraging rule of law, including criminals, exploitative 
business persons and corrupt bureaucrats. Russian organized 
crime will likely continue to oppose Russian efforts to collect 
taxes in a fair manner, pay its civil service a living wage, 
maintain high caliber professionals in government, build 
effective self-regulatory organizations, and sanction those who 
engage in unfair trade and business practices. Reforms that 
would begin to provide an environment better suited for Russia 
to combat its organized crime problem would include effective 
anti-corruption measures, increased freedom of the press, a 
fairer and more effective tax system, financial sector 
regulatory reforms, legal reforms, and effective implementation 
of the recently passed money laundering legislation.

          The investment that Russia has attracted over the 
        past few years is minuscule, compared to that which has 
        flowed to other transition economies, and to that which 
        the country should attract, given its rich natural 
        endowment and its talent and educated workforce. If you 
        deduct negative investment, i.e., capital flight, the 
        picture is a bit more discouraging. Capital flight is 
        estimated at about $2 billion per month. That amount 
        attracted is meanwhile worse than minuscule. As 
        President Putin said in his April Address to the 
        Federal Assembly, up to now the only investors who have 
        come here are those who have to be here, whether 
        because they focused on Russia's natural resources or 
        are supplying Russia's still fledgling consumer 
        industry . . . The reasons for this situation are the 
        very issues that the Russian government is now moving 
        to confront. They include corporate governance abuses, 
        the country's weak judicial system, and inadequate 
        defense of property rights, excessive bureaucracy and 
        lack of transparency, and corruption. All of this 
        further adds up to a profound issue of the lack of 
        trust in economic institutions that continues to hinder 
        normal economic relationships and structures from 
        developing. (Farewell speech, U.S. Ambassador to 
        Moscow, Ambassador James Collins, American Chamber of 
        Commerce, June 15, 2001)

          The excitement over reform in Russia--the passage of 
        a budget, tax changes, a growing economy and political 
        stability--is increasing among the international 
        business community. In fact, it seems that Russia will 
        soon become the darling of foreign investors, with 
        political risk now practically nil and state coffers 
        overflowing with petrodollars. But within this 
        favorable situation, some critical factors remain 
        largely ignored. The real environment in which Russian 
        business operates, at least those firms that are 
        profitable, lies within the shadow of criminal 
        organizations with strong links to both the government 
        and bureaucracy . . . Since Russian crime syndicates do 
        not have the documented origins and family structure of 
        the Cosa Nostra--and are often loosely tied through 
        backroom dealings--statistics on how many Russian 
        businesses are actually under the control of the 
        ``Mafia'' are virtually impossible to come up with. But 
        the fact that almost all of the thousand-odd contract 
        killings of business people here over the past seven 
        years remain unsolved speaks for itself. (Editorial, 
        ``A Culture of Crime,'' Russia Journal, July 23, 2001)

          Average Russians continue to suffer abuse daily at 
        the hands of the militia, the traffic police, and 
        corrupt bureaucrats. The state may try them more than 
        once for a crime. They may be detained without charges 
        for seventy-two hours or held in a tuberculosis-ridden 
        pre-trial detention center for years. Opening a 
        business involves as much paperwork and bribery as 
        ever. The mafiya still extracts dan from entrepreneurs. 
        The countrywide decay that began during the Yeltsin 
        years continues, with television towers catching fire, 
        nuclear submarines sinking, military aircraft crashing 
        to earth, apartment buildings exploding from leaks in 
        decrepit gas pipes, and entire regions of the country 
        going without heat and electricity in winter months. 
        Thirty-six percent of the population, or 52 million 
        people, live below the subsistence level, set at a 
        dollar a day. (Article, ``Russia is Finished,'' 
        Atlantic Monthly, May, 2001, Jeffrey Tailer)

    Russian Organized Crime: Economic Impact and Characteristics \2\

    There is widespread consensus that the weakness of the 
Russian state, the existence of a pre-existing black market, 
and the corruption that pervaded the privatization process 
inhibited the development of formal legal standards and norms 
that would have exercised effective control over Russia's rapid 
transition from a command to a market economy. There is less 
consensus about the role played by organized crime in these 
problems. Some commentators seek to differentiate the economic 
impact of capital flight involving corruption and theft of 
resources from traditional forms of organized crime, such as 
drug trafficking, trafficking in women, motor vehicle theft, 
and extortion.\3\ However, standard characterizations of 
organized crime tend to define the activity in ways that render 
such differentiation meaningless: organized crime encompasses 
economically motivated illicit activity undertaken by any 
group, association or other body consisting of two or more 
individuals, whether formally or informally organized, where 
the negative impact of said activity could be considered 
significant from an economic, social, violence generation, 
health and safety and/or environmental perspective.\4\ 
Furthermore, even if one limits the definition of organized 
crime to that activity involving illicit force or the threat of 
force by non-state actors, such as contract killings or 
extortion, it remains clear that Russian organized crime 
pervaded the Russian transition, affecting such important 
economic sectors as oil and gas, minerals and other extractive 
industries, financial services sector institutions; and 
substantial portions of Russia's cross-border trade.\5\
---------------------------------------------------------------------------
    \2\ For the sake of length and clarity, this paper looks at Russian 
organized crime in terms of criminal activity arising in and out of 
Russia itself, regardless of which Russian-speaking ethnic group 
carries out the activity. In general, the observations within this 
essay would apply with equal force to most other components of the 
former Soviet Union, including in particular Ukraine and Kazakhstan, 
and to some extent Belarus, Georgia, Armenia, and the Baltics. The 
tribal history and future of most of the other ``stans,'' which include 
the withdrawal of substantial components of the former Soviet presence, 
represent a distinct set of problems, including Islamicism and poppy 
cultivation, which require separate analysis.
    \3\ See e.g., L. Grigoryev, A. Kosarev, ``Capital Flight: Scale and 
Nature,'' February 24, 2000, available from the International Monetary 
Fund (IMF), Bureau of Economy Analysis, arguing that most of the money 
laundered out of Russia represents avoidance of currency exchange and 
tax laws, rather than income obtained through drug trafficking, 
financial manipulations or racketeering. The authors argue that whereas 
in the west, the transferred funds would represent theft of a company's 
resources from owners or shareholders, in a Russian context, ``owners 
and managers oftentimes do not draw much of a distinction between cash 
belonging to the enterprise and their own cash.'' As argued below, the 
lack of such distinctions is one of the major problems confronting 
Russia.
    \4\ This definition is taken from the 1998 ``Organized Crime Impact 
Study,'' of the Solicitor General of Canada. Other definitions include 
INTERPOL's 1988 definition of organized crime as ``Any enterprise or 
group of persons engaged in a continuing illegal activity which has as 
its primary purpose generation of profits, irrespective of national 
boundaries,'' from INTERPOL's First National Symposium on Organized 
Crime at St. Cloud, France, May 1988; the German national police or 
Bundeskriminalamt (BKA) definition of organized crime as ``Any group of 
people who have consciously and deliberately decided to cooperate in 
illegal activities over a certain period of time, apportioning tasks 
among themselves, and often using modern infrastructure systems, with 
the principal aim of amassing substantial profits as quickly as 
possible,'' and the current INTERPOL definition, ``Any group having a 
corporate structure whose primary objective is to obtain money through 
illegal activities, often surviving on fear and corruption.'' The 
United Nation's Convention Against Transnational Organized Crime, 
signed in Palermo, Italy in December 2000, defines organized crime as 
actions undertaken by a group of three or more persons in violation of 
national law for economic or financial benefit. Each of these 
definitions captures the activities in Russia that are the subject of 
this article.
    \5\ A report in St. Petersburg Times, June 25, 1999, suggested that 
contract ``hits'' were most common in the oil and gas, metals and 
banking sectors.
---------------------------------------------------------------------------
    Recent figures suggest that the influence of organized 
crime in Russia's economy remains a significant element of 
Russia's economy, as well as its political life. On February 7, 
2001, Alexander Kulikov, the Chairman of the state Duma 
security committee announced that the shadow economy had become 
a matter of national concern, as the level of criminal business 
was seriously undermining the economic security of the state. 
Citing statistics from Russia's Interior Ministry, Kulikov 
stated that some 40 percent of Russia's economy was engaged in 
the shadow sector through parallel commercial structures 
involving ``filial companies'' and ``dummy firms,'' in such 
sectors as alcohol, gambling and show business.'' \6\ According 
to Kulikov, between 50 and 85 percent of all banks operating 
throughout Russia are under the control of organized crime, 
while revenues from the shadow economy making up 40 percent of 
Russia's gross domestic product (GDP), with nearly 9 million 
citizens involved in such activities. Kulikov also claimed that 
``over the last five years, the number of organized crime 
groups increased 17 times, while the number of groups with 
corrupt links rose 170 times.'' \7\
---------------------------------------------------------------------------
    \6\ "Criminal Business Undermining Economic Security of Russia,'' 
February 7, 2001, RIA Novsti.
    \7\ Id.
---------------------------------------------------------------------------
    Notably, Russia's economy ministries take a different view. 
Recently, Russia's Economic Development and Trade Minister, 
German Gref, contends that conditions for investment in Russia 
by foreigners are ``better than ever'' and that a ``silent 
revolution'' has taken place in Russia's economy, making the 
picture for the future positive.\8\ While the recovery has 
closely paralleled the worldwide increase in prices for natural 
resources, in particular, oil and gas, some analysts also 
contend not only that the impact of Russian crime on Russia's 
economy in the past has been overstated but also that it is 
likely to diminish even further in the future.\9\ For the most 
part, however, there is a consensus that capital flight, 
infrastructure decay, tax collection, loss of foreign 
investment, remain current, not historical problems, and each 
problem has been exacerbated by Russian corruption and 
organized crime.\10\
---------------------------------------------------------------------------
    \8\ Interview, Russia TV channel, Moscow, BBC Monitor, June 24, 
2001,
    \9\ See e.g., ``Think Again,'' Anders Aslund, Foreign Policy, July/
August 2001, arguing that the 44 percent loss of GDP in Russian from 
1989 to 1998 is ``grossly exaggerated'' due to statistical quirks; that 
the virtual barter economy is ``marginal,'' and that because 
privatization ``permanently deprives public servants of public property 
. . . they can no longer charge money for the privilege of using it.'' 
Aslund states that the Russian investment climate remains poor because 
of ``excessive bureaucracy and corrupt law enforcement,'' 
distinguishing these elements from what he views to be essentially 
honest ``privatization.''
    \10\ See e.g., CRS: RL30394: Russian Capital Flight, Economic 
Reforms, and U.S. Interests: An Analysis, William H. Cooper, Specialist 
in International Trade and Finance, Foreign Affairs, Defense, and Trade 
Division, John P. Hardt, Senior Specialist in Post-Soviet Economics, 
Foreign Affairs, Defense, and Trade Division, March 10, 2000, ``Capital 
flight is a symptom of poor economic conditions in Russia. But it also 
re-enforces poor economic conditions as it deprives the economy of the 
critical investment and budgetary resources to build sustainable 
economic growth and finance social welfare programs.'' See also 
testimony of U.S. Secretary of the Treasurer Larry Summers before House 
Committee on Banking, September 21, 1999, stating that ``money 
laundering requires neither official corruption nor capital flight. 
However, the three often come together where the rule of law is weak 
and confidence in the economy is low.''
---------------------------------------------------------------------------

                    historical and cultural elements

    While globalization and privatization have clearly fueled 
Russian organized crime, its presence in Russian society goes 
back to Czarist times, and endured throughout the Soviet 
period.\11\ Salient factors pertaining to the relationship 
between the Russian Government and Russian organized crime that 
have endured throughout the 20th century include:
---------------------------------------------------------------------------
    \11\ See e.g., ``A State of Lawlessness, Corruption, Coercion Reign 
in Russia,'' David Hoffman, Washington Post, September 10, 1999, noting 
``throughout its history, from the czars to the Soviet Communist Party, 
Russia has no tradition of the rule of law. The legacy of previous 
generations runs deep and includes a chasm between state and society 
and a heritage of arbitrary and unreachable authorities. Power was 
exercised ruthlessly and without recourse for its victims. Today's 
Russia, despite the changes of recent years, still bears the deep 
imprint of this history.''

   Disconnection between the authority and legitimacy 
        of the head of state (whether the Czar, Stalin, or 
        Yeltsin) and the actions of the often arbitrary or 
        ineffective government operating beneath the head of 
        state, with the result that the head of state has often 
        acted to undermine the authority of key ministries and 
        agencies.\12\
---------------------------------------------------------------------------
    \12\ While this assessment may not be true of the Putin government, 
the current structural elements of Russian organized crime are a 
continuing consequence of the conditions of their formation and 
operation during the Yeltsin period.
---------------------------------------------------------------------------
   Rulemaking and regulation which in practice and 
        effect are experienced as arbitrary and capricious by 
        the governed, making their rationality, as well as 
        legitimacy, questionable.
   A lack of a developed and vigorous civil society. 
        Social structures and institutions apart from the 
        government are not only weak but are accompanied by 
        governmental structures that function incompetently.
   Corruption as a way of life for officials, whether 
        motivated by a desire simply to make ends meet or by 
        greed.
   Corruption as a way of life for the private sector, 
        however large or small that has been, to get its 
        business done.
   Little transparency in governmental operations, 
        leading to inadequate oversight and lack of popular 
        participation in governmental decisionmaking.
   Collusion and even merger of key governmental 
        officials and structures with counterpart criminals and 
        criminal organizations on the outside.\13\
---------------------------------------------------------------------------
    \13\ A comprehensive journalistic description of this phenomenon in 
the Yeltsin era is set forth in ``Comrade Criminal--Russia's New 
Mafia,'' Stephen Handelman, Yale University Press, 1995.
---------------------------------------------------------------------------
   A tradition of governance that emphasizes the rule 
        of people or party and not the rule of law. Both the 
        Czars and the Communists, in effect, were both above 
        and beyond the law.

    These conditions, which have undermined the Russian 
Government and strengthened Russian organized crime, are the 
heritage of both Czarist Russia and the Soviet state. Lenin and 
Stalin built power upon the delegitimatization of the Czarist 
state. The new Soviet Union was not an expression of a 
government in a traditional sense, but of a system of 
governance that aimed to further the ends of a political party, 
the Bolsheviks, whose means, if not their explicit goals, 
differed in scale but not in substance from those used by 
organized crime the world over. Core values of criminals 
everywhere are disdain for rule of law and for democracy. 
Criminals have no reason to adhere to either principle, except 
to the extent that they are threatened by sanctions being 
enforced by those who do adhere to those principles. The 
Russian Communist Party had similar reasons to oppose both the 
principles of rule of law and of democracy. Any increase in 
either of those two trends created a concomitant and relatively 
proportional increase in the risks that sanctions would be 
applied to the Communists and their relative power in society 
would decrease.
    During the Brezhnev stagnation, the ideological and 
patriotic fervor sustained by the victory over the Germans in 
World War II and the grab for empire in Central Europe in the 
post-war period waned. Significant elements of the Communist 
Party, the Soviet Government, and the Soviet economy developed 
into a system of ``mafiyas'' that had a close resemblance to 
governance in Sicily. Favorites obtained territories that they 
were permitted to exploit. In that corruption, lay what a 
number of commentators have described as the seeds of the 
criminalization of the modern Russia, through the development 
of criminal practices, by three identifiable classes of 
persons:

   Nomenklatura, whose access to resources and licenses 
        provided a means of trading access and permission for 
        material goods and special privileges. The nomenklatura 
        consisted of both state managers and members of the 
        institutions of social control such as the KGB, the 
        Ministry of Interior and even the Soviet military.
   Ethnic traders, whose non-Russian status gave them 
        greater access to the West, western institutions, and 
        capitalist activities at a time when direct 
        participation in commerce would have been ideologically 
        risky for members of the nomenklatura themselves. The 
        traders, who included Jews, Armenians, and Georgians, 
        among others, formed the bow wave of this group, acting 
        as importers and exporters under the Soviet regime, 
        often in complex relationships with governmental 
        enterprises, elements of the nomenklatura, elements of 
        Soviet intelligence, and elements of the Soviet 
        military;
   Thieves in law and other Russian criminals who honed 
        bureaucratic survival skills in the gulag; later these 
        groups formed close ties with those involved in Russian 
        wrestling, hockey, and other sports where physical 
        strength provided a basis for prestige and power on the 
        one hand, and for demonstrating the ability to provide 
        physical protection (or physical intimidation) on the 
        other.

    During the 30 year period of the cold war (roughly, from 
the death of Stalin through the death of Chernyenko), Geneva, 
Paris, Vienna, and Tel Aviv became important entry points for 
covert financial activities by the Soviet Union. Riga, 
Kalingrad, and Crimea developed port capabilities suitable for 
smuggling. Third world outposts in the Middle East, Africa, 
South East Asia, and during the 1980s, Central America, became 
opportunities for refining techniques of transporting 
prohibited goods through corrupt or weakened governmental 
mechanisms. False invoicing, fraudulent documentation, the use 
of shell companies and cut-outs, all essential elements of the 
tradecraft of Soviet espionage, became techniques widely known 
through the relatively small community of people who handled 
the Soviet's economic contacts with the West. These techniques, 
together with a culture of non-transparency and corruption, 
would translate easily into post-Communist Russia, and 
eventually play a substantial role in swallowing up reform. 
Indeed, they inflicted profound systemic harm to Russia's 
initial efforts, from 1990 through 2000, to modernize its 
political and economic system in a manner that would strengthen 
rule of law and democracy.
    In this context, the Gorbachev reforms weakened the 
position of the Communist Party in society and of the state 
itself. Glasnost created the intended consequence of greater 
democratization and strengthened those elements of society, 
such as the academic and professional elites, the core of the 
then Russian upper middle class, whose political and economic 
opportunity would increase with greater democratization and 
strengthened rule of law. However, the reform process had the 
paradoxical result of also strengthening those elements of 
government that saw the weaker state as presenting a once-in-a-
lifetime opportunity to seize control of important resources, 
and those elements of society that saw the weaker state as an 
unprecedented opportunity to engage in predatory or criminal 
behavior with little fear of retribution.
    The Communist Party and the Soviet State had historically 
functioned as mechanisms to divide up the wealth of whatever 
they controlled as the arbiters of the command economy. With 
the breakup of the Communist Party and the Soviet State as the 
entities which by right or might controlled all the wealth of 
the Soviet Union, who had the right to the resources was an 
extraordinarily open question. Not surprisingly, therefore, the 
three groups who provided the basic components of a novel and 
distinctive form of organized crime--the nomenklatura 
(including important elements of the military, law enforcement, 
and Soviet intelligence), the ethnic traders, and the criminals 
and athletes--found enormous and lucrative opportunities to 
collude with one another to convert the resources of the Soviet 
Union's command economy to their personal ownership and 
control. The mechanisms by which they accomplished this were as 
myriad as the opportunities provided by the transition from the 
Soviet economy to the so-called market economy. Some of the 
more significant included:

   The issuance of large quantities of ruble loans by 
        Soviet financial institutions to well-placed persons 
        who later became known as oligarchs. These ruble loans, 
        issued at interest rates that were intentionally well 
        below market, were immediately converted into dollars. 
        The mass conversion of these rubles into dollars in 
        turn facilitated the depreciation of the ruble against 
        the dollar, providing instant wealth the holders of the 
        dollars, who were able to repay their debts at a few 
        kopecks to a ruble. This activity had a massive impact 
        in reducing the value of the ruble against other 
        currencies and its buying power within Russia. It 
        simultaneously provided a mechanism by which those with 
        the ability to borrow rubles (i.e., ruble debtors) had 
        a lever to convert a substantial portion of the 
        inherited capital of the Soviet Union into personal 
        fortunes. The concomitant corollary of this activity 
        was the devaluation and the commonplace reduction to 
        beggary of the millions of souls who had the misfortune 
        of actually holding rubles. These soon became worthless 
        and were exchanged at a ratio of 100 to 1 for new 
        rubles.\14\ Thus the wealth of a nation, such as it 
        was, was efficiently converted into the capital of the 
        few. Prominent examples of this class of oligarch/
        criminal include Boris Berezovsky, Vladimir Gusinsky, 
        Alexander Smolensky, and Mikhail Khodorkovsky.\15\
---------------------------------------------------------------------------
    \14\ The initial devaluation of the Russian ruble in the early 
1990s was far more profound in its consequences than the more recent 
devaluation of 1999, which merely reduced the ruble's value by 75 
percent, with the other three-fourths of the ruble's value mostly going 
to the lucky holders of Russian bonds who had been able to book the 
interest rates without holding as their own the worthless notes once 
the IMF recognized the folly of being the guarantor of the integrity of 
Russia's banking system. The systemic misleading of the IMF by Russia's 
Central Bank (Central Bank of the Russian Federation), including its 
long-term chief Central Banker, as evidenced in the Financial 
Management Company (FIMACO) affair in spring 1999, prior to the ruble's 
collapse, provided evidence that Russian financial services regulation 
did yet to meet global standards.
    \15\ Khodorkovsky declared his flagship bank, Menatep, bankrupt at 
the time of the Russian ruble crisis, moving its assets to a second 
Menatep in St. Petersburg, and re-opening the Moscow offices of Menatep 
in the form of an oil company that he had purchased through 
manipulating Menatep's assets. In the United States, this activity 
would constitute racketeering. In Russia, Khodorkovsky continues to be 
a successful businessman and financier.
---------------------------------------------------------------------------
   Chubais' voucher-for-shares plan, which enabled the 
        oligarchs who had previously enriched themselves 
        through dollar-ruble manipulations to further secure 
        the ownership of the vast preponderance of Russia's 
        wealth-generating industries, especially those in oil 
        and gas, metals, timber, and other extractive 
        industries.
   The sale of natural resources owned by the 
        government to private persons through various 
        mechanisms, including many involving false invoicing, 
        false financing, false titling, and false ownership, 
        enabling those who were able to control the export of 
        any particular quantity of natural resources to steal 
        most if not all of its value without having to pay 
        market prices for the goods, taxes on the goods, funds 
        to invest in the productive infrastructure to continue 
        the goods, or any other costs besides those associated 
        with bribing or killing anyone who might prevent them 
        from so exporting the goods.
   The exploitation of the state to secure unique 
        benefits, such as exemption from taxation and from 
        oversight, as was exemplified by Viktor Chernomyrdin's 
        effective stewardship over Gazprom during the period he 
        was Prime Minister of Russia.

    Thus, collusion between those controlling Russia's 
resources, traders and brokers, and armed enforcers built the 
new system of Russian governance and economics. Under Brezhnev 
and his successors, the Russian command economy had required 
coercion, extortion, theft, repression, and systemic corruption 
in order to function. In the Yeltsin period, this devolved into 
a new public-private system for government that preserved most 
of these mechanisms (i.e., coercion, extortion, theft, 
repression and systemic corruption) but substantially 
privatized them, and made them even harder to control: in 
short, Yeltsin's reforms, taking place in the context of a 
corrupted Soviet state, resulted in empowering a criminal class 
to take over an economy, and in important areas, its 
government.
    As a consequence of these structural and cultural features 
of Russian life, Russian organized crime has not been simply 
about the provision of illegal goods and services; it is also 
about the control of legal goods and services. In Russia there 
is not simply a criminal-political nexus but a political-
criminal-business troika, consisting partly of dense network 
connections among key people in the three sectors ands partly 
of some figures straddling the three sectors, and engaging in 
politics, licit commerce and illegal business. These networks 
are ubiquitous. They have several dimensions: direct person to 
person relations; shared ownership of, or interest in, specific 
companies; and linkages through pivotal figures who are clearly 
network connectors.
    Russian organized crime is thus characterized by at least 
three seamless webs--the seamless web between extortionists and 
security companies, the seamless web between licit and illicit 
business, and the seamless web between criminals on the one 
side and political and bureaucratic elites on the other. Out of 
these seamless webs has emerged a triangle of crime, business, 
and politics. There are two major reasons why this triangular 
relationship is extremely strong and resilient. First, each of 
the participants brings a different but complementary dimension 
to the table, thereby ensuring that the exchange relationships 
are beneficial to all. The political figures have access to the 
resources of government; the business figures bring both access 
to wealth and connections in the worlds of commerce and 
finance; and the criminal organizations provide coercive power 
and plausible deniability for the other two groups.\16\ The 
triangular relationship is an alliance of convenience rather 
than of natural affinity, but the benefits are so deep that, in 
effect, the relationship has become institutionalized. Second, 
the triangle is based on the lack of clear distinctions in 
Russia between what is legal and what is illegal; what is 
public and what is private; and what is permissible and what is 
prohibited. Furthermore, so long as there is no clarity in the 
borders among these areas, the stability and durability of the 
triangle are likely to continue unhindered.
---------------------------------------------------------------------------
    \16\ The authors would like to thank Gregory Baudin-O'Hayon, a 
Graduate Research Associate at the Ridgway Center, University of 
Pittsburgh and William Cook, formerly a Graduate Research Associate at 
the Ridgway Center, University of Pittsburgh for the ideas, research, 
and network diagrams that have informed this part of the analysis.
---------------------------------------------------------------------------

     the element of violence in russian organized crime and mafiya 
                               businesses

    It is often observed that in Russia those would limit 
themselves to legitimate business activity in other countries 
must engage in criminal activities such as tax evasion and 
money laundering in Russia, in order to carry out legitimate 
business. While this observation may be true in the case of 
particular individuals, the magnitude of clearly criminal 
violence involving extortion has been an impressive feature of 
Russia's economic transition. During this transition, cities as 
diverse as Yekaterinburg and St. Petersburg have been 
characterized by clashes among rival groups that surpass 
anything that occurred in Chicago during Prohibition. One 
result of this has been the success of a new generation of 
Russian criminals who do not accept the old rules of the vor-v-
zakone and see the rapid accumulation of wealth as their raison 
d'etre. The criminals, however, have gone well beyond killing 
one another. While rivalry in the criminal world is certainly 
not unique to Russia, what has been far more surprising is the 
diversity of the targets of Russian contract killings. The 
victims have included bankers and businessmen, journalists and 
reformist politicians, local bureaucrats, hotel managers, and 
anyone who poses a threat or presents an obstacle to criminal 
activities. In one prominent case, American businessman, Paul 
Tatum was killed amidst reports that he had been feuding with 
his Russian business partners in the Radisson Hotel joint 
venture. Another prominent victim was Galina Staravoitova, a 
leading Duma deputy active in combating organized crime and 
corruption.\17\ Other victims in recent years have included: 
Ilya Waisman, economic and finance director of the Baltica Beer 
Company, who, in January 2000, was shot and killed at his home 
in St. Petersburg; Uralmash General Director Oleg Belonenko who 
was killed in July 2000; and Alexander Volkovsky, President of 
the Russo-Balt Petroleum Company, who was shot in the entrance 
to his apartment building in January 2001. Not all hits are 
successful of course. Among those who survived an attempted 
contract killing was Deputy Mayor of the Moscow city 
government, Iosif Ordzhonikidze, a figure with considerable 
reputation as a facilitator for business.
---------------------------------------------------------------------------
    \17\ See William A. Cook and Gregory Baudin-O'Hayon, ``A Chronology 
of Russian Killings'' Transnational Organized Crime, Vol. 4 No. 2 
Summer 1998 pp. 117-201.
---------------------------------------------------------------------------
    Official statistics suggest some improvement in the 
situation, with only 386 contract killings in Russia in 2000, a 
major decline from the 500 to 600 that occurred each year 
through most of the 1990s.\18\ Obtaining accurate figures, 
however, remains difficult, not least because different 
officials often release contradictory statistics. In June 1999, 
for example, senior Ministry of Interior official, Akhmed 
Khairov, deputy head of the Interior Ministry's major crimes 
section told journalists that 567 people were murdered in 
contract killings in Russia during the first 5 months of 1999--
more than double the 232 killed during the same period in 1998. 
Khairov attributed the increase to the financial collapse of 
August 17, 1998 and the increase in unpaid debts.\19\ Yet in 
March 2001, Alexander Kirushev, deputy chief of the Ministry of 
Interior's Criminal Investigation Main Administration noted 
that the number of contract killings in 2000, was only 386--
down from the 591 committed in 1999. Unless the fall-off rate 
in the second half of 1999 was unprecedented (only 24 contract 
killings in 7 months), this seems to be a considerable under-
estimate for that year. Even allowing for the discrepancy 
however, the overall trend does seem to have been a marked 
reduction in the number of contract killings (accompanied by an 
increased success rate in solving these murders). However, the 
apparent trend should treated with some caution. An examination 
of the incidence of contract killings reveals a clear tendency 
to cluster in particular industries or economic sectors for 
several months (or in some cases 1 or 2 years) and then to 
disappear. This can be explained in several ways. Perhaps the 
most plausible explanation is that contract killings cease when 
organized crime has achieved its objectives and successfully 
infiltrated a particular sector such as banking or a particular 
industry such as aluminum. By eliminating those who resist 
them, organized crime can have a highly coercive impact on 
those who are left--without further killing. Similarly, the 
reduction in contract killings of vory-v-zakone or criminal 
authorities suggests that internecine warfare in the criminal 
world has given way to an established pecking order in which 
territories and markets have been divided up in ways that are 
more or less acceptable. In short, the decline in contract 
killings suggests not a decline in the power and influence of 
organized crime but its consolidation.
---------------------------------------------------------------------------
    \18\ Aleksandr Strogin ``Contract Killings Being Cleared Up After 
All. One Has Already Been 60-Percent Cleared Up'' Moscow Kommersant, 21 
Mar 2001 p. 3.
    \19\ See St. Petersburg Times, June 25, 1999, ``Russia's economic 
woes have put the cut-throat back into competition, with the first 5 
months of 1999 seeing the incidence of contract killings double, 
Interior Ministry officials said Thursday. Between January and May this 
year, 567 businessmen were slain on the orders of their competitors, 
compared to 232 such killings over the same period last year and 599 
contract killings for the whole of 1998, according to police figures. 
The figures also show contract ``hits'' are most common in the oil and 
gas, metals and banking sectors, said Akhmed Khairov, deputy head of 
the Interior Ministry's major crimes section.''
---------------------------------------------------------------------------
    Indeed, as the comments by Kulikov quoted above indicate, 
organized crime has had considerable success in infiltrating 
and controlling legitimate businesses and economic sectors. The 
methods by which Russian organized crime has achieved this 
include contract killings but only as part of a complex mixture 
of guile and intimidation, political influence and acts of 
violent criminal intimidation. On the basis of an analysis of 
the Russian aluminum industry as well as the energy sectors in 
St. Petersburg, it is possible to identify forms of behavior 
that tend to be present in all such cases (and that provide 
ample warning indicators):

   Murder and other violent attacks on personnel in a 
        particular company or industry sector who might be an 
        obstacle to the takeover.
   Equity or share purchases designed to obtain a 
        controlling interest in a particular company. In some 
        cases, shares are obtained through coercion and 
        violence; in other cases where it is necessary to avoid 
        Russian anti-monopoly legislation they are done through 
        front companies that obscure the real ownership and 
        interest.
   Insertion of personnel into management positions or 
        on to boards of directors. Packing the board is also a 
        means of ensuring that once the takeover has succeeded 
        control is maintained
   Obtaining support from corrupt links with 
        politicians who are visibly in favor of the takeover 
        effort and lend their power and prestige to at least 
        those parts of it that are legal and transparent.

    These apparently disparate tactics typically blend into a 
coherent and effective strategy that facilitates at least 
short-term domination of an industry that in some cases is 
transformed into a longer-term pattern.
    There is one view of mafia business, presented most fully 
by Diego Gambetta that suggests that the mafia is really about 
the business of private protection.\20\ Federico Varese has 
applied this argument to Russia, and suggested that although in 
many cases the relationship between criminal organizations and 
businesses are purely parasitical, in other instances there 
really is protection for businesses as the criminals developed 
a vested interest in their success.\21\ In some cases the 
protection is requested; in others it is imposed. Whatever form 
it takes, extortion appears to be the single most important 
staple of organized crime activities at the local level, 
particularly as rivalries have given way to more stable spheres 
of influence among criminal organizations.
---------------------------------------------------------------------------
    \20\ Diego Gambetta, The Sicilian Mafia: The Business of Private 
Protection,  Cambridge, MA: Harvard University Press, 1993.
    \21\ See e.g., Federico Varese, ``What is the Russian Mafia?'' Low 
Intensity Conflict and Law Enforcement, Vol 5 No. 2, pp. 129-138. See 
also Varese's forthcoming book on the Russian Mafia published by Oxford 
University Press.
---------------------------------------------------------------------------
    As well as ubiquitous protection rackets, Russian criminals 
traffic in a wide variety of products--stolen, regulated and 
illegal. Trafficking in women, nuclear material, arms, 
endangered species, drugs, icons, stolen cars, give the Russian 
organized crime scene a comprehensiveness that at least matches 
and perhaps surpasses that in Italy, China or Japan. In some 
cases Russian criminal organizations traffic commodities out of 
Russia; in other cases Russia itself provides the market--as 
for drugs and stolen cars. The wide portfolio is perhaps 
exemplified best by the Solntsevo group that reportedly 
controls the University, and Cosmos hotels; several casinos; 
the Solntsevo car exchange; all non-food markets in the 
Southwest District of Moscow; and commercial transportation to 
and from Vnukovo airport. In addition, about 300 commercial 
firms and banks are believed to be under Solntsevo's ownership 
or control. These extend beyond Moscow to Samara and Crimea and 
even to Hungary, Britain, and Israel.\22\
---------------------------------------------------------------------------
    \22\ For a useful discussion see Jeffrey Robinson, The Merger, 
London: Simon and Schuster UK, 1999.
---------------------------------------------------------------------------

                 typologies of russian organized crime

    Organized crime historically has been first and foremost 
about muscle. In the case of Russian organized crime this 
element is certainly not lacking. Yet there is also a high 
degree of sophistication. A great deal of Russian organized 
crime is financial crime or what has traditionally been 
categorized as white-collar crime rather than the more mundane 
forms of organized crime. Sophisticated fraud and embezzlement 
schemes, proximity to the banking sector, the widespread use of 
front and shell companies to move money and illegal products 
across borders, and the extension of networks of power and 
influence into the licit economy are all characteristics of 
Russian organized crime that stand out. Even if the financial 
dimensions of Russian organized crime are not completely 
unprecedented, they are a much more important part of Russian 
organized crime than the provision of illegal goods and 
services.
    The Russian criminal scene is characterized by considerable 
diversity, and it is possible to identify at least six 
different kinds of criminal groups in Russia:

   Businesses that are ostensibly (and in some 
        instances perhaps even predominantly) licit but with 
        their origin in criminal activities and a residual 
        tendency to use violence and corruption to protect and 
        promote their activities and to deal with competitors.
   Criminal organizations that have close links with 
        officials and that are a key part of the competing 
        administrative financial criminal oligarchies that are 
        one of the dominant forces in Russia today and that 
        operate at local and regional levels as well as 
        nationally.
   Ethnic criminal organizations that include Slavic, 
        Azeri, Georgian, and Chechen groups and that often 
        specialize in one of more criminal activities. Although 
        weakened somewhat by the ``wars'' with the Slavic 
        criminals, these groups remain a significant part of 
        the organized crime scene in Russia.
   What might be termed umbrella criminal associations 
        that encompass a wide range of smaller groups and 
        engage in a wide variety of criminal activities. 
        Perhaps the exemplar of this kind of association is the 
        Solntsevo group. One of Moscow's premier criminal 
        organizations, Solntsevo has several layers of strong 
        leadership, a well-established structure, a high level 
        of professionalism, some 300 individual crime groups in 
        its fold, and extensive transnational connections.
   Predatory criminal organizations that essentially 
        engage in small-scale criminal activities such as 
        localized extortion, car theft and the like, and that 
        do not have links with corrupt officials. These 
        organizations are more like street gangs than organized 
        crime, although the more successful ones evolve into 
        organized crime groups and develop links with the 
        business, political, and administrative elites.
   Specialized organizations including groups of 
        contract killers that are the equivalent of the old 
        ``murder incorporated'' in the U.S. mafia.

    This diversity--although sometimes a source of conflict 
among the different kinds of organization--makes the Russian 
criminal world particularly difficult to contain. Tactics that 
work well against some groups are less effective against others 
with different characteristics.

               Differences from Organized Crime Elsewhere

    Russian organized crime has some features in common with 
organized crime elsewhere, including the interpenetration of 
organized crime with government corruption, its reliance on 
extortion and bribery, and its provision of black-market goods 
and services in prohibited economic sectors. However, for 
reasons of history and culture, it also has distinct 
characteristics, even where it resembles other recent models 
for widespread organized crime.
    For example, in post-World War II Italy, organized crime 
flourished through a menage a trois between Italy's political 
parties, especially the Christian Democrats, the Mafia, and 
Italy's labor unions, whereby the three groups traded jobs, 
business, and money among one another to sustain the power of 
each for some 45 years until the culture demanded a more law-
based system.\23\ However, even Italy's heavily criminalized 
political class remained only a strand, albeit a thick strand, 
in a broader set of political, social, and economic 
institutions. While the Italian mob may have held enormous 
influence with Italy's political parties and its governmental 
personnel practices, especially at the local level, it never 
dominated Italian business life or controlled a preponderance 
of Italian resources. Legitimate businesses in the north were 
not mobbed up. They controlled their own capital, and that 
capital was invested in legitimate enterprise.
---------------------------------------------------------------------------
    \23\ See ``Excellent Cadavers,'' Alexander Stille, Pantheon, 1995.
---------------------------------------------------------------------------
    Similarly, other powerful criminal cultures in larger 
countries in the world have tended to be limited to inhabiting 
portions of society, rather than a country's heart. For 
example, Nigerian crime features tribal predation. Criminal 
cells or families prey on innocents elsewhere in Nigeria, or 
outside Nigeria, but seldom their own people. In China and 
Japan, particular criminal subcultures maintain limited and 
unreliable ties to elements of the government (Chinese triads, 
Japanese yakuza), but do not control vast components of their 
country's respective national resources. In drug trafficking 
countries, such as Colombia, criminal enterprises can exercise 
enormous political and economic influence, and infiltrate 
governmental institutions and businesses, but the traffickers 
are viewed by everyone as external elements to the institutions 
they are corrupting, rather than as components of them as in 
Russia. In most other countries, such as the United States, 
Canada, Western Europe, and the Middle East, criminal groups 
exist almost entirely as subcultures, often based on 
disaffected components of society, segregated by and with 
resentments arising from economic class or ethnicity.
    In short, Russian organized crime has differed from 
organized crime in other regions in being less of a subculture, 
and more central to what has always been a centralized state 
with relatively few other political institutions to act as 
counterweights.

  The Scope and Impact of Russian Organized Crime Activities Outside 
                                 Russia

    Globalization has meant that the infrastructure of the 
western democracies, for finance, information, 
telecommunications, governance, has rapidly spread throughout 
the world to constitute an ever-thickening web of connectivity. 
Post-Communist Russian organized crime arose just as this 
infrastructure was becoming rapidly more democratized through 
the proliferation of telecommunications technologies and 
electronic networks of various kinds. With the technical 
borders down, and the legal barriers against Russian contact 
with the west eradicated almost as rapidly as the Berlin Wall 
was bulldozed into history, Russian organized crime found an 
infrastructure outside Russia well-designed to facilitate every 
form of criminal activity, and ill-designed to investigate or 
prosecute it.
    In considering the scope and impact of Russian organized 
crime outside Russia, there are several questions that need to 
be considered. These include:

   Where is Russian organized crime going? What is it 
        doing there and what is it seeking to achieve?
   How is the presence developed? What kind of criminal 
        activities come with the presence?

                   where is russian organized crime?

    There are four main answers to this question:

   Given the extreme cold of Russian winter, Russian 
        organized crime has often followed the sun.\24\ Among 
        the locations that Russian organized crime has become 
        prominent are various Caribbean islands, Israel, the 
        Costa del Sol, the French Riviera, South Florida, and 
        Thailand. The playgrounds of the rich are very 
        attractive for organizations and individuals whose 
        primary activity is the accumulation of wealth through 
        illegal means.
---------------------------------------------------------------------------
    \24\ The authors are grateful to Gregory Baudin-O'Hayon for this 
observation.
---------------------------------------------------------------------------
   Some Russian organized crime moved out of Russia but 
        stayed close to it. Budapest, Berlin, and Vienna, for 
        example, all witnessed a significant increase in the 
        Russian criminal presence. In some respects these 
        cities were natural haunts for Russian organized crime 
        as they were familiar from the cold war era, and in the 
        case of Berlin and Vienna provided convenient windows 
        on the west while having the advantage of proximity.
   Russian organized crime looks for opportunities that 
        come with an acceptable level of risk, engaging in what 
        can be described as jurisdictional arbitrage. One of 
        Israel's attractions, for example, until summer 2000, 
        was the lack of any anti-money laundering legislation. 
        When this permissive environment was combined with the 
        law of return and the lack of questions about the 
        personal wealth that immigrants brought with them it is 
        clear that Israel was an attractive, low-risk 
        destination for Russian criminal organizations. The 
        United States carries a higher level of risk but also 
        provides enormous opportunities for criminals, 
        particularly in areas such as Medicare, car insurance, 
        and gasoline taxation where fraud schemes are very 
        lucrative. The capacity to meld into the ethnic Russian 
        communities also makes the United States attractive to 
        Russian organized crime.\25\ Conversely, where ethnic 
        communities of this kind are not well established, 
        Russian organized crime is less likely to have a 
        significant presence. Neither Britain nor Sweden, for 
        example, has experienced the influx of Russian 
        organized crime that was expected.
---------------------------------------------------------------------------
    \25\ Analysts affiliated with the National Institute of Justice 
estimate that approximately 15 criminal groups arising out of the 
former Soviet Union are currently operating in the United States, and 
that 8 or 9 of them maintain links to Russia. The analysts estimate 
membership of those groups to be 5,000 to 6,000 members. Finckenauer, 
James O. and Elin J. Waring, Russian Mafia in America, Boston: 
Northeastern University Press, 1998.
---------------------------------------------------------------------------
   Russian organized crime follows the Russian 
        Diaspora. It is sometimes argued that organized crime 
        is extremely difficult to transplant to other 
        countries, particularly when it is based on protection 
        activities. Where and when organized crime can be 
        embedded in migrant ethnic communities, however, then a 
        successful transplant is feasible. Most migrant 
        organized crime, initially, at least, preys on its own 
        community, before subsequently expanding into the 
        broader society and economy of the host nation.

               what kinds of presence and how developed?

    To date, Russian organization crime penetration of other 
countries has developed into variations of six models:

   Direct criminal presence in another country 
        accompanied by a full panoply of criminal activities, 
        as demonstrated by Russian organized crime in the 
        United States, Israel, much of Western Europe, and most 
        formerly Eastern bloc countries in Central Europe.
   More limited criminal presence for the purpose of 
        using the country's services on a regular basis, to 
        make it a reliable part of the criminal organization's 
        infrastructure, as in the use of Austria, Cyprus and 
        Switzerland for financial and business dealings; and 
        the use of the Baltic countries, especially Latvia, for 
        smuggling.
   Criminal presence in a neutral (not a targeted or 
        host) country that offers opportunities for contacts 
        and negotiations with other criminal organizations 
        rather than criminal activities per se. Some Caribbean 
        islands have been used in this way as a meeting ground 
        for Russian criminals and Colombian drug traffickers.
   Modest (or largely indirect) presence through 
        connections with indigenous criminal organizations. In 
        effect, the presence of Russian criminals is designed 
        merely to facilitate cooperative relationships with the 
        indigenous criminal organizations. Any Russian criminal 
        presence in Colombia, for example, would likely be at 
        the invitation of Colombian drug traffickers interested 
        in exploiting the burgeoning Russian drug market or in 
        obtaining arms.
   A purely ``pass through'' financial presence. The 
        proceeds of Russian crime often go through or are 
        secreted in jurisdictions in which there is little or 
        no Russian physical presence. This is certainly the 
        case with some of the offshore financial centers such 
        as the Caymans, Nauru, Vanuatu, and Liechtenstein that 
        have been used by Russian criminal organizations to 
        move, launder, and hide their proceeds.
   Rest, relaxation, and consumerism. Russian criminals 
        have congregated in resort communities in Southeast 
        Asia and Western Europe, buying real estate and 
        expensive goods, with little impact on the overall 
        environment of such communities, which tend to accept 
        money as money regardless of its provenance, with 
        little change to the underlying culture of hedonism.

    The extent of the Russian organized crime threat in a 
country depends largely on the viability and effectiveness of 
the institutions of governance. Where there is a viable, highly 
legitimate, well-functioning democracy based on the rule of 
law, then the threat is predominantly a law and order one, with 
some residual concerns over what might be termed the corrosion 
of institutions. Where these conditions are absent then the 
threat is more serious. In host states--as well as its home 
state--Russian organized crime uses corruption as an instrument 
to neutralize law enforcement and the criminal justice system, 
to co-opt support and buy impunity. Such tactics have an 
insidious impact and when a state already has serious 
governance problems these will be exacerbated.

      The Impact of Russian Organized Crime on Russia's Evolution

    Russian organized crime has been a major impediment to 
progress toward democracy, the rule of law and free markets in 
Russia. It will continue to be so. There are two closely 
interwoven myths about Russian organized crime that have been 
perpetrated largely by economists in the United States and 
Western Europe and that continue to have some currency. They 
need to be dispelled. The first is that Russian organized crime 
is similar to the robber baron phase in American history. In 
fact, the robber barons built infrastructure and created 
wealth; Russian organized crime in contrast has looted the 
country, imposed parasitical relationships on licit business, 
driven out much legal entrepreneurship, and become an 
impediment to foreign investment. The second myth is that 
Russian organized crime is a passing phenomenon that will 
diminish significantly as the process of free market reform 
continues, that it is a temporary feature of transition rather 
than an enduring feature of post-Communist Russia, simply a 
short term nuisance unlikely to have long term impact. This 
ignores several characteristics of organized crime: it is a 
political as well as economic force, it consolidates its power 
in ways that enable it to outlast the market conditions that 
initially facilitated its expansion, it creates symbiotic 
linkages with politics and business that are difficult to undo, 
and it is not simply dependent on rents from imperfect 
competition in the Russian economy. Indeed, Russian organized 
crime represents a concentration of illegal power that is not 
going to go away and will continue to hinder efforts to 
establish a strong legitimate Russian state, to eradicate 
corruption and to develop a system that is clearly based on the 
rule of law. Born in part out of state weakness Russian 
organized crime aims to perpetuate this weakness.
    Some argue that Russia is going beyond the neutralization 
of the state and is exhibiting symptoms of state capture. A 
recent paper of the World Bank Institute suggests that in 
Russia oligarchs have ``captured the state,'' shaping the 
policy and legal environment to their advantage at the expense 
of the rest of the country.\26\ The notion of state capture has 
the following components: (1) corrupt individuals have access 
to the resources of the state and are able to exploit these 
resources for their own purposes; (2) the state can only act 
effectively, at least domestically, when its actions do not 
seriously impinge on the power and well-being of the corrupt 
individuals; (3) state institutions can be used as fronts for 
corruption and extortion; (4) it is not clear where the state 
ends and the corrupt private-sector organization begins--or 
vice versa; and (5) the corrupt organization usurps some of the 
functions of the state.
---------------------------------------------------------------------------
    \26\ ``Seize the State, Seize the Day--State Capture, Corruption 
and Influence in Transition,'' Joel S. Hellman, Geraint Jones and 
Daniel Kaufmann, World Bank Institute, September 2000, Policy Research 
Working Paper 2444.
---------------------------------------------------------------------------
    The process of usurping state powers is nowhere more 
obvious than in the areas of business protection and taxation. 
Because the state has not provided legal protection and 
arbitration for licit business, organized crime has filled the 
breach, in effect exploiting lack of state capacity and filling 
the resulting functional holes. Organized crime provides 
contract enforcement and debt collection. In the area of 
taxation, the problem in Russia is that the system is not only 
burdensome and ineffective, but also provides perverse 
incentives for tax evasion and criminal behavior. Businesses 
typically evade taxes; criminal organizations discover this 
(often obtaining information through the banking system) and 
then extort businesses that find it cheaper to pay ``taxes'' 
imposed by criminal organizations than those imposed by the 
Russian state. Consequently, Russia has failed to develop a tax 
base adequate to fund government services in a variety of 
sectors including law enforcement. This then becomes one of 
several interlocking vicious circles: lack of resources makes 
it difficult for the Russian state to combat organized crime; 
in turn organized crime becomes more powerful and acquires more 
resources that would normally accrue to the state. According to 
World Bank Institute analysis, countries with these features, 
such as Russia exhibit increasing concentration of wealth among 
the most corrupt firms, reduction in the ability of the state 
to provide necessary public goods, and weakened economic 
growth.\27\
---------------------------------------------------------------------------
    \27\ Id.
---------------------------------------------------------------------------
    To combat organized crime, most countries adopt a 
conventional, predominantly law enforcement approach, in which 
investigations lead to arrests, arrests to prosecutions, 
prosecutions to trials, and trials to convictions of 
individuals and the eventual dismantling of criminal 
organizations. In the case of organized crime in Russia this is 
patently inadequate. It is necessary to adopt a much broader 
approach aimed at creating a far less congenial environment 
within which organized crime has to operate. In Russia it is 
crucial to establish clear lines of demarcation between public 
and private, legal and illegal, permissible, and impermissible 
activities. In addition, it is necessary to correct a tax 
system that provides perverse incentives for criminality. 
Consideration might also be given to a strategy of 
legitimization that would provide incentives for the inflow of 
flight capital--whether clean or dirty--and for the 
transformation of businesses founded on criminal activity into 
legitimate businesses that would abandon old habits and 
patterns of behavior. In effect, organized crime will be 
impossible to reduce unless major changes are made in both the 
environment and in the payoff structures.
    Putin inherited a Russia with limited institutional 
locations of integrity from which one could theoretically 
construct a decriminalized government. Regional governors, like 
the Duma, heavily intersect with some of Russia's most 
prominent criminals. Institutions like the Procuracy routinely 
lie to western counterparts about the information they have on 
Russian criminals, when the criminals are sufficiently 
prominent.\28\ The Ministry of Internal Affairs (MVD) 
undertakes effective prosecutions of lower-level criminals who 
lack a sufficient krysha or roof to avoid sanctions, and is 
equally effective at investigating the bad acts of oligarchs 
who have been insufficiently adroit with the rulers of the 
day.\29\ However, substantial areas of criminal activity and 
corruption are simply off limits, even to MVD officials who 
would like to enforce the law.\30\
---------------------------------------------------------------------------
    \28\ This phenomenon was most clearly demonstrated in the case of 
Sergei Mikhailov, head of the Solntsevo organization. When the Swiss 
Government asked the procuracy in 1998 for information on Mikhailov's 
criminal activities, which had previously been detailed to the Swiss by 
an MVD general, the Procuracy stated it had no such information. 
Mikhailov was acquitted, and the MVD general was forced to seek asylum 
in Switzerland.
    \29\ The current legal problems in Russia of formerly successful 
oligarch Vladimir Gusinsky provide a vivid recent example.
    \30\ One of the authors had numerous conversations in Moscow in 
1997, 1998, and 1999 with relatively senior Russian officials from 
Russia's foreign ministry, the MVD, the Procuracy, the VEK, the 
Customs, and the Tax Police concerning this issue in the course of his 
work for the State Department. In summary, officials from each of these 
agencies stated that Russia was not yet a normal country, and that 
anyone who put himself at risk as a result of investigating a well-
placed official or oligarch would have far more at risk than merely the 
loss of their job.
---------------------------------------------------------------------------
    One factor in the prevalence of organized crime's 
involvement in Russia's economy is the structural similarity 
between a command economy, operating by force, and criminal 
activity, which similarly relies upon force. Another factor is 
the merger between groups: in Russia it remains often difficult 
to tell who is merely a businessman, and who is a criminal. It 
is not just a matter of appropriate epithets: a careful link 
analysis of the business activities of most of the oligarchs 
show social, economic, and personnel connections with various 
members of the more prominent purely criminal groups, such as 
Solntsevo, Mogilevich, and Ismailov. The difficulty of 
distinguishing between the monopolists, the oligarchs and the 
criminals in Russia was aptly illustrated in the Bank and New 
York/Benex money laundering/capital flight case. The operation 
laundered funds for prominent politicians, oligarchs, and 
criminals alike. The countries of Nauru and Vanuatu performed 
similar functions, laundering the proceeds of narcotics 
trafficking, organized crime, tax avoidance, and theft with the 
same legal and accounting mechanisms.
    Within Russia, resources that once were available to anyone 
with the will and location to secure them have now been 
converted to a more stable form of ownership that remains, 
however, potentially subject to further direction from the 
Russian state, as recent media takeovers have demonstrated. 
These assets were and remain the wealth of a command economy, 
not the wealth of a market economy. Those who converted these 
resources have primarily not been persons operating through the 
mechanisms of a market economy, but rather those operating 
through the decaying infrastructure of the old command economy. 
The persons who secured the wealth have not been faced in 
Russia with a system of rule of law or democracy that would 
confine their activities looking forward. For the reasons set 
forth in the World Bank Institute study, having obtained wealth 
and power, Russian criminals and oligarchs are unlikely now to 
abandon the unfair business techniques upon which they have 
built their empires. Generally, criminals and oligarchs limit 
themselves to legitimate and legal activities to the extent 
that there is no competitive threat to them when they do so. If 
other unfair competitors remain to intrude on their turf, they 
unfairly compete themselves. In Russia, individuals with 
extremely unsavory reputations, such as the Chernoy brothers, 
one of whom became a key figure in the aluminum industry amidst 
a spate of unsolved business killings, wind up having business 
dealings with a wide range of the most powerful and prominent 
people.\31\
---------------------------------------------------------------------------
    \31\ For example, Chernoy was in business with, and sold assets to, 
oligarchs Boris Berezovsky and Roman Abramovitch. The Moscow Tribune, 
February 16, 2000, ``Russian Aluminum--When Politics Melts Metal,'' by 
John Helmer.
---------------------------------------------------------------------------

                  Money Laundering and Financial Crime

    Russia's placement on the list of 15 non-cooperative 
countries by the G-7 in summer 2000 reflected the enormity of 
its money laundering and financial integrity problems. The 
combined lack of transparency and lack of integrity in Russia's 
financial system have made it a sieve for most forms of 
financial abuses, with catastrophic consequences for the safety 
and soundness of Russia's financial system, for Russian tax 
collection, and for sustained foreign investment commensurate 
with Russia's potential economy. These twin problems have 
facilitated not only money laundering and capital flight, but 
unfair competition, abusive business practices, the theft of 
Russian natural resources, the depreciation of the Russian 
ruble against hard currencies, and the creation of a business 
climate that is estimated by foreigners as among the worst in 
the world. Russian elites, including important members of the 
former Communist Party nomenklatura, pro-Western ``reformers,'' 
bankers, brokers, and traders, and heads of criminal 
organizations, have collectively exploited the interface 
between Russian banking after the fall of Communism with the 
global financial services infrastructure of the West to steal 
Russia's wealth and commit massive frauds that have repeatedly 
shaken Russia's financial stability.
    Moreover, the laundering over the past decade of the 
proceeds of stolen Russian resources, profits made through the 
manipulation of and devaluation of the ruble, the proceeds of 
drug trafficking, arms trafficking, prostitution, alien 
smuggling, theft, and extortion, combined with the proceeds of 
capital flight, have made Russia's money laundering problem a 
global one, affecting countries literally all over the world. 
Russian money is laundered in former Communist countries like 
Latvia, Hungary, Slovenia, Poland and Ukraine; in the Middle 
East through Lebanon, the United Arab Emirates and Dubai; 
throughout Western Europe, including substantial amounts of 
activity in Austria, Cyprus and Switzerland; through the 
Russian community based in Israel; through off-shore havens 
such as the British Virgin Islands, Cayman Islands, Isle of Man 
and the Bahamas; through brass-plate institutions in the 
Caribbean (Antigua, Belize, Dominica) and the South Pacific 
(Nauru, Niue, Tonga, Vanuatu); and through and into the world's 
major financial markets in the United States and the United 
Kingdom. Russian money has been also laundered in the 
Seychelles, which has some 600 offshore companies for Russian 
persons and entities, and South Africa, where Russian money 
laundering and illicit finance has become a factor in the 
diamond business. Russian criminal groups involved in money 
laundering have been active in Central America (Costa Rica and 
Panama), engaged in money laundering and criminal activities in 
collaboration with Colombian and Bolivian criminals in the 
cocaine business, and moved into purchasing illicit businesses 
in the Pacific in places such as Thailand and Macao. In short, 
there is evidence of illicit Russian money streaming throughout 
the money-laundering infrastructure of the world, and the 
Russian money has already had some impact in weakening 
regulatory and enforcement structures in many locations, 
especially those involving poorer and smaller governments.
    The persistence of large-scale capital flight, the legacy 
of an intrusive state bureaucracy, underdeveloped market 
institutions and lack of fiscal resources further complicate 
the fight against money laundering in Russia. Thus, Russia's 
money laundering problem is a subset of and simultaneously a 
contributing factor to Russia's governance problem, inexorably 
intermingled with it.
    In Russia, no financial institution has ever been 
sanctioned for laundering money. There remains no system for 
financial services record keeping that is demonstrably enforced 
by bank regulators and no obligations to report the true 
beneficial owner of bank accounts. Elaborate mechanisms have 
been established by Russian financial elites in collusion with 
Russian financial institutions and in some cases with Russian 
officials that have successfully moved billions of dollars a 
year in funds offshore where they cannot be traced. Russia's 
areas of vulnerability and deficiency extend to every aspect of 
its financial services sector, and there may be no other nation 
in which the lack of transparency regarding transfers of funds 
plays a greater role in debilitating its economy. Significant 
areas of special vulnerability include:

        the gray economy, russia's tax system and capital flight

    Russian regulatory and law enforcement officials have 
estimated that the gray economy accounts for some 40 percent of 
the total Russian economy, although other estimates put the 
number as high as 60 percent. Gray economic activity consists 
both of legal activities that are not reported to the tax 
authorities, leaving the income untaxed and unreported, and 
illegal activities, which are also not reported to the state 
and therefore not taxed. The gray economy includes and rewards 
barter, avoids documentation, and facilitates money laundering. 
It in turn has been created in part by Russia's complex tax 
system that has led to an environment in which many businesses 
view total compliance with all assessed taxes and penalties to 
be incompatible with staying competitive. The introduction of a 
flat rate social tax promises to simplify--and thereby 
improve--the tax situation in Russia. One difficulty, however, 
is that the Tax Police has only 7,000 of the 13,000 personnel 
it believes necessary to implement collection and to ensure 
that the funds enter the government budget. The Russian 
business sector's well-developed mechanisms for hiding funds 
from tax authorities will continue to pose a challenge even to 
the best funded enforcement agency.

       poor accounting, auditing, and documentation requirements

    With no properly functioning regulatory mechanisms, such as 
effective banking regulators or an equivalent of the U.S. 
Securities and Exchange Commission, and with poor civil 
enforcement remedies, Russia has lacked mechanisms to develop 
and to demand high standards for accounting, auditing and 
documentation, even as Russia's tax system has driven 
businesses to develop methods for false bookkeeping. The lack 
of authentic documentation, and the ease of developing false 
documents make it easy for Russians to launder money through 
the formal financial services sector, as part of routine 
import-export activity.

prominence and connection of organized crime to officials and official 
                               structures

    As noted above, the chaotic business environment of post-
Communist Russia has facilitated the development of criminal 
organizations, such as the Solntsevo, Ismailov, and Mogilevich 
groups, with close ties to government officials and official 
structures, that provide them protection from enforcement 
activity, through a mechanism sometimes described as a krysha, 
or roof. Significant criminal proceeds are generated in Russia, 
including funds from narcotics trafficking, smuggling, tax 
evasion and tax fraud, arms trafficking, extortion, theft of 
government property, and corruption. The interpenetration of 
government and criminal structures to engage in financial crime 
and corrupt activities provides a favorable condition for money 
laundering.

             rent-seeking activity by government officials

    Low civil service salaries, corruption, the Communist 
heritage, and cultural experience, have provided a foundation 
for widespread payoffs of government officials in exchange for 
economic privileges such as business permits, government 
contracts, exemptions from taxes and customs duties, and 
protection from investigations. Each of these activities plays 
a significant role in Russia's money laundering problem.

                     ease of moving funds offshore

    Collusion between those involved in capital flight, those 
involved in organized crime, those involved in money 
laundering, and Russian's major financial institutions has made 
it easy for criminals to move funds offshore. Russian 
regulatory and law enforcement officials have estimated that 
since independence in December 1991, more than $100 billion in 
illegal proceeds have been generated from criminal activity and 
subsequently laundered. As noted above, criminal funds leaving 
Russia have been transferred to financial institutions in the 
former Soviet Union, especially Latvia, Western Europe, the 
United Arab Emirates, Cyprus, the United States, and throughout 
the world's offshore sector, including some of the havens in 
the South Pacific. The use of correspondent bank accounts in 
foreign banks, in particular in the Baltics, Cyprus and 
offshore zones, has been a significant problem, due to the 
ability of the money launderers to commingle funds from many 
sources through this mechanism.

        inadequate knowledge base, training, government capacity

    Russian law enforcement agencies have very limited 
experience in investigating and prosecuting significant 
financial crime cases, confront problems of integrity, 
training, capacity, and resources, and have to contend with 
uncertain laws, duplicitous sources of potential evidence, and 
major gaps in the overall regime for combating money 
laundering, such as the failure to require currency reporting 
or mandatory suspicious activities report (SAR) reporting.
    In this environment, passage by Russia of comprehensive 
money laundering legislation, as was in process in July 2001, 
constitutes a first step to money laundering reform in what 
would under any circumstances be a lengthy journey.

                      Options for Reform in Russia

    The so-called new Russians who today control the most 
important elements of Russian wealth inherited from the Soviet 
Union, its industries, its raw materials, its lands and its 
infrastructure have demonstrated their ability to seize the 
resources of the former Soviet state. These people have not, 
however, by and large demonstrated a capacity to build, to put 
people to work, to invent, to improve, or to invest and 
maintain that which they have effectively exploited. Rather, 
they are people who were able to exploit politics to obtain 
wealth and power without regard for market integrity, 
transparency, democracy, or rule of law. Strengthened civil 
institutions, greater transparency, and greater market 
integrity all would create opportunities for others with less 
existing power and wealth to become potential competitors with 
the criminals who now control the vast preponderance of 
Russia's wealth. Accordingly, Russia's organized criminals have 
continued to slow the development of such institutions.
    The transformation of Russia from a criminalized country to 
one where free markets and democracy are realities requires 
precisely those steps that most threaten those whose power 
depends on discouraging rule of law: bad businessmen and 
incompetent, corrupt bureaucrats. For Russia to evolve in a 
positive fashion, its government must collect taxes in a fair 
manner, pay its civil service a living wage, maintain an 
adequate number of high caliber professionals in government, 
supplement that government with self-regulatory organizations 
made up of businesses whose owners recognize that a level 
playing field is an essential element for keeping the game 
going, and sanction those who engage in unfair trade and 
business practices. These are formidable challenges for any 
country in transition. In a Russian context, their viability 
remains threatened by most of the more powerful interests with 
power in the country, including the oligarchs and the 
nomenklatura.
    Accordingly, a package of reforms that would begin to 
provide an environment better suited for Russia to combat its 
organized crime problem would include:

                        anti-corruption measures

    Reducing the number of persons in government, increasing 
the salaries of those remaining in government, and creating 
strong disincentives to taking bribes.

                        increased press freedom

    The essential oversight function of an open press remains a 
prerequisite for effective reforms; the recent consolidations 
of Russian broadcasting under the control of the Kremlin has 
the potential for sufficiently impairing oversight by the press 
as to render other anti-corruption measures of little utility.

                          improving tax system

    Strengthening the fiscal position of the federal 
government, through enforcing and collecting federal taxes at a 
sustainable rate. Recent changes to the Russian tax code, 
including a 13 percent flat rate on federal income tax, 
strongly endorsed by the International Monetary Fund, represent 
a potentially positive development.

                  financial sector regulatory reforms

    Creating a modern capital market, strengthening the banking 
system and banking supervision. Russian financial institutions 
continue to operate on a quasi-barter basis, with little long-
term lending to independent borrowers. The Central Bank of the 
Russian Federation (Central Bank of Russia) has had a poor 
track record of safety and soundness regulation and 
supervision. Securities regulation, investor protection, and 
basic elements of corporate governance are further necessities 
for the recovery of the financial sector.

                             legal reforms

    In May 2001, Putin announced his intentions for a sweeping 
reform of the judicial system, which would curb the powers of 
prosecutors and police, introduce jury trials, and increase 
funding for the courts. Creating transparent mechanisms with 
adequate and fair process to resolve both criminal and civil 
cases are essential elements of changing the environment to one 
less likely to facilitate organized crime, by creating the 
possibility of alternatives to private dispute resolution 
systems involving extortion and protection.

                      money laundering legislation

    Russia needs to complete passage of the comprehensive 
preventive law passed by the Duma in July 2001, to create clear 
legal obligations for customer identification and record 
keeping, and a mandatory suspicious transaction reporting 
regime without any monetary threshold. Related reforms would 
include clear legal provisions protecting financial 
institutions from criminal or civil liability in respect of 
disclosures made in good faith; much stricter controls on the 
licensing of banks and exchange houses; a clear timetable for 
the conversion of any existing anonymous accounts into normal 
accounts subject to the usual customer identification 
requirements; regulations issued by the Central Bank of Russia 
to ensure steps are taken to verify beneficial owners when an 
account is opened or a transaction is conducted; and provisions 
to insure that beneficial owners are identified and not hidden 
through intermediaries.

                  Policy Options for the United States

    In the post-World War II period, the United States has had 
a series of well-defined policies toward the Soviet Union, 
which roughly can be divided into the periods of containment, 
during the Stalin through Khruschev period of the cold war; 
competition and co-existence, during the period of Brezhnev 
through Chernyenko; and growing cooperation during the 
Gorbachev era of perestroika and glasnost. Following the 
collapse of the Soviet Union and the ascendancy of Boris 
Yeltsin, U.S. policy could be defined in brief as one of 
constructive engagement, in which the United States 
aggressively and assiduously worked to secure Russian 
integration with the world economy, Russian political, economic 
and legal reform, and democratization.
    Current policy toward Russia in the context of organized 
crime could be seen as containing elements of each of these 
models. Existing U.S. policy in the area of international 
financial regulation, and limitations on the issuance of visas 
to suspected Russian criminals, could be seen as a form of 
containment strategy. Limited new assistance programs and new 
investment by the United States could be viewed as a kind of 
co-existence strategy, one that lives side-by-side with 
individual cases of cooperation in a law enforcement context, 
and constructive engagement through some forms of continuing 
assistance.
    These strategic choices play out in practice through a 
series of policy options for the United States, many of which 
may be seen in the first instance as not relating directly to 
organized crime, but which could have substantial impact on the 
Russian governance issues that most directly would impact 
organized crime. These could include:

   The level and nature of assistance to be offered 
        Russia by the United States, and the kinds of 
        conditions imposed on such assistance. Such assistance 
        could focus on rule of law, democratization, judicial 
        training and reform, civil society and democracy 
        programs, support for an independent press, and 
        corporate governance, among those programs that could 
        potentially have an impact on organized crime. Such 
        programs could potentially be structured with 
        conditionality, so that failures of cooperation or 
        follow-through could result in diminished assistance.
   U.S. policy toward balance of payments support from 
        the International Monetary Fund, and the issue of 
        conditionality. The United States could take the 
        position that further assistance to Russia from the IMF 
        depends on not only the enactment but also the 
        implementation of comprehensive financial services 
        regulatory reforms, with higher standards for auditing 
        and accounting of businesses that include some 
        mechanism for public scrutiny.
   Promoting or limiting direct Russian access to the 
        U.S. financial system. Currently, the Federal Reserve 
        has not authorized Russian entities to carry out 
        banking services in the United States, due to 
        inadequate supervision within Russia. The United States 
        could set down an assessment mechanism and schedule for 
        further consideration of granting Russia greater access 
        to the United States as a result of Russia undertaking 
        further reforms. Alternatively, the United States could 
        consider further limits on access by Russian financial 
        institutions to correspondent banking services by U.S. 
        financial institutions; further enhanced scrutiny under 
        Treasury regulations; or multilateral sanctions, as 
        could be imposed by the Financial Action Task Force as 
        a result of Russian failure to enact and enforce anti-
        money laundering laws.

    Other options for U.S. action that would focus more 
directly on Russian organized crime could include:

   Allocating further resources to the creation of law 
        enforcement and intelligence data bases focused on 
        Russian organized crime;
   Establishing better mechanisms for interagency 
        cooperation within the United States targeting those 
        identified as major Russian organized crime threats;
   Identifying priority cases involving Russian 
        organized crime for investigation and possible 
        prosecution domestically, with resources appropriately 
        configured to ensure appropriate treatment of priority 
        cases.
   Identifying priority cases involving Russian 
        organized crime for bilateral or multilateral or 
        bilateral action involving relevant U.S. law 
        enforcement partners. These could include more focused 
        attention by the United States to take advantage of the 
        capabilities of existing foreign law enforcement 
        institutions, including the European Union's Europol; 
        data bases pertaining to Russian organized crime at 
        INTERPOL; possible further harmonized efforts by the 
        national Customs authorities through the World Customs 
        Organization; or a more case-oriented use of U.S. 
        funded International Law Enforcement Academies, such as 
        the Academy at Budapest. Such efforts could include 
        initiatives aimed at disrupting criminal organizations 
        in situations where prosecution was not feasible.
   Upgrading existing efforts to establish names 
        databases for immigration purposes, to prevent Russian 
        criminals from securing entry into the United States.
   Strengthening programs aimed at responding to the 
        problem of trafficking in women to create a strategy 
        that targets the criminal organizations engaged in the 
        trafficking on an ``end-to-end'' basis, similar to the 
        ``kingpin'' strategy used to combat Colombian cocaine 
        drug traffickers.
   Enacting legislation in the United States to add 
        foreign corruption as a predicate offense to U.S. anti-
        money laundering laws.
   Seizing the assets of Russian criminals through 
        aggressive use of forfeiture laws.
   Publicizing information pertaining to incidents of 
        Russian corruption, theft of resources, or criminal 
        activity, adopting a ``name and shame'' approach that 
        could make it more difficult for Russian criminals to 
        do business in the United States and other countries.
   Imposing higher standards of due diligence for 
        investments involving U.S. guarantee programs or other 
        assistance to insure that U.S. programs do not 
        inadvertently support corrupt individuals or entities.
   Using U.S. law enforcement, diplomatic reporting, or 
        intelligence reporting, to create a black list of 
        persons and entities not eligible for benefits under 
        U.S. guarantee programs, such as those financed by the 
        U.S. Export-Import Bank (Exim Bank) and the Overseas 
        Private Investment Corporation (OPIC).

    Even if these measures are instituted and the United States 
does develop and implement a well-coordinated strategy to 
combat organized crime and corruption in Russia, along with 
dealing with the transnational dimensions of the problem, 
success will be measured incrementally. The problem of Russian 
organized crime and corruption is a Russian problem which the 
United States can try to contain, influence, or combat but 
cannot hope to eradicate.
    Some analysts continue to have a hopeful view regarding 
Russia's ability to combat organized crime. They cite the 
recent passage of a series of economic and political reforms by 
the Duma prior to its summer recess as evidence that under 
Putin, substantial further progress is not only possible, but 
likely. For example, in August 2001, the World Bank's chief 
economist for Russia, Christof Ruehl, told Reuters he was 
``cautiously optimistic, with the accent on optimistic,'' 
regarding Russia's medium-term economic future, due to the 
``good start made on the reform agenda'' by President 
Putin.\32\
---------------------------------------------------------------------------
    \32\ ``World Bank Optimistic on Russian Reforms,'' Reuters, August 
10, 2001; See also ``Russian economy seen more robust, not out of 
woods, Reuters, August 9, 2001, describing the optimistic views of 
various Western businessmen and economists regarding Russian reforms.
---------------------------------------------------------------------------
    If this perspective were to be adopted, it would argue for 
the kind of policy recently articulated by U.S. Secretary of 
the Treasury Paul O'Neill, who has focused on banking reforms, 
trade liberalization, and strengthening of accounting controls 
as mechanisms to strengthen Russia's economy and to bring it 
into line with world standards. Under this approach, the United 
States would work with Russia on a bilateral basis, and with 
the international lending institutions multilaterally, to 
promote good practice in business and in government in Russia's 
regions, as well as in Moscow and St. Petersburg. Secretary 
O'Neill has emphasized the importance of reforms reaching the 
local level in addition to the federal level. Other elements of 
the agenda would include advancing work on WTO accession, 
consulting on market economy status for Russia, cooperating on 
an anti-money laundering law, and exploring new Export-Import 
Bank financing.\33\
---------------------------------------------------------------------------
    \33\ ``How Russia Can Fulfill Its Potential,'' Secretary of the 
Treasury Paul O'Neill, Wall Street Journal, August 9, 2001.
---------------------------------------------------------------------------
    Other analysts, describing Russia as ``Zaire with 
permafrost,'' believe that organized crime has become so 
central to the identity of the post-Soviet Russian state that 
it is unrealistic to expect any Russian Government, whatever 
its rhetoric, to combat organized crime with a sustained and 
systematic strategy. They argue that ``within a few decades 
Russia will concern the rest of the world no more than any 
Third World country with abundant resources, an impoverished 
people, and a corrupt government. In short, as a Great Power, 
Russia is finished.'' \34\ From this perspective, the U.S. 
Government must recognize the limits of the possible. The first 
decade of the Russian transition has underlined the limits of 
western-oriented reforms in a Russian context. Rather than an 
easy transition in Russia to a free market and liberal 
democracy, the Russian transition has featured a state that has 
been both criminalized and corrupt. For such analysts, there 
remain basic questions as to the degree to which Russia may be 
capable of fundamental reform. They point out that organized 
crime and corruption in Russia survived the Czars and outlasted 
the Communist Party, and will be a likely feature of the 
Russian social, political, and economic environment for the 
foreseeable future, regardless of any steps undertaken by the 
United States and other countries.
---------------------------------------------------------------------------
    \34\ See e.g., Jeffrey Tayler, ``Russia is Finished,'' Atlantic 
Monthly, May, 2001.
---------------------------------------------------------------------------
    If this perspective were to be adopted, it might imply a 
possible strategic bifurcation for U.S. treatment of Russia: 
continued engagement with Russia within a national security 
context as a nuclear power and a mixture within the economic 
context of a policy of containment of Russia to protect against 
contagion from inadequate regulatory and law enforcement 
systems, mixed with continued efforts, to be sustained over 
many years, to build a better climate for reform.






               Financial Reform: Taxes, Budgets and Banks


                          TAX REFORM IN RUSSIA



                        By Z. Blake Marshall \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   125
Policy Progress to Date..........................................   128
    Tax Code: part I.............................................   128
    Tax Code: part II............................................   129
Personal Income Tax..............................................   129
Unified Social Fund Tax..........................................   130
Value Added Tax (VAT)............................................   130
Turnover Taxes...................................................   130
The Road Ahead: Next Steps for Policymakers......................   131
    Profits tax..................................................   131
    Customs duties...............................................   133
    Value added tax (VAT)........................................   135
    Administrative procedures....................................   136
    Production sharing agreements (PSAs).........................   137
Conclusion.......................................................   138
                                Summary

    Of all the commercial policy issues brought to the fore 
during Russia's decade-long market transition, one has 
consistently topped the list of investor concerns: the dire 
need for reform of Russia's complex, unpredictable and 
inefficient tax system.
---------------------------------------------------------------------------
    \1\ Dr. Marshall is the Executive Vice President of the U.S.-Russia 
Business Council.
---------------------------------------------------------------------------
    Russia's tax system remains a major obstacle to foreign 
investment and to business activity more generally, cited time 
and again by companies as a primary obstacle impeding their 
business plans, deterring new market participants and 
constraining Russia's considerable economic potential. The 
number of taxes with which a firm must comply, coupled with a 
perpetually changing compliance regime, leaves companies 
operating in an atmosphere of uncertainty that compromises 
business planning. Dating from the excess-wage tax controversy 
of the mid-1990s (which was ultimately abolished under pressure 
from business groups), corporate attitudes have reflected 
continual attempts to combat the imposition of a (often 
redundant) new tax, an arbitrary interpretation of an existing 
obligation, or capriciousness and harassment in the audits and 
penalties realm.
    As Organization for Economic Cooperation and Development 
(OECD) analysts point out, the difficulties experienced by 
businesses have not primarily been a function of the rates 
prescribed by law: ``Statutory tax rates were in fact not very 
high by world standards--other than in the case of wage taxes--
even before the recent tax reform. It has been more a question 
of the multitude of different taxes levied and, primarily, the 
methods of determination of the actual tax base.'' \2\
---------------------------------------------------------------------------
    \2\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, 2001, p. 121.
---------------------------------------------------------------------------
    Efforts to rationalize and streamline the tax system are 
inextricably linked to the country's fiscal health, as 
collection difficulties have plagued Russia's attempt to 
balance its social commitments and foreign debt burden, topics 
that are addressed elsewhere in this volume. Thus policy and 
rate revisions have an impact on compliance--a widening of the 
tax base that complements reforms aimed at improving tax 
administration and enforcement.
    Given this dual importance, the business community has been 
encouraged by the significant steps forward that Russia has 
made in the past 2 years. For the better part of a decade, the 
average company operating in Russia has been responsible for 
deciphering and complying with a combination of roughly 50 
taxes and social fund payments levied at the federal, regional 
and local levels. As a result of tax reforms put into effect 
for 2001, that number has been cut in half.\3\
---------------------------------------------------------------------------
    \3\ Ibid., p. 23.
---------------------------------------------------------------------------
    This progress has not gone unnoticed in the business 
community. A recent Economist Intelligence Unit survey of 100 
multinational companies operating in Russia found that two-
thirds of the firms polled believe Russia's tax environment to 
be improving, with a mere 5 percent of the opinion that it is 
getting worse. It is not difficult to imagine that statistic's 
relationship to another telling data point: More than 80 
percent of the respondents reported making a profit last year 
(and greater than half of them expect their 2001 sales to grow 
between 10 and 25 percent).\4\
---------------------------------------------------------------------------
    \4\ Reuters, April 11, 2001.
---------------------------------------------------------------------------
    Regarding the budgetary impact of recent reforms on a gray 
economy pegged at 30 percent, Deputy Minister of Economic 
Development and Trade Arkady Dvorkovich recently commented that 
``half of these companies might come out from the shadows 
purely thanks to tax reform.'' \5\ The early evidence this year 
supports this and similarly optimistic projections, as the 
government's collection rate rose to 90 percent in the first 
quarter of 2001, compared to only 60 percent in the first 
quarter of last year.\6\
---------------------------------------------------------------------------
    \5\ St. Petersburg Times, June 13, 2001.
    \6\ Associated Press, April 5, 2001.
---------------------------------------------------------------------------
    The amounts collected have soared in tandem, as receipts 
for the first quarter of 2001 grew 36 percent year on year.\7\ 
In addition to the increased receipts, ``the federal government 
has managed the difficult task of collecting all taxes in cash 
since the second quarter of 1999. This contrasts with a strong 
reliance on various money surrogates in the past.'' \8\ Figure 
1 portrays the steady climb in tax revenue as a percentage of 
gross domestic product (GDP), an important indicator of the 
Russian Government's fiscal health.
---------------------------------------------------------------------------
    \7\ Agence France Presse, April 22, 2001.
    \8\ OECD Policy Brief, Economic Survey of the Russian Federation, 
March 2000, p. 5.
---------------------------------------------------------------------------
    Furthermore, there are clear indications that, contrary to 
the policy stagnation and stalled reforms that characterized 
much of the late 1990s, the Putin Administration is taking this 
issue seriously and is committed to building on recent 
successes. Minister of Economic Development and Trade German 
Gref is clear on the priority affixed to tax reform initiatives 
for 2001: ``Our plans for this year can best be described as 
Napoleonic--we would like, above all else, to complete the next 
phase of tax reform.'' \9\ With further reforms pursued in 
2001-2002, this next phase will determine whether the Putin 
team meets its goal of lowering the nominal tax burden from 43 
percent to 35 percent of GDP by the end of 2003.\10\
---------------------------------------------------------------------------
    \9\ Gref, German O. Speech to the U.S.-Russia Business Council, 
April 3, 2001.
    \10\ Bush, Keith. The Russian Economy in June 2001, p. 21.

---------------------------------------------------------------------------
    FIGURE 1._RUSSIAN GOVERNMENT TAX REVENUE AS A PERCENTAGE OF GDP

[GRAPHIC] [TIFF OMITTED] T6171.026


  * Preliminary data for the first quarter of 2001.

  Source: Ministry of Finance of the Russian Federation.

    This paper will discuss the nature of Russia's tax system 
from the perspective of business interests. In doing so, it 
will document the progress Russian officials have made in 
adopting constituent pieces of the Tax Code, as well as the 
remaining tax policy and tax administration challenges that are 
key to Russia's realization of its economic potential.
    The progress to date covers both the enactment of part I of 
the Tax Code and the adoption and implementation of significant 
pieces of part II, including what could be fairly characterized 
as a radical liberalization of the income tax, social funds and 
turnover tax regimes. The adoption of four key chapters of part 
II last year has set the stage for further legislative progress 
on the profits tax--which, as discussed below, passed its 
second reading in the state Duma just prior to the summer 
recess--and other significant areas of importance to Western 
business.
    Beyond the realm of rates and policies, the system of 
interpreting and implementing legislation must also be 
addressed. A key determinant of the system's evolving fairness 
and transparency is the extent to which Russia's 180,000 tax 
inspectors across the country adhere to uniform standards 
applied on a consistent basis. The same consistency should be 
fairly expected at the federal level from the Ministry of Taxes 
and Levies. For several years now, the system of auditing 
taxpayers has relied upon targeting law-abiding foreign 
companies when revenue shortfalls have to be remedied. Clearly, 
Russia must strive to bring pure tax evaders into the system, 
rather than repeatedly targeting firms that are willing to 
comply with a stable, predictable system.\11\
---------------------------------------------------------------------------
    \11\ U.S.-Russia Business Council and American Chamber of Commerce 
in Russia, Commercial Engagement with Russia: Policy Recommendations 
for the Bush Administration, March 2001.
---------------------------------------------------------------------------

                        Policy Progress to Date

                            tax code: part i

    Part I of the Tax Code, the ``tax constitution'' of Russia, 
consists of 142 articles that outline basic principles, key 
definitions, and rights and responsibilities.\12\ In codifying 
the relationships between taxpayers and the tax authorities, 
part I has had a far-reaching effect on the way the tax system 
is perceived, favorably impacting the business environment and 
inspiring increased company confidence. For the first time in 
its post-Soviet transition, Russia has arrived at a legislative 
framework with a fairer balance between the tax authorities and 
taxpayers. By clearly setting forth taxpayer rights and 
official responsibilities, it rid the system of unclear appeals 
procedures as well as a variety of punitive sanctions levied 
without recourse.
---------------------------------------------------------------------------
    \12\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 115.
---------------------------------------------------------------------------
    The changes brought about by implementation of part I, 
which came into force in January 1999, included several 
important provisions concerning both tax relief and 
enforcement. For example, part I took the bold step of 
reversing, in effect, the burden of proof in tax dispute 
between the tax authorities and the taxpayer--the latter is now 
presumed innocent until proven otherwise. The rights of the 
taxpayer include protection against arbitrary penalties not 
justified by the tax authorities in a court of law, placing the 
burden squarely on the Russian Government to prove taxpayer 
liability. The 19 penalties prescribed in part I are much less 
severe than their predecessors, and they also attempt to 
differentiate between ``negligent'' or ``intentional'' behavior 
and violations due to other mitigating circumstances.\13\
---------------------------------------------------------------------------
    \13\ Ibid., p. 140.
---------------------------------------------------------------------------
    Part I of the Code also included a provision allowing 
companies to transfer certain assets to newly established 
subsidiaries as they undergo restructuring. Previously, these 
asset transfers were taxable because they were considered 
trading transactions. That is no longer the case, except in 
circumstances where there are sufficient grounds to prove that 
the restructuring process was designed purely as an instrument 
for tax evasion.\14\
---------------------------------------------------------------------------
    \14\ American Chamber of Commerce in Russia Tax Committee, informal 
memoranda, March 1999.
---------------------------------------------------------------------------
    Also important to companies operating in Russia was the 
elimination of tax restrictions on sales below cost. Originally 
intended to curb tax evasion, these measures instead had a 
debilitating effect on manufacturers. Their removal allows law-
abiding firms to pursue flexible marketing strategies that 
include selling at a loss.
    As a result of the part I implementation, tax collection 
has become the liability of the so-called agent who controls 
the source of the taxable payments (such as an employer, in the 
case of income tax). Prior to 1999, companies could simply 
refer the tax authorities to an entity that received a payment, 
thereby making tax collection difficult, if not impossible, if 
the receiving company happened to be located outside of Russia. 
The revamped policy establishes that an agent that fails to 
transfer the requisite duties can be fined 20 percent of the 
amount due.\15\
---------------------------------------------------------------------------
    \15\ Ibid.
---------------------------------------------------------------------------
    Finally, part I also revised the definitions that apply to 
terms such as the ``arm's length principle,'' ``related 
parties,'' and ``market price.'' These concepts were either 
undefined or received minimal treatment in the preexisting 
Russian legislation. Thus part I of the Tax Code sought to 
limit the tax-reduction tactics available to Russian companies 
via transfer-pricing schemes that allowed subsidiaries to 
minimize taxable profits and offshore parent firms to pay rates 
lower than their Russian equivalent.\16\ The stricter 
definitions contained in part I allow officials to examine 
contracts to ensure that related companies (defined as having 
more than 20 percent cross-ownership) are acting in accordance 
with market conditions (acceptable percentage variations 
established for prices charged) and not engaging in tax 
evasion. During the state Duma's fall session, the Ministry of 
Finance plans to introduce further amendments to part I 
pertaining to transfer pricing.\17\
---------------------------------------------------------------------------
    \16\ Ibid.
    \17\ Interfax, May 29, 2001.
---------------------------------------------------------------------------

                           tax code: part ii

    Several important chapters of part II of the Tax Code were 
adopted last summer by the Federal Assembly and signed by 
President Putin on August 6, 2000. When they came into force on 
January 1 of this year along with a law on implementing 
instructions for part II, these chapters signified a huge 
stride forward in Russia's efforts to rationalize it tax system 
and make it more closely conform to international practice.
    To put the magnitude of these accomplishments into 
perspective, the four chapters adopted covering the flat income 
tax, social taxes, excise taxes, and the value added tax (VAT) 
represent 60 percent of the revenue side of Russia's ledger, 
and revenues from these four line items increased by 60 percent 
through the first 5 months of 2001 on a year-on-year basis.\18\ 
As Figure 2 indicates, when the profits tax is added in, these 
taxes account for roughly three-fourths of Russia's tax 
revenue. In addition, companies welcomed a long-awaited 
reduction in turnover taxes. Several of these sweeping changes 
are described below.
---------------------------------------------------------------------------
    \18\ Ministry of Economic Development and Trade; and Interfax, June 
13, 2001.
---------------------------------------------------------------------------

                          Personal Income Tax

    Perhaps the most attention has been given to the Russian 
Government's introduction of a 13 percent flat income tax in 
place of progressive rates ranging from 12 to 30 percent. The 
new flat tax generated an immediate impact as soon as it took 
effect, as income tax revenues increased by 70 percent in the 
first quarter of 2001 compared to the fourth quarter of last 
year.\19\ According to Minister of Finance Aleksei Kudrin, 
through the first 5 months of 2001, collections of the income 
tax were up 52 percent over the comparable period in 2000.\20\
---------------------------------------------------------------------------
    \19\ Gref, op. cit.
    \20\ RIA Novosti, June 19, 2001.

---------------------------------------------------------------------------
       FIGURE 2._TAX REVENUES AS A PERCENTAGE OF THE 2000 BUDGET

[GRAPHIC] [TIFF OMITTED] T6171.025


  Source: Audit Chamber of the Russian Federation.

                        Unified Social Fund Tax

    The adoption of the unified social fund tax integrated four 
previously separate budgetary line items into one, a move that, 
according to Minister Gref, ``had wonderful anti-corruption 
consequences, making the revenue and expenditure sides of these 
funds more transparent.'' \21\ In place of the previous 39.5 
percent flat rate, the new rates follow a regressive scale from 
35 percent down to 5 percent.
---------------------------------------------------------------------------
    \21\ Gref, op. cit.
---------------------------------------------------------------------------

                         Value Added Tax (VAT)

    Several improvements to the VAT--the stable source of one-
third of Russia's tax revenue (see Figure 2 above)--were 
introduced with the adoption of chapter 21 of part II last 
year. Among the most important is the new exemption on capital 
construction that took effect on January 1. This provision 
eliminated the previously unrecoverable 20 percent charge on 
capital investment in Russia, and its adoption was influenced 
by several years of sustained engagement on the part of both 
the U.S. Government and Western business groups.

                             Turnover Taxes

    Turnover taxes such as the housing fund tax and the road 
users tax have for many years been the primary example of 
Russia's penchant for taxes based on gross revenues rather than 
profits. These charges have long acted as a major disincentive 
to investment, as they disproportionately impact new businesses 
and those running operating losses. The conceptual underpinning 
of turnover taxes encourages businesses to understate or 
suppress their actual revenues, thereby gravitating into the 
infamous shadow economy. This of course distorts competition by 
shifting the relative tax burden onto those companies that 
comply in a straightforward manner.
    Last year, the Putin team sought the complete elimination 
of turnover taxes but was forced into a compromise to 
orchestrate legislative approval of its tax package. Their 
overall reduction from 4 percent to 1 percent represented the 
outright elimination of the housing tax (1.5 percent) and a 
decrease in the road tax from 2.5 percent to 1 percent until 
its planned abolition in 2003.\22\ In his annual address to the 
Federal Assembly in April, President Putin stressed that ``our 
strategic priority today is the consistent lowering of taxation 
on non-rental income and the final elimination of the turnover 
tax.'' \23\
---------------------------------------------------------------------------
    \22\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 123.
    \23\ Putin, Vladimir V. State of the Nation Address to the Federal 
Assembly, April 3, 2001.
---------------------------------------------------------------------------

              The Road Ahead: Next Steps for Policymakers

    This section elaborates on additional strands of Russian 
tax reform, picking up where last year's accomplishments left 
off. What are the next steps as perceived by the business 
community, and what are the relative priorities identified by 
the Putin Administration? In terms of the work remaining to be 
done by the Russian Government to build on last year's 
momentum, this section will focus on five key areas: profits 
tax, customs duties, VAT, tax administration concerns, and tax 
provisions associated with production sharing agreements (PSAs) 
in the energy sector.

                              profits tax

    Companies active in the Russian market have for several 
years urged the Russian Government to move away from a variety 
of revenue-based methods of taxation. One of the primary focal 
points in this campaign has been an effort to make net profit, 
as defined by international norms, the basis on which firms 
calculate the profits tax. The level of taxation is not the 
root of the problem, as Russia's current 35 percent rate (43 
percent for financial services firms) is on par with, or even 
less than, the corporate rates in other industrialized 
countries.\24\
---------------------------------------------------------------------------
    \24\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 125.
---------------------------------------------------------------------------
    Despite a multi-year lobbying effort to allow widely 
accepted business deductions, the profits tax is still not 
payable on net profit. Advertising costs, training expenses, 
business travel, loan financing, and depreciation allowances 
are only deductible within very restricted norms. For example, 
deductible domestic travel expenses are capped at $11.40 per 
day, and depreciation schedules far exceed the economic life of 
certain assets (e.g., buildings spread over 250 years).\25\ As 
a result, as a recent OECD study points out, ``the tax base for 
the Russian profits tax has been and still is larger than the 
comparable corporate tax base in other industrialized 
countries, often resulting in a higher . . . effective profits 
tax rate than the nominal statutory rate.'' \26\
---------------------------------------------------------------------------
    \25\ Ibid., pp. 126-127.
    \26\ Ibid., p. 23.
---------------------------------------------------------------------------
    Fortunately, relief is on the way. The Putin Administration 
has sought to build on last year's successes by overhauling the 
profits tax to stimulate business activity and recapture firms 
from the shadow economy, making this initiative the top tax-
related priority for 2001.
    In what Deputy Finance Minister Sergei Shatalov referred to 
as an ``essential measure that can bring about revolutionary 
changes in Russia,'' the state Duma voted just prior to the 
summer recess to approve, by a vote of 339 to 6, chapter 25 of 
part II of the Tax Code, ``On the Tax of Profit of 
Organizations.'' \27\ The passage of this second reading, the 
most critical of the three readings, means the bill is expected 
to sail through third reading ratification early in the fall 
session and should be signed into law to take effect on January 
1, 2002.
---------------------------------------------------------------------------
    \27\ Agence France Presse, June 22, 2001.
---------------------------------------------------------------------------
    In addition to business-friendly provisions pertaining to 
thin capitalization rules and depreciation of fixed assets, the 
bill has produced two major accomplishments that will have a 
far-reaching impact on bottom-line performance when enacted 
next year: a considerable rate reduction and full deductibility 
of legitimate business expenses. In allowing deductions for all 
``necessary, reasonable and documented'' expenses, the new law, 
according to Ernst & Young's Peter Arnett, ``is moving away 
from the prescriptive Soviet approach, moving expense 
deductibility from an exclusive list to an inclusive list.'' 
\28\
---------------------------------------------------------------------------
    \28\ St. Petersburg Times, op. cit.
---------------------------------------------------------------------------
    Furthermore, companies have been urging the Russian 
Government to promote both purchased and leased capital 
investments. To do so, financing and depreciation norms have to 
be revised, so that businesses are allowed to expense the full 
cost of fixed or leased assets over a period that reflects the 
economics of the transaction.\29\
---------------------------------------------------------------------------
    \29\ U.S.-Russia Business Council and American Chamber of Commerce 
in Russia, op. cit.
---------------------------------------------------------------------------
    The final product, which lowered the tax rate from 35 
percent to 24 percent, was yet another example of executive-
legislative compromise. The Putin Administration, mindful that 
each percentage point reduction equates to 25 billion rubles 
(approximately $850 million) in foregone revenue, had sought to 
lower the rate to 25 percent.\30\ The government proposal 
called for 8 percent to be allocated to the federal budget and 
the remaining 17 percent shared among regional and local 
budgets, while regions would be allowed to reduce the rate by 
up to 3 percent.\31\ The formula currently in effect allocates 
11 percent to the federal budget, with 19 percent going to 
regions and 5 percent to localities. However, some regions 
waive all but a fraction of a percentage point as an investment 
and company registration incentive.\32\
---------------------------------------------------------------------------
    \30\ Interfax, June 20, 2001.
    \31\ Financial Times, June 20, 2001.
    \32\ Ibid.
---------------------------------------------------------------------------
    Many in the state Duma, including a majority of the Budget 
Committee, had favored setting the rate at 23 percent, while 
retaining tax privileges and investment incentives opposed by 
the Ministry of Finance. Ultimately, the government agreed to 
split the difference, settling on the 24 percent rate in 
exchange for the removal of the investment deduction and other 
exemptions. Of that amount, 7.5 percent will go to the federal 
government and 14.5 percent to the regions, with the remaining 
2 percent allocated to local budgets.\33\ An incentive 
provision allowing regions to reduce the tax by as much as 4 
percentage points was also part of the compromise version that 
passed.\34\
---------------------------------------------------------------------------
    \33\ Oganes Sarkisov, Taxation of Businesses in Russia: An Update, 
July 6, 2001.
    \34\ Troika Dialog, Duma Spring Term Report, July 2001.
---------------------------------------------------------------------------
    Businesses will feel the immediate impact of this changed 
environment in 2002, as the Finance Ministry estimates the 
enactment of the profits tax chapter will reduce the overall 
tax burden by some 100 billion rubles, or 1.1 percent of 
GDP.\35\ As Steve Henderson, a tax partner at Deloitte & Touche 
puts it, ``there seems to be a race on to see how much the 
economy will move when the profits tax rate is lowered. 
Globally, there is a tendency toward more consumer-based tax 
regimes. Companies will have more of their money available to 
invest and optimize operations.'' \36\ The direct correlation 
to investment growth is striking--according to Alfa Bank, over 
half (54 percent) of capital investment in Russia is funded by 
company profits, while bank financing accounts for only 3 
percent.\37\
---------------------------------------------------------------------------
    \35\ Interfax, April 5, 2001.
    \36\ St. Petersburg Times, June 19, 2001.
    \37\ St. Petersburg Times, June 13, 2001.
---------------------------------------------------------------------------
    And, as Minister Gref points out, the Russian Government 
will reap the rewards as well: ``we have taken a long time 
discussing this law with our businesses and with the State 
Duma, and if this law is passed, it will provide a great 
stimulus to our economy. We expect to increase revenue by 1.75 
percent of GDP.'' \38\ The importance of the profits tax to the 
Russian federal budget is depicted in Figure 3.
---------------------------------------------------------------------------
    \38\ Gref, op. cit.
---------------------------------------------------------------------------

                             customs duties

    Russia's customs regime is an area where tremendous 
progress has been made but significant challenges remain. The 
issues described below continue to hamper business activity and 
compromise the system's potential for revenue collection.
    Customs duties evasion is a major policy dilemma for the 
Russian Government as well as for competition in the 
marketplace. Tax evasion on goods coming in across the border 
costs the Russian Government billions of rubles in lost in 
revenue. In addition, gray-market imports that avoid paying 
customs duties are clearly less expensive than their 
domestically produced counterparts and legitimate foreign 
imports. This illustrates yet another example of instances in 
which companies that comply are competitively disadvantaged, as 
the prices of their products obviously reflect higher 
importation costs.
    As Russia seeks to become increasingly integrated into the 
global marketplace, it will have to ameliorate the conditions 
encountered in cross-border trading activity: overly complex 
and contradictory clearance procedures, ambiguous legislation 
pertaining to goods classification, and--most troubling in some 
respects--the threat of retroactive reassessment of goods 
imported many years ago. These issues introduce additional 
risks and costs that often alter the commercial terms of the 
original trade transaction.\39\
---------------------------------------------------------------------------
    \39\ U.S.-Russia Business Council and American Chamber of Commerce 
in Russia, op. cit.

---------------------------------------------------------------------------
    FIGURE 3._PROFITS TAX REVENUE AS A PERCENTAGE OF FEDERAL BUDGET

[GRAPHIC] [TIFF OMITTED] T6171.024


  Source: Ministry of Finance of the Russian Federation.

    Indeed these issues, and a variety of tariff barriers that 
are out of sync with international norms, implicate Russia's 
accession to the World Trade Organization (WTO). Their WTO 
relevance has provided an impetus to the Putin Administration's 
pursuit of customs reform. In January, the Russian Government 
reduced duties on one-fourth of all goods coming into the 
country, a measure that yielded a 25 percent revenue surge in 
the first quarter of 2001 compared to the fourth quarter of 
last year.\40\
---------------------------------------------------------------------------
    \40\ Gref, op. cit.
---------------------------------------------------------------------------
    Importantly, the Russian Government has also taken steps to 
unify and recategorize import duties, a move that has greatly 
simplified the quest to comply with customs procedures and may 
help reduce both customs corruption and gray-market activity. 
Minister Gref has labeled the 30 percent reduction in 
classification line items (from 13,500 to 9,500) ``an absolute 
revolution in customs tariffs'' that will yield substantial 
benefits in the battle against corruption.\41\
---------------------------------------------------------------------------
    \41\ Ibid.
---------------------------------------------------------------------------
    Despite these recent accomplishments, much work remains for 
Russia to fashion a customs regime that will facilitate--not 
hinder--its aspirations to become a full participant in the 
global economy. The concrete objectives for the remainder of 
this year and into 2002 include codification of chapter 26 of 
part II of the Tax Code and the adoption of a new Customs Code.
    President Putin himself has emphasized the importance of 
continued customs reform: ``measures have already been taken to 
simplify and lower the level of import tariffs, but this is 
insufficient. A radical change in the system of customs 
administration is necessary. The main task of the year in this 
sphere is the approval of a new Customs Code, moreover as a law 
that has direct force. Naturally, the code must correspond to 
the norms of the World Trade Organization (WTO), accession to 
which remains our priority.'' \42\
---------------------------------------------------------------------------
    \42\ Putin, op. cit.
---------------------------------------------------------------------------

                         value added tax (vat)

    The VAT is intended to be a levy charged to the final 
consumers of goods and services, not to firms producing these 
goods and services. Like the profits tax, its 20 percent rate 
and other statutory features make the Russian VAT not terribly 
unlike European variants, at least in theory: ``Despite its 
superficial similarity to other countries' VAT laws, however, 
the Russian VAT does not function in a manner consistent with a 
traditional VAT.'' \43\
---------------------------------------------------------------------------
    \43\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 129.
---------------------------------------------------------------------------
    In order to fulfill its intended purpose, businesses should 
collect and pay VAT to the Russian budget at each stage of 
production, and it should not be a cost to businesses 
themselves. Unfortunately, despite last year's amendments to 
the VAT Law, this is still not the case in Russia. Companies 
continue to grapple with a limited ability to fully credit VAT 
on purchases, making the Russian variant, in effect, a tax on 
production: ``The result is that the effective VAT rate is 
usually greater than the statutory VAT rate and becomes a cost 
to business.'' \44\
---------------------------------------------------------------------------
    \44\ Ibid., p. 24.
---------------------------------------------------------------------------
    For several years, companies in Russia have been required 
to charge VAT on all exports to other Commonwealth of 
Independent States (CIS) countries. Charging VAT at the point 
of origin on intra-CIS trade, unlike the practice in other CIS 
countries, hinders the export operations of Russia-based 
manufacturers and limits investment in Russia, as it decreases 
Russia's attractiveness as a manufacturing base for exports to 
CIS markets. Russia's past reluctance to move away from the 
point-of-origin principle in favor of the destination principle 
(having refused to ratify a CIS protocol) has in part reflected 
serious concern over revenues derived from oil, gas and 
electricity sales Russia's CIS neighbors.\45\
---------------------------------------------------------------------------
    \45\ U.S.-Russia Business Council and American Chamber of Commerce 
in Russia, Commercial Issue Briefs, June 2000.
---------------------------------------------------------------------------
    Fortunately, as a result of lobbying efforts by both the 
Russian private sector and foreign investors, Russia has 
recently acted to remedy this problem. Moving to the 
destination principle for intra-CIS trade, effective July 1 of 
this year, affords Russia the opportunity to encourage 
manufacturers to build and expand facilities in Russia to 
supply CIS markets, thereby deriving the direct economic 
benefits of job creation and budgetary revenues.
    Resolving several remaining issues would make the VAT 
system more transparent and therefore better understood by 
investors. As a result, businesses would be discouraged from 
avoiding VAT payments, which would be collected more easily 
from the end consumer (who has fewer means of tax evasion). 
Following are several examples of the difficulties encountered 
by businesses.

   While last year's changes contained in part II 
        provide that VAT is creditable when paid on certain 
        nondeductible business expenses, such is not the case 
        in practice.\46\ VAT should be recoverable on all 
        genuine business expenses (e.g., advertising) 
        irrespective of their treatment for other accounting 
        purposes (e.g., profits tax calculation).\47\
---------------------------------------------------------------------------
    \46\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 131.
    \47\ U.S.-Russia Business Council and American Chamber of Commerce 
in Russia, Commercial Issue Briefs, op. cit.
---------------------------------------------------------------------------
   There continues to be a considerable difference 
        between the provision of VAT refunds in theory and in 
        practice. Business experience has shown that a legal 
        entitlement to a VAT refund is not correlated to the 
        timely issuance of that refund, if it is processed at 
        all. Certain companies such as PSA investors, start-ups 
        and export-oriented firms encounter great difficulties 
        in collecting their refunds notwithstanding the 
        unambiguous provisions in both part I of the Tax Code 
        and the VAT Law. Prior to last year's adoption of 
        chapter 21 of part II, interest did not accrue on the 
        refund amounts due, and firms were not permitted to 
        offset these refunds owed against other current tax 
        liabilities. Provisions were introduced beginning in 
        January of this year to address these deficiencies, but 
        they have not yet been widely tested in practice.\48\
---------------------------------------------------------------------------
    \48\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 132.
---------------------------------------------------------------------------
   Interpretation of VAT-related legislation still 
        lacks clarity and consistency (e.g., rules pertaining 
        to when cross-border services are subject to VAT).\49\
---------------------------------------------------------------------------
    \49\ U.S.-Russia Business Council and American Chamber of Commerce 
in Russia, Commercial Issue Briefs, op. cit.
---------------------------------------------------------------------------
   Finally, because the requirement of moving from a 
        cash basis to an accruals basis for VAT poses 
        substantial costs to businesses on a cash-flow basis, 
        consideration should be given to easing the practical 
        burden of this transition.\50\
---------------------------------------------------------------------------
    \50\ Ibid.
---------------------------------------------------------------------------

                       administrative procedures

    While the Russian Government's commitment to tax reform is 
evidenced by numerous recent improvements in legislation, the 
application of Russian tax law remains inconsistent and 
arbitrary. The OECD highlights three factors that contribute to 
this situation: a lack of modernization such as computers to 
track accounts, inadequate training of tax inspectors, and 
limited knowledge of market-oriented tax policy on the part of 
Russian judges.\51\ Clearly, practical measures in these areas 
could yield substantial dividends.
---------------------------------------------------------------------------
    \51\ OECD, The Investment Environment in the Russian Federation: 
Laws, Policies and Institutions, op. cit., p. 24.
---------------------------------------------------------------------------
    In terms of the appeals process, the recourse available to 
companies is twofold. Firms can pursue an administrative appeal 
through channels of higher local, regional and federal 
authorities, or seek redress through a court action.\52\ 
Because there are no tax courts per se in Russia, tax disputes 
involving businesses are currently addressed in arbitration 
courts, where companies have been enjoying ever greater 
success: ``Although precise statistics are not available, it is 
estimated that taxpayers win over 50 percent of cases involving 
disputes with the tax authorities.'' \53\
---------------------------------------------------------------------------
    \52\ Ibid., p. 141.
    \53\ Ibid., p. 141.
---------------------------------------------------------------------------
    The Russian Government could demonstrate progress in the 
area of tax administration by focusing on three key issues:

   The federal government should promote greater 
        consistency by exercising central control over regional 
        tax bodies that adopt inconsistent interpretations and 
        apply inappropriate pressure on firms in their quests 
        for additional revenue.
   While this year's modifications to the VAT regime 
        ameliorated many previous inadequacies, it has not 
        solved the problems concerning repayment of excess VAT 
        persist--the tax authorities must take steps to ensure 
        that refunds are available with minimum delay.
   Finally, an effective mechanism for tax appeals 
        outside of the court process is sorely needed. A 
        central ombudsman or a dispute resolution center would 
        dispense with relatively uncomplicated tax disputes 
        more efficiently and consistently than current 
        administrative practice.

                  production sharing agreements (psas)

    Russia's tax-related progress in support of a viable PSA 
regime has lagged behind its counterparts in the tax reform 
process. Exploiting the current window of opportunity offered 
by high oil prices means ensuring that the new Tax Code will 
work fairly and efficiently with respect to investors in the 
energy sector. Specifically, Russian policymakers should follow 
through on the enactment of the PSA law with specific Tax Code 
provisions that support the PSA tax rules.
    The Russian Government pledged to introduce the relevant 
chapter of part II of the Tax Code by June 20. The draft given 
a first reading in the state Duma prior to the summer recess, 
however, was the Duma's version, not the draft under 
development by the Ministry of Economic Development and Trade. 
It met with strong objections by some deputies and executive 
branch colleagues striving to make the PSA regime operational. 
It remains unclear whether this Duma draft will be heavily 
amended or another draft might be substituted and introduced in 
the fall session.
    It is equally critical that other new chapters of the Tax 
Code reaffirm, rather than contradict, the tax regime currently 
contained in the PSA law. Another possible test looming for the 
fall session involves the draft of chapter 27 concerning 
taxation of natural resource production, which is designed to 
supercede the mineral replacement tax and certain royalty 
payments to the Russian Government.

                               Conclusion

    Russian tax reform has a beleaguered history over the past 
decade, with conflicts within the Duma and between the 
legislative and executive branches slowing progress to a near 
halt for certain intervals in the 1990s. For the most part, the 
failure to move more expeditiously in establishing a fair, 
stable and transparent tax system has not been caused by a 
knowledge deficit concerning the problems and their solutions: 
``Russian policymakers and experts drafted a new Tax Code based 
on such principles as early as 1993, but this and subsequent 
reform initiatives have for many years been mired in political 
controversy, both at the federal and regional level, often 
becoming hostage to other political bargains.'' \54\
---------------------------------------------------------------------------
    \54\ Ibid., p. 122.
---------------------------------------------------------------------------
    Thankfully, the commercial policy area that has caused 
businesses the greatest frustration during Russia's market 
transition is now also exhibiting some of the most successful 
policy initiatives and concrete accomplishments. The Finance 
Ministry's Chief of Tax Policy, Alexander Ivaneyev, projects 
that the Russian Government will push through the final phase 
of tax reform in 2002, with the adoption of measures covering 
property taxes, the use of natural resources and a single 
agricultural tax to act as a companion to the profits tax.\55\
---------------------------------------------------------------------------
    \55\ Interfax, May 29, 2001.
---------------------------------------------------------------------------
    To be sure, remaining tax, corporate governance and other 
structural reforms lend a cautionary note to the optimism 
unfolding in the business community. But the recent track 
record on tax reform may help Russia finally close the chapter 
on its post-crisis recovery--debates over lingering devaluation 
dividends and exogenous factors such as commodity prices 
notwithstanding--and begin a new chapter featuring truly 
sustainable, diversified economic growth.
    According to Peter Westin, chief analyst at ATON Investment 
Bank in Moscow, when the income tax set at 13 percent combines 
with a profits tax of 24 percent beginning next year, Russia 
will suddenly have one of the lowest marginal tax rates in the 
world.\56\ And the revenue benefit from increased compliance 
and overall economic activity could be precisely the boon the 
Russian Government needs to help manage its roughly $30 billion 
debt burden in 2002-2003. Though the reduction in Russia's 
profits tax is not as dramatic, the Irish rate-cutting example 
of a decade ago helps to illustrate the potential. When Ireland 
lowered its profits tax to 10 percent for the manufacturing and 
certain other sectors, its revenues increased from $655 million 
in 1991 to $3.7 billion in 2000, with the profits tax share of 
total revenue nearly doubling from 8 percent to 15 percent in 
that time.\57\
---------------------------------------------------------------------------
    \56\ Interfax, June 20, 2001.
    \57\ St. Petersburg Times, June 19, 2001.
---------------------------------------------------------------------------
    The continuing development of the Tax Code will provide 
tremendous economic benefits to Russia if it results in a tax 
system conducive to capital formation rather than one marked by 
investment disincentives. The Russian Government would do well 
to capitalize on the momentum of the past 18 months and ensure 
that the guiding principle for subsequent draft laws is that 
they are enacted in a form that promotes business and 
investment.
    Success will be defined by the extent to which the Tax Code 
gives legal force to an equitable system of taxation that 
treats all businesses fairly. The creation of a level 
playingfield requires unambiguous laws that achieve their 
intended tax objectives and are consistently administered.







           PUTIN'S DILEMMA: AUSTERE BUDGETING IN A POOR STATE



                       By James A. Duran, Jr.\1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   141
An Impoverished State with Limited Fiscal Resources..............   144
Bargaining Over the Budget.......................................   145
Building Budget Institutions.....................................   147
Reducing Public Expenditures on Housing and Municipal Services...   150
Targeting Social Welfare Entitlements............................   153
Pension Fund Reform Scheduled To Be Enacted in 2001..............   154
Executing Legal Reform...........................................   155
Raising Educational Standards....................................   157
Conclusion.......................................................   159
                                Summary

    President Vladimir Putin and the Council of Ministers are 
pushing an ambitious program to restructure five non-defense 
institutions inherited from the Soviet era. They are obstacles 
to Russia's transition to a liberal market economy. A change in 
the basic institutional environment to which the population had 
become accustomed threatens the welfare of a poor population. 
Under the centrally planned economy (CPE), a form of social 
contract emerged. The ``nanny'' state managed by a small elite 
created a broad network of social and economic benefits that 
provided a high degree of certainty to the great majority of 
the citizenry. Employees' wages were low, but they received 
proportionately very high subsidies for food, housing and 
municipal services, utilities, sports and cultural facilities, 
education, health care, social welfare entitlements, pensions, 
etc. Since 1991 the challenge to the reformers has been to 
restructure the social contract to one based on high wages 
giving individual households the right to select the goods and 
services they prefer in the market economy. Unfortunately, 
wages for most households have remained low while prices for 
food, consumer goods, and many services have risen sharply. A 
majority of households remain heavily dependent on subsidized 
institutions from the old order. Russian leaders have hesitated 
to restructure these obligations in fear of provoking social 
disorder.
---------------------------------------------------------------------------
    \1\ James A. Duran, Jr. is Professor Emeritus of History, Canisius 
College; Councillor of The Atlantic Council of the U.S.; an author of 
the Atlantic Council's Bulletin originally entitled Perestroika Update: 
The U.S.S.R. in Transition, later retitled as The Russian Federation: 
Political and Economic Update, from 1992 through 1998.
---------------------------------------------------------------------------
    Putin's dilemma is rooted in the lack of sufficient fiscal 
resources to finance major reforms. The combined federal, 
regional, and local budgets fall far short of paying current 
obligations. Though currently enjoying the second consecutive 
year of growth, the Russian Federation ranks only at about the 
level of Mexico in gross domestic product (GDP), i.e., 
fourteenth in the world. Since 1989 the real GDP has fallen by 
an estimated 50 percent. With all levels of government taking 
about 40 percent of GDP in revenues, raising taxes to finance 
further reforms would discourage entrepreneurs from investing 
in the nascent economy. Seventy-eight percent of GDP growth in 
2000 resulted from increased earnings in energy and primary 
commodities exports. Budget revenues would drop sharply if 
world market prices were to plummet. Aware of this reality, the 
central government has pursued an austere balanced budget 
policy. In 2000 and 2001 the federal budget amounted to about 
$42.4 billion. Adjusting for purchasing power parity at the 
official rate of exchange, that total would at most be around 
$170 billion. About one-half goes to servicing debt, foreign 
and internal, and financing the security forces. That 
allocation leaves little money for funding the regular internal 
responsibilities of the federal government. In 2000 funds set 
aside for regional and local budgets were about 15 percent of 
GDP, the same percentage as the central government. As this 
paper will explain, most regional and local governments had 
insufficient resources to finance fully all their functions and 
in particular federal mandates inherited from the old CPE 
system. Ministers, academics, and analysts warn of a possible 
fiscal-budgetary crisis in 2003. Foreign debt servicing in that 
year is scheduled to rise to $18.2 billion, an increase of more 
than $5 billion over each of the prior 2 years. If world market 
conditions deteriorate, the Russian federal budget will need 
assistance from the International Monetary Fund (IMF) to 
sustain even current levels of spending adjusted for 
inflation.\2\
---------------------------------------------------------------------------
    \2\ Nina Pautola, ``Russia's External Debt, Solvency and Options 
for Alternative Capital Inflow,'' Russian Economic Trends, v. 9, no. 1, 
2000, pp. 30-38; Rossiyskaya Gazeta, 12 May 2001, FBIS-SOV-2001-0514; 
Russian Economic Developments, no. 96, March 2001, pp. 6-7; John P. 
Hardt, Russia's Paris Club Debt and U.S. Interests, CRS Report for 
Congress RL30617, updated June 6, 2001; John P. Hardt, Putin's Economic 
Strategy and U.S. Interests, CRS Report for Congress RL31023, June 19, 
2001; Vremya MN, June 15, 2001, FBIS-SOV-2001-0615; Andrei Nesterenko, 
``The Modernization Challenge Facing President Putin,'' Finance and 
Development, A Quarterly Magazine of the IMF, vol. 37, no. 3, 
September, 2000, pp. 1-7; ``IMF Concludes Post-Program Monitoring 
Discussion on the Russian Federation,'' IMF Public Information Notice 
(PIN) no. 01/68, July 18, 2001.
---------------------------------------------------------------------------
    The first two sections of this paper describes the fiscal 
conditions of the Russian state and the institutional changes 
that have taken place in the procedures for formulating and 
administering the state budget. During the Soviet CPE era the 
budget was secondary to the annual plan, the parameters of 
which were decided by a powerful Communist Party elite. Today 
the Russian Federation budget determines the cash flows 
necessary for implementing desired policies. Intense political 
bargaining by vested interest groups is comparable to the 
debates that occur in most liberal democratic states. With the 
help of bilateral and international agencies, the Russian 
bureaucracy at the central federal level has been trained to 
formulate, execute and audit the revenues and expenditures in a 
radically different way than was done previously. Focus has now 
shifted to improving the competence of regional and local 
officials in the administration of their fiscal affairs.
    The succeeding sections of the paper analyze major policy 
debates on proposals to execute major reforms in five different 
sectors that affect the livelihood of every Russian citizen.
    (1) A major problem concerns the shift from financing basic 
expenditures such as housing maintenance, municipal services, 
and utilities out of the budgets of local governments to 
individual households. During the CPE period only 2 to 3 
percent was paid by the tenants with the rest being provided 
through state agencies or enterprises. Much of that burden, 
amounting to 4 percent of GDP, was transferred during 
privatization of enterprises to fiscally strapped regional and 
local governments. While tenants now cover up to 40 percent of 
charges, the government with lower budgets and individuals with 
modest incomes lack resources to do much more than deal with 
emergencies. Sixty percent of urban infrastructure has 
deteriorated so badly that billions of rubles need to be 
expended on renovation and new installations.
    (2) Another 4 percent of GDP is spent on a broad range of 
more than 160 social welfare entitlements for which 47 
categories of citizens are eligible regardless of need. Full 
payment would require an estimated 22 percent of GDP. The 
federal government has made the regional and local governments 
responsible for funding these mandates without transferring 
adequate fiscal means to do so. The question remains how to 
reduce the number of these commitments and focus distribution 
of funds to the truly needy. An estimated two-thirds of 
payments now goes to those above subsistence level.
    (3) During this fall's session of the Federal Assembly, 
legislation to reform the old-age pension system funded by the 
extra-budgetary Pension Fund will probably be enacted. Inspired 
by the Chilean model, a portion of each worker's contributions 
will be transferred into a savings account to be invested in 
bond or stock funds. With a poorly developed financial services 
sector, finding suitable investments represents a major 
challenge. The combination of very low birthrates and a large 
relative increase of retirees constitutes a serious problem. 
Reform is essential if an already austere state budget is to 
avoid an additional rapidly growing fiscal burden beginning in 
7 to 8 years.
    (4) The fourth reform is designed to increase the 
confidence of the public in the judicial system. President 
Putin and his government are making the reform of the judiciary 
and of the Criminal Procedure Code a high priority and have 
proposed a large increase in appropriations in the federal 
budget for 2002. Funds are sought to increase dramatically the 
number of judges by 2003. In addition, the new lower level of 
justices of the peace to handle relatively minor cases is to be 
rapidly expanded. Such procedures as requiring that judges give 
prior approval to arrest warrants and the introduction of plea 
bargaining have the potential for significantly reducing the 
widespread abuse of prisoners held for long periods in pre-
trial detention centers.
    (5) The final reform to be analyzed is the comprehensive 
restructuring of the educational system from bottom to top. 
Recent studies have shown that the Russian work force is 
significantly less skilled even than that of the People's 
Republic of China. Even with the 50 percent raise proposed in 
the 2002 budget, teachers' salaries on average will still be 
below the official subsistence level. One goal is to expand the 
opportunity for graduates from regular secondary schools to 
gain entry into higher education institutions through the use 
of vouchers.
    Prospects for approving most of the Putin Administration's 
programs appear promising. The present state Duma is more 
supportive of the executive branch's proposals than were the 
preceding legislatures during Boris Yeltsin's two terms as 
President. There is broad support for the restructuring of 
fiscal federalism. Too often a balanced budget at the center 
has resulted in passing federal mandates down to the regional 
and local levels which lack the means to pay. Federal 
authorities who control sources of revenue have been changing 
the rules virtually every year. Local officials bear the brunt 
of criticism from citizens deprived of what they regard as 
their just due. Responding to considerable pressure, the 
central government published a proposal on August 21, 2001, to 
set out in statute a clear division of responsibilities and 
revenues until 2005. More needs to be done to improve budget 
practices on the lower levels of government. Sound 
administrative practices are vital when reforms change the 
institutional framework within which citizens must live and are 
being implemented when resources are scarce.

          An Impoverished State with Limited Fiscal Resources

    Russian leaders face a dilemma in that they must operate 
within austere fiscal limits. Although Russia encompasses a 
huge territory and is richly endowed with natural resources and 
a relatively literate population of 147 million, the nominal 
GDP in 2000 was only about $276 billion calculated at the 
official exchange rate. Of that total, state authorities 
consumed about 42 percent in revenues. Taxes collected to fund 
federal budget outlays amounted to 16.2 percent of GDP, 
regional and local budgets--15.1 percent, and the four major 
social insurance funds (The Pension Fund, Social Insurance 
Fund, State Employment Fund, and Medical Insurance Fund)--10.8 
percent. The federal 2000 budget of $42.4 billion in nominal 
terms approximately equals that of Finland. Since many prices 
fall below their counterparts in advanced market economies, 
estimates of purchasing power parity range from 3\1/2\ to 4 
times more than the nominal rate of the ruble on international 
exchange markets. The result is a federal budget about $170 
billion.\3\
---------------------------------------------------------------------------
    \3\ Russian Economic Developments, No. 96, March 2001, pp. 6-7; 
Nesterenko. op. cit., p. 2, Padma Desai, ``Putin's bluff,'' Financial 
Times, June 21, 2001, p. 16.
---------------------------------------------------------------------------
    President Putin and the Council of Ministers understand 
that businesses are too heavily taxed. Present exorbitant rates 
slow economic growth and stimulate off-the-books transactions 
and capital flight. The reduction of the personal income tax to 
a 13 percent flat rate effective January 1, 2001, has 
contributed to a 70 percent increase in this source of revenue 
during the first 5 months of 2001, although the double-digit 
inflation of 16 to 18 percent reduced real gain. On second 
reading the Duma has approved a reduction of the tax rate on 
corporate profits from 35 percent to 24 percent effective on 
January 1, 2002. Another measure under consideration is 
slashing the 29.6 percent combined social insurance payroll tax 
by a point or two since revenues allotted to the Pension Fund 
are running a surplus. Obviously, there is risk in supporting 
this supply-side policy, but incentives are essential in the 
effort to stimulate economic growth.\4\
---------------------------------------------------------------------------
    \4\ Ian Cochrane, Vladimir Gidirim, Tim Carty and Zhanna 
Dobritskays, ``The Russian Tax System: Achievements in 2000 and the 
Possible Agenda for 2001,'' Russian Economic Trends , v. 9, no. 3, 
2000, pp. 17-21; ITAR-TASS, April 25, 2001, FBIS-SOV-2001-425; ITAR-
TASS, April 23, 2001, FBIS-SOV-2001-0423; Kommersant, April 21, 2001, 
p. 1; Moscow Mayak Radio, June 19, 2001, FBIS-SOV-2001-0628; 
Rossiyskaya Gazeta, June 26, 2001, p. 1, FBIS-SOV-2001-0626; Obshchaya 
Gazeta, June 14, 2001, FBIS-SOV-2001-0613.
---------------------------------------------------------------------------
    A reason for Putin's continued popularity has been his 
insistence that pensions and federally budgeted salaries be 
paid on time. After years of uncertainty, some stability in 
household cash flow represents a significant improvement for 
the recipients. For years the state did not collect enough in 
rubles to cover these outlays. In 1996 nearly half the receipts 
for the ``consolidated'' budget, i.e., those of the central, 
regional and local governments, were in the form of ``mutual 
offsets,'' i.e., barter in the form of goods and services, and 
monetary surrogates such as promissory notes, bills of 
exchange, local vouchers, etc. In addition, tax evasion was 
widespread. Cash was scarce. Salaries, wages, and allowances of 
budget-funded civil servants and the military fell into 
arrears. Delays in paying pensions were partly due to the 
failure of the government itself to pay the payroll taxes it 
owed to the Pension Fund. Simultaneously, legislators pressed 
hard to increase pensions and salaries to match inflation, but 
the recipients by no means received full indexing. Such 
privatization schemes as the scandalous ``loans for shares'' 
occurred in part because desperate leaders wanted cash to 
disburse to employees and pensioners, particularly as elections 
were approaching. As of July 2001, some arrears to civil 
servants and the military have yet to be paid.\5\
---------------------------------------------------------------------------
    \5\ David Woodruff, Money Unmade, Barter and the Fate of Russian 
Capitalism (Ithaca, New York: Cornell University Press, 1999), pp. 79-
176; ITAR-TASS, May 22, 2001, FBIS-SOV-2001-0522; Elena Romanova, 
``Pension Arrears in Russia: The Story Behind the Figures,'' Russian 
Economic Trends, v. 8, no. 4, 1999, pp. 14-24; Sergei Guriev and Barry 
Ickes, ``Barter in Russian Enterprises: Myths vs. Empirical Evidence,'' 
Russian Economic Trends, v. 8, no. 2, 1999, pp. 6-13; Padma Desai and 
Todd Idson, Work Without Wages, Russia's Nonpayment Crisis (Cambridge, 
Mass.: The MIT Press), pp. 2-23.
---------------------------------------------------------------------------

                       Bargaining Over the Budget

    The contentious but democratic haggling over budget 
assumptions and spending priorities among representatives of 
the executive branch, the state Duma deputies, and the 
Federation Council senators who represent the regions is in 
itself evidence of transition to a new political system. 
Without the approval of the legislature, the budget cannot 
become law. Bargaining is prolonged since there has been no 
disciplined, pro-government majority in the Duma. Nominated by 
the President and confirmed by the Duma, the Premier is 
primarily the President's man. Putin's Council of Ministers is 
charged with managing economic and routine internal affairs. 
The ministers are chosen not because they are prominent figures 
with strong political support in the legislature, but mainly 
for their technocratic skills. The Presidential Administration, 
comparable to the Executive Office of the U.S. President, is 
divided into departments which oversee all state activities. 
The Security Council and its staff responsible for security 
affairs, internal and external, are directly responsible to the 
President, who chairs its meetings. The ``power'' ministers 
running military, police, and intelligence affairs are also 
directly subordinate to him. Unlike in the Soviet era, sharp 
public disputes occur among ministers and members of the 
Presidential Administration even as bargaining on the budget is 
underway with the legislators.\6\
---------------------------------------------------------------------------
    \6\ Andrei Kunov and Alexei Sitnikov. ``The `Constitutional 
Economy' of Russia: Political Roots of Economic Problems,'' Russian 
Economic Trends, v. 8, no. 4, 1999, pp. 6-14; Eugene Huskey, 
Presidential Power in Russia (Armonk, New York, M.E. Sharpe, 1999), pp. 
43-182; Steven S. Smith and Thomas F. Remington, The Politics of 
Institutional Choice, The Formation of the Russian State Duma 
(Princeton, NJ, Princeton University Press, 2001), pp. 27-92, 116-160; 
Thomas F. Remington, Politics in Russia (New York, Longman, 1999), pp. 
40-57, 124-173.
---------------------------------------------------------------------------
    Leaders of the executive and legislative branches in the 
past decade have established procedures in the Budget Code for 
enacting the annual state budget that basically conform to the 
standards of the G-7. They understand that managing cash flows 
is central to the implementation of desired policies. The 
Ministry of Finance is the principal agency that enters into 
negotiations with the government departments and agencies as 
well as with governors of the 89 regions (oblasts, territories, 
and ethnic republics) composing the Federation. The President 
lays out his priorities in the Annual Budget address to the 
parliament in June or July. By mid-August, the Cabinet presents 
its detailed proposal in the hope that the the budget will be 
enacted into law before the beginning of the fiscal year 
starting on January 1. The Duma Budget Committee and other 
committees on matters that fall under their jurisdictions 
review the document and make their recommendations. The budget 
bill must submit to four readings, one more than usual. The 
second and third are the most important. Upon passage, the bill 
is sent to the Federation Council for its review and approval 
by the Senators.\7\
---------------------------------------------------------------------------
    \7\ Andrei Kunov and Alexis Sitnikov, ``Economic Legislation of the 
Duma: The Role of Organizational Structure,'' Russian Economic Trends, 
v. 8, no. 2, 1999, pp. 14-21; Interfax, May 3, 2001, FBIS-SOV-2001-
0503; Rossiyskaya Gazeta, May 4, 2001, FBIS-SOV-2001-0508; Remington, 
Politics in Russia, pp. 124-173; The World Bank, Fiscal Management in 
Russia (Washington, DC, The World Bank, 1996), pp. 41-65, hereafter 
referred to as Fiscal Management in Russia, 1996; Russian Economic 
Trends, v. 6, no. 1, 1997, pp. 9-11.
---------------------------------------------------------------------------
    Diverse coalitions representing various vested interest 
groups form and dissolve in the quest for budget commitments. 
Ministers engage in tough bargaining to gain support for their 
policies and sometimes are forced to make distasteful 
compromises which often cause an increase in budget obligations 
to ensure enactment. Disagreements between the two houses are 
resolved through a conciliation procedure involving Duma 
deputies, Senators, representatives of the Council of Ministers 
and the Presidential Administration. Finally, the President 
signs the budget into law. At a recent meeting of the collegium 
of the Ministry of Finance, Putin complained that 3 months of 
the fiscal year had passed before the bureaucracy completed all 
the paperwork authorizing the disbursement of funds in 2001.\8\
---------------------------------------------------------------------------
    \8\ Kommersant, September 15, 1999, p. 2; Kommersant, September 24, 
1999, p. 2; Kommersant, September 25, 1999, p. 2;  Izvestiya, October 
27, 1999, p. 1; Izvestiya, December 4, 1999, p. 5, Kommersant, December 
4, 1999, p. 4; Rossiyskaya Gazeta, April 17, 2001, p. 3 in FBIS-SOV-
2001-0417; Moskovskiye Novosti, July 17, 2001, FBIS-SOV-2001-717; 
Remington, Politics in Russia (New York, NY: 1999), pp. 124-173.
---------------------------------------------------------------------------
    This democratic process, although prolonged, for adopting 
the budget sharply contrasts sharply with the document produced 
by the highly centralized Soviet system. At that time the 
state-owned, comprehensive CPE was directed by a tiny elite, 
the Communist Party Politburo with its Central Committee 
secretariat and key ministers. Priorities were decided in 
camera. The budget was merely an instrument for implementing 
the annual economic plan. It also was a unitary system since 
the budgets of the lower echelons of government were 
incorporated into the final product. A brief annual budget bill 
was passed by the U.S.S.R. Supreme Soviet after a pro forma, 
carefully scripted debate. By mid-1988, Gorbachev's reforms 
freed some sectors of the economy which caused severe fiscal 
problems and rising inflation. In October the U.S.S.R. Minister 
of Finance revealed a major state secret: namely, the Soviet 
Union had been running a deficit budget since 1976 and the 
country had plunged into a severe fiscal crisis. Records 
indicate that the deputies in the Supreme Soviet did not seem 
to understand the profound implications of this revelation. 
Before the U.S.S.R. dissolved in December, 1991, this old CPE 
fiscal system had already collapsed.\9\
---------------------------------------------------------------------------
    \9\ Fiscal Management in Russia, 1996, 7-11; James A. Duran, Jr., 
``Russian Fiscal and Monetary Policy: A Tough Road Ahead,'' The Former 
Soviet Union in Transition, U.S. Congress, Joint Economic Committee. 
103d Congress, 1st Session, S. Print 103-1, February 1993, v. 1, pp. 
196-217; Vremya MN, June 22, 2001, FBIS-SOV-2001-0622.
---------------------------------------------------------------------------

                      Building Budget Institutions

    In 1991 leaders of the new Russian state faced the awesome 
task of building an essentially new set of institutions to 
manage fiscal affairs. With IMF assistance particularly since 
1995, needed reforms have been put in place in the center which 
remains in a dominant position. The Ministry of Finance has 
been reconstituted and its staff retrained and expanded to play 
the central role in state finances. Only in 1995 did Russia 
adopt the basic line-item classification system developed as 
the standard for members of the IMF. The Ministry of Economics, 
currently the Ministry of Economic Development and Trade, 
prepares medium- and long-term forecasts, draws up detailed 
plans and estimates costs of proposed reforms. Its current 
head, German Gref, is influential with President Putin. Under 
the old CPE system corporate managers and individual households 
did not have to worry about paying taxes to the government as 
is customary in market economies. CPE accounting systems were 
rudimentary and centralized in the Central Bank of the Russian 
Federation (Central Bank of Russia or CBR) or the few 
specialized state banks. In moving to a market economy, Russian 
managers and accountants have become obligated to meet the 
rigorous reporting standards required by tax authorities. 
International accounting standards are scheduled to be fully in 
effect by January 1, 2003. An essentially new state Tax Service 
had to be established to extract revenue from a population with 
no taxpaying tradition. Inspectors have often been harassed or 
even physically attacked. Though their salaries are paid by 
Moscow, they remain vulnerable to local pressure. Like most 
federal civil servants in Russia, they are dependent on 
regional and local authorities for housing and municipal 
services. The state Tax Police were established in part to 
protect these collectors. The present Duma has made major 
market-oriented improvements in the Tax Code, but debate still 
continues on revising additional chapters. Many Russian 
entrepreneurs as well as foreigners conducting business in the 
country will be pleased when comprehensive and relatively 
stable regulations governing taxes and taxpayers' rights have 
been instituted. As in any market economy, debate will continue 
as various interest groups seek to alter the laws to their 
advantage.\10\
---------------------------------------------------------------------------
    \10\ Fiscal Management in Russia, 1996, xxv-xxvi, 83-88; Russian 
Federation, OECD Economic Surveys, March 2000 (Paris, France: OECD, 
2000), pp. 118-120, hereafter referred to as OECD, 2000; Milka 
Casanegra de Jantscher, Carlos Silvani, and Charles L, Vehorn, 
``Modernizing Tax Administration,''  Fiscal Policies in Economies in 
Transition edited by Vito Tanzi (Washington DC: International Monetary 
Fund, 1992), pp. 120-141, hereafter referred to as Fiscal Policies in 
Economies in Transition; RFE/RL Newsline, June 22, 2001; Frank Gregory 
& Gerald Brooke, ``Policing Economic Transition and Increasing Revenue: 
A Case Study of the Federal Tax Police of the Russian Federation 1992-
1998,'' in Europe-Asia Studies, v. 52, no. 3, May, 2000, pp. 433-455.
---------------------------------------------------------------------------
     Recognizing the urgent need for reform, the government as 
instructed by President Putin published its ``Program for the 
Development of Budget Federalism for the Period Until 2005'' on 
August 21, 2001. A national commission is to prepare 
legislation for legislative enactment in 2002. The goal is to 
establish by statute the specific revenues assigned to regions 
and the specific programs which they are obligated to support. 
While Russia is constitutionally designated as a Federation, 
the center controls revenue and has placed mandates on the 
regions that cannot fully paid from their funds. Unlike in 
Western federal systems, the 89 regions comprising the 
Federation at present have no separate taxing authority. Nor do 
local governments whose revenues are included within the 
regional unit. The rates of virtually all revenues are set by 
laws passed by the central legislature in Moscow. These include 
the value added tax (VAT), corporate profits tax, turnover tax, 
personal income tax, sales tax, excises, export and import 
duties, levies on natural resources, social insurance 
contributions, land taxes, licensing fees, etc. Budget debates 
in Moscow focus not only on the rates, but also on the 
proportions to be allocated to the central budget and to the 89 
regions. Through 2000 the division between the center and the 
regions was about 50-50. Recently President Putin and the 
Council of Ministers pushed through a 56-44 formula for 2001. 
On the expenditure side, more than 80 percent of regional 
expenditures are mandated by the center. Only by drastically 
underfunding most social welfare entitlements do lower-level 
administrators gain some limited resources to meet emergencies. 
About 1.7 percent of GDP is transferred through the Fund for 
Financial Support of Subjects of the Federation to poor regions 
that register claims. Unfortunately, the criteria can be 
manipulated by lobbying and do not take into adequate account 
the economic capacity of the region. Conscientious fiscal 
administrators are apt to receive the least amount. Thus, the 
present system of fiscal federalism puts lower officials in a 
very difficult position. Federal regulations and the outright 
fiscal unfeasibility of executing them lead officials to resort 
to informal practices to enhance their resources. Given the 
very low salaries paid to civil servants, a degree of 
corruption is inevitable. For these reasons, major legislation 
to restructure the federal fiscal system will probably be 
enacted in 2002.\11\
---------------------------------------------------------------------------
    \11\ Rossiyskaya Gazeta, July 18, 2001, p. 2, and August 21, 2001, 
p. 4; OECD 2000, pp. 116-149; Alexei M. Lavrov, Alexei G. Makushkin, et 
al., translated by James E. Walker, The Fiscal Structure of the Russian 
Federation, Financial Flows Between the Center and the Regions (Armonk, 
NY: M.E. Sharpe, 2001), pp. 1-8, 39-43, hereafter referred to as The 
Fiscal Structure of the Russian Federation; Jorge Martinez-Vasquez and 
Jameson Boex, Russia's Transition to a New Federalism (Washington, DC: 
The World Bank, 2001), pp. 1-54, 89-96, hereafter referred to as 
Russia's Transition to a New Federalism..
---------------------------------------------------------------------------
    Managing revenues and disbursements efficiently presents a 
difficult challenge to any government. During the Soviet 
period, this task was handled largely through accounts for all 
state agencies and enterprises held in the CBR or specialized 
state-owned banks. With the role of the CBR being steadily 
reduced to functions normal in Western market economies, a new 
institution, the state Treasury, was initiated in 1993. All 
revenues were to be deposited into its accounts and legally 
budgeted expenditures disbursed to agencies as authorized by 
decrees of the Ministry of Finance. By March, 1995, only 47 of 
the 74 regional offices were fully operational. Even then, a 
common electronic system had not been completed. The last 
regional office was established in Tatarstan only in March, 
2001. During the interim while the Treasury system was being 
built, certain private, politically well-connected private 
banks were authorized to administer official accounts. Many 
earned a bad reputation by using these funds to speculate for 
private gain. During 2001 the seven regions possessing the 
largest budget deficits were placed under special Treasury 
monitoring. Initial results indicate a dramatic improvement in 
their fiscal affairs.\12\
---------------------------------------------------------------------------
    \12\ Rossiyskaya Gazeta, May 23, 2001, pp. 1, 3. FBIS-SOV-2001-
0523; The Fiscal Structure of the Russian Federation, pp. 4-6, 59-61; 
Fiscal Management in Russia (The World Bank, Washington, DC, 1996), pp. 
77-78, 159-163, hereafter referred to as Fiscal Management in Russia; 
Russia's Transition to a New Federalism, pp. 51-52.
---------------------------------------------------------------------------
    Implementation of a standard system of accounting in all 
ministries and government agencies has proven to be a time-
consuming task. Cash management, debt management, and 
procurement, relatively unimportant under central planning, are 
indispensable to function in a market economy. By October 1, 
2001, the books of the Ministry of Defense, reportedly the last 
ministry remaining outside the system, are supposed to be 
brought into compliance with Treasury requirements. The 
dismissal of the Ministry's Colonel General of Finance, General 
Auditor, and General Accountant for incompetence resulted from 
the installation of the new accounting procedures. These 
officials could not account for the disappearance in London of 
$450 million in hard currency.\13\
---------------------------------------------------------------------------
    \13\ Fiscal Management in Russia, pp. 83-88; Moscow News, No. 1-2, 
January 10-16, 2001, p. 2; A. Premchand and L. Garamfalvi, ``Government 
Budget and Accounting Systems,'' in  Fiscal Policies in Economies in 
Transition, pp. 268-290.
---------------------------------------------------------------------------
    Provision was made in the 1993 Constitution for an 
Accounting Chamber headed by an Auditor General for a period of 
5 years and similar in function to the U.S. General Accounting 
Office. The newly created office is responsible to the Federal 
Assembly. Its duties are to conduct budget evaluations and 
audits. The first Auditor General was a professional, but, as a 
moderate Communist, found himself at odds with the market 
reformers. He and his staff conducted hundreds of audits 
involving privatizations but their efforts failed to reverse 
any privatizations resulting from breach of contract. Many of 
the new private owners had violated their contractual 
obligations to invest and to preserve jobs. Instead, they had 
stripped assets for personal gain rather than honoring their 
contractual obligations to invest and to preserve jobs. Only 
one prosecution was initiated. In 2000 former premier Sergei 
Stepashin, a prominent political figure during the Yeltsin 
years, became Auditor-General. He was emphatic that suspect 
regional administrations were to be strictly audited to ensure 
that government funds were spent for authorized purposes. His 
first target was Kalmykia, one of the most independent acting 
republics in the Federation. Stepashin has also advocated 
increasing the powers of the Auditor-General to include the 
right to initiate prosecutions for malfeasance rather than to 
depend on the independent Procurator-General (Attorney-
General). So far, this suggestion has not been approved. A 
proposal by Putin to place the Auditing Chamber directly under 
the President has not been met with enthusiasm by many 
parliamentarians.\14\
---------------------------------------------------------------------------
    \14\ RFE/RL Newsline, June 26, 2001; June 27, 2001; July 3, 2001; 
and July 10, 2001; Rossiyskaya Gazeta, November, 15, 2000, p. 2; 
Kommersant, November 15, 2000, p. 3; Sevodnya, Nov. 9, 2000, p. 5 in 
The Current Digest of the Post-Soviet Press (hereafter referred to as 
CDPSP), v. 52, no. 45, December 6, 2000, p. 14; Noviye Izvestiya, 
September 29, 2001, p. 2 in CDPSP, v. 52, no. 39, October 25, 2000, p. 
12.
---------------------------------------------------------------------------
    Arguably, the first Russian federal budget that was 
fiscally sound was enacted after the financial collapse of 
August 1998 and implemented in 1999. The emerging fiscal crisis 
had precipitated a rapid turnover of cabinet ministers between 
1997 and 1998. Russia was confronted with the pressing need to 
reduce expenditures in order to match the revenues available to 
the government. Resort to excessive internal short-term, high-
rate borrowing complicated the problem since the rapidly 
increasing expenditures outlays to service the debt crippled 
normal government fiscal operations. The left-dominated state 
Duma would not agree to sharp cuts in expenditures and other 
reform measures. After Asian stock markets crashed and oil 
export revenues dropped sharply, foreigners lost confidence in 
investing in the financial markets of developing countries 
including Russia. Consequently, the Federation defaulted on its 
internal debt obligations and the ruble's value fell by 80 
percent. Without the crash of 1998 deputies in the Duma, 
particularly the leftists, would not have been motivated to 
support the reduction of budget outlays and changes in tax 
laws. The crash of 1998 served as a harsh lesson to deputies in 
the Duma. The austere budget for 1999 proposed by the outgoing 
Kireyenko government was enacted into law with their approval. 
For the first time the government was able to fund most 
commitments made in the budget fully without resort to major 
sequestration or excessive borrowing. The budgets for 2000 and 
2001 are in the same category.\15\
---------------------------------------------------------------------------
    \15\ ITAR-TASS, July 3, 2001, in FBIS-SOV-2001-0703; Interfax, June 
5, 2001, FBIS-SOV-2001-0605; Vremya MN, June 15, 2001, FBIS-SOV-2001-
0615.
---------------------------------------------------------------------------

     Reducing Public Expenditures on Housing and Municipal Services

    Despite progress toward fiscal accountability, entrenched 
institutions inherited from the Soviet period continue to drain 
precious funds at an exorbitant rate. President Putin and his 
ministers are wrestling with the difficult job of designing a 
strategy that would shift part of the costs for financing 
housing and municipal services to private consumers. At 
present, an estimated 4 percent of GDP from the consolidated 
federal and regional-local budgets is allocated to cover the 
expenses for housing maintenance, heating and water systems, 
waste disposal, utilities, and public transportation. 
Currently, local governments allocate 24 to 34 percent of their 
budgets for maintaining this sector. In many localities the 
remaining money is barely sufficient to pay the salaries of 
their employees. Investment in renovation and installation of 
new infrastructure has remained at a near standstill for a 
decade because of lack of funds. An estimated 60 percent of 
water and district heating systems are worn out and need 
replacement. Experts predict that breakdowns such as occurred 
during winter 2000-2001 in the North and Far East are likely to 
multiply in future winters unless vital funds are made 
available. If a reform in this sector could reduce the budget 
burden by 1 percent of GDP, the solvency of regional and local 
budgets would be dramatically improved.\16\
---------------------------------------------------------------------------
    \16\ Rossiyskaya Gazeta, February 3, 2001, pp. 2, 6, in CDPSP, v. 
53, no. 5, February 28, 2001, p. 9; Trud, February 16, 2001, p. 1, in 
CDPSP, v. 53, no. 7, March 14, 2001, p. 13; ITAR-TASS, August 21, 2001, 
FBIS-SOV-2001-0821; Interfax, August 14, 2001, FBIS-SOV-2001-0815.
---------------------------------------------------------------------------
    This situation is an example of how reform is obstructed by 
the unbalanced social contract inherited from the Soviet 
period. Employees were paid very low wages in cash, but through 
employers received proportionately high benefits, i.e., housing 
and municipal services, utilities, kindergartens, clinics, 
restaurants, sports and cultural facilities, etc., for which 
they paid only 2 to 3 percent of costs. That percentage was 
less than the average household spent on vodka and cigarettes. 
The enterprise, ministry, academic or research institute, or 
other state organization took care of the expenses incurred by 
their employees, who essentially lived within ``company 
towns.'' Capital costs were funded through the annual plan, not 
bonds which had to be paid off by real estate taxes. As major 
enterprises were privatized and entered into the market 
economy, the responsibility for funding many of these 
facilities and services were shifted mainly to the jurisdiction 
of local governments. The latter in 1994 only received one-
fourth of the federal compensation theoretically authorized by 
privatization laws to cover the additional budgetary 
obligations. Many citizens took advantage of the opportunity to 
privatize their apartments. Unlike in western condominiums, 
owners of these apartments have not assumed responsibility for 
paying basic maintenance and capital expenses associated with 
their buildings. In most cases local governments continue to 
bear the responsibility for the most of the costs incurred. 
Only slowly have payments made by tenants and owners risen to 
cover an estimated 40 percent of the charges.\17\
---------------------------------------------------------------------------
    \17\ Kommersant, March 20, 2001, p. 8 in CDPSP, v. 51, no. 12, 
April 18, 2001, p. 8; Vremya MN, June 1, 2001, FBIS-SOV-2001-0601; 
Rossiyskaya Gazeta, June 26, 2001, FBIS-SOV-2001-0626; The Changing 
Social Benefits in Russian Enterprises (Paris, OECD, 1996); Andrea 
Stevenson Sanjan, ``State-Society Relations and the Evolution of Social 
Policy in Russia,'' in State-Building in Russia, The Yeltsin Legacy and 
the Challenge of the Future edited by Gordon B. Smith (Armonk, N.Y.: 
M.E. Sharpe, 1999), pp. 177-199; Linda J. Cook, ``The Russian Welfare 
State: Obstacles to Restructuring,'' in Post-Soviet Affairs, v. 16, no. 
4, October-December, 2000, pp. 355-378; Nigel M. Healey, Vladimir 
Leksin, and Alexandr Svetsov, ``The Municipalization of Enterprise-
Owned `Social Assets' in Russia,'' Post-Soviet Affairs, vol. 15, no. 3, 
July-September, 1999, pp. 262-280.
---------------------------------------------------------------------------
    The majority of households cannot afford a change in the 
system that would raise their monthly bill for housing, 
municipal services and utilities by 150 percent. The average 
monthly wage in 2000 was only 2,268 rubles ($78), which is less 
than the official subsistence for an adult and child. 
Increasing salaries would resolve the problem by enabling the 
workers to pay for these basic living costs. Several deputies 
successfully introduced an amendment to the proposed Labor Code 
mandating that the legal minimum wage equal the subsistence 
level. Aleksandr Pochinok, the capable Minister of Labor and 
Social Development, cautioned that the government could not 
implement this measure in the near future. The additional cost 
of increasing pay for government-funded employees would be 800 
billion rubles from the federal budget and almost 2.5 trillion 
rubles from regional and local budgets. That expenditure would 
surpass total outlays of the consolidated budgets of all three 
levels of government. The compromise version included the 
mandate, but provided that it would go into effect only after a 
separate authorization bill was enacted.\18\
---------------------------------------------------------------------------
    \18\ Vremya MN, June 1, 2001, FBIS-SOV-2002-0601.
---------------------------------------------------------------------------
    This complex issue is compounded by the problems of the 
Russian Unified Energy Systems (UES) and Gazprom, the 
monopolistic electricity and natural gas companies who are owed 
68 billion rubles by local consumers. Regional and municipal 
administrators often have deliberately avoided their 
responsibilities to cover energy bills and have pressured 
regional regulators to set the rates below costs. Even those 
charges were not fully paid. As a result, UES power plants, 
particularly in the North and Far East, lacked funds for 
essential coal supplies. Managers of some privatized mines 
chose not to ship supplies to generating and heating plants 
with overdue debts. So outages occurred in the midst of a hard 
winter. Successful reform and eventual privatization of the two 
great natural monopolies is partly dependent on adjustments in 
the housing and municipal services sector.\19\
---------------------------------------------------------------------------
    \19\ Izvestiya, November 23, 2000, p. 6 in CDPSP, v. 52, no. 47, 
December 20, 2000, pp. 5-6; Novyie Izvestiya, December 8, 2000, pp. 1-2 
in CDPSP, v. 52, no. 49, January 3, 2001, p. 12; Kommersant, January 
24, 2001, p. 4; Rossiyskaya Gazeta, February 3, 2001, pp. 2, 6 in 
CDPSP, v. 53, no. 5, February 28, 2001, pp. 9-10.
---------------------------------------------------------------------------
    No final decision on the strategy for reforming this sector 
which affects the household budgets of Russia's families. On 
March 15, 2001, the Council of Ministers approved a plan, but 
on July 5 switched to a ``new model.'' In the earlier session 
plans were approved to have the public pay 100 percent of their 
housing, municipal services, and utilities by 2003. If a 
family's payments were to exceed 22 percent of its total 
income, then they would be entitled to a subsidy equal to the 
amount of payments above a threshold percentage. The Chairman 
of the State Committee on Construction, Housing, and Municipal 
Services estimated that 30 percent of citizens would be 
eligible for subsidies. President Putin later said a majority 
could apply. Moscow's deputy mayor immediately objected to the 
proposed increase in coverage since the city would be required 
to spend an additional 18 billion rubles if the new system were 
to be in effect. He called for its introduction in 2007 at the 
earliest. The governor of Perm Oblast said that subsidies 
should begin at 10 to 12 percent of family income. At the 
Cabinet session of July 5, a new model gained support. The aim 
to keep the family burden under 22 percent was honored and the 
deadline delayed. However, direct subsidies to families would 
be replaced by a transfer of funds already allocated for 
housing and utilities to building associations. These groups 
would then be free to contract with service providers instead 
of relying on the government-connected types now in place. This 
important advance would create competition and lead to lower 
charges for building maintenance. Critics point out that such 
associations, though provided for in the law on privatizing 
housing, are poorly developed and often controlled by small 
cliques who exploit their position for private gain. No final 
decision has been reached on the question of how to deal with 
this controversial issue. Meanwhile, the World Bank and the 
Russian Government in the past 6 months have concluded three 
agreements to provide $287.5 million for selected projects in 
housing and municipal services.\20\
---------------------------------------------------------------------------
    \20\ Kommersant, March 20, 2001, p. 8; Moscow Mayak Radio, July 5, 
2001, FBIS-SOV-2001-0705; ITAR-TASS, 5 July 2001, FBIS-SOV-2001-0705; 
World Bank, Press Releases, December 21, 2000, March 27, 2001, and June 
7, 2001;  Rossiyskaya Gazeta, May 30, 2001, FBIS-SOV-2001-0531; 
Rossiyskaya Gazeta, May 29, 2001, FBIS-SOV-2001-0529; ITAR-TASS, May 
29, 2001, FBIS-SOV-2001-0529; Rossiyskaya Gazeta, May 31, 2001, in 
FBIS-SOV-2001-0521; Obshchaya Gazeta, July 12, 2001, FBIS-SOV-2001-
0712.
---------------------------------------------------------------------------

                 Targeting Social Welfare Entitlements

    A debate has begun on restructuring the extensive system of 
social welfare entitlements established by the Soviet regime. 
The Soviet leadership of the ``workers' state'' developed a 
system of more than 160 entitlements that operated for seven 
decades and consumed over 4 percent of GDP. These benefits 
mandated by the center were paid primarily by regional and 
local governments at levels far lower than promised. If the 
benefits were paid in full, they would probably cost 22 percent 
of GDP. Approximately two-thirds of the population qualified 
for one or more of the 47 categories. Payments and costly 
privileges were awarded to veterans and their children, 
pensioners, orphans, disabled, students, families with many 
children, rural residents, victims of Chernobyl, victims of 
political repression, etc. Only about one-third of benefits go 
to those individuals who are classified as needy. For example, 
municipal bus companies can barely afford to keep their current 
operations functioning and are required to permit nearly two-
thirds of passengers to ride without charge or at reduced 
fares.\21\
---------------------------------------------------------------------------
    \21\ OECD 2000, pp. 129-136; Moscow News, no. 24, June 21-27, 2000, 
p. 2; The World Bank, From Plan to Market, World Development Report 
(New York: Oxford University Press, 1996), pp. 77-84; The World Bank, 
Balancing Protection and Opportunity: A Strategy for Social Protection 
in Transition Economies, May 3, 2000 (Washington, DC, The World Bank, 
2000), pp. 24-29, 35-40, hereafter referred to as A Strategy for Social 
Protection in Transition Economies; Vremya MN, March 14, 2001, p. 5, in 
CDPSP, v. 51, no. 12, April 18, 2001, p. 8.
---------------------------------------------------------------------------
    Federal transfer payments have been grossly inadequate. 
After 1991 a key stratagem for reducing central government 
expenditures was to shift the financial burden down to the 
fiscally hard-pressed regions. Regional leaders tried 
desperately to restrict the growth of this burden on them 
through other means. Laws have been in force since 1993 
explicitly prohibiting the center from devolving responsibility 
for paying these mandates unless it provided the funds to pay. 
However, eligible citizens in 1997 began to bring suits in the 
courts against local authorities who refused to pay various 
entitlements. Typically, the judges ruled in favor of the 
plaintiffs since the statute governing federal transfers to the 
regions has ambiguous language stating that mandates are 
calculated as part of the formula for determining the sum to be 
awarded. The regions have grudgingly paid when courts so 
ordered, but overall most of these entitlements are at best 
partially honored.\22\
---------------------------------------------------------------------------
    \22\ OECD 2000, p. 131.
---------------------------------------------------------------------------
    This whole system of social welfare entitlements needs to 
be restructured to reduce the number of entitlements and to 
redefine the conditions for eligibility so that the needy are 
targeted. In his annual budget message for 2002, the President 
declared that ``unfunded federal mandates'' need to be 
clarified as part of the project to reform budgetary relations 
between the center and the regions. Russian leaders are moving 
slowly because they understand the political risks when 
sensitive vested interests are at stake.\23\
---------------------------------------------------------------------------
    \23\ Text of Russian president's annual address to the Federal 
Assembly, Russia TV, April 3, 2001, Johnson's Russia List JRL #5185, 
April 4, 2001, p. 13 (hereafter cited as Putin's State of the Union 
Message); ``Russian Federation President's Budget Message to the 
Russian Federation Federal Assembly: On Budget Policy for 2002,'' 
Rossiyskaya Gazeta, April 23, 2001, FBIS-SOV-2001-0425, p. 5, hereafter 
cited as Putin's Annual Budget Message; Rossiyskaya Gazeta, April 24, 
2001. FBIS-SOV-2001-0425.
---------------------------------------------------------------------------

          Pension Fund Reform Scheduled To Be Enacted in 2001

    Prospects for enactment of old-age pension reform in 2001 
were good. After much debate, a solid majority of the 
leadership including the President supported changes in the 
system to ease the future burden on the state budget. 
Currently, the extra-budgetary Pension Fund is receiving 82.5 
percent of the 29.6 percent of the payroll tax levied to 
support the four social insurance funds. It is running a 
surplus. The Fund received about 8 percent of GDP. Since 1990 
old-age pensions have been reduced to approximately the same 
level which is below subsistence for recipients regardless of 
years in the work force or total contributions as a result of 
inflation. This pay-as-you-go (PAYG) system would need to be 
restructured since birthrates have fallen below replacement 
level for a number of years. In Russia the ratio of pensioners 
to workers will reach a critical stage in 7 to 8 years beyond 
which the Pension Fund's budget will operate at a deficit. That 
situation would require supplementary appropriations from the 
federal budget.\24\
---------------------------------------------------------------------------
    \24\ Irina Denisova, Maria Gorban and Ksenia Yudaeva, ``Social 
Policy in Russia: Pension Fund and Social Security,'' Russian Economic 
Trends, v. 8, 1999, no. 1, pp. 12-23; Sevodnya, September 23, 2000, p. 
3, in CDPSP, v. 52, no. 39, October 25, 2000, p. 15; Obshchaya Gazeta, 
November 9, 2000, in JRL #4640, November 27, 2000; Putin's State of the 
Union Message, JRL #5185, 4 April 2001, p. 12; Rossiyskaya Gazeta, May 
30, 2001, FBIS-SOV-2001-0530; A Strategy for Social Protection in 
Transition Economies, pp. 1-28; George Kopits, ``Social Security,'' in 
Fiscal Policies in Economies in Transition, pp. 291-311.
---------------------------------------------------------------------------
    Draft laws for changing the pension system in the medium- 
and long-term were scheduled to be enacted in 2001. In March a 
major dispute on the structure of the future system erupted at 
the Cabinet level on the eve of the first meeting of the 
presidentially appointed National Council on Pension Reform. 
The director of the Pension Fund, Mikhail Zurabov, slated to be 
the rapporteur from the Cabinet to the Council, differed with 
the newly defined terms earlier agreed to by the Cabinet. He 
wanted to maintain the present system, altering coefficients to 
provide a lower rate for pensioners. First Deputy Premier 
Mikhail Dmitriyev and Economics Development Minister German 
Gref with the support of the President agreed to the 
introduction of a partially savings-based system in which the 
Pension Fund would be obligated to turn over some of its 
financial flows to investment and management companies. On May 
30 the National Council approved four draft laws and the 
ministries have begun to draw up detailed bills for 
consideration by the Duma in September.\25\
---------------------------------------------------------------------------
    \25\ Sevodnya, March 6, 2001, p. 1, in CDPSP, v. 53, no. 10, April 
4, 2001, p. 11; Izvestiya, April 19, 2001, p. 5 in CDPSP, v. 53, no. 
16, May 16, 2001, p. 15.
---------------------------------------------------------------------------
    Deeply influenced by the Chilean model, the system is 
predicated on the principle that the rates of return from 
investment in stock and bond mutual funds will yield higher 
returns in the medium- and long-term to pensioners than has 
historically been the case from public systems. Six percent of 
the social insurance tax paid by employers is to be transferred 
to individual pension accounts for participants under 35 and 2 
percent for those aged 35 to 50. Individuals over 50 would not 
participate in savings-based funds. Since retirement age is set 
at 50 for women and 55 for men, their investments would lack 
time to accrue sufficient resources. Boris Nemtsov of the Union 
of Rightists, Grigory Yavlinsky of Yabloko, and Moscow Mayor 
Yuri Luzhkov of Fatherland supported the savings account 
system. They advocated that individuals be given the right to 
decide whether to use private pension funds or insurance 
companies instead of the services of a ``government broker.'' 
The possible inheritance of the savings account by the worker's 
legal heir is also under consideration. Public opinion polls 
indicate that 60 percent of those questioned favor the 
reform.\26\
---------------------------------------------------------------------------
    \26\ Izvestiya, April 19, 2001, p. 5, in CDPSP, v. 53, no. 16, May 
16. 2001, p. 15; Vremya MN, July 18, 2001, FBIS-SOV-2001-0718; Moscow 
News, no. 29, July 18-24, 2001, p. 3.
---------------------------------------------------------------------------
    Advantages to implementing this updated system were 
numerous. A huge future burden on the state Budget could be 
avoided. The steady flow of cash into investment funds could 
help provide the badly needed capital to sustain the 
development of the financial services sector. National Council 
members understand that the present lack of reliable investment 
options is a major deterrent to economic growth. The initial 
investments anticipated early in 2003 will probably be in 
interest-bearing medium-term state bonds. The stock markets are 
still too small to absorb so much money. A higher rate of 
return on investments in funds would potentially give latitude 
to the government to reduce the payroll tax, all of which is 
presently paid by employers.\27\
---------------------------------------------------------------------------
    \27\ Sevodnya, September 23, 2000, p. 3, in CDPSP, v. 52, no. 39, 
October 25, 2000, p. 15.
---------------------------------------------------------------------------
    On April 19, 2001, President Putin submitted a bill to the 
legislature to tighten the system for administering pensions. 
Originally, the Pension Fund was responsible for collecting its 
own revenues, but the task was transferred to the state Tax 
Service on January 1, 2001. Eligibility and disbursements were 
handled at the regional level. Unfortunately, some governors 
have been successful in pressuring lower officials to divert 
funds from their intended purpose. Last year regions were given 
the right by Presidential decree to transfer power to the 
central agencies who would determine eligibility and pay 
pensioners. About 30 regions reacted positively. The President 
has now asked that this significant change of policy be 
mandatory throughout Russia.\28\
---------------------------------------------------------------------------
    \28\ Kommersant, April 20, 2001, p. 4.
---------------------------------------------------------------------------

                         Executing Legal Reform

    At the opening session of the national congress of Russian 
judges on November 27, 2000, President Putin stated that a high 
priority over the next 2 to 3 years was to strengthen and 
reform the Russian judicial system. Businessmen needed to be 
assured that their property and human rights will be enforced 
by the courts. Putin asserted that his aim is to adhere to 
international human rights standards. He cited inadequate 
funding of the courts as ``a cause of miscarriages of justice'' 
and the arbitrary hearing of cases by overworked judges. On 
June 28, 2001, 4 bills on judicial reform passed the first 
reading in the Duma with more than 380 votes for each. During 
the second reading the debate will focus on the limits to be 
set on the tenure of judges. The goal is to implement the 
reforms by 2004.\29\
---------------------------------------------------------------------------
    \29\ Izvestiya, Nov. 28, 2000, p. 3 in CDPSP, v. 52, no. 48, 
December 27, 2000, p. 10; Nezavisimaya gazeta, November 30, 2000, p. 3 
, CDPSP, v. 52, no. 48, December 27, 2000, pp. 10-11; ITAR-TASS, May 
29, 2001, FBIS-SOV-2001-0529; Vremya MN, June 21, 2001, FBIS-SOV-2001-
0622; Moskovskiye Novosti, 26 June 2001, FBIS-SOV-2001-0628; Gordon B. 
Smith, ``The Disjuncture Between Legal Reform and Law Enforcement, The 
Challenge Facing the Post-Yeltsin Leadership,'' in State Building in 
Russia, The Yeltsin Legacy and the Challenge of the Future, pp. 101-
122.
---------------------------------------------------------------------------
    The courts are overburdened. Sixteen thousand judges heard 
more than 5 million civil cases, more than 1 million criminal 
cases, and 2 million administrative cases in 2000. Judicial 
workloads have tripled in the last 6 years. One thousand judges 
are being added in 2001. Though the federal government pays 
their salaries, judges and their staffs remain dependent on 
regional and local authorities for professional facilities, 
housing, municipal services and utilities. Putin proposes to 
terminate the requirement that judicial appointments be cleared 
with regional officials. Many judges are holdovers from the 
Soviet period and have not proven to be willing or able to keep 
up with the rapid legal changes that have occurred since then. 
The 1970s administrative code for the courts, though much 
amended, is still in force.\30\
---------------------------------------------------------------------------
    \30\ Izvestiya, Nov. 28, 2000, p. 3, in CDPSP, v. 52, no. 48, 
December 27, 2000, p. 10; RFE/RL Russian Political Weekly, vol. 1, no. 
18, July 2, 2001, p. 7.
---------------------------------------------------------------------------
    The dramatic increase in spending to finance the judicial 
system in 2001 is a strong indicator that the Putin 
Administration is serious about enhancing the courts' 
credibility. At 11 billion rubles ($367 million) in 2001, the 
request for 2002 is reportedly for 18.8 billion rubles ($630 
million) in 2002. In addition to monies from the regular budget 
line, additional sums are to be drawn from the extra-budgetary 
Federal Targeted Program for the Development of the Judicial 
System to be funded at the level of 44 billion rubles ($1.5 
billion) over the next 4 years. Unfortunately, administration 
of the court system's budget still remains under the 
jurisdiction of the Ministry of Justice which raises the 
question of separation of powers. The judges prefer that 
responsibility be transferred to the Supreme Court's 
Administrative Department to ensure the independence of the 
judicial branch.\31\
---------------------------------------------------------------------------
    \31\ Sevodnya, Nov. 28, 2000, p. 5 in CDPSP, v. 52, no. 48, 
December 27, 2000, p. 10; Moskovskiye Novosti, June 26, 2001, FBIS-SOV-
2001-0628.
---------------------------------------------------------------------------
    When Putin withdrew proposed amendments to the Criminal 
Procedural Code requiring prosecutors and security agencies to 
seek an arrest warrant from a judge before taking an accused 
into custody, critics viewed his decision as evidence of a 
return to authoritarian ways. The President justified his 
retreat by noting such legislation would necessitate adding 
3,000 judges and 6,900 court employees at a cost of 1.5 billion 
rubles ($50 million) to implement the new court procedures. The 
amendments have since been reintroduced over the strong 
objections of the Prosecutor-General, Minister of Interior, and 
head of the Federal Security Agency. Putin has also announced 
his support for introducing jury trials throughout the country 
to be effective by January 1, 2003.\32\
---------------------------------------------------------------------------
    \32\ Sevodnya, January 23, 2001, p. 5, and Novyie Izvestiya, Jan 
24, 2001, p. 1, both in CDPSP; v. 53, no. 4, February 21, 2001, pp. 5-
6; Kommersant, April 4, 2001, pp. 1-2; Moskovskiye Novosti, June 26, 
2001, FBIS-SOV-2001-0628.
---------------------------------------------------------------------------
    Other measures to strengthen the judicial system have not 
fared well. The President has complained about the 
unsatisfactory performance of the marshals (bailiffs), still 
under the Ministry of Justice, in enforcing decisions. The new 
justice of the peace courts designed to handle a large number 
of relatively minor matters have been established in only five 
regions in the first year. While the center is responsible for 
their salaries, the regions are supposed to pay for office and 
hearing facilities as well as housing and municipal services. 
Putin has now proposed to take the whole justice-of-the-peace 
system out of the jurisdiction of regional authorities and 
included funds for this drastic step in the 2002 fiscal 
year.\33\
---------------------------------------------------------------------------
    \33\ Nezavisimaya gazeta, November 30, 2000, p. 3 in CDPSP, v. 52, 
no. 48, December 27, p. 10; Mayak Radio, June 28, 2001, in FBIS-SOV-
2001-0628.
---------------------------------------------------------------------------

                     Raising Educational Standards

    A comprehensive plan to restructure the educational system 
from preschool through the university level is being 
implemented. While Russians are a very literate population, the 
quality of education has fallen behind that of advanced 
countries. Findings of a study for the World Bank released in 
August, 2000, revealed that students in the former Soviet-
dominated bloc now receive on average 5 years less education 
than is the norm for the Organization for Economic Cooperation 
and Development (OECD) states. A study frequently cited by 
Russian sources concludes that the proportion of the Russian 
work force rated as highly skilled is now less than 10 percent 
compared with China at 28 percent, the United States at 42 
percent, and Germany at 54 percent. More than 1.5 million 
Russian children between 7 and 15 are not attending school and 
15 to 20 percent have low reading and writing skills. Another 
36 percent are in schools operating in multiple shifts, which 
means that school days are short and extra-curricular 
activities are minimal. Vocational education programs and 
access to computer training are urgently needed as well as 
modern equipment and qualified teachers. Since 1991 per capita 
spending for public school students has dropped by 38 percent. 
Only 3.2 percent of GDP is allotted to education.\34\
---------------------------------------------------------------------------
    \34\ Trud, October 18, 2001, p. 1, in CDPSP, v. 52, no. 43, 
November 22, 2000, p. 16; Sevodnya, September 28, 2000, p. 6, in CDPSP, 
v. 52, no. 41, November 8, 2000, p. 20; ITAR-TASS, May 24, 2001, FBIS-
SOV-2001-0524; Nezavisimaya gazeta, May 4, 2001. p. 4 in CDPSP, v. 53, 
no. 19, p. 4; Rossiyskaya gazeta, June 23, 2000, p. 9, in CDPSP, v. 52, 
no. 27, August 2, 2000, p. 8; Sevodnya, September 1, 2000, pp. 1, 3 in 
CDPSP, v. 52, no. 35, September 27, 2000, p. 14; Sevodnya, September 
28, 2000, p. 6 in CDPSP, v. 52, no. 41, November 8, 2000, p. 20; Novye 
Izvestiya, August 9, 2000, p. 12, in CDPSP, v. 52, no. 32, September 6, 
2000, p. 12; Hidden Challenges to Education Systems in Transition 
Economies, (Washington, DC; The World Bank, 2000), pp. 2-5, 13-27.
---------------------------------------------------------------------------
    In August 2000 the Council of Ministers approved the 
recommendations for school reform over the next decade 
presented by Yaroslav Kuzminov, rector of the Higher School of 
Economics. Based on British models the plan is to extend 
general education from 10 to l2 years for all students and to 
upgrade the quality of instruction. After the tenth grade they 
will be assigned to college-preparation or vocational-education 
tracks. All curricula are to be revamped with more options for 
students. One goal is to connect all schools to the internet 
over the next 4 years. Extensive retraining programs will be 
required for teachers, e.g., 276,000 in information technology 
alone. Vocational-technical education should be upgraded in 
equipment and instruction. Kuzminov advocates the doubling of 
budget expenditures from the present 3.2 percent of GDP. He 
warns that the People's Republic of China will overtake Russia 
in trained professionals if a greater commitment is not 
made.\35\
---------------------------------------------------------------------------
    \35\ Rossiyskaya Gazeta, June 23, 2000, pp. 8-9, in CDPSP, v. 52, 
no. 27, August 2, 2000, p. 9; Novye Izvestiya, Aug. 9, 2000, p. 4, in 
CDPSP, v. 52, no. 32, September 6, 2000, p. 12; Sevodnya, September 28, 
2000, p. 6, in CDPSP, vol. 52, no. 41, November 8, 2000, p. 20; Trud, 
October 1, 2001, p. 1, in CDPSP, v. 52, no. 43, Nov. 22, 2000, p. 16.
---------------------------------------------------------------------------
    Such a thorough transformation inevitably encounters 
hostility and widespread opposition. On February 27, 2001, a 
demonstration organized by the teachers' union reportedly drew 
300,000 protesters to demand payment of back pay which averaged 
3 months in arrears and a 50 percent increase in salary. The 
average pay of teachers is below the minimum subsistence 
standard set at 1,285 rubles ($43) per month on January 1, 
2001. The Deputy Premier responsible for the sector promised to 
pay promptly any arrears overdue for more than 1 month and to 
raise salaries in the first 6 months of 2002 by 20 percent. She 
claimed that the government lacks the resources to pay teachers 
as much as other budget-funded employees. Salaries are funded 
by the center. Municipal services including utilities, many 
supplies and school buildings, i.e., two-thirds of educational 
expenditures, are the responsibility of regional and local 
governments. Provision has been made to raise teachers' pay by 
50 percent in the proposed 2002 federal budget. That will not 
calm all their worries about change. Equally striking was the 
signature of 1,988,232 teachers in a petition opposing 
proposals to restructure the educational system from top to 
bottom in February. Many fear that the new system will deprive 
their own children of a chance for higher education by sharply 
reducing the number of student stipends.\36\
---------------------------------------------------------------------------
    \36\ Sevodnya, February, 28, 2001, p. 2 in CDPSP, v. 53, no. 9, 
March 28, 2001, p. 13; Trud, April 20, 2001, p. 7 in CDPSP, v. 53, no. 
19, June 6, 2001, p. 5; Trud, September. 21, 2000, p. 7 in CDPSP, no. 
52, no. 39, October. 25, 2000, p. 16; Obshchaya Gazeta, August 16, 
2001, FBIS-SOV-2001-0819.
---------------------------------------------------------------------------
     The rectors of most universities are bitterly against the 
implementation of proposals that will affect their 
institutions' admissions procedures and financing. The rector 
of the prestigious Moscow State University stated bluntly: 
``Our triumphant system of higher education must not be put 
under the complete control of the `invisible hand of the 
market.' '' In his State of the Union message, Putin endorsed 
new policies designed to increase opportunity for young people 
of humble origin living in the provinces. Differentiation by 
social class already exists as 82.5 percent of students at 
prestigious universities come from a small number of elite 
secondary schools. Only 6.5 percent are from ordinary public 
schools. The old Soviet system of admissions still dominates 
whereby each higher education institution designs and 
administers its own tests for admission. Since most state 
institutions give the entrance tests only once per year in the 
city where they are located and on the same day, failure to 
attend means postponing entry into higher education for a year, 
taking a second test offered later by a less prestigious 
institution, entering the workforce with poor qualifications, 
or going into the military. The Ministry of Education has 
initiated a pilot project to give a national high school 
graduation/college admission exam comparable to the U.S. 
Scholastic Aptitude Test (SAT) which is to be conducted by 
outside examiners at 20 sites in each of three regions. 
Opportunities to collect substantial fees for special tutoring 
and bribes to influence decisions on admissions may be 
considerably reduced.\37\
---------------------------------------------------------------------------
    \37\ Nezavisimaya Gazeta, September 1, 2000, p. 15, in CDPSP, v. 
52, no. 35, September 27, 2000, p. 14; Moskovskiye Novosti, no. 47, 
November 28-December 4, 2000, p. 19 and Noviye Izvestiya, December 8, 
2000, p. 2, both in CDPSP, v. 52, no. 49, January 3, 2001, p. 14; 3 
articles in Kommersant, April 26, 2001, p. 8, in CDPSP, v. 53, no. 19, 
June 6, 2001, pp. 1-3; Nezavisimaya Gazeta, September 1, 2000, pp. i, 3 
in CDPSP, v. 52, no. 35, September 27, 2000, pp. 14-15; Izvestiya, 
January 27, 2001, p. 5 in CDPSP, v. 53, no. 4, February 21, 2001, p. 
16.
---------------------------------------------------------------------------
    Even more threatening to the rectors is a radical 
initiative to issue full or partial tuition vouchers to the 
best achievers on the national examination. These students will 
be able to take their vouchers to any institution of higher 
education of their choice. Provision will be made for living 
allowances to children from poor families. Those not qualifying 
for vouchers will have to pay their own way. As is the case 
now, those possessing dollars are likely to gain entry. Whether 
or not an institution flourishes will depend to a significant 
degree on the competition to attract students with 
vouchers.\38\
---------------------------------------------------------------------------
    \38\ Kommersant, June 23, 2000, p. 8 in CDPSP, vol 52, no. 27, 
August 2, 2000. pp. 8-9; Moskovskiye Novosti, no. 47, November 28-
December 4, 2000, p. 19 in CDPSP, v. 52, no. 49, January 3, 2001, p. 
14; Kommersant, April 26, 2001, p. 8 in CDPSP, v. 53, no. 19, June 6, 
2001, pp. 1-2.
---------------------------------------------------------------------------
    The acquisition of resources to maintain higher education 
standards has been a serious problem for rectors since 1991. 
State funding for higher education amounts to only 0.6 percent 
of GDP. That sum compares unfavorably with 5.2 to 5.5 percent 
allotted in France, Germany and the United Kingdom. The state 
will continue to fund salaries, the physical plant, utilities 
and equipment on campuses. In addition, the rectors will be 
encouraged to raise money from private sources with the state 
offering matching grants. Already substantial sums have been 
acquired from the private sector by renting out facilities or 
winning research contracts. Now the government is mandating 
that these revenues be reported. It is hoped that 50 percent of 
operating revenues will eventually come from non-governmental 
sources as well as individual students paying their whole 
tuition. Budget resources are unlikely to increase 
significantly in the next few years.\39\
---------------------------------------------------------------------------
    \39\ Rossiyskaya Gazeta, June 23, 2000, pp. 8-9 in CDPSP, v. 52, 
no. 27, August 2, 2000, p. 9; Kommersant, April 26, 2001, p. 8, 
Nezavisimaya Gazeta, May 4, 2001, p. 3 and Trud, April 20, 2001, p. 5, 
all three in CDPSP, v. 53, no. 19, June 6, 2001, pp. 1-2, 4-5.
---------------------------------------------------------------------------

                               Conclusion

     As explained in this paper, the Putin Administration is 
engaged in executing an ambitious agenda of reforms targeted at 
overcoming institutional obstacles inherited from the Soviet 
CPE era. Budget resources will remain very scarce in the years 
immediately ahead. Some changes, e.g., reduction of subsidies 
in the housing and municipal services sector as well as social 
welfare entitlements would recast basic elements of the old 
social contract still in place. Restructuring the pension 
system is imperative to lessen the future burden on the 
Federation budget and to channel the flow of much needed 
resources into the financial services sector. Strengthening a 
reformed judicial system is taking place and the charge will be 
a relatively light burden on the Treasury. An expensive 
upgrading of the quality of education is essential for Russia 
to be competitive with G-7 states in global markets and to 
sustain economic growth.
    Unlike in the early years of the transition, a system of 
institutions for the sound management of fiscal affairs now 
exists at the federal level. Even without a formal agreement 
with the IMF, sound budget policies are being implemented. Too 
often the center has achieved the macro-economic goal by 
shifting financial responsibility for support of federal 
agencies, including the military and social welfare 
entitlements, to lower levels of government. Simultaneously, 
the center has repeatedly changed the share of revenues 
assigned to subordinate authorities which lack the means 
required to pay obligations in full. This uncertain situation 
makes the implementation of sound budget practices difficult 
and often impossible. Inevitably, governors and mayors are 
accused of arbitrariness as they reduce payments to match 
available funding. Under considerable political pressure the 
Putin Administration in August, 2001, proposed a legislative 
act to distinguish the responsibilities belonging to the center 
and those to the regions and local governments. The agency 
responsible for a particular function should be able to fund it 
from its own resources. In addition, the division of revenues 
should be set until 2005 to make possible reasonable budget 
management.
    The President and his ministers understand that the key to 
retaining the support of a majority of the population for 
market reforms is dependent on significant improvements in the 
standard of living. The ``socially oriented'' 2002 budget 
proposal submitted to the state Duma has at its core a dramatic 
increase in the salaries of civil servants and the military by 
50 to 70 percent. However, households will have to expend part 
of their higher income on increased charges for housing 
maintenance, municipal services, and utilities. As these 
expenses are phased in, expectations of the public about the 
proper responsibilities of the state will likely change to be 
comparable to those in the ``social market'' societies of 
Western Europe. Such a trend is positive for the interests of 
the United States.






                        RUSSIAN DEFENSE SPENDING



                       By Christopher J. Hill \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   161
Introduction.....................................................   162
The Russian Defense Budget.......................................   162
Defense Spending Outside the Official Defense Budget.............   166
Trends in Defense Spending.......................................   167
The Allocation of Russian Defense Spending.......................   169
    Allocation by branch of service..............................   169
    Allocation by function.......................................   171
Financial Aspects of Weapons Production..........................   174
The Defense Burden...............................................   175
Defense Spending in Dollars......................................   176
Prospects........................................................   177
                                Summary

    The published Russian defense budget is an inadequate guide 
to the country's total defense spending because many items 
which would be incorporated in any Western calculation are 
ignored. The true level of outlays last year was approaching 
twice the acknowledged figure.
---------------------------------------------------------------------------
    \1\ Dr. Hill has worked in a number of government offices in the 
United Kingdom. He is currently head of the Defense Economics branch of 
the Ministry of Defense (MOD). His doctorate is from Manchester 
University.
---------------------------------------------------------------------------
    Despite an increase of around 16 percent after inflation in 
the last 2 years, overall defense expenditure in 2000 was well 
under 40 percent of that in 1992 and just 15 percent of that of 
the Soviet Union at its 1988 peak. Moreover, last year almost 
three-fifths of the money was spent on personnel, leaving a 
hopelessly inadequate level of funding for weapons research, 
development, procurement and maintenance. As orders for new 
weapons have dried up, defense industries have been hard hit 
and many, perhaps most, are now by any normal measure bankrupt.
    Russia devotes well over 5 percent of its gross domestic 
product (GDP) to defense, twice the North Atlantic Treaty 
Organization (NATO) average, but because of inadequate 
accounting procedures, both the political and military 
leadership is of the view that the burden is under 3 percent. 
Total defense outlays in 2000 were equivalent to around $50 
billion, the third largest in the world.
    The Russian Government hopes to double Defense Ministry 
spending per serviceman by 2005 and to triple it by 2010. 
Despite plans for substantial cuts in the size of the armed 
forces, these goals are unlikely to be realized. The overall 
weapons inventory will fall during the rest of this decade. 
Only thereafter will capability gradually improve.

                              Introduction

    This paper looks at the financial resources which the 
Russian Government has made available for defense over recent 
years. It examines what the authorities in Moscow have 
themselves said about the level of such spending and assesses 
the comprehensiveness and reliability of those statements. 
Alternative ruble valuations are then offered as well as a 
judgment on the likely real trend in defense outlays once 
inflation has been taken into account. This is followed by some 
thoughts on the allocation of those funds both by branch of 
service and by function. After a short digression on the 
financial state of Russia defense industries, the report 
returns to its main theme, exploring the burden defense 
spending currently places on the Russian economy, comparing 
that both with the past and with other countries. In 
recognition of the problems many readers have with the use of 
rubles, an attempt is also made to convert Russian military 
spending into dollars via specially constructed ruble-to-dollar 
defense exchange rates. Finally, the piece offers a scenario 
for defense spending over the next decade and considers whether 
it will be sufficient to support any major resurgence in 
military capability during that period.

                       The Russian Defense Budget

    Every year Russia compiles a defense budget. There are 
extensive discussions over available funding and priorities 
within the Ministry of Defense (MOD) and between that 
organization and both the Presidency and the Ministry of 
Finance before the government determines its spending plans, 
usually in the summer or fall. The figures are then submitted 
to the Duma where they are subjected to close scrutiny and in 
some years substantially revised. With the calendar and Russian 
fiscal years coinciding, the aim is to secure final approval of 
the budget before the end of December though this has not 
always been achieved.
    Table 1 shows the defense budget allocation approved by the 
Duma in each of the last 10 years. Massive increases have 
occurred in all but 1 year, with an average annual rise over 
the entire period in excess of 100 percent.
    Unfortunately, the funding actually given to the MOD, now 
usually published on a monthly basis, rarely bear much relation 
to the figures in the original budget. Outlays have regularly 
been revised, formally or informally, during the course of the 
year because of changed expectations on inflation, problems in 
securing budget revenues or altered perceptions of MOD 
requirements. This change has not always been in the same 
direction. In 1998, for example, the budget allocation was 81.8 
billion rubles but, with the economy in trouble, the MOD was 
ultimately allowed to spend only 65.1 billion rubles. The 
following year the defense budget as approved by parliament 
foresaw outlays of 93.7 billion rubles but this was later 
increased to 109 billion rubles while the final count showed 
that over 116 billion rubles had actually been spent. In 2000 
the budget was revised upward from 143 billion rubles to 154 
billion rubles and outlays finally topped 190 billion rubles. 
Annual budget outlays for all years since 1992 and monthly 
outlays for 1998 through 2000 are given in Tables 2 and 3.

             TABLE 1.--THE OFFICIAL DEFENSE BUDGET 1992-2001
                         [In billions of rubles]
------------------------------------------------------------------------
------------------------------------------------------------------------
1992....................................................          R0.384
1993....................................................           3.116
1994....................................................          40.626
1995....................................................          48.577
1996....................................................          80.185
1997....................................................         104.300
1998....................................................          81.765
1999....................................................          93.702
2000....................................................         143.000
2001....................................................         218.924
------------------------------------------------------------------------



                              TABLE 2.--OFFICIAL DEFENSE BUDGET OUTLAYS, 1992-2000
                                             [In billions of rubles]
----------------------------------------------------------------------------------------------------------------
                                                                     Approved     Reported final      Under/
                              Year                                defense budget  defense budget   overspend in
                                                                    allocation        outlays         percent
----------------------------------------------------------------------------------------------------------------
1992............................................................          R0.384          R0.855            +123
1993............................................................           3.116           7.210            +131
1993 Revised....................................................           8.327           7.210             -13
1994............................................................          40.626          28.028             -31
1995............................................................          48.577          47.800              -2
1995 Revised....................................................          59.379          47.800             -20
1996............................................................          80.185          63.900             -20
1997............................................................         104.300          79.700             -26
1997 Revised....................................................          83.000          79.700              -4
1998............................................................          81.765          65.100             -20
1999............................................................          93.702         116.800             +25
1999 Revised....................................................         109.000         116.800              +7
2000............................................................         143.000         190.800             +33
----------------------------------------------------------------------------------------------------------------


    Even when these adjustments have been carefully noted, 
headline figures on defense spending are of themselves of 
limited worth without clear evidence on their coverage and 
composition. After decades during which Moscow effectively 
refused to provide any meaningful commentary on, or 
justification for, its claimed level of outlays, glasnost led 
to a gradual opening of the database and by the mid-1990s 
intended expenditure in a whole range of sub-categories was 
being published. The analysis this generated from both Russian 
and overseas scholars appears, however, to have alarmed some in 
the Kremlin and thereafter tighter censorship was exercised. 
Last year the initial allocation for all of the activities of 
the MOD and for the Ministry of Atomic Energy's work on nuclear 
weapons were together summed up in just four published line 
items. Funding for maintenance of the armed forces and for 
military procurement was put into appendices which were 
classified. No information has been supplied on how final 
spending levels differed from those planned even in the 
broadest categories.

                          TABLE 3.--OFFICIAL DEFENSE BUDGET OUTLAYS BY MONTH, 1998-2000
                                             [In billions of rubles]
----------------------------------------------------------------------------------------------------------------
                                                                  1998              1999              2000
                                                           -----------------------------------------------------
                                                                      Total             Total             Total
                                                            Monthly   to end  Monthly   to end  Monthly   to end
                                                            outlays     of    outlays     of    outlays     of
                                                                      month             month             month
----------------------------------------------------------------------------------------------------------------
January...................................................     R3.7     R3.7     R3.0     R3.0    R11.6    R11.6
February..................................................      3.6      7.3      4.3      7.3     10.2     21.8
March.....................................................      3.6     10.9      9.0     16.3     20.1     41.9
April.....................................................      4.0     14.9      8.3     24.6     14.0     56.0
May.......................................................      2.5     17.4      7.9     32.5     14.1     70.1
June......................................................      4.8     22.2      8.1     40.6     12.1     82.2
July......................................................      2.5     24.7      8.7     49.3      9.8     92.0
August....................................................      3.5     28.2      8.6     57.9     16.9    108.9
September.................................................      5.4     33.6     13.1     71.0     12.5    121.4
October...................................................      5.5     39.1     12.9     83.9     22.8    144.2
November..................................................      8.7     47.8      9.6     93.5     19.5    163.7
December..................................................     17.3     65.1     22.6    116.8     27.1    190.8
----------------------------------------------------------------------------------------------------------------


    After an outcry from deputies in the Duma and others, this 
policy of concealment was partially reversed for the 2001 
budget and the breakdown of intended expenditure was made 
available (see Table 4).
    Although a significant advance over the previous year, the 
2001 budget still leaves over one-third of the defense budget 
expenditure unexplained. The vast majority of the money is 
almost certainly intended for the state defense order which 
covers primarily the research, development and procurement of 
weapons and spare parts. However, detailed information in this 
area remains classified. There has been no revival of the data 
provided through 1997 on the percentage allocation of 
procurement spending by branch of service and the costs of 
individual weapons programs are rarely mentioned. Moreover, 
comparisons with earlier years are difficult because of 
structural changes. As the government eventually, and 
reluctantly, conceded, most of the apparent rise in defense 
spending in 2001 is the result of nothing more than a decision 
to fund international peacekeeping activities, military reform 
and the railway troops out of the defense budget rather than, 
as previously, other parts of the government budget. Nor are 
such structural changes unique to this year. In 1995, for 
example, some hitherto unacknowledged research and development 
outlays were transferred for the first time into the defense 
vote. Then, in 1998, military pensions were moved in the 
opposite direction, a decision which explains most, though not 
all, of the apparent decline in nominal planned spending in 
that year. In 2000, part of the MOD's civilian pay bill was 
apparently met from outside the defense budget though whether 
this continued in 2001 is unclear.

               TABLE 4.--THE OFFICIAL DEFENSE BUDGET, 2001
------------------------------------------------------------------------
                                                Billions of   Percentage
               Budget line item                    rubles     allocation
------------------------------------------------------------------------
Personnel maintenance.........................        R91.6         41.8
    Monetary allowances including wages for            62.5
     civilian personnel.......................
    Food......................................           17
    Uniforms..................................          3.6
    Holiday pay and assignments for health                3
     care.....................................
    Benefits and compensations................          1.4
Combat training and logistics.................        37.51         17.1
    Housing maintenance and repair............         15.9
    Payment for and storage of special fuels..           12
    Transportation............................          5.7
    Maintenance, operation and repair of                1.8
     property and installations...............
    Other expenditures........................          1.9
Atomic energy program.........................        5.129          2.3
Mobilization and reserve training.............        2.277          1.0
CIS collective security and peacekeeping......        2.715          1.2
Education and health care expenditures........         2.15          1.0
Insurance guarantees..........................          1.5          0.7
Central military command......................        0.912          0.4
Defense industries............................        0.302          0.1
Other (unspecified)...........................       74.829         34.2
                                               -------------------------
        Total defense budget..................      218.924          100
------------------------------------------------------------------------


    Although the Ministry of Finance has in recent years 
exercised considerable power over the amount of money actually 
released to the MOD through the defense budget, it seems 
thereafter to have had little ability to monitor its usage. The 
MOD has operated through special accounts in the Central Bank 
of the Russian Federation (Central Bank of Russia or CBR) to 
which others have had little, if any, access. Funds have been 
switched between objectives with minimal consultation or 
transparency, opening the MOD to accusations of non-
accountability, corruption, waste and political manipulation. 
The Ministry of Finance has been trying to wrestle control of 
detailed defense budget spending from the generals since at 
least 1997 but only over the past year has its campaign begun 
to bear fruit. President Putin has now, against the MOD's 
wishes, insisted that in future all of the Ministry's payments 
must be processed by federal treasury bodies which will be 
expected to ensure that monies are spent only in accordance 
with the budget law. To assist them a new budget code and 
stricter accounting practices are being introduced. The 
appointment in March 2001 of Lyubov Kudelina, an economics 
graduate with over 20 years' experience in the Finance 
Ministry, as a Deputy Defense Minister with special 
responsibility for budgets and finance, is clearly meant to 
underline the new order. It is, however, too early to say how 
effective in practice will be the intended tighter financial 
management.

          Defense Spending Outside the Official Defense Budget

    Russian tallies of final defense spending, though of more 
value than the figures contained in planned budgets, still 
present an inadequate picture of the true level of outlays. 
This is because the government in Moscow operates on a very 
different definition of what constitutes defense spending than 
the one adopted by NATO countries. Expenditure on many of 
Russia's military personnel is not found, as it would be in the 
west, in the defense allocation but rather in other parts of 
the state budget. Examples include internal security troops, 
the federal border guard, the presidential guard, the federal 
security service, those forces formally designated for the 
protection of the Russian federation and, until this year, 
railway troops. In total these organizations contain well over 
500,000 people and deploy significant numbers of aircraft, 
helicopters, armored combat vehicles, artillery pieces and 
patrol craft.
    Other elements of defense spending are also located in 
supposedly civilian component of the state budget. These 
include: research and development work of specific military 
interest funded through the basic science and research vote; 
subsidies for defense enterprises and defense related 
construction as well as support for many defense related so-
called presidential programs, met through the industry, energy 
and construction budget; money for conventional arms control 
and non-proliferation, including for the destruction of 
chemical weapons, treated separately in the state budget; 
subsidies to defense industries paid through the allocation to 
closed territories; national defense costs defrayed through 
provision made to the federations; military courts paid for out 
of the justice budget; and, as already mentioned, military 
pensions.
    There are also a number of off-budget sources of defense 
spending. Oblasts and cities have on occasions provided direct 
financial assistance for local defense enterprises and military 
units \2\ while the factories themselves sometimes subsidize 
weapons production and repair out of the proceeds of their 
civilian activities, often, it should be said, from ignorance 
of true costs. Some money earned from the export of military 
equipment is also plowed back into defense, in particular 
spending on research and development of new technologies. In 
December 2000 Leonid Safronov, Deputy Minister of Industry, 
Science, and Technology, announced that the government planned 
to impose a duty of 6.5 percent on military exports. The money 
thus obtained would then be divided up among new promising 
projects. The MOD earns significant sums of money by hiring out 
soldiers to local authorities and civilian enterprises, by 
leasing property and by selling second hand equipment, 
including weapons. These funds are then used to supplement the 
central government's budget allocation. Again, both the MOD and 
defense factories engage in barter deals, many of whose details 
are probably not even reported to the center, and borrow funds 
at extremely soft interest rates. And, finally, the MOD saves 
much money by delaying payments as long as possible, thus 
ensuring, at a minimum, that intervening inflation will reduce 
the real value of the debt while hoping that the central 
government will ultimately assume responsibility for meeting 
the obligations. The latter ploy has proved highly successful. 
In late 2000 the government agreed to take over from the MOD 
responsibility for debts it had incurred to the defense 
industries.
---------------------------------------------------------------------------
    \2\ The Moscow city government has, for example, funded major 
overhaul work on Russian naval vessels.
---------------------------------------------------------------------------
    The total value of off-budget defense spending is very 
difficult to estimate and clearly varies widely between years, 
dependent partly on the seriousness of the MOD's financial 
plight and the condition of the overall economy. Defense 
outlays drawn from allegedly civilian parts of the state budget 
are easier to identify although some uncertainty obviously 
remains. Nonetheless, it seems likely that in 2000 not far 
short of half of budget funded defense spending came from 
outside the official defense budget. In 1999 the proportion had 
been even higher.

                       Trends in Defense Spending

    A major problem with all Russian defense budget figures is 
that they are given only in the prices of the year under 
consideration. Measuring the real change in spending over time 
requires an allowance to be made for inflation. Moscow does not 
publish--and probably does not calculate--an inflation rate 
specifically for the defense sector. Inflation data for 
consumer goods and, indeed, for products offered wholesale is 
provided and some commentators have used particularly the first 
of these in an attempt to measure real changes in planned 
outlays. However, prices in individual sectors of an economy 
often change at very different paces, particularly in countries 
(like Russia) where general inflation is high and market 
mechanisms are inadequately developed, and there is no warrant 
for assuming that the price of Russian weapons has, over either 
the short or the long term, increased in line with that of 
consumer goods. Calculations of the real change in official 
defense spending made on this basis are thus of uncertain 
validity. Add in the problem of trying to determine the 
inflation adjusted level of defense spending outside the 
published defense budget when even its nominal level is not 
entirely clear and it is obvious that, at the very least, some 
method for cross checking the results is needed.
    This is provided by the building block approach, initially 
developed in the United States during the 1950s. In concept it 
is very simple: identify every item that falls within what NATO 
would call defense expenditure, determine the outlays on each 
of them and then add everything together to produce a figure 
for total defense spending. Thus, for example, spending on 
weapons procurement is calculated by identifying every system 
that has been purchased and how many of each has been obtained 
and then multiplying that by the unit price. Similarly, 
military pay is determined according to how many servicemen 
there are in each rank and the salary, including the various 
allowances, given to those ranks. Constant prices of a selected 
year are normally used to overcome the problems of inflation. 
The method ought to be foolproof. The problem is, of course, 
getting hold of all of the inputs. Even in post cold-war 
Russia, much of the information is highly classified and some 
may not be collated at all. How, for instance, can even the 
most dedicated Western analyst hope to identify and price every 
piece of new construction or repair at every military facility 
or know in detail the cost of work in each field of defense 
research? In many areas, there is no alternative but to 
aggregate and estimate. Nobody should pretend that the final 
results are perfect. They are, however, even for determining 
aggregate levels of spending, usually an improvement over 
anything that can be obtained by accepting or, indeed, 
manipulating Russian Government figures.
    Figure 1 shows the real value of total Russian defense 
spending over recent years according to building block 
calculations carried out by the author. It reveals a stark fall 
in outlays through 1998, at which point they were worth only 
about one-third of those some 6 years earlier. Such a steep 
rate of decline would appear to be unparalleled among major 
states that have not suffered defeat in war. There has been 
some recovery over the past 2 years but in 2000 total defense 
expenditure was still in real terms worth well under 40 percent 
of that in 1992 and 15 percent of that of the Soviet Union at 
its 1988 peak.

    FIGURE 1._TOTAL DEFENSE SPENDING ON NATO DEFINITIONS, 1992-2000

              [Billions of rubles at constant 2000 prices]

[GRAPHIC] [TIFF OMITTED] T6171.003


    The dramatic decline in defense outlays during the early 
and mid-1990s was primarily the result of severe economic 
difficulties. Russian GDP fell by over 40 percent between 1992 
and 1998, inflation ballooned out of control for a time and 
remained high throughout the period, unemployment increased to 
around 12 percent of the workforce, living standards for most 
people plummeted and the government found it very difficult to 
raise the revenue needed to meet its obligations. Beyond this, 
however, defense was accorded a much lower priority by 
President Yeltsin and most of his senior advisers than it had 
been by their Soviet predecessors. The cold war was over, the 
West was sympathetic to the regime and, in any case, the 
military still possessed huge amounts of modern, serviceable 
equipment.
    During 1999 and 2000 Russian defense spending rose in total 
by an estimated 16 percent after inflation. The beginnings of 
genuine economic recovery--GDP grew by about 14 percent over 
the same period--meant that, for the first time in years, it 
was possible to find extra resources for defense without 
hitting significantly either standards of living or the rest of 
the economy. Beyond that, however, the military put forward an 
increasingly powerful case for more resources. The 
international scene appeared to be darkening. NATO's actions in 
Yugoslavia were presented as evidence that the West, despite 
fine words, remained fundamentally hostile to Russian interests 
and was willing to pursue its goals with vigor unless 
constrained by the existence of strong Russian forces. Islamic 
militancy in Chechnya and Central Asia not only brought home 
the reality of the threat to national unity and to Russian 
influence in the near abroad but also underlined the weakness 
of the Russian forces. No longer was it possible to claim that 
weaponry and skills inherited from the days of the Soviet Union 
were adequate. Finally, the replacement as Russian President of 
Yeltsin by Putin brought to the fore a man with both more 
sympathy for security concerns and a greater belief in the need 
to keep the military onside.

               The Allocation of Russian Defense Spending

    One advantage of the building block methodology is that, 
with defense spending computed item by item, it is possible to 
recompile it according to different definitions. The two most 
useful are by branch of service and by function.

                    allocation by branch of service

    Figure 2 shows our estimate of the percentage distribution 
of outlays by service in 2000.\3\
---------------------------------------------------------------------------
    \3\ For the purposes of this figure the SSBN fleet is considered 
part of the strategic forces rather than the navy.
---------------------------------------------------------------------------
    The calculations indicate that in 2000 nearly two-thirds of 
total defense outlays went to the regular forces, with the 
remainder split between the various paramilitary organizations 
(border guards, internal security troops and the like), MOD 
civilians and certain centralized MOD functions which cannot 
sensibly be allocated to a particular service. Within the money 
devoted to the regular forces, the largest share went to the 
ground forces followed by the air and air defense forces and 
the strategic forces. Such distributions usually change only 
slowly over time but in Russia during the 1990s there was a 
significant enhancement in the proportion of funding allocated 
to the strategic forces. The reasons for this are not discussed 
by the Russians in public but to a western observer they are 
clear. Strategic weapons provide far more ``bangs for the 
buck'' than conventional systems and make better sense while 
the major threat is thought to come from a technically 
superior, nuclear armed, NATO. In the 1970s and 1980s Moscow's 
understanding of a war with NATO was, in crude terms, one in 
which its heavily superior conventional forces drove through 
Germany, placing on Western leaders the unpalatable choice 
between surrender or resort to nuclear weapons. In the 1990s, 
with the break-up of the Warsaw Pact, this was no longer 
practicable. Weapons of mass destruction were now seen as 
increasingly essential to offset conventional weaknesses which, 
through lack of money and other resources, could not be 
addressed.

        FIGURE 2._DEFENSE SPENDING BY BRANCH OF SERVICE IN 2000

[GRAPHIC] [TIFF OMITTED] T6171.002


    Over the last 2 years there have been some signs that this 
emphasis is beginning to be questioned. Many in the MOD have 
come to accept that the military problems Russia faces--and is 
likely to continue facing over the next decade--cannot be met 
by strategic forces. Intercontinental and submarine launched 
ballistic missiles are of little use in the conflicts in 
Chechnya or the near abroad. The challenge there is from bands 
of Islamic militants and the requirement in military terms is 
for better trained and better equipped ground and air forces. 
The reduction in the relative financial priority for these 
branches of service has, it is thought, run counter to Russia's 
true needs.
    Not all, however, yet share the new thinking. One reason 
for the very public spat that occurred over summer and autumn 
2000 between the then Defense Minister Sergeyev and the Chief 
of the General Staff Kvashnin was the very different 
perspectives they held on the relative importance of strategic 
and conventional forces. After much hesitation President Putin 
appeared to back Kvashnin, agreeing that more money needed to 
be put into conventional systems and that--partly to save 
money--the Strategic Missile Forces should by 2006 lose their 
independence and be absorbed into the air force. The latest 
information suggests, however, that the battle is far from 
over.\4\
---------------------------------------------------------------------------
    \4\ In spring 2001 Kvashnin was still continuing his campaign, 
reportedly telling the Academy of Military Sciences that ``the Russian 
army is a man with one arm pumped up (that's the Strategic Missile 
Troops) while the other is short and dried-up (that's the general 
purpose forces). That's not a normal man; it's some kind of mutant. I 
can't allow that. It won't work! We'll dry up together!!''
---------------------------------------------------------------------------

                         allocation by function

    In the Soviet era over two-thirds of all defense spending 
was typically allocated to the research, development, 
procurement and maintenance of military equipment and 
supporting infrastructure. This left a smaller proportion for 
personnel related expenditure (pay, allowances, pensions, food, 
clothing, accommodation, etc.) than in the United States or 
United Kingdom despite the very large numbers that the Soviet 
Union had under arms. The explanation, of course, was that most 
servicemen were conscripts who could be forced to endure 
dreadful living standards, receiving in return just pocket 
money. The change in the distribution of Russian spending over 
the last decade has been dramatic, as our estimates for 2000--
given in Figure 3--demonstrate.

           FIGURE 3._DEFENSE SPENDING BY FUNCTION IN 2000 \1\

[GRAPHIC] [TIFF OMITTED] T6171.001



  \1\ These figures, being based on NATO definitions of what 
constitutes defense spending and how it should be allocated by 
category, inevitably differ from the partial data given by the 
Russians for the functional breakdown of the defense budget.

    Personnel related spending now accounts for approaching 
three-fifths of all defense outlays, a significantly higher 
proportion than in the West. Despite this, however, the MOD has 
still not been able to meet all its obligations. Officer 
salaries, once the envy of most employees in the civilian 
economy, have fallen dramatically in real terms as infrequent 
pay rises have failed by a long way to keep pace with 
inflation. Table 5 shows typical earnings for spring 2001.

         TABLE 5.--SALARIES OF MILITARY OFFICERS IN SPRING 2001
                           [Rubles per month]
------------------------------------------------------------------------
                                             Basic   Additional
                                             salary   payments    Total
------------------------------------------------------------------------
Lieutenant in charge of platoon...........   R1,627       R743    R2,370
Captain in charge of company..............    2,080         NA        NA
Lieutenant Colonel in charge of battalion.    2,562        953     3,515
Colonel in charge of regiment.............    4,041         NA        NA
Major General in charge of division.......  \1\ 5,0      1,301     6,329
                                                 28
------------------------------------------------------------------------
\1\ A different source gives this figure as 4,786 rubles.
NA--Not available.


    Although precise calculations are difficult, it seems 
likely on these figures that a pay increase of more than one-
third would be needed to provide most Russian officers with the 
same income relative to their civilian counterparts as would be 
normal in a western society. Moreover, although the large pay 
arrears that built up during the Yeltsin era have now largely 
been cleared, neither the recently growing economy nor supposed 
government sympathy for the military's plight has changed the 
fundamental position of the military officer. Published data 
suggests that over the past 2 years the only servicemen to 
secure pay rises much above inflation have been those sent to 
hot spots such as Chechnya.
    Although a large number of officers have been forced to 
take second jobs (thus provoking media sarcasm over ``part-time 
soldiers''), Russian statistics suggest that at the beginning 
of 2001 almost half of service families were living below 
subsistence levels and some 170,000 personnel were still on 
housing waiting lists. Morale among officers is unsurprisingly 
very low while recruitment is increasingly difficult. The 
average age of pilots in the air force has reached 37 compared 
to 30 in 1992. Frustrated by financial hardship, many officers, 
both senior and junior, have turned to corruption. In December 
2000 Colonel General Oleynik, head of the Directorate of Budget 
and Finance, was dismissed (perhaps a little harshly) for 
involvement in the alleged laundering of $450 million of 
defense budget funds through a Ukrainian company. As of late 
spring 2001, a further 13 generals were also said to be under 
investigation for corruption by the military prosecutor. In a 
report to the state Duma in May 2001 the Russian Audit Chamber 
stated that last year the Defense Ministry lost some 1.5 
billion rubles through embezzlement and other illegal 
activities
    The situation for conscripts is, of course, even worse than 
that for officers. As in the Soviet era, pay consists of no 
more than pocket money while the quality of benefits-in-kind 
(food, clothing, accommodation, etc.) has declined. Diet is at 
best monotonous and there have been occasions on which units 
have run out of basic foodstuffs. Worn out uniforms are not 
replaced and there has usually been no money to repair and 
maintain barracks. Sanitary conditions are often appalling. 
Inevitably, although discipline has generally been maintained, 
there are many reports of suicides, desertions, nervous 
breakdowns and physical ill health. On a per capita basis 
outlays on medical services in the forces were last year just 
one-fifth of those in Russia as a whole--and the latter were, 
by either Western or even past Soviet standards, grossly 
inadequate.
    However insufficient, the money made available to support 
servicemen has been generous compared to that directed toward 
equipment research, development, procurement and maintenance. 
These now account for less than two-fifths of total defense 
funding. Although much basic research has continued, 
particularly in areas where the cost is not excessive, there 
have been problems maintaining momentum through the prototype 
construction, testing and evaluation phases. Program timings 
have been stretched and in some cases projects survive in 
little more than name. Russia's weapons research and 
development network, though still extensive and, by West 
European standards, achieving impressive results in some areas, 
is but a shadow of its former self.
    As both total defense outlays and the proportion of those 
remaining allocated to equipment procurement have fallen, 
orders for new weapons dried up. By the late 1990s the value of 
overall weapons production had declined to less than one-tenth 
of what it was at the start of the decade. As Table 6 shows, 
many key sectors were hit even harder than that.

                                     TABLE 6.--WEAPONS PRODUCTION 1990-2000
----------------------------------------------------------------------------------------------------------------
                                                                    1990    1992    1994    1996    1998    2000
----------------------------------------------------------------------------------------------------------------
Tanks...........................................................   1,600     500      40       5      10      30
Light AFVs......................................................   3,400     700     400     300     250      50
Fighters........................................................     400     150      50      20      30      40
Bombers/ASW/SMAC................................................      40      20       2       1       0       0
ICBMs/SLBMs.....................................................     120      70      25      20      15       5
Major warships..................................................       2       2       0       1       0       1
Submarines......................................................      12       6       4       3       1       1
----------------------------------------------------------------------------------------------------------------


    Official figures showing a significant percentage growth in 
state spending on defense equipment procurement over the past 2 
years must, if true, reflect the acquisition of smaller systems 
and spares which attract little publicity. Certainly, there is 
little to justify them in terms of major weapons production. 
Despite its relative funding priority, the output of ICBMs has 
fallen to such an extent that around 60 percent of the missiles 
currently deployed are now past the service life originally 
planned for them. Tank manufacture has virtually ceased at one 
of the two plants still working in the field and only continued 
at the other in a desultory manner. Of the two major fighter 
production firms, one--MiG--apparently has very few orders 
while the principal bomber facility may also have little to do. 
Last year it was reported that only 1 percent of Russian 
military aircraft had been built since 1995 and almost half of 
the fleet dated to before 1985. The shipyards have a similar 
shortage of orders. Moreover, with conventional systems, a 
large share of the manufacturing that has taken place is aimed 
at the export market, particularly China and India, leaving 
virtually nothing for Russia's own forces. All of the new 
submarines constructed in recent years have, for instance, been 
destined for overseas.
    The MOD did not just have to give up its hopes of new 
weapons systems. Funding has been so tight that it has also 
continually postponed necessary maintenance contracts. As a 
result, by late 1999, only 30 percent of the ground forces' 
helicopters and 60 percent of its tanks were reported as being 
in satisfactory condition. The air force claimed around the 
same time that some 500 of its fixed wing aircraft and 
helicopters were in need of major renovation while the navy 
said that three-fourths of the vessels still in service needed 
refitting or repairs. These figures, though obviously open to 
definitional questions, give an accurate flavor of the 
deterioration in capability.
    Moreover, even when systems were operational, there was 
often insufficient funding to train servicemen fully in their 
use. Average flying time for air crews, low by Western 
standards even in Soviet times, fell sharply. With just one-
fifth of the fuel supplies the air force judged necessary, 
bomber pilots managed on average only 20 hours of airborne 
training last year while fighter pilots did even worse, 
securing just 10 hours. Around 400 of the 1500 pilots 
graduating from military schools since 1995 have apparently yet 
to get airborne. The air force has publicly blamed limited 
flight training for the 50 percent increase in accidents that 
took place last year. The navy has had similar problems. In 
2000 warships were reportedly at sea on average for just 6.4 
days while the naval air force spent 11 percent less time in 
the air than in 1999, itself a poor year even by previous 
Russian standards. Ground troops have reported insufficient 
fuel to run vehicles and have had to restrict activity.
    Infrastructure has also suffered. Excluding military 
housing, it currently receives only an estimated 6 percent of 
overall defense outlays. Keynote projects have been few in 
number and more basic improvements limited. By last year two-
thirds of military airfields were said to be in need of major 
overhaul and modernization while only one-fifth of the money 
which experts said was needed to tackle the problem was made 
available. One report concluded gloomily that, if the situation 
did not change, practically all military runways could be out 
of service by 2005. Ship repair facilities were also still 
ignored; the navy claimed that only 4 percent of the necessary 
funding was supplied in 2000. Although in 1997 Russia pledged 
to eliminate its chemical weapons stocks within 10 years only 
meager progress has been made, largely because of lack of 
money. In 2000 the budget allocated little more than one-sixth 
of the sum specialists said was required if Russia was to meet 
its obligations. Substantially more resources have, however, 
been promised for this year.

                Financial Aspects of Weapons Production

    The MOD's financial problems have inevitably had a knock-on 
effect on its suppliers, particularly defense industries. Not 
only has much less been ordered but, even when contracts have 
been agreed, payments have often been delayed for months. 
Without funds the plants cannot pay their own workers or 
suppliers and have fallen deeply into debt. Many, perhaps most, 
are by any normal measure bankrupt and would in a market 
economy have been closed. In Russia they have been left to 
stagger on as several restructuring and rationalization plans 
have first been heralded and then abandoned once the social and 
financial costs have become apparent. Staff are rarely sacked. 
Instead they are moved to a shorter working week, often doing 
little productive even when in the factory. According to 
specialist Russian journals, one-fourth of employees have been 
forced to take unpaid leave lasting, on average, 40 days. In 
the West individuals placed in such a situation would have left 
in large numbers. In Russia, however, workers have remained 
tied to the company both by the lack of alternative employment 
and by social considerations. For instance, the factory, even 
when it cannot pay employees' wages, still owns their flat 
which has to be vacated if a job is taken elsewhere. 
Unsurprisingly, there is vast overmanning. The aviation and 
aerospace industry in Russia employs around eight times as many 
people as that of the whole of Western Europe but has an output 
that is dramatically smaller. The average age of workers across 
defense industry is now well over 50.
    The Russian Government has in recent months been preparing 
new plans to tackle the crisis in the defense industries. 
Firstly, it has said that, with the state budget now in 
surplus, decisive action will be taken to settle state debts to 
defense industry enterprises. The exact size of these remains a 
matter of disagreement between the administration and the 
factories but the former fixes them 32.5 billion rubles and has 
promised that, by January 1, 2003, half of this will have been 
paid in money and the rest covered by bonds. Potentially even 
more important for the long term, Deputy Prime Minister Ilya 
Klebanov has announced that, in order to reduce overlap and 
eliminate waste, a new and major restructuring program is in 
preparation for the sector. It is to involve mergers and 
closures and be spread over a decade. Full details are as yet 
unavailable but some reports suggest that, within the first 3 
or 4 years, one-third of the enterprises could disappear. 
Funding of 2 to 3 billion rubles a year is said to be needed to 
support the program.
    Past experience suggests that all schemes should be treated 
with caution. Promises of debt repayment could easily evaporate 
if the government's financial position were to weaken and any 
radical defense industrial restructuring is in our view likely 
to be much more expensive than forecast and to face 
considerable opposition. Changes will probably be on a much 
smaller scale than economists would like or is needed to bring 
capacity into line with orders. Moreover, whatever 
organizational changes are made, an elderly workforce and 
obsolescent production machinery will remain a poor basis on 
which to build any rapid and sustained recovery in production 
levels.

                           The Defense Burden

    Russian statisticians calculate the financial burden 
defense places on the economy by measuring official budget 
outlays as a proportion of GDP (see Table 7). For 2000 the 
result was 2.7 percent, a little below that in the United 
States and broadly in line with the figures for France and the 
United Kingdom. The impression given is thus one of moderation. 
However, a more accurate comparison, taking into account 
military spending funded outside the official defense budget, 
suggests that the true burden in Russia last year was well over 
5 percent. As such it was twice the NATO average and also 
probably twice that in China.\5\ On a more positive note it 
should, however, be recognized that the burden has fallen 
significantly over the past decade: in 1992 it was on our 
estimates approaching 10 percent, one of the largest in the 
world.
---------------------------------------------------------------------------
    \5\ China admits to a defense burden of only 1.4 percent of GDP 
but, like Russia, conceals much of its military spending in supposedly 
civilian parts of the state budget and in non-budgetary accounts.

 TABLE 7.--THE DEFENSE BURDEN ON OFFICIAL RUSSIAN STATISTICS, 1992-2000
             [Final defense outlays as a percentage of GDP]
------------------------------------------------------------------------
                          Year                              Percentage
------------------------------------------------------------------------
1992....................................................             4.7
1993....................................................             4.4
1994....................................................             4.6
1995....................................................             3.1
1996....................................................             3.0
1997....................................................             3.1
1998....................................................             2.4
1999....................................................             2.6
2000....................................................             2.7
------------------------------------------------------------------------


    The implications for Russian defense reform of this 
substantial and ongoing understatement of the burden are not 
entirely clear. However, it seems likely that, with both the 
government and the military apparently laboring under the 
impression that the defense sector is much less of a charge on 
society than is really the case, the pressure for radical 
change has been weakened. Indeed, in recent years one of the 
most persistent refrains in the armed forces' repeated demands 
for more funding rather than large scale restructuring has been 
the claim that, financially, they are treated badly compared to 
their counterparts in many other countries. That argument may 
eventually be undermined. Deputy Defense Minister Lyubov 
Kudelina has recently called not only for much greater 
transparency in spending but also a full analysis of non-
defense budget funding. If conducted properly, this will, of 
course, show the Russian forces still absorb what is, by 
current international standards, a high proportion of national 
resources.

                      Defense Spending in Dollars

    Few Western readers are likely to be wholly satisfied with 
expenditure data in rubles, seeking instead numbers in a 
currency they believe they can understand. But how can one 
convert rubles into, for example, dollars? The methodology 
normally adopted is straightforward: a market exchange rate, 
quoted in the quality financial press and elsewhere, is applied 
via simple division to the published defense budget and a 
result thereby obtained. Unfortunately, however, while the 
ruble is not freely convertible and while trade constitutes a 
relatively small proportion of Russian GDP, there is no reason 
to believe that market exchange rates even approximately 
reflect the military purchasing power of the currency. The 
discrepancy can be enormous. In 2000, for example, the initial 
budget allocation for defense was on this approach worth only 
about $5 billion, not dramatically more than that of Singapore. 
Even taking into account the additional money poured into the 
defense budget during the year, outlays were still valued at 
under $7 billion, significantly less than those of Canada. The 
Russian armed forces (including paramilitaries) are, however, 
in terms of manpower nearly 15 times the size of their Canadian 
counterparts and they have, in addition to a major strategic 
missile capability, 7 times as many large naval vessels, 14 
times as many combat aircraft and approaching 200 times as many 
tanks.
    Statistics derived from market exchange rate conversions 
are thus quite obviously seriously flawed--though that does not 
prevent them either from being quoted in otherwise serious 
publications or for wholly erroneous deductions on the nature 
of Russian policy or its industrial efficiency being drawn 
therefrom. We prefer to make our own estimates from scratch, 
with the goal of measuring the financial cost of replicating 
the Russian military effort in the United States.\6\ As before, 
we adopt the building block methodology and cover all items 
that NATO countries would consider part of their defense 
spending. Some simplification of procedures is necessary 
because of lack of information but in principle equipment unit 
prices are determined according to how much it would cost a 
U.S. factory to produce, repair and maintain systems with the 
technical characteristics and quality of manufacture that 
exists in Russia. Fuel costs are similarly based on U.S. prices 
and Russian usage rates. Russian military and MOD civilian 
personnel are assigned a dollar valuation dependent on factors 
such as their rank, educational standard, training, assessed 
morale and (where relevant) leadership skills. The dollar cost 
of food, clothing and accommodation takes account of the low 
standards normal in Russia.
---------------------------------------------------------------------------
    \6\ It does not, however, measure Russian military capability which 
reflects resource flows over many years, the efficiency with which 
those resources are deployed and a wide range of intangibles. Some 
commentators, failing to recognize this and, above all, to 
differentiate properly between inputs and outputs, have drawn 
conclusions on relative capabilities which--whether valid or 
otherwise--cannot be justified simply from defense spending data.
---------------------------------------------------------------------------
    The calculations are complex and subject to uncertainty but 
the bottom line is that, on our estimates, the United States 
could last year have procured the full Russian military effort 
for around $50 billion. This puts Russia in third place 
globally, far behind the United States itself and--on our 
calculations--some way adrift also of China. The latter is 
thought to have overtaken Russia in terms of defense resource 
allocation around the mid-1990s and now, despite the recent 
upsurge in Russian outlays, to devote around 25 percent more a 
year to the military. The leading European defense powers, the 
United Kingdom and France, together with Japan, still in 2000 
lagged behind Russia.

                               Prospects

    At the time of writing (July 2001) the Russian Government 
has just approved the basic outlines of the 2002 federal 
budget. These show a defense allocation of 262.9 billion 
rubles, an increase of 20.5 percent over planned spending this 
year. Were inflation in the defense sector to equal that 
expected for the overall economy (an admittedly uncertain 
thesis), the new budget would involve a real rise in outlays of 
over 8 percent, more than twice likely GDP growth. The 
proposals are, however, subject as always to scrutiny by the 
Duma and are likely to be revised before passing into law. 
There are few details on how any additional money is to be 
distributed but 9.3 billion rubles will be set aside to provide 
servicemen with an above-inflation pay award. Unconfirmed 
reports suggest that as a result the monthly salary (including 
bonuses) of a platoon commander will rise from 2,370 rubles to 
4,012 rubles while that of a battalion commander will be 
increased from 3,515 rubles to 6,199 rubles President Putin has 
also recently submitted legislation to the Duma which will 
bring military salaries into line with that of Russian civil 
servants by January 2004. According to preliminary data, this 
is likely to require a further rise in military pay over and 
above anything given to civil servants. The deputies are 
expected to vote on the proposed law in the autumn.
    Despite the commitment to increasing pay, Defense Minister 
Ivanov has said that he wishes to cut the proportion of the 
defense budget going on the maintenance rather than development 
of the armed forces from 70 percent in 2000 to 60 percent in 
2005 and 50 percent by 2010.\7\ The only way of achieving this 
is, as he and other ministers have admitted, by a substantial 
reduction in force numbers. Despite inevitable qualms from some 
senior military officers, details of these cuts have been 
announced. The posts of some 365,000 Defense Ministry 
servicemen, 105,000 servicemen from other power ministries and 
130,000 civilians are to be axed by 2005. Figures published 
separately for the downsizing in individual services do not add 
up exactly to these numbers (perhaps suggesting some ongoing 
debate) but provide an indication of priorities. Within the 
MOD, 180,000 military slots (52 percent) will be lost by the 
ground forces, 60,000 (40 percent) by the strategic rocket 
forces, 50,000 (29 percent) by the navy and 50,000 (27 percent) 
by the air and air defense forces. Among the other departments 
with military employees, the Ministry of the Interior will 
probably have to surrender 37,000 posts (18 percent),\8\ while 
the number of border guards will be reduced by 30,000, railway 
troops by 10,000 and ``Emergency Situations'' forces by 4,500. 
Further cuts, post-2005, have also not been ruled out though at 
the moment they are judged unlikely.
---------------------------------------------------------------------------
    \7\ As so often with Russian statements, the language is imprecise 
but it seems likely that, by maintenance, Ivanov meant nearly 
everything outside the defense order.
    \8\ Some sources have said that the reduction will be larger, 
perhaps 53,000 posts (26 percent).
---------------------------------------------------------------------------
    The Russian authorities have claimed that this reduction in 
posts will enable Defense Ministry spending per serviceman to 
double by 2005 and triple by 2010. Assuming--as seems likely--
that the starting point for the calculation was the official 
figure of almost 1.2 million men serving in the MOD's forces in 
2000, this means that real levels of defense spending are 
planned to rise by almost 7 percent a year through 2005. 
Without any further reductions in posts after 2005, attainment 
of the 2010 target would involve a further hike in outlays over 
the second 5 year period of about 8.5 percent per annum after 
inflation.
    These goals are clearly extremely ambitious and we doubt 
whether, without a substantial deterioration in the 
international political climate, they will be realized. The 8.3 
percent growth in GDP achieved last year was in large measure 
the result of increased energy and other raw material prices 
and the continuing impact of the undervaluation of the ruble on 
international markets. The boost provided by these factors is 
already starting to subside and although, barring a major 
international recession, the days of negative growth seem to be 
over, it is probable that over the next decade GDP will rise by 
on average no more than 3 to 4 percent per annum. If total 
defense spending were to expand at the same pace as the 
Russians appear to be planning for the MOD budget and economic 
growth were 3 to 4 percent a year then the defense burden would 
swell from just over 5 percent of GDP last year to more than 6 
percent in 2005 and approaching 8 percent by 2010.\9\ At these 
levels it would increasingly impinge on the resources available 
either to invest in the civilian economy or improve standards 
of living.
---------------------------------------------------------------------------
    \9\ The Russian Government will, of course, at the moment be 
seeing--and making judgments based on--different and more benign 
forecasts of the defense burden. According to German Gref, the Minister 
of Economic Development and Trade, the authorities in Moscow are 
forecasting annual average economic growth of 5 percent a year through 
2010 rather than the 3 to 4 percent we posit. Moreover, they will 
equate defense spending with the defense budget, thus omitting all 
outlays on military activities funded through other parts of the state 
budget or by non-budgetary means. The Putin government may well believe 
that, even with the massive hikes planned for defense outlays, the 
latter will, in 2010, still account for just 3.5 percent of GDP. This 
level has long been seen as reasonable and, indeed, during the Yeltsin 
era, became something of a totem target for those seeking increased 
spending.
---------------------------------------------------------------------------
    Moreover, even if the planned rises in defense spending 
were to be obtained, it is doubtful whether the sought after 
re-orientation of outlays away from personnel and toward 
equipment could be fully achieved. Despite official claims that 
there are 1.2 million military personnel in the MOD, we believe 
that actual numbers are significantly smaller. Some of the 
projected cutbacks may thus involve little more than the 
scrapping of vacant posts. In these cases the financial savings 
will be minimal. Furthermore, where regular servicemen are 
retired, they will be entitled by law to substantial housing 
and severance benefits. Independent Russian analysts have 
calculated the additional financial cost of cutting personnel 
by the planned amount at 21 billion rubles over 5 years, a 
figure we believe to be a little too high but which is 
nonetheless indicative of the heavy charge on the defense 
budget. Former Defense Minister Sergeyev is alleged to have 
written last year to Prime Minister Kasyanov arguing that it 
was impossible to reduce military personnel numbers by even 
50,000 because they could not be provided with their housing 
entitlements.
    There is also a concern that, in determining the rank mix 
needed to yield their planned savings, the authorities are 
storing up problems for the future. They have, indeed, said 
that almost two-thirds of the eliminated MOD military slots 
will need to be those of officers, including a very large 
number of senior staff. Insofar as the current force structure 
is top heavy, this emphasis makes sense. However, from around 
2005 onward, Russia faces a severe and unavoidable demographic 
crunch, with the number of 18-year-old males available for 
conscription falling within 5 years by over 40 percent. Since 
at least the mid-1990s there have been many complaints from the 
forces that, even with the existing demographic pool, it has 
been difficult to secure sufficient numbers of healthy, well 
educated recruits. Unless the number of conscripts is cut more 
sharply than is at present envisaged, this problem will become 
much more acute toward the end of the decade. If, however, the 
government decides to reduce the number of conscripts in line 
with availability, the only way of preserving its planned force 
size will be to retain more regulars than envisaged. This will 
inevitably be costly.
    Moreover, there has long been a recognition among Russian 
specialists of the benefits of eliminating conscription and 
converting the forces to an all-professional basis. Indeed, at 
one point, President Yeltsin declared that 2000 would see the 
final compulsory inductions into the armed forces. This 
deadline has now obviously been shelved but even a gradual 
shift over the next decade to increase the proportion of 
regulars in the services will add significantly to the wage 
bill.
    Were the Russian Government to achieve its goals of 
tripling defense budget spending per soldier by 2010 and re-
orienting outlays so that by the same date half of outlays were 
directed toward ``developing'' rather than ``maintaining'' the 
forces, then in real terms the MOD ``development'' budget 
(largely weapons research, development and procurement together 
probably with additional infrastructure) would rise by around 
230 percent over the period. This seems implausibly high and we 
have therefore made our own projections. These cover all 
defense spending rather than just that funded through the 
defense budget. They are based on the assumptions that for the 
remainder of the decade total defense outlays will rise in real 
terms by 3.5 percent a year on average, in line with GDP, and 
that the share of those outlays allocated to development will 
increase by much less than Moscow currently envisages. As a 
result, development spending is forecast to grow by about 
three-fourths, much less than that implicit in the Russian data 
but still a very impressive figure.
    There are, of course, an almost infinite number of ways in 
which this additional money could be allocated. Nonetheless, it 
is clear that there will be no immediate, large scale, boom in 
weapons procurement. Neither the government nor the armed 
forces perceive any great benefit from increased acquisition of 
most of the weapons systems currently in the inventory, these 
usually having been developed in the 1980s or earlier and now 
considered less and less a match for their Western 
counterparts. Rather there is a belief that the emphasis needs 
to be placed on creating, almost across the board, a new 
generation of equipment which contains the latest technology. 
In financial terms, therefore, a high priority will probably be 
given to weapons research institutes. They are likely to 
receive substantial amounts of extra money for better machine 
tools and other equipment while their staff, hitherto very 
poorly paid, should see their status enhanced. This will, of 
course, be accompanied by an expectation of better results but 
it is unlikely that many major new weapons systems, including 
even those that have been in development status for some years, 
will be ready for quantitatively significant levels of 
production much before 2007-2008.\10\
---------------------------------------------------------------------------
    \10\ According to Yuriy Koptiev, general director of the 
Rosaviakosmos state agency, the new fifth generation fighter, the PAK 
FA, is unlikely to be ready for delivery to the armed forces before 
2011-2012 even if sufficient money is found for its development. The 
Russian Government has, indeed, said that between now and 2015 the 
armed forces will probably buy only 7 to 10 percent of Russian aircraft 
industry output, with a further 13 to 15 percent being purchased by 
domestic airlines and the rest exported.
---------------------------------------------------------------------------
    Manufacturing facilities will in any case need several 
years to prepare for the arrival of new systems. If the 
government presses ahead with its much needed reorganization 
and restructuring plans, heavy demands will inevitably be 
placed on defense industry management. There will be new chains 
of command and of supply to forge,\11\ existing equipment and 
manpower to relocate or jettison and a more commercially 
oriented ethos to instill. Moreover, with many of the promised 
weapons systems technically much more advanced than their 
predecessors, increasingly sophisticated manufacturing 
equipment will have to be bought and staff will have to undergo 
training in its use.
---------------------------------------------------------------------------
    \11\ The production of large ASW vessels apparently requires the 
cooperation of 2,000 sub-contractors!
---------------------------------------------------------------------------
    The cost of developing better weapons systems and 
modernizing manufacturing plants to produce them in quantity 
will be enormous and, if done properly, could easily absorb all 
of the additional development funding contained in our 
forecast. In practice, however, significant sums are likely to 
be diverted for the better maintenance and repair of the 
existing weapons inventory. In part this is because, given the 
unavoidable delays in bringing new weaponry into service, the 
operational life of existing systems will need to be extended, 
often well past original expectations. Beyond that, however, 
the forces have, since the most recent Chechen conflict, became 
increasingly aware that the reliability of many of their older 
weapons systems (including associated vehicles) is uncertain 
and thus likely to undermine operations and put soldiers' lives 
at risk. They will press for a better adherence to recommended 
servicing schedules than has been typical over the past decade.
    Nonetheless, despite life extensions programs and better 
maintenance, many Russian weapons systems are so elderly that 
the forces will in practice have little option but to scrap 
them in the coming few years. As a result the total inventory 
is likely to decline significantly. Exact figures are difficult 
to predict but our best forecast for holdings in the major 
weapons category is shown in Table 8.

                                  TABLE 8.--WEAPONS INVENTORY IN 2000 AND 2010
----------------------------------------------------------------------------------------------------------------
                                                                      Modern                             Major
                                                                      tanks                 Combat      surface
                                Year                                   and                 aircraft   combatants
                                                                     armored  Artillery   and attack      and
                                                                    vehicles             helicopters  submarines
----------------------------------------------------------------------------------------------------------------
 2000.............................................................    45,000     33,000       2,800          95
 2010.............................................................    35,000     20,000       1,900          60
----------------------------------------------------------------------------------------------------------------


    It is thus evident that, through 2010, there is unlikely to 
be any significant improvement in the overall capability of 
Russian forces. Post that date, however, as new weapons systems 
begin to enter the inventory in quantity, the picture should 
gradually improve. There will be fewer men than at present but 
they should be better trained and probably better motivated. 
The move away from conscripts toward an all-professional force 
could well be completed in this timeframe. Ultimately, although 
there is no possibility of Russia's conventional forces being 
rebuilt to the point where their strength relative to that of 
their Western counterparts is comparable to that enjoyed by the 
Soviet military throughout the cold war, they should, with 
sufficient funding, re-emerge as a modern and powerful presence 
on the world stage.








   RUSSIAN FINANCIAL TRANSITION: THE DEVELOPMENT OF INSTITUTIONS AND 
                           MARKETS FOR GROWTH



                         By David M. Kemme \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   183
Introduction.....................................................   183
Development of Financial Institutions and Competitive Financial 
  Markets........................................................   185
     Why focus on the banking sector?............................   186
     Demonetization and non-payments.............................   188
     Financial repression and liberalization.....................   190
The State of the Banking System: Crisis, Recovery and Crisis?....   198
    System characteristics and policy framework..................   198
    Recovery of banking activity.................................   200
Concerns and Issues..............................................   203
References.......................................................   208
                                Summary

    A well-developed financial intermediation industry 
increases domestic savings, efficiently allocates investment 
resources to the most productive uses in the economy and 
increases the rate of economic growth. In the Soviet economy 
the banking system served as a means of collecting household 
savings and a means of distributing centrally determined 
capital grants to enterprises. Banks then audited enterprise 
financial activities to ensure compliance to the financial 
plan. After a decade the transition from the Soviet banking 
system to a market oriented banking system is incomplete and 
fraught with uncertainty. While the number of financial 
institutions has increased dramatically, the state sector still 
dominates financial sector activity, the legal and regulatory 
framework is incomplete, information necessary for risk 
management is of poor quality and policymakers and regulators 
have been slow to act to improve intermediation services. While 
significant progress has been made, the commonly recognized 
characteristics of a sound financial system are not yet met.
---------------------------------------------------------------------------
    \1\ David M. Kemme is the William N. Morris Chair of Excellence in 
International Economics, University of Memphis. The author would like 
to thank Josef Brada, Martin Gilman, Kim Iskyan, Lucjan Orlowski and an 
anonymous reviewer for helpful comments on an earlier draft.
---------------------------------------------------------------------------

                              Introduction

    The Russian financial crisis of 1998 not only destroyed the 
credibility of financial policymakers and the confidence of 
investors, but also delayed significant institutional reforms 
necessary for long-term economic progress. While the favorable 
external environment of the mid-1990s provided support for 
domestic reforms and adjustment, events in global financial 
markets alone are not sufficient to explain the domestic 
financial collapse. Russian financial authorities were not only 
determined to prevent exogenous external shocks from spilling 
over into domestic financial markets, but also determined to 
defend the exchange rate peg as the domestic GKO market 
collapsed.\2\ The failure to deepen the reform of institutions 
and appropriately manage financial risk at both the macro-
economic and micro-economic level set the stage for crisis. The 
deterioration in the terms of trade and the government's 
inability to maintain federal revenue flows worsened fiscal 
imbalance and overall macro-economic internal balance. Huge 
interest rate swings and the devaluation of the ruble destroyed 
the balance sheets of major banks.\3\ The Russian economy moved 
from a somewhat optimistic macro-economic environment in 1997 
and the first quarter of 1998, to financial collapse by the end 
of 1998.\4\ By mid-1999 the economy had stabilized and 
policymakers were taking measures to bolster the fiscal 
system.\5\ Does the positive economic news represent real 
progress in domestic structural reform and solid economic 
performance? Or, have the increases in the world price of oil 
and stabilization of global financial markets provided the 
supportive external environment that allows the fragile Russian 
economy to grow even without significant domestic reforms?
---------------------------------------------------------------------------
    \2\ Gosudarstvennye kaznacheiskie obiazatelstva (GKOs), are short-
term treasury bills. Foreign investors owned about 30 percent of GKOs. 
Granville (2000), p. 201 reports that in early 1998 there were some 
$365 billion (more than 3,000 percent of the banking system assets) of 
outstanding foreign exchange forward contracts, mainly the result of 
foreign counter parties hedging their GKO investments. Devaluation 
would, and ultimately did, render many banks insolvent.
    \3\ See Granville (2000), pp. 196-203 for a description of the GKO 
market collapse, resulting devaluation and debt default.
    \4\ During the early 1990s there were expressions of concern about 
the stability of the banking system and in 1995 there was a liquidity 
crisis on the inter-bank lending market. However, some analysts were 
dismissive about the possibility of a banking system crisis: ``This 
talk about crisis in the midst of one of history's largest banking 
booms has an air of unreality to it.'' Warner (1998), p. 335. It was 
true that banks had extraordinary opportunities for profits because of 
the low cost of funds, but conditions can and did change rapidly. Less 
than a year later in the same journal, but after the crisis, Buchs 
(1999), p. 700 notes ``. . . it is less the crisis itself but the 
timing of the crisis which was a surprise in Russia.''
    \5\ For a review of economic performance during the 1990s see IMF 
(1999), OECD (1997) and OECD (2000). Selected economic data may be 
found in Tables 7 to 9. OECD (1997) Annex V also provides a detailed 
chronology of economic events and policy measures. On August 17, 1998 
Russian authorities devalued the Ruble, imposed a unilateral 
restructuring of GKO debt and declared a 90-day moratorium on private 
debt repayments. Estimates of losses to investors range from $20 
billion to $90 billion. IMF (1999), p. 39. For a detailed description 
of the 1998 crisis see Buchs (1999) and ``What Went Wrong,'' Russian 
Economic Trends, September 1998. And for a description of the results 
see Westin (1999).
---------------------------------------------------------------------------
    This paper focuses on development of the domestic banking 
industry not only as an essential element of transition to a 
market economy, but also as a necessary factor for long-term 
economic growth. There is an extensive theoretical and 
empirical literature indicating a significant causal influence 
of the level of financial development upon long run economic 
growth.\6\ Financial development improves the allocation of 
savings to investment opportunities. The possibility of 
choosing more productive investments, which in turn generate 
higher rates of aggregate economic growth, requires improved 
management of liquidity risks, more efficient diversification 
of investor's portfolios and higher quality of information 
about various projects and investor's abilities. As the demand 
for these services arises, specialized institutions develop. 
But, the literature indicates that aggregate income and savings 
must reach certain levels, or thresholds, before institutions 
and markets develop spontaneously. In transition economies 
economic policymakers may intervene, providing an environment 
for institutional development that may supercede spontaneous 
market developments.\7\
---------------------------------------------------------------------------
    \6\ The level of financial development is usually described by 
measures of ``depth,'' for example, the ratio of banking assets to 
gross domestic product (GDP), or market capitalization to GDP, etc. 
Berthelemy and Varoudakis (1996) and Pagano (1993) provide a brief 
review of the connection between financial development and growth. 
Levine (1997) also provides a survey of issues of financial development 
and growth, Levine and Zervos (1998) examines potential links between 
both stock markets and commercial banks and growth, while Beck, Levine 
and Loayza (2000) and Levine, Loayza and Beck (2000) provide more 
recent empirical evidence linking financial development to economic 
growth.
    \7\ The literature discuses two approaches to financial 
development. ``Demand following'' financial development follows 
widening of markets and product differentiation, which then requires 
more efficient risk diversification and control of transaction costs. 
This type of financial development is viewed as passive or it plays at 
most a permissive role in the growth process. ``Supply leading'' 
financial development precedes the demand for financial services and 
proponents argue it has a clear autonomous positive effect on growth 
due to the enhanced ability to mobilize resources, moving them from 
traditional to modern, high growth sectors. Supply leading financial 
development may dominate the early stages of development or transition, 
making possible the financing and increasing the effectiveness of 
sectors, institutions and activities neglected under central planning, 
until demand following financial development takes over (a la 
Gerschenkron, 1962).
---------------------------------------------------------------------------
    If one takes a more activist, ``supply leading'' financial 
development approach to transition and development, 
policymakers first must ask: (1) Among financial institutions 
what areas should be developed/supported first? (2) What are 
the most appropriate mechanisms to enhance the efficiency of 
the financial institutions identified? (3) What is the impact 
of competition and what is the optimal level of competition (in 
banking)? And, then, more specifically, (4) at what stage of 
financial development is the Russian economy and what policies 
should be implemented to enhance long term economic growth?
    In the next section I briefly address questions one and two 
based upon a brief review of the financial development 
literature. This provides a framework for analysis of policy 
and institutional developments. The following section is a 
review of the banking sector's recovery from the 1998 crisis. 
Here I also discuss policy and institutional issues which must 
be resolved to ensure stable, long-term economic growth. The 
last section concludes with concerns and issues to be resolved.

Development of Financial Institutions and Competitive Financial Markets

    The Soviet centrally planned economy had little need for a 
developed financial sector. The payments system was simple and 
sound: cash was used for household transactions and enterprise 
deposit transfers were made within the monobank for inter-
enterprise transactions. Capital and investment funds were 
available via direct grants from the state budget according to 
the central plan. The banking system functioned simply as a 
payments system and state auditor to monitor plan 
fulfillment.\8\ Monetary policy was accommodating, ensuring 
that cash supplies met demand and enterprise deposit creation 
from the state budget corresponded to plan, both according to 
micro-objectives as well as balancing in the aggregate to 
prevent inflation. Barter transactions in both the household 
and enterprise sectors and unplanned transactions within the 
enterprise sector were tolerated to smooth the operation of the 
plan. The financial plan governed the allocation of society's 
savings among potential investment opportunities typically 
based upon political objectives rather than financial 
criteria.\9\ While the banking system in a market economy is a 
critical element of the payments system, it also plays an 
active role in the allocation of investment resources.
---------------------------------------------------------------------------
    \8\ The three primary functions of the Soviet monobank were 
financial control of enterprises, dispersement of funds allocated by 
the central plan and mobilization of domestic savings to finance 
domestic debt of the state sector.
    \9\ For the classic description of the Soviet system of money and 
banking see Garvey (1977). For a more recent discussion of both Soviet 
banking and transition in the early 1990s see Tompson (1997).
---------------------------------------------------------------------------

                    why focus on the banking sector?

    In the Soviet system the banking system did not provide 
financial intermediation services. Developed market economies, 
though, have both stock and bond markets and developed 
financial intermediaries such as banks. There is considerable 
discussion about which is more important. There is also a 
debate about the effectiveness of universal banking vis-a-vis 
specialized banking coupled with stock markets. Despite the 
nuances and the different routes taken, developed market 
economies have tended to converge toward a similar model of 
corporate finance. In developed economies, retained earnings or 
internally generated funds account for roughly 60 to 90 percent 
of investment financing, bank loans account for roughly 15 to 
30 percent and bond and equity offerings just a few percent. In 
developing economies both bank loans, accounting for 25 to 35 
percent, and equity markets, accounting for as much as 25 
percent, play a slightly more important role in investment 
financing than in developed economies. While this varies over 
time and across countries, retained earnings remain the 
dominant source of funds, with bank lending next, and equities 
markets relatively unimportant in terms of providing finance 
for investment projects. In fact, Stiglitz (1993) argues that 
stock markets are primarily a means of sharing risk, not 
raising investment funds. When there are production risks, 
information asymmetries and costly monitoring, debt contracts 
with fixed repayment dates will always be preferred (by 
investors) to the purchase of shares with periodic 
reimbursement by payments of dividends that are subject to 
productivity shocks. Thus, bank intermediation is likely to 
play a significantly larger role in investment financing 
regardless of stage of development.
    Monitoring costs are minimized with debt contracts because 
such costs are incurred only in the case of insolvency, while 
financing via shares requires continuous, ongoing monitoring. 
Banks and lending intermediaries have an advantage over stock 
and bond markets because they can be more efficient in terms of 
information gathering and monitoring. It is not efficient for 
an individual investor to undertake these costs, but banks can 
spread them out over many investors (depositors). Because some 
of the information collected on the performance of a firm 
becomes public, there is also a free rider problem that makes 
capturing payment for monitoring costs problematic. With large 
diversified portfolios banks can guarantee a yield on deposits 
and make a credible commitment to monitoring investment 
projects. Thus, the informational advantage of banks as a 
source of external financing of investment is a strong argument 
in favor of emphasizing the development of the banking system 
as a means of enhancing capital accumulation. In fact, Wright, 
Buck and Filatotchev (1998) provide evidence that banks in 
Russia are beginning to develop oversight and monitoring 
relationships with loan recipients, albeit at a relatively slow 
pace. Banks may not be superior to stock markets at all stages 
of development, however. Both provide diversification and 
management of liquidity risk, provide a monitoring mechanism, 
which improves the management of resources, and provide means 
of evaluating the returns on investment activities, all of 
which contribute to the efficient allocation of resources. 
Competition among banks and between banking intermediaries and 
stock markets leads to lower intermediation costs and 
contributes to economic growth. But competition also leads to 
increased probability of insolvency, credit rationing and 
related adverse effects on growth. The optimal level of 
competition is a policy issue of importance in both market 
economies and transition economies.
    The performance of intermediation services takes a well-
functioning payments system for granted. In any economy a well-
functioning payments system, a reliable and flexible means of 
exchange and payment, is necessary for growth. While the Soviet 
economy payments system was reliable, it was not flexible and 
does not satisfy the needs of participants in a market economy. 
Without direct capital grants from the central budget, 
enterprise projects must compete for funds, either internally, 
from retained earnings, or externally, from bank loans or 
securities offerings. Outside-the-payments-system transactions 
such as barter are also possible, but are costly. These costs 
often eliminate potential productivity gains due to increases 
in the division of labor and thus reduce the profitability of 
potential projects. In a market economy a financial system with 
low transaction costs develops in order to reduce the 
opportunity cost of holding money. As a result the payments 
system in a market economy evolves toward a credit system 
managed by banking intermediaries. Technological advances 
continuously reduce the information costs of utilizing credit 
while financial assets and credit instruments gradually replace 
traditional monetary assets. This is reflected by increases in 
the weight of financial activities in gross domestic product 
(GDP) as economic development takes place. Thus, the velocity 
of narrow monetary aggregates increases after a certain stage 
of development and the increase in this measure of velocity is 
paralleled by the development of intermediation 
technologies.\10\
---------------------------------------------------------------------------
    \10\ Note that in very early stages of economic development the 
economy is increasingly monetised as transactions become more 
complicated and sophisticated, thus there is a secular downward trend 
in money velocity. However, after some threshold level of development, 
pressure to reduce the opportunity cost of holding money leads to the 
replacement of money with credit instruments and an increase in the 
velocity of narrow money aggregates. The strong empirical link between 
GDP and degree of monetisation is demonstrated by Goldsmith (1969).
---------------------------------------------------------------------------

                    demonetization and non-payments

    In a transition economy changes in the velocity of narrow 
money aggregates must be interpreted with caution, however. 
Measurement problems are severe. In Russia the method for 
calculating GDP is being refined, defining and measuring 
monetary aggregates is difficult, and the amount of dollars in 
cash in circulation is large and difficult to measure.\11\ 
Further, significant changes in the behavior of economic agents 
have occurred and creation of new monetary and credit 
instruments is rapid and unpredictable. Demonetisation in the 
Russian economy may increase or decrease velocity for reasons 
completely independent of financial development. For example, 
in 1994 the Central Bank of the Russian Federation (Central 
Bank of Russia or CBR) began to implement more stringent 
prudential regulations at the same time monetary policy was 
tightened. A crisis in the inter-bank lending market in 1995 
led financial intermediaries to innovate, creating new types of 
securities to facilitate payments.\12\ There was a rapid 
increase in the use of cash surrogates including barter, 
sometimes complicated offset arrangements (zachety), bills of 
exchange (veksels), and various federal, regional and local 
securities.\13\ There was also a rapid increase in payments 
arrears. While some of these activities may be considered a 
first step toward financial deepening, employing primitive 
payments and intermediation technologies with high transactions 
costs, such as barter and illiquid offset arrangements, is 
clearly a step backward.\14\ Only if orderly secondary markets 
for zachety and veksels are developed may it be interpreted as 
a step forward. Matters were complicated at this time as the 
practice of issuing credit denominated in bills of exchange 
allowed banks to facilitate tax evasion, disguise bad loans by 
converting them to veksel credits and avoid provision 
requirements. Lack of transparency in accounting complicated 
matters further as prices varied depending upon the means of 
payment, confounding efforts to improve corporate governance, 
restructure enterprises and enforce tax and other 
regulations.\15\ Corruption and illegal activities also 
flourished.\16\ By 1997-1998 money surrogates accounted for 
over half of industrial transactions and consolidated budget 
revenues. In many regions of the country this share reached 70 
percent.\17\
---------------------------------------------------------------------------
    \11\ Buchs (1999) reports dollarization of 10 percent of GDP.
    \12\ Tightening of monetary policy and higher real interest rates 
led to liquidity problems and banks in turn borrowed heavily on the 
inter-bank loan market for liquidity. Both volume and rates increased 
leading many banks to withdraw from the market. On August 23-24 
overnight rates spiked, lending was rationed and the market collapsed. 
The Central Bank was only partially accommodating and several hundred 
banks failed. See OECD (1997), p. 82 for additional details.
    \13\ OECD (1997), Annex II discusses the development of various 
money surrogates. Veksels may be promissory notes or, if tradable, 
bills of exchange. They perform a much broader role, however, serving 
as the equivalent of debt instruments like certificates of deposit, 
commercial paper, simple IOUs and bonds.
    \14\ While OECD (1997), Chapter 2 describes the introduction of new 
securities and means of payment as important innovations and monetary 
and institutional changes at this time in a positive tone, the chapter 
concludes with a section titled ``Commercial banking in the Russian 
Federation: the first signs of stability or impending crisis?'' 
Conditions deteriorated rapidly from the time of printing and within a 
year the financial system collapsed.
    \15\ Barter and offset prices tended to be higher than veksel 
prices that in turn were higher than cash prices for the same 
commodities. See OECD (2000) pp. 91, 92.
    \16\ See Gaddy and Ickes (2001), Woodruff (1999) and Commander and 
Mumssen (1998) for further analysis of non-monetary transactions and 
the impact upon decisionmaking in the Russian economy.
    \17\ For additional details on demonetisation see OECD (2000), 
Chapter 2.
---------------------------------------------------------------------------
    While Pinto, Drebentsov and Morozov (2000) argue for a 
complete dismantling of the non-payments system, there were 
some positive aspects.\18\ It in fact represented an 
evolutionary step in the financial development process. In 
response to very contractionary macro-economic policy and the 
elimination of direct enterprise subsidies, in a system with 
soft budget constraints, cash short enterprises resorted to 
non-cash surrogates for payments both with each other and with 
the Treasury. Fiscal authorities permitted and enhanced the 
development of non-cash instruments for fiscal purposes as a 
means of supporting inefficient enterprises, which could no 
longer be subsidized directly. As international financial 
institutions objected to the use of a particular instrument it 
was eliminated, but quickly replaced by another nearly 
equivalent instrument.\19\
---------------------------------------------------------------------------
    \18\ Note that Pinto, et al. (2000), p. 1, defines non-payments as 
(1) arrears and (2) all forms of non-cash settlements including barter, 
veksels or promissory notes and tax offsets whereby government spending 
arrears and overdue tax payments are mutually cancelled. I focus on 
non-cash payments or cash surrogates since these actually are a means 
of conducting payments, either at a discount or premium, which may 
compete with payments within the banking system.
    \19\ For example, treasury tax offsets were employed in 1994-1996 
then replaced by direct monetary offsets in 1996, 1997, which were 
replaced by reverse monetary offsets in 1997, 1998, which in turn were 
replaced by targeted financing. See Pinto, Drebentsov and Morozov 
(2000).
---------------------------------------------------------------------------
    The share of non-cash transactions varied by industrial 
branch, but clearly increased through the 1990s, as indicated 
in Figure 1 and Table 1. The increase in offset arrangements in 
1996-1998 also paralleled the increase of enterprise payments 
arrears, as they became the dominant form of non-cash payments. 
While it may be argued that offset arrangements prevented a 
further contraction in the economy and to some extent provided 
liquidity (some offsets were tradable) they also were very 
inefficient as a means of payment since transactions costs were 
extremely high and they facilitated the continuing distortion 
of relative prices.\20\ With the development of alternative 
credit instruments barter should decrease over time.
---------------------------------------------------------------------------
    \20\ It is also important to note that a large portion of the 
increase in arrears was due to the accumulation of penalties and fines 
on enterprises for late payment of taxes and payments to the 
government. Government-organization to government-organization payments 
arrears do not accrue fines and penalties and thus the proportion of 
enterprise arrears to government as a proportion of total arrears 
increased. Penalties and fines amounted to 65 percent of all debt to 
the Federal budget by the end of 1997. While the initial payment arrear 
is viewed by some as an increase in ``soft credit'' to the enterprise 
sector, the accumulation of fines and penalties probably should not be. 
See Mumssen (1998) and OECD (2000).
---------------------------------------------------------------------------
    There are three causes noted for the Russian 
demonetisation: (1) barter occurred between enterprises that 
had Soviet era links and was facilitated by trade institutions 
that act much like Gossnab \21\ did, (2) macro-economic policy, 
the elimination of directed credits and high interest rates, 
increased the opportunity cost of money, encouraging financial 
innovation and the creation of non-money means of payments, and 
(3) barter and varying prices for differing means of payment 
facilitated tax avoidance. Clearly all three reasons 
contributed to the demonetisation, but by 1999 world oil prices 
and export earnings increased, and interest rates came down, 
all providing greater liquidity to the economy overall, and the 
need for monetary surrogates declined. The banking system 
stabilized and transaction levels within the payments system 
returned to more normal levels. While stable, the system is 
still far from liberalized.
---------------------------------------------------------------------------
    \21\ Gossnab, the State Committee on Material and Technical Supply, 
was one of the most important state committees instrumental in 
developing, coordinating and enforcing the central plan during the 
Soviet era.

---------------------------------------------------------------------------
       FIGURE 1._SHARE OF NON-CASH RECEIPTS FOR INDUSTRIAL FIRMS

[GRAPHIC] [TIFF OMITTED] T6171.028


  Source: OECD (2000) p. 85. Original Source: Russian Economic 
Barometer.


      TABLE 1.--TYPES OF PAYMENTS BY LARGE FIRMS AND NATURAL MONOPOLIES BY INDUSTRIAL BRANCH, DECEMBER 1998
                                       [As a percentage of total payments]
----------------------------------------------------------------------------------------------------------------
                                                              Cash   Offsets  Securities  Barter   Other   Total
----------------------------------------------------------------------------------------------------------------
All firms..................................................    43.4     29.5      11.5       7.5     8.1     100
Electricity................................................    19.5     45.2      16.7       4.1    14.5     100
Fuels......................................................    39.4     36.5      15.2       4.7     4.2     100
Machine-building and metalwork.............................    14.1     37.4      31.3      13.5     3.7     100
Construction and construction materials....................    26.0     44.6       7.8      18.5     3.1     100
Transportation.............................................    37.4     45.8      11.0       0.3     5.5     100
Light industry and food....................................    69.8     12.7       4.0       7.6     5.9     100
Agriculture................................................    65.1      3.3       0.5      28.6     2.5     100
Trade and public catering..................................    84.4     11.6       3.2       0.3     0.5    100
----------------------------------------------------------------------------------------------------------------
Source: OECD (2000), p. 87. Original source Goskomstat.

                financial repression and liberalization

    McKinnon (1973) defines financial repression as any policy 
or regulation that prevents financial intermediaries from 
operating at a level in accordance with their technological 
potential. Typical repressive policies of the banking system in 
a market-type economy are forms of implicit or indirect 
taxation of financial intermediaries or transactions. The most 
common are bank reserve requirements with low or zero yield, 
ceilings or controls on lending and deposit rates, and the 
inflation tax on monetary assets in general. The costs include 
the loss in efficiency due to the distortions in interest 
rates, credit rationing and overall discouraged savings due to 
low deposit rates.\22\ In addition, the market structure itself 
must be considered as a potential limiting factor on the 
development of the financial system. Stiglitz (1994) emphasizes 
market failure and the need for government intervention of 
various sorts to improve efficiency in the financial 
system.\23\ There is considerable debate in the literature on 
both the optimal level of competition and the need for and type 
of government intervention, however.\24\
---------------------------------------------------------------------------
    \22\ The costs can be significant. In a study of twenty-six 
developing countries the inflation tax was estimated at 2.8 percent of 
GDP and ceilings on interest rates generated a tax equivalent to 1.8 
percent of GDP. See Berthelemy and Varoudakis (1996).
    \23\ Stiglitz (1994) notes seven types of market failure: (1) 
monitoring as a public good, (2) externalities of monitoring, selection 
and lending, (3) externalities of financial disruption, (4) missing and 
incomplete markets, (5) imperfect competition, (6) Pareto inefficiency 
of competitive markets, and (7) uninformed investors. He then provides 
a taxonomy of government interventions which may be appropriate. Levine 
(1996) provides a framework for policy analysis and government 
intervention. Harwood and Smith (1997) provides an extensive look at 
financial development strategies for developing countries.
    \24\ For example, Jaramillo-Vallejo (1994) takes issue with 
Stiglitz's arguments for government intervention.
---------------------------------------------------------------------------
    With virtually no lending activity, strict controls on 
deposit accounts and rate ceilings and complete monopolization 
of the banking system during the centrally planned era, the 
Russian banking system has evolved from what may be considered 
an extreme in terms of financial repression. To complicate 
matters Russian bank management was not prepared to operate the 
newly created commercial banks as profit maximizing banks in a 
market economy.\25\ Russian banks were not able to identify 
potentially profitable investments, due to the lack of business 
reputations and reliable credit histories, predominance of 
insider control (politically supported) in enterprises, weak 
contract enforcement and an underdeveloped legal system. 
Although bank managers are slowly developing the skills to 
engage in effective project appraisal and monitoring, they have 
weak incentives to develop these skills as long as there are 
alternative, cheaper sources of high profits, like government 
securities.
---------------------------------------------------------------------------
    \25\ Tompson (1997) argues that at least through the mid-1990s 
Russian banks really did not bank. They did little to collect deposits 
and did little lending except to the state. A large share of their 
liabilities were free and a large share of their assets were idle. 
Banks maintained a high level of excess reserves even during highly 
inflationary periods. This activity is not necessarily financial 
repression via government policies, but by poor management. Iskyan and 
Besedin (2000) call Russian banks ``bank-like institutions'' and Schoor 
(2001) maintains most banks are simply treasury operations of their 
enterprise owners.
---------------------------------------------------------------------------
    The benefits of liberalization seem obvious, but the pace 
and timing of liberalization are critical. Many argue that the 
fiscal deficit must be under control prior to liberalization 
because significant increases in interest rates to dampen 
growth or control inflation may lead to adverse selection in 
bank lending activity, thereby threatening the soundness of the 
banking system. In addition, many argue that a perfectly 
competitive banking industry will underprovide financial 
services because of the public good nature of the information 
on profitability of entering the deposit market by individual 
banks and the high cost of entering the market. Thus, Hellman, 
et al. (1997) argue that ``mild'' financial repression may be 
beneficial because it creates rent opportunities that enhance 
incentives for financial deepening and deposit 
mobilization.\26\ And Van Wijnbergen (1983) argues that 
informal financing that developed early in many developing 
economies may actually be more efficient than intermediated 
financing in a liberalized system. But this is true only if the 
informal sector has higher quality information on risk and 
lending opportunities. While all three caveats may apply to the 
Russian economy to a limited extent, recent research indicates 
that the effects of financial liberalization on economic growth 
are ``not subsumed by other economic reforms or proxies for the 
development of capital markets and financial intermediation.'' 
\27\ Therefore liberalization, per se, should proceed as 
quickly as possible.
---------------------------------------------------------------------------
    \26\ It is difficult to ascertain what level of repression is 
optimal. E.g., mild financial repression may include deposit rate 
ceilings, which enhance franchise values. However, if ceilings and 
other regulations diminish competition and hinder the efficient 
allocation of resources diminishing growth then liberalization is in 
order.
    \27\ Bekaert and Harvey (2001), p. 11.
---------------------------------------------------------------------------
    A liberalized financial system contributes to overall 
economic growth by increasing savings. Financial markets and 
banking intermediaries improve the mobilization of savings, 
providing higher than expected yields and greater 
diversification of risk. This in turn encourages financial 
savings rather than the purchase of consumer durables (or real 
assets with a low rate of return). Such a reorientation of 
savings reinforces the deepening of the financial system.\28\ 
This pattern may not be observed in the transition economy as 
pent up consumer demand is released in the initial period. The 
financial crisis in Russia (as well as other transition 
economies) then introduced skepticism on the part of savers and 
weakened the credibility of the financial system overall. The 
fact that there is no universal deposit insurance system for 
Russian savers also discourages savings. Because Sberbank is 
the only institution with state support perceived to be 
equivalent to deposit guarantees, households transferred 
deposits from independent, private commercial banks to 
Sberbank.\29\ The share of total household deposits held by 
Sberbank increased from just over 50 percent in mid-1994 to 
over 85 percent by January 1999, then declined slowly to just 
over 75 percent in April 2001. One reason that other commercial 
banks, private and state-owned, cannot compete in the deposit 
market is because they lack the deposit guarantees that 
Sberbank offers implicitly. Thus, to increase savings 
government policy should reduce the risks to depositors 
associated with saving via bank deposits by developing a system 
of deposit insurance and by eliminating the household deposit 
monopoly Sberbank enjoys. There has been tremendous resistance 
to this, however, as evidenced by the continuing discussion of 
the proposed federal laws on deposit insurance.\30\
---------------------------------------------------------------------------
    \28\ Actually, income and substitution effects make the a priori 
outcome on growth indeterminate.
    \29\ The August 1998 crisis led Sberbank to lose half of its net 
assets when the government defaulted on GKOs. The government bailed out 
Sberbank, whereas depositors at other failing institutions (Menatep, 
Most, SBS-Agro, Inkombank, Mosbusiness Bank, and Promstroibank) were 
required to transfer deposits to Sberbank at unfavorable terms. See 
Buchs (1999) p. 693 and Schoers (2001).
    \30\ The Antimonopoly Ministry, however, has initiated three 
proceedings against Sberbank and the CBR since the beginning of this 
year. However, all decisions taken concerning the promotion of 
competition in the banking sector must be submitted to the CBR, which 
``seems to deliberately hinder any attempts to achieve this task.'' 
Russian Economic Trends, (April 2001), p. 6. It should also be 
emphasized that Sberbank's advantages in the deposit market also 
contribute to an inefficient allocation of capital at the macro-level 
since its assets are held predominately in government securities or 
loans to large state-owned enterprises, replicating investment patterns 
of the Soviet era.
---------------------------------------------------------------------------
    A liberalized system also improves the allocation of 
resources, increasing capital productivity and economic growth. 
The inherent difficulties of resource allocation, with 
productivity risks, insufficient and imperfect information on 
the return on investment and entrepreneurs' skills, provide 
opportunities for creation of financial intermediation 
services. Financial institutions provide diversification of 
risks associated with productivity and demand shocks, manage 
liquidity risks and evaluate potential projects and 
entrepreneurs. These activities increase the rate of economic 
growth by increasing the resources invested in productive 
activities, increasing technological specialization,\31\ 
reducing the premature liquidation of capital \32\ and 
increasing productive efficiency. Evaluating projects and 
entrepreneurs, essentially assessment and monitoring, has very 
large fixed costs which financial intermediaries can spread 
over many investors, no one of which would be willing to pay 
the initial fixed costs. The intermediary can evaluate more 
projects, collect more information and provide it in a 
standardized form to large numbers of investors who then choose 
among varying levels of risk depending upon their risk 
preference. As a result of better assessment of risk and better 
information, more resources can be directed toward the most 
productive or profitable projects. Monitoring and diversifying 
systemic shocks also allows an increase in resources invested 
in productive, but riskier projects, therefore increasing the 
overall productivity of the economy's capital stock.
---------------------------------------------------------------------------
    \31\ To reduce the risk of disruption in the demand for products 
produced with highly specialized technologies (technology risk) firms 
often invest in less specialized and therefore less productive, 
flexible technologies. Therefore, diversification via activities of 
financial intermediaries, allows more investment in highly specialized, 
more productive technologies.
    \32\ The law of large numbers reduces the probability that all 
depositors/investors withdraw at the same time.
---------------------------------------------------------------------------
    The working of financial intermediaries described above 
stands in stark contrast to the allocation of capital in the 
Soviet system in which crude indicators of effectiveness, 
imperfect information and political forces guided central 
planners' investment decisions. The Russian banking system is 
painfully evolving from one which served as the agent of 
central planners toward a system of market driven, profit 
oriented financial intermediaries. But it is far from that 
goal. First, the financial services industry is far from 
competitive. Although the number of commercial banks is large, 
just over 1,300, activity is highly concentrated. As of April 
2001, Sberbank accounted for over 75 percent of household 
savings deposits. Sberbank accounts for about 20 percent of 
lending and Vneshtorg Bank accounts for about 5 percent. These 
banks have very little lending experience and will likely favor 
large enterprises in priority sectors not unlike the Soviet 
pattern of investments. As Table 2 indicates total domestic 
credit as a share of GDP is about 60 percent of the comparable 
market economy and private sector credit relative to GDP is 
less than 50 percent of the market economy benchmark. Second, 
while the number of privately-owned banks is decreasing, the 
state also continues to found new banks, Rosiiski Bank 
Razvitiya (the Russian Development Bank) in 1999 and 
Rosselkhozbank (the Russian Agricultural Bank) in 2000, which 
are likely to have different investment objectives, enjoy the 
implicit guarantees of the state, and therefore will likely 
provide directed, soft credits to industry and agriculture. 
Given that private sector lending activity is lagging 
dramatically (as indicated in Table 2) a more appropriate 
policy may be the creation of institutions subject to market 
discipline, but designed to meet the financing needs of small 
and medium enterprises in the private sector. On the positive 
side, smaller, regional banks, which were less affected by the 
1998 crisis, are in a position to expand their activities.\33\
---------------------------------------------------------------------------
    \33\ See Schoors (2001)

 TABLE 2.--TOTAL DOMESTIC CREDIT AND PRIVATE SECTOR CREDIT AS PERCENT OF
                    GDP AND MARKET ECONOMY BENCHMARK
------------------------------------------------------------------------
                                                          1994     1999
------------------------------------------------------------------------
Total domestic credit, percent of GDP.................     31.7     32.7
Market economy benchmark, percent.....................     52.0     51.3
Proportion of benchmark level.........................     61.0     63.7
Private sector credit, percent of GDP.................     12.1     11.5
Market economy benchmark, percent.....................     44.2     43.3
Proportion of benchmark level.........................     27.4    26.6
------------------------------------------------------------------------
Source: Derived from Tables 1 and 2 of Fries and Taci (2001). Benchmarks
  are based upon regression estimates of each ratio as a function of GNP
  per capita for a sample of 127 market economies. See Fries and Tacci
  (2001) for details.

    Third, information on enterprise performance, potential 
investment returns and entrepreneurial talents is very limited 
and of poor quality regardless of whether intermediaries or 
individual investors collect the information. In fact, even 
official, legally required information is often incorrect.\34\ 
Fourth, most banks are acting primarily as treasury operations 
of their owners or acting implicitly as an agent of the 
government in lending activities, in effect continuing the 
history of centrally directed capital grants, but now with a 
weak expectation of repayment. As indicated in Tables 3 and 4 
loans (claims on the private sector) account for roughly one-
third of the banking sector's assets. Tompson (1997) notes in 
1995 that only 49.5 percent of assets were nominally income 
earning, probably much less if non-performing loans were 
excluded.\35\
---------------------------------------------------------------------------
    \34\ Iskayan and Besedin (2000), p. 5 reports that ``a CBR audit of 
financial statements submitted to it found that roughly half of a 
representative group of banks systematically falsified reports.'' In 
addition, even if information reported is correct, Russian accounting 
standards make it difficult to understand an enterprise's condition and 
inter-enterprise payments problems, and non-payments, make it difficult 
for managers to assess their own enterprise's performance, much less to 
convince potential lenders/investors.
    \35\ Thomson (1997), p. 1176. Note the level of lending was low and 
very short term, typically 30 to 60 days. No doubt the high and 
variable inflation of the time was a significant deterrent to lending. 
Although inflation has been reduced banks still tend to lend short term 
to finance transactions (e.g., imports) or acquisitions rather than 
longer term investment projects.
---------------------------------------------------------------------------
    The distribution of assets indicates moral hazard issues 
remain a serious problem. It was suggested above that the 
introduction of deposit insurance would enhance competition, 
increase aggregate savings and improve the allocation of 
liabilities within the banking system. A second, perhaps more 
important reason to introduce a system of risk-based deposit 
insurance, is that an explicit system of guarantees is a more 
efficient means of reducing moral hazard and improving resource 
allocation than the current system of implicit guarantees. 
Since the financial institution itself determines the size of 
the implied guarantee, the institution can expand the implicit 
subsidy by doing more and riskier lending. Explicit risk-based 
guarantees can be limited, however. By pricing the deposit 
insurance in accordance with the institution's risk profile, 
moral

  

                             TABLE 3.--CONSOLIDATED ACCOUNTS OF CREDIT INSTITUTIONS
                                      [In million rubles, December 31] \1\
----------------------------------------------------------------------------------------------------------------
                                           1995       1996        1997         1998         1999         2000
----------------------------------------------------------------------------------------------------------------
Reserves \2\..........................  R36,712.3  R47,123.4    R72,974.5    R67,762.9   R160,017.3   R301,124.5
Foreign assets........................   46,149.4   72,874.8     72,717.3    219,593.0    370,651.3    476,581.8
Claims on general government..........   62,638.5  150,721.3    194,689.0    259,401.6    437,675.2    526,020.7
    of which, claims on governments of      721.7    2,790.4     18,691.8     24,445.6     19,870.5     18,531.3
     constituent territories of RF and
     local self-government bodies.....
Claims on non-financial state            62,460.4   69,371.4     33,217.4     33,078.8     46,901.2     73,972.6
 enterprises..........................
Claims on non-financial private         133,786.8  157,337.2    236,438.4    345,962.6    521,644.8    867,132.2
 enterprises and households...........
Claims on other financial institutions      525.0      242.0      8,075.9      7,270.7     13,060.2     14,525.0
                                       -------------------------------------------------------------------------
        Total assets..................  342,272.4  497,670.1    618,112.5    933,069.6  1,549,950.0  2,259,356.8
                                       =========================================================================
Demand deposits.......................   69,331.9   87,303.0    162,532.1    149,470.7    249,673.7    443,020.9
Time, saving and foreign currency       124,496.6  164,898.7    158,714.8    283,996.1    456,527.8    680,646.9
 deposits.............................
    of which, deposits in foreign        55,255.7   69,447.7     80,454.7    190,872.7    290,212.9    420,090.5
     currency.........................
Deposits, access--temporarily           .........  .........      6,270.5     22,595.1     10,223.6      6,373.3
 restricted \3\.......................
Money market instruments..............   11,858.5   30,372.2     42,435.9     43,311.9    107,817.2    191,059.0
Foreign liabilities...................   29,969.8   58,892.5    104,197.4    203,136.8    222,626.6    248,920.7
General government deposits...........    9,741.1   11,557.2     18,236.1     20,676.5     28,671.8     54,547.2
    of which, deposits of governments     4,251.9    4,210.6      9,139.9     10,148.2     15,626.8     36,641.8
     of constituent territories of RF
     and local self-government bodies.
Obligations to monetary authorities...    8,005.1    6,798.8      8,779.8     71,893.6    200,121.4    205,439.4
Capital accounts......................   66,687.8  123,817.5    143,909.4    157,594.7    293,199.4    437,265.2
Sundry (balance)......................   22,181.5   14,030.3    -26,963.5    -19,605.7    -18,911.6    -7,915.9
----------------------------------------------------------------------------------------------------------------
\1\ From the consolidated balance sheets of credit institutions, Sberbank Savings Bank, and Vneshekonom Bank.
\2\ Reserves of credit institutions comprise cash reserves in vaults and their funds in accounts with the CBR.
\3\ Deposits with temporarily limited access comprise funds in accounts with credit institutions which cannot be
  used by their holders within a certain time limit in accordance with a contract or transaction terms or
  current conditions of a credit institution's activity.
Source: The Bulletin of Banking Statistics, various issues, CBR.


                TABLE 4.--SELECTED ASSETS AND LIABILITIES OF COMMERCIAL BANKS, INCLUDING SBERBANK
                                               [In billion rubles]
----------------------------------------------------------------------------------------------------------------
                                                                                   Bank
                                                                                 savings
                                                           Claims on   Claims       by
                                                  Total       the      on the    Russian    Foreign    Foreign
                                                 assets     general    private   citizens  currency  liabilities
                                                          government   sector     (ruble   deposits
                                                                                household
                                                                                deposits)
----------------------------------------------------------------------------------------------------------------
1995..........................................    R342.3      R62.6     R133.8      R70.6     R55.3       R30.0
1996..........................................     497.7      150.7      157.3      118.4      69.4        58.9
1997..........................................     622.7      191.5      225.9      148.2      80.5       104.2
1998..........................................     933.1      259.4      346.0      149.5     190.9       203.1
1999..........................................   1,549.7      437.7      521.6      211.1     290.2       222.5
2000..........................................   2,259.4      526.0      867.1      304.2     420.1       249.0
2001 (April)..................................   2,472.0      561.3      989.2      342.5     477.1      256.4
----------------------------------------------------------------------------------------------------------------
Source: Russian Economic Trends, June 2001, Original Source: Goskomstat, CBR.


hazard can be limited and discrepancies between depositors', 
insurers' and lenders' risk tolerances are narrowed. Thus, a 
system of risk-based deposit insurance benefits not only 
individual depositors, but also reduces system risk by reducing 
moral hazard. A prerequisite for an effective system of risk-
based deposit insurance is the ability to measure risk, i.e., 
accurate financial information and uniform accounting standards 
providing greater transparency of bank activity. Legal reforms 
in the Russian banking system are gradually providing the 
foundations for these prerequisites, but currently, accurately 
measuring risk exposure of individual banks is difficult if not 
impossible.
    The financial system is not passive in a market economy, 
but accelerates growth in the real sector. The organization of 
financial intermediation networks is expensive, however. The 
level of financial sector development and economic activity is 
inter-related. Because the bulk of costs in establishing an 
intermediation network are the initial fixed costs, threshold 
effects are typical. An economy develops a specific type of 
intermediation system corresponding to the overall level of 
economic activity, which may be proxied by the level of per 
capita income. Then as per capita income increases, at some 
point the benefits of expanding or innovating within the 
intermediation system are perceived and capturable, the next 
stage of financial development begins. The benefits of 
deepening the financial system have a positive effect on 
overall economic growth and create the possibility of a 
circular relationship between financial development and growth. 
In this case a ``virtuous circle'' in which high income levels 
support development of the financial system and development of 
the financial system makes possible higher rates of growth. On 
the other hand, an underdevelopment trap or low-level 
equilibria may result. In an underdeveloped economy with few 
growth prospects, low-income levels make the development of the 
financial system impossible, which in turn hinders the 
allocation of resources to investment and further weakens 
growth.\36\ When financial institutions are inadequately 
developed selecting more flexible, less specialized, and 
therefore less productive technologies mitigates production 
risk. But reduction in risk by technological flexibility in 
production weakens the incentives to develop financial markets 
and banking intermediaries that involve substantial fixed 
costs. This results in a low level equilibrium with an 
underdeveloped financial system.\37\ A more developed financial 
system enables selection of more specialized, more risky but 
more productive production technologies. And, the resulting 
increase in risk is more easily diversified and mitigated by 
the existence of a developed financial system.
---------------------------------------------------------------------------
    \36\ See Greenwood and Jovanovic (1990), Levine (1992b), Townsend 
(1983).
    \37\ See Saint-Paul (1992).
---------------------------------------------------------------------------
    Before turning to a description of the Russian banking 
system it is important to realize that the banking industry in 
a market economy is typically not a perfectly competitive 
industry, but characterized by varying degrees of imperfect 
competition. Thus, in a transition economy policies should 
encourage competition, recognizing that the optimal level of 
competition is unclear. Natural imperfections in the banking 
system in a market economy arise due to the information 
intensive functions of the system. The activity of gathering 
and processing information on investments involves large fixed 
costs, which leads to imperfect competition and market 
segmentation. Because lenders (savers) and investors 
(borrowers) are generally not the same individuals there are 
information asymmetries since investors have better access to 
information about the quality and likely success of investment 
projects than lenders do. Therefore the functioning of 
financial markets is characterized by adverse selection and 
adverse incentives. Although banking is often monopolistically 
competitive Stiglitz (1994) argues greater competition is a two 
edged sword. Compression of intermediation margins via greater 
competition erodes profits and makes the system more vulnerable 
to productivity shocks as it increases the possibility of 
insolvency. Unlike other sectors insolvency in the banking 
sector can have wide spread negative repercussions on the rest 
of the economy as the volume of lending and activity in the 
real sector decline. Also, when a bank goes bankrupt the 
information it has collected on its particular clients or 
sector of lending activity may simply disappear. If so this 
leads to borrower rationing, which has a negative impact upon 
growth--the opposite effect that we would expect from 
compressing intermediation margins. The optimal level of 
competition, or the optimal intermediation margin, is not that 
of a perfectly competitive market. Reaching that optimal level 
is difficult in a well-functioning market environment and 
particularly difficult in a transition environment like that of 
Russia today.

     The State of the Banking System: Crisis, Recovery and Crisis?

              system characteristics and policy framework

    While the overall level of financial development in a 
transition economy is difficult to measure, traditional 
indicators of financial development indicate the Russian 
financial sector is underdeveloped vis-a-vis market economies 
even after the crisis and stabilization of the system. As Table 
5 indicates banking system assets as a percentage of GDP has 
increased from 22.2 percent in 1995 to 32.0 percent in 2000. 
This ratio for a market economy is typically in the 50 to 60 
percent range.\38\ Loans to GDP has increased from 8.7 percent 
to 12.3 percent. Banking system capital as a percentage of GDP 
has fluctuated, but averaged about 5.5 percent, in the range of 
a market economy, typically 5 to 6 percent.\39\ While these 
aggregate measures seem to be improving it should be noted 
again that total domestic credit relative to GDP is about 60 
percent of the comparable market economy and private sector 
credit relative to GDP is well less than half that of the 
comparable market economy (see Table 2). Further, these 
proportions have not changed during the last 5 years. 
Importantly the aggregate measures conceal the fact that the 
Russian banking industry is highly concentrated. At the end of 
1997, just prior to the 1998 crisis, the top 5 banks accounted 
for 36 percent of total assets, and the top 50 accounted for 71 
percent.\40\ Also, as mentioned above, Sberbank holds roughly 
75 percent of household deposits. Including enterprise deposits 
the top 5 banks accounted for 58 percent of ruble deposits and 
the top 50 banks accounted for 65 percent at the end of 
1997.\41\
---------------------------------------------------------------------------
    \38\ Great Britain and Japan are extremes with bank system assets 
as a percent of GDP at 270 percent and 159 percent in 1990 and 1993 
respectively. Warner (1998), Table 2.
    \39\ Note though that GDP has fluctuated greatly and published data 
are sometime suspect. Therefore these ratios should be interpreted with 
caution. See Iskyan and Besedin (2000) p. 21.
    \40\ Russian Federation (1997), p. 88.
    \41\ Russian Federation (1997), p. 88.

                            TABLE 5.--BANKING SYSTEM CHARACTERISTICS (END OF PERIOD)
                                                  [In percent]
----------------------------------------------------------------------------------------------------------------
                                                              1995     1996     1997     1998     1999     2000
----------------------------------------------------------------------------------------------------------------
Assets/GDP................................................     22.2     23.2     25.1     34.0     32.6     32.0
H.H. deposits/GDP.........................................      4.6      5.5      6.0      5.5      4.4      4.3
Loans/assets..............................................     39.0     31.6     36.3     37.1     33.7     38.4
Loans/GDP.................................................      8.7      7.3      9.1     12.6     11.0    12.3
----------------------------------------------------------------------------------------------------------------
Source: Calculated from Tables 2 and 7.

    Since 1998 bank restructuring has taken place, albeit at a 
pace that some see as too slow. The crisis led to a dramatic 
decline in bank capital and a deposit run on the large Moscow 
banks leaving the majority of them insolvent. The CBR adopted 
emergency measures forcing six large commercial banks to 
transfer the bulk of household deposits to Sberbank, with any 
remaining deposits frozen.\42\ This prevented further 
withdrawals by the population and stabilized the payments 
system. However, the CBR was unable to move quickly to close 
large insolvent banks, which were at the heart of the 
influential Financial Industrial Groups, or to extend 
rehabilitation credits in a timely manner. Although the bank 
had the power to revoke licenses and take over the management 
of insolvent banks, the attempts to do so immediately after the 
crisis were unsuccessful.\43\ Legal delays and political 
maneuvering allowed assets to be transferred from the failing 
institutions to newly created shell banks and balance sheets 
were unilaterally restructured. Although the Agency for 
Restructuring Credit Organizations (ARCO) was established 
rather quickly, in November 1998, its effectiveness also was 
limited in the early period after the crisis.\44\ It was 
capitalized with 10 billion rubles, the state holding 51 
percent of its shares and the CBR 49 percent, an amount 
estimated at about 10 percent of that necessary for a complete 
recapitalization of the banking system.\45\
---------------------------------------------------------------------------
    \42\ These banks were Inkombank, SBS-Agro, Moct Bank, Rosiiskii 
Kredit, Menatep and Promstroibank. Also see OECD (1997) Annex I for a 
discussion of the largest 23 banks prior to the crisis.
    \43\ For example, the CBR's initial attempt to revoke the license 
of Inkombank was contested in court and it was not until June 2000 that 
the revocation of the license was allowed to stand and a Moscow 
arbitration court named external managers to liquidate the bank. See 
Iskyan and Besedin (2000) for a chronology of this case and a primer on 
asset stripping. Also see Schoors (1999). Another notable case is that 
of Promstroibank. In July 1999 the CBR withdrew Promstroibank's license 
and it was declared bankrupt. Various government officials declared 
their support of Promstroibank, the bankruptcy procedures were halted 
and the license suspension declared illegal, even though the bank was 
insolvent. In November 2000 an arbitration court ruled the CBR's 
actions were legal and proceedings were to continue. See Russian 
Economic Trends (November, 2000), p. 17.
    \44\ It lacked funding and authority. Its first board meeting was 
held in March 1999. See Russian Economic Trends, March 1999, p. 3.
    \45\ Russian Economic Trends, December, 1998, p. 3
---------------------------------------------------------------------------
    By mid-2000 the results of ARCO's modest efforts were 
becoming visible.\46\ Temporary administration was imposed upon 
Most Bank in May and Vneshtorg Bank purchased it in October 
2000. SBS-Agro and Mezhkombank were bankrupted. Bankruptcy 
proceedings continue with Promstroibank and Menatep, 
Mosbusiness Bank and Imperial Bank remain in receivership, or 
are battling for survival.\47\ The first bank to emerge from 
ARCO management, in 2001, is Chelyabkomzembank, purchased by 
Rosselkhozbank the wholly state-owned bank created in April 
2000. A restructuring plan for Uneximbank was approved and 
shareholders approved its merger with Rosbank (the bridge bank 
of Rosiiski Kredit).\48\ In addition, the Central Bank is 
expected to divest itself of ownership in all banks. It sold 
its interest in five Russian-owned foreign-based banks 
(rosagranbanks) to Vneshtorg Bank this year and will sell its 
ownership in Vneshtorg Bank by 2002 and in Sberbank by 2004.
---------------------------------------------------------------------------
    \46\ While there are tangible results of ARCO's efforts critics 
maintain they are negligible since these banks are very small compared 
to the overall banking system and these bailouts may be seen as 
benefiting incompetent managers and therefore increasing moral hazard. 
The overall benefit to the banking system remains an open question.
    \47\ See Russian Economic Trends, various issues, (2000), (2001).
    \48\ Note that Uneximbank may be the only bank to be successfully 
restructured without assistance from ARCO or any other state agency. 
Russian Economic Trends, October 2000, p. 13.
---------------------------------------------------------------------------
    The foundation of the Russian banking system is provided by 
two fundamental laws, the Law on Central Bank of the Russian 
Federation and the Law on Banks and Banking Activity and by 
various parts of the civil code, in particular bankruptcy 
provisions and the tax code. The CBR carries the responsibility 
for not only monetary policy, but also bank licensing and 
prudential and regulatory oversight. Although the banking laws 
originated from the Soviet era, they have been amended many 
times. The 1995 amendments gave the Central Bank greater 
independence and made it the lender of last resort.\49\
---------------------------------------------------------------------------
    \49\ For additional details see OECD (1997), pp. 83, 84.
---------------------------------------------------------------------------
    In 1999 Russian authorities provided a stronger foundation 
for bankruptcy and bank rehabilitation, and the framework to 
accelerate the process of bank restructuring by passing two new 
laws. The Law on Insolvency of Credit Organizations 
strengthened the CBR's intervention powers and the Law on 
Restructuring of Credit Organizations (June 1999) gave sole 
responsibility for restructuring banks to ARCO, provided for an 
equitable and transparent mechanism for shareholder write 
downs, and empowered ARCO to invalidate transactions made with 
the intent to defraud depositors and creditors of insolvent 
banks.\50\ In spring 2001 the Duma passed three bills 
(incorporating most of the Putin government's proposal referred 
to as the Gref program or the ``IMF package'') which gave the 
CBR additional supervisory powers, introduced the legal 
concepts of a banking group and holding, streamlined the 
procedures for bankruptcy of credit organizations and revised 
the responsibilities of bank founders, shareholders and 
managers.\51\ Inter alia, specific legal criteria were 
introduced to facilitate the CBR's actions to withdraw banking 
licenses and initiate bankruptcy procedures which are expected 
to eliminate the legal wrangling typical of most recent actions 
initiated by the CBR. Given the new legislation it appears that 
a second phase in bank restructuring may now be undertaken.\52\
---------------------------------------------------------------------------
    \50\ IMF (1999).
    \51\ See Iskyan and Besedin (2001), Appendix B for a summary of the 
Gref program and the corresponding legislation.
    \52\ Russian Economic Trends, June 2001, p. 8.
---------------------------------------------------------------------------

                      recovery of banking activity

    Only recently has macro-economic performance allowed banks 
to rebuild reserves and slowly increase the level of confidence 
of depositors and investors. Growth in the banking sector has 
been driven by the overall positive developments in the real 
sector and increasing demand for banking services. Bank loans 
increased 66 percent in 2000 and nine out of ten banks were 
reporting profits. By the first quarter of 2001 assets of 
commercial banks reached 93 percent of the pre-crisis level in 
real terms, and hard currency assets were 43 percent of total 
assets.\53\ As personal incomes recovered, household deposits 
in the banking sector have increased and the share held by 
Sberbank has stabilized at just over 75 percent in June 2001. 
(Also see Figure 2.) By spring 2001 lending had increased to 
about 40 percent of assets in the Russian banking sector. This 
is improved, but still very low compared with the 80 to 90 
percent typical of a bank in a developed market economy. 
Further, Sberbank and Vneshtorg Bank, the two largest state-
owned banks, accounted for most of the lending to the real 
economy.\54\
---------------------------------------------------------------------------
    \53\ Russian Economic Trends, June, 2001, p. 7.
    \54\ Russian Economic Trends, May 2001, p. 6.

  FIGURE 2._HOUSEHOLD DEPOSITS IN SBERBANK AND OTHER COMMERCIAL BANKS

                          [In billion rubles]

[GRAPHIC] [TIFF OMITTED] T6171.038


  Source: Russian Economic Trends, June 1999, p. 4. Original 
Source: Goskomstat.

    Although lending has increased, Russian commercial banks 
still hold unusually large amounts of non-income producing 
excess reserves, illustrated in Figure 3. Due to the high risk 
of lending to the productive sphere of the economy loans amount 
to less than 45 percent of assets. Nearly 15 percent of assets 
are held in non-interest bearing accounts at the CBR. Given the 
high inflation environment this obviously impacts bank 
profitability. The lack of lending to enterprises, investment 
into the real economy, also limits economic growth. This is not 
a new phenomenon, however. Throughout the 1990s banks held very 
low levels of income earning assets.\55\ This is attributable 
to the inability of bank managers to find, evaluate and monitor 
viable investment projects, and extreme caution with respect to 
the possibility of bank deposit runs and risks associated with 
inter-bank lending. The government has pressured banks to 
increase lending and, as mentioned above, created two new 
banks, Rosiiski Bank Razvitiya (the Russian Development Bank) 
and Rosselkhozbank (the Russian Agricultural Bank), to expand 
lending in critical areas.\56\
---------------------------------------------------------------------------
    \55\ See OECD (1997), pp. 85-86.
    \56\ Of course the consequences of such pressures are problematic 
to the extent that related-party lending some of which may not be 
market driven intermediation, and lending to state institutions 
distorts the allocation of financial capital. Related-party lending and 
its consequences is very difficult to measure, however. See Iskyan and 
Besedin (2001) p. 15.
---------------------------------------------------------------------------
    Increased lending is a double-edged sword, however. The 
rapid increase in bank lending requires increased diligence 
upon the part of bank regulators. Although bank capital 
increased 43 percent in 2000, undercapitalization is still a 
serious problem.\57\ Total equity capital is no more than 6 
percent of GDP. Further, under relatively weak supervision many 
banks violate existing accounting rules, supplying the CBR with 
false financial statements. Regional offices are alleged to 
ignore the exaggerated statements of financial performance. 
According to the CBR 60 percent of banks overstated their 
profits and equity in official reports. At the same time CBR 
regional offices classified 9 percent of these banks as stable 
and with no faults. In addition, according to the CBR at least 
20 percent of the banks classified as stable may be in 
difficulty.\58\ To improve financial reporting, in October 2000 
the CBR launched the introduction of international accounting 
standards (IAS) for six banks. For these banks IAS-based 
reports will be provided in 2001. Other banks are expected to 
adopt IAS reporting, but over a process of many years. While 
adopting IAS is highly beneficial, CBR authorities at all 
levels must also be diligent and determined in enforcing 
prudential regulations. While significant legislative progress 
has been made, CBR regulatory efforts are still insufficient.
---------------------------------------------------------------------------
    \57\ This is for the banking system. Of the approximately 1,300 
banks, the 1,115 smallest have capital ranging from $0.1 million to $5 
million (Iskyan and Besedin (2001), p. 14). Many of these institutions 
simply conduct treasury functions of their enterprise owner or operate 
as foreign exchange offices rather as banks
    \58\ Russsian Economic Trends, July 2000, p. 14.

 FIGURE 3._SHARE OF COMMERCIAL BANKS' CLAIMS ON THE PRIVATE SECTOR AND 
                SHARE OF EXCESS RESERVES IN TOTAL ASSETS

                              [In percent]

[GRAPHIC] [TIFF OMITTED] T6171.037



  Source: Ivanova and Schoors (2000), p. 5.

                          Concerns and Issues

    It is clear that Russian policymakers have made much 
progress in reconstructing the banking system in the aftermath 
of the 1998 crisis. Recent legislation has increased the 
authority of the Central Bank to expedite bankruptcy and 
restructuring programs for individual banks and the economic 
recovery has provided an environment for improving bank 
profitability. The banking system in the aggregate, however, is 
still far from a vibrant, sound banking system. Koch (1998) 
provides a framework for analysis of the banking system 
presented in Table 6. In each of the six categories there is 
substantial work to be done.

            TABLE 6.--INDICATORS OF A ROBUST FINANCIAL SYSTEM
------------------------------------------------------------------------
-------------------------------------------------------------------------
1. Legal and juridical framework
    Well-defined property rights and contract law
    Market contracts easily enforceable in practice
    Ability to pledge and seize collateral
    Well-developed bankruptcy code
2. Accounting, disclosure and transparency
    Loan valuation, asset classification and provisioning practices
     reflecting sound assessment of counterparties
    Effective and regular auditing mechanisms
    Information on the creditworthiness of financial institutions made
     publicly available on a regular, frequent basis
    Timely publication of relevant aggregate financial data (macro-
     economic indicators, reserves, banking sector statistics, etc.)
    Availability of impartial credit rating or credit information
     facilities
3. Stakeholder oversight and institutional governance
    Capital adequacy requirements commensurate with risk
    Replacement of management for poor performance
    Enforceable legal liability of managers
    Pervasive use of effective systems of risk management and internal
     control
4. Market structure
    Financial sector open to qualified new entrants, including those
     from abroad
    Share of foreign participants in total assets
    Financial sector concentration ratios
    Liquid inter-bank money and capital markets
    Regulations permitting a full range of financial instruments
    Sound and effective payment and settlement systems
5. Supervisory/regulatory authority
    Independent from political interference in the daily conduct of
     supervision and appropriate accountability for achieving clearly
     defined objectives
    Power to force disclosure, impose penalties, etc.
    Adequate resources for staffing, training, compensation
    Conducts supervision on a consolidated basis
    Shares information with other supervisors
    Verification of information on risk management and internal control
     systems and on asset quality by regular examinations or external
     audits
    Adherence to norms established by international consultative bodies
     (Basle Committee, etc.), in principle and in practice
    Measures to address particular types of risk:
        Evaluation of risk management systems
        Connected lending
        Risk exposure and loan concentration
        Special attention to foreign currency and interest rate risk
         management and exposures
        Heightened scrutiny of asset quality and capital adequacy in the
         face of sharp asset price movements
    Strategy for addressing financial insolvency:
        Procedures for prompt corrective action or the equivalent
        Appropriate exit policy
6. Design of the safety net
    Explicit rather than implicit deposit insurance, paid for by banks
     and targeted especially toward protecting small depositors
    Appropriate allocation of losses among stakeholders
    Stringent conditionality for the use of public money
------------------------------------------------------------------------
Source: Koch (1998). Original source: Group of Ten (1997).

    As mentioned above new legislation improved the legal 
juridical framework, but much of the legislation is untested in 
practice. The bankruptcy code is improved, but it is too early 
to tell if legal challenges and political pressures have been 
eliminated from the process. Accounting, disclosure and 
transparency is improving and the CBR's recent project on IAS 
is a tremendous step. However, even when bank reporting reveals 
problems authorities have been reluctant to take appropriate 
actions. For example, in the spring of this year the CBR 
reported ``the risk exposure of Russian banks exceeds all 
reasonable limits.'' \59\ But the CBR does not appear to be 
taking any action to ameliorate excessive risk exposure. Will 
the CBR be able and willing to take a more active approach in 
system risk management?
---------------------------------------------------------------------------
    \59\ Russian Economic Trends, April 2000, p. 6. While banks may be 
lending to more risky ventures there is also a serious problem in 
matching the term structure of assets and liabilities. Approximately 25 
percent of loans are for terms of 1 year or more whereas about 14 
percent of liabilities are for 1 year or more. Without a highly liquid, 
capital market with sufficient depth a liquidity crisis may easily 
develop.
---------------------------------------------------------------------------
    The 1998 crisis revealed that stakeholder oversight and 
institutional governance was a serious problem. New legislation 
was required to better define the legal liabilities of managers 
and enable management to be replaced during the restructuring 
process. Internal controls were notoriously weak and creditor 
rights were not clearly delineated and forcefully represented 
by authorities during the early phase of restructuring. 
Managers were able to strip the assets of banks and effectively 
rob depositors and creditors. ARCO still holds ownership stakes 
in over a dozen banks in the process of restructuring and new 
legislation will likely enable the process to work more 
smoothly in the future. However, political pressure and legal 
challenges will not likely disappear.
    Market structure issues, ranging from the concentration of 
the industry, efficiency of financial products markets, 
relative lack of lending to the private sector, ease of entry 
and development of new financial institutions are a serious 
concern. Certain markets remain nearly monopolized. Sberbank's 
domination of the household deposit market gives it enormous 
power in the enterprise lending market. Further, many argue 
there remains too much state ownership to effect competitive 
market-oriented behavior on the part of financial institutions. 
Sberbank and Vneshtorg Bank are more than 50 percent owned by 
the Central Bank, ARCO has a dominant share of over a dozen 
institutions, and the Russian Federal Property Fund owns a 
majority of Roseksim Bank. The creation of the Russian 
Development Bank and the Russian Agriculture Bank seem to move 
the industry toward greater participation by the state rather 
than less, and greater lending to state-owned enterprises 
rather than to the private sector. In addition, state 
organizations account for very large shares of deposits and 
assets for many banks. All of which provides tremendous 
opportunity for political pressures to influence bank behavior. 
One positive factor is that the Duma has required the Central 
Bank to divest itself of ownership of commercial banks by 2005. 
Exactly how this is done is of critical importance. To date the 
Central Bank has sold its stake in five rosagranbanks to 
Vneshtorg Bank--ownership remained in the state sector. While 
this does remove one conflict of interest and enables the 
Central Bank to take a slightly greater arms length view of 
these banks, the state still has ownership of them and 
political pressures are only one small step further away.
    In addition, money and capital markets lack depth and 
breadth, which in turn may allow an individual, apparently 
healthy, participant to precipitate a market wrenching 
liquidity crunch.\60\ In 1995 the Central Bank was slow to 
provide additional liquidity and nearly 200 banks failed. Can 
the Central Bank identify participants with excessive risk 
exposure and limit their participation to dampen system risk? 
Tough supervisory and prudential regulation is required. Given 
the admissions of rather lax enforcement of existing 
regulations, not so stringent enforcement of loan 
classification and provisioning requirements and the propensity 
for individual banks to distort information in the reporting 
process, serious questions remain.
---------------------------------------------------------------------------
    \60\ For example, in May 2001 Infobank, a creditworthy institution 
with many large retail customers, nearly went bankrupt defaulting on 
payments on the inter-bank credit market. This could have precipitated 
a liquidity crisis similar to that of 1995. Russian Economic Trends, 
June 2001.
---------------------------------------------------------------------------
    Finally, the safety net for depositors, an explicit, 
universal deposit insurance program, paid for by the banks, but 
targeting household depositors is critical. It is the 
foundation for creating greater confidence in the banking 
system and increasing the amount of savings mobilized and 
available for investment. It also allows smaller banks to 
compete with Sberbank for deposits, promotes competition, 
reduces moral hazard and diversifies system risk. Yet the Duma, 
after much debate and many readings has failed to act.
    In summary, tremendous change has taken place in the 
Russian banking system through the 1990s and since the 1998 
crisis. The overall economic environment has improved and 
supported the recovery of the financial system (see Tables 7 to 
9). It is an open question however, whether or not the systemic 
changes and the attitudes of regulators and policymakers have 
changed sufficiently to prevent a banking crisis comparable to 
that of 1998.

                                      TABLE 7.--SELECTED ECONOMIC ACTIVITY
----------------------------------------------------------------------------------------------------------------
                                                                                         Nominal
                                                             Nominal                  expenditures      Real
                                              Real GDP,    consumption      Real         on new     expenditures
                               Nominal GDP   (seasonally  of goods and   consumption  construction     on new
                               (In billion    adjusted)   services (In  of goods and       and      construction
                                 rubles)    (1997 = 100)     billion    services \2\    equipment        and
                                                           rubles) \1\  (1995 = 100)   (In billion    equipment
                                                                                         rubles)    (1997 = 100)
----------------------------------------------------------------------------------------------------------------
1995........................      R1,540.5         102.6        R664.8         100.0        R267.0         128.5
1996........................       2,145.7          99.1         950.1          97.9         376.0         105.3
1997........................       2,478.6         100.0       1,124.0         100.9         408.8         100.0
1998........................       2,741.1          95.1       1,339.9          95.5         407.1          88.0
1999........................       4,757.2         100.2       2,191.7          82.7         670.4          92.7
2000........................       7,063.4         108.6       2,911.4          91.0       1,165.2         108.8
2001 (April)................  ............  ............       1,114.3          93.0         331.0        110.2
----------------------------------------------------------------------------------------------------------------
\1\ Series on consumption and investment differs slightly from SNA concept.
\2\ Nominal consumption deflated by CPI.
Source: Russian Economic Trends, February 2001. Original Source: CBR.


                                  TABLE 8.--MONETARY AGGREGATES (END OF PERIOD)
----------------------------------------------------------------------------------------------------------------
                                                                                                     Outstanding
                                                        Net           Net     M0--currency             stock of
                                         Monetary  international   domestic        in        M2 \3\    GKOs and
                                         base (In   reserves \1\  assets \2\   circulation    (In        OFZs
                                          billion   (In billion       (In      (In billion  billion  nominal (In
                                          rubles)     dollars)      billion      rubles)    rubles)    billion
                                                                    rubles)                            rubles)
----------------------------------------------------------------------------------------------------------------
1995...................................    R103.8        $7.7         R68.1        R80.8     R220.8      R73.7
1996...................................     130.9         1.7         123.0        103.8      288.3      237.1
1997...................................     164.5         4.0         142.1        130.4      374.1      384.9
1998...................................     210.4        -8.4         249.3        187.8      448.3         NA
1999...................................     324.3        -3.2           0.0        266.5      704.7         NA
2000...................................     519.6        16.0          88.6        419.3    1,144.3      184.2
2001, April............................     531.1        20.4            NA        435.4    1,210.0     189.5
----------------------------------------------------------------------------------------------------------------
\1\ Since June 2000 net international reserves and net domestic assets are estimated by RET.
\2\ Net domestic assets of the monetary authorities equal monetary base minus net international reserves. Net
  domestic assets are calculated using exchange rates of 27 rubles per dollar for 2000, 24.18 rubles per dollar
  for 1999, 6.0 rubles per dollar for 1998, 5,560 rubles per dollar for 1997, 4,640 rubles per dollar for 1996,
  and 3,550 rubles per dollar for 1995. In 1999 there were some changes in methodology for net domestic assets
  and net international reserves data.
\3\ M2 includes currency in circulation, demand deposits, and time deposits (there is a break in the series from
  December 1996, from then it includes only deposits at banks with active licenses).
NA--Not available.
Source: Russian Economic Trends, June 2001, original source: CBR.


                               TABLE 9.--INTEREST RATES (AVERAGE ANNUAL RATES) \1\
----------------------------------------------------------------------------------------------------------------
                                                                                               GKO
                                                                                             average      RTS
                                                  CBR      Lending    Deposit   Overnight   secondary    index,
                                               refinance   rate \2\   rate \2\    inter-     market     monthly
                                                rate \1\  (percent)  (percent)  bank rate  yield, all   average
                                               (percent)                        (percent)  maturities  (01.09.95
                                                                                            (percent)    = 100)
----------------------------------------------------------------------------------------------------------------
1995.........................................       185      320.3      102.0      190.4      161.8        80.9
1996.........................................       110      146.8       55.1       47.6       85.8       160.3
1997.........................................        32       32.0       16.8       21.0       26.0       427.9
1998.........................................        60       41.5       17.1       50.6         NA       277.6
1999.........................................        57       40.1       13.7       14.8         NA       106.9
2000.........................................        32       24.2        6.5        7.1       12.7       199.5
2001, April..................................        25       17.4        3.5   .........  ..........    166.0
----------------------------------------------------------------------------------------------------------------
\1\ Unweighted monthly average.
\2\ Data prior to January 1997 are not compatible with current methodology. From 1998 data on lending rate are
  for commercial banks excluding Sberbank.
NA--Not available.
Source: Russian Economic Trends, June 2001, original source: CBR.

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     Breakup of Monopolies: Energy, Transportation and Agriculture





  THE RUSSIAN ENERGY SECTOR: CURRENT CONDITIONS AND LONG-TERM OUTLOOK



                        By Matthew J. Sagers \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   213
Introduction.....................................................   217
 Oil Sector......................................................   219
    Crude oil production.........................................   219
    Oil exports..................................................   223
    Refinery operations and oil consumption......................   226
Gas Sector.......................................................   231
    Gas production...............................................   231
    Gas exports..................................................   233
    Gas consumption..............................................   234
Coal Sector......................................................   236
Electric Power Sector............................................   239
    Electricity production.......................................   239
    Electricity consumption......................................   239
    Organizational structure.....................................   242
The Russian Federation's Primary Energy Balance in Long-Term 
  Perspective....................................................   244
References.......................................................   252
                                Summary

    Energy production holds a central place in the economic and 
political life of the Russian Federation, as the country is a 
leading energy-producing country, ranking first in the world in 
gas production, third in oil production, fifth in hydro and 
nuclear generation, and sixth in coal production. The reform 
and re-emergence of this key part of the economy are integrally 
linked to the country's overall economic transformation and 
recovery, due not only to the energy sector's direct impact on 
gross domestic product (GDP) and overall value-added in the 
economy, but also to its importance in foreign exchange 
earnings and Russia's fiscal stability. Similar to the overall 
economy, however, Russia's energy sector initially experienced 
a sizable decline coincident with the launch of Russia's 
transition from a centrally planned to a market-type economy, 
although after bottoming out in 1997, it has since been rising. 
2000 was a very good year for Russian energy production, with 
aggregate primary energy output rising by 2.1 percent; oil 
production climbing by 6.0 percent; coal production up by 3.5 
percent; and electricity generation increasing by 3.8 percent; 
however, natural gas production declined, falling by 1.1 
percent.
---------------------------------------------------------------------------
    \1\ Matthew J. Sagers was Director of Energy Services at PlanEcon, 
Inc. until October 2001 when he shifted positions to Director, Energy 
Economics for Eurasia and Eastern Europe at Cambridge Energy Research 
Associates. He holds a Ph.D. in Geography from The Ohio State 
University.
---------------------------------------------------------------------------
    Broadly speaking, energy sector reforms over the past 
decade have typically lagged behind those in the economy at 
large. But increasingly, the outcome of general economic 
reforms will depend to a large extent upon the success of those 
in the energy sector. If properly managed, Russia's energy 
resources can help accelerate the economic reform process; if 
poorly managed, it can easily hinder that process.
    Russia's principal energy policy document is the Energy 
Strategy of Russia to 2020, which was officially approved by 
the government in November 2000.\2\ The Energy Strategy states 
Russia's priorities for its long-term energy policy and the 
mechanisms for its implementation. The Strategy is set within 
the context of a resumption of economic growth in Russia, and 
there is a broad concern that, given the poor state of the 
Russian energy sector, it may not be able to provide for both 
increasing energy demand within Russia as well as generate the 
energy exports needed to sustain economic growth. Thus, the 
Strategy continues to emphasize improvements in energy 
efficiency and reform of energy pricing structures.
---------------------------------------------------------------------------
    \2\ Government of the Russian Federation, 2000.
---------------------------------------------------------------------------
    The Energy Strategy's projections for energy supply to 2020 
are based on a major change in energy policy outlook. It 
expresses major concern over the energy security risk from what 
is deemed to be too high a dependence on natural gas. The 
Strategy envisages a change in the fuel mix such that the share 
of natural gas in total primary energy consumption decreases 
from about 50 percent in the late 1990s to 42 to 45 percent in 
2020. In its place, the share of coal is planned to increase 
from 17 to 18 percent in the late 1990s to 22 percent in 2010 
and to 21 to 23 percent in 2020. Nuclear energy is also slated 
to increase, expanding to 6 percent in 2020 from current levels 
of 5 percent, while oil's share in primary energy consumption 
will remain practically unchanged. The Strategy projects 
primary energy production in Russia in 2020 in a range of 1,525 
to 1,740 million metric tons of coal-equivalent (mtce) (1,068 
to 1,218 million metric tons of oil equivalent [mtoe]).\3\
---------------------------------------------------------------------------
    \3\ The energy data presented in this report are given in the 
metric units commonly used in Russia rather than standard U.S. 
measures. An exception is Russian aggregate energy balances, which are 
reported here in the usual international standard of million metric 
tons of oil equivalent (mtoe); Russian aggregate balances are presented 
in terms of million metric tons of coal equivalent (standard fuel or 
mtce) while U.S. aggregate balances are often presented in quadrillion 
British thermal units (btu) (or quads). The conversion coefficient to 
mtoe from mtce is 0.7. Similarly, oil production is reported in million 
metric tons (mmt) per year instead of million barrels of oil per day 
(mbd), for which the conversion coefficient is 0.02 (i.e., 7.3 barrels 
per metric ton of oil). Natural gas production is reported in billion 
cubic meters (bcm) per year (at 20 deg.C and a pressure 760 mm of 
mercury) instead of the U.S. measure (billions of cubic feet [bcf] 
measured at 15 deg.C and 760 mm of mercury); the conversion coefficient 
from bcm to bcf is 35.315.
---------------------------------------------------------------------------
    However, PlanEcon's most recent energy forecast for 
Russia\4\ takes an entirely different tack. It does not view 
the large dependence on gas as a particular cause for concern; 
instead, this is viewed as a natural consequence of Russia's 
massive reserves of natural gas. The PlanEcon forecast projects 
total output of primary energy in 2020 in Russia at a much 
higher level than in the Strategy (1.446.3 mtoe, 46.7 percent 
higher than the 2000 figure), combined with less energy 
consumption, and therefore higher energy exports. In 
particular, coal production is expected to resume its long-term 
secular decline; oil output is expected to continue to recover 
(albeit slowly); and gas production is anticipated to turn 
around shortly, due both to improvements in the domestic 
investment climate (reflecting higher prices and toughening 
payment conditions) and to more buoyant demand from expanding 
economic activity in the region. Thus, natural gas is expected 
to garner a steadily rising share of Russia's energy production 
over the next two decades, reaching 58.3 percent by 2020. Over 
the entire 2000-2020 period, aggregate primary energy output in 
Russia is projected to increase at an annual average rate of 
about 1.9 percent in the PlanEcon forecast.
---------------------------------------------------------------------------
    \4\ Sagers and Movit, 2001.
---------------------------------------------------------------------------
    For the most part, this forecast presumes the 
implementation of the bulk of the measures outlined in the 
proposed Putin-Gref reform program. This program includes 
general reliance on market forces and mobilizing private 
investment, strong elements of commercialization and 
marketization in the reform of the ``natural monopolies'' in 
the gas and electric power sector, particularly in terms of 
price reform, and the prospects of fairly strong economic 
recovery.
    In PlanEcon's energy forecast, Russian oil production is 
projected to grow at an average rate of 1.4 percent per year 
over the entire 20 year period to 2020, to reach 392.7 million 
metric tons (mmt) in 2010, and then 423.2 mmt by 2020. The 
official Russian Energy Strategy to 2020 envisions oil output 
at 335 mmt in 2010 and 360 mmt in 2020, an average annual rate 
of growth over the 20 year period of only 0.5 percent. The 
Strategy's overall oil production forecast seems far too 
conservative given what was achieved in 2000 (e.g., higher 
investment, expanded drilling, more new fields) and the changes 
in the investment climate that are likely to be realized over 
the next few years.
    Despite Gazprom's current worries over its ability to 
produce gas in the future (a key feature of the Strategy's 
outlook), in PlanEcon's view, the decline in Russia's gas 
output is largely an organizational/institutional issue related 
to the lack of incentives to invest rather than a question of 
reserves or even the capacity to mobilize investment. Thus, 
with the current direction of reforms in the gas sector (albeit 
quite modest), production is likely to be able to turn around 
relatively quickly to support rising gas demand. PlanEcon 
projects Russian gas output in 2005 at 642.6 billion cubic 
meters (bcm), expanding to 797.0 bcm in 2010 and 1,030 bcm in 
2020; gas output growth is forecast to average 2.9 percent per 
annum over the 20 year period.
    In contrast, the Russian Energy Strategy, because of its 
goal of diminishing the domestic economy's reliance on gas, 
projects gas output at only 655 bcm in 2010 and a mere 700 bcm 
in 2020. Furthermore, the expanded production is largely geared 
toward higher exports, while domestic consumption is envisioned 
as remaining relatively flat over the next two decades.
    The Energy Strategy takes the view that energy consumption 
in Russia has become too unbalanced in favor of gas. In 
particular, the Strategy calls for greater use of coal and 
nuclear power to meet the increased demand for electricity. The 
Strategy projects a decline in the share of gas in Russian 
primary energy consumption to about 40 percent by 2020, led by 
a decline in the share of gas in fuels use by the electric 
power sector from the current 62 percent to 51 percent by 2020. 
Concomitantly, according to the Strategy, the share of coal in 
primary energy consumption will rise slightly over the 20 year 
period, to about 22.5 percent by 2020.
    PlanEcon's view is that coal and nuclear are not only 
intrinsically much more expensive than gas, but also come with 
enormous environmental liabilities. Therefore with huge 
reserves of relatively economic and clean natural gas, we 
forecast that Russia's reliance on coal for power generation 
and process heat is likely to wane further. The declining 
relative importance of metallurgy in the country's aggregate 
economic output should also serve to reduce the share of coal 
in primary energy consumption as well. Thus, by 2010, PlanEcon 
projects that the share of gas will be up to 57.1 percent, and 
that it will rise further, to 60.6 percent, by the end of the 
forecast horizon in 2020.
    Russian coal production, in energy equivalent terms, is 
projected to slowly decline over the forecast horizon in the 
PlanEcon forecast (-0.5 percent per year on average). In 
contrast, the Energy Strategy envisions coal production rising 
to 320 mmt in 2010 and over 400 mmt in 2020. In the Strategy, 
major technological breakthroughs are postulated in coal 
production, processing and transportation that result in 
declining costs, and therefore end-user prices, of coal. In 
PlanEcon's view, such a prognosis seems highly unlikely, 
particularly the geographic locus of both production 
(increasingly concentrated in Siberia) and energy consumption 
(in European Russia).
    The projected level of primary electricity production in 
the current PlanEcon forecast envisions the completion of only 
six new (1,000 MW) nuclear units during the forecast period, 
including four before 2005. The recently approved Energy 
Strategy calls for the completion of five new units (which were 
already well advanced in construction during the Soviet period) 
before 2005, identifying these as the cheapest generating 
capacity (in costs per MW or per kWh) that Russia could bring 
on stream. PlanEcon concurs in this assessment mainly because 
of the sizable investment that has already been sunk into these 
units. However, PlanEcon does not consider the Strategy's 
longer term plans for further nuclear expansion beyond these 
initial units to be realistic.
    On the demand side, PlanEcon projects that the growth in 
primary energy consumption will lag well behind the trend in 
aggregate economic activity. Primary energy consumption is 
projected to rise at an average rate of only 1.7 percent per 
year over the 20 year period.
    The projection of primary energy production and consumption 
provides a forecast for their difference, or net energy exports 
for Russia. Russian net energy exports reached a trough in 1993 
at 302.8 mtoe, a decline relative to 1990 of 24.4 percent. Net 
energy exports are projected to rise to 565.3 mtoe in 2020, an 
increase of 55.5 percent above the level of 2000. This is 
projected to be comprised mainly of oil and gas, with gas 
surpassing oil in importance in the export mix by 2015.

                              Introduction

    This report provides an overview of Russia's energy sector, 
particularly its current situation, and provides an assessment 
of its long-term outlook. The Russian Federation is a leading 
energy-producing country, ranking first in the world in gas 
production, third in oil production, fifth in hydro and nuclear 
generation, and sixth in coal production. In 2000, the Russian 
Federation produced in aggregate 997.8 mtoe of primary energy 
(i.e., energy not resulting from the transformation of other 
sources).
    Energy production holds a central place in the economic and 
political life of the country. In the Soviet period, the energy 
sector was developed to provide resources for heavy industry 
and the defense-related sectors, as well as to earn foreign 
exchange for financing vital imports. Under present conditions, 
the emphasis has been shifted to the creation of an efficient 
market economy, which in the long run will be able to provide a 
higher level of well-being for the country's population.
    The reform and re-emergence of this key part of the economy 
are integrally linked to the country's overall economic 
transformation and recovery, due not only to the energy 
sector's direct impact on GDP and overall value-added in the 
economy, but also to its importance in foreign exchange 
earnings and Russia's fiscal stability.\5\ In 2000, the energy 
sector accounted for perhaps 16 percent of value-added in the 
economy (GDP) and about 45 to 48 percent of Federal budget 
revenues as well as 54.0 percent of foreign exchange earnings 
and 29.0 percent of the gross value of industrial output in the 
country. In the current situation, raw materials extraction, 
particularly of fuels, figures as a key engine of economic 
growth, generating vital foreign-exchange earnings and 
attracting foreign investment.
---------------------------------------------------------------------------
    \5\ Sagers, Kyukov, and Shmat, 1995.
---------------------------------------------------------------------------
    Similar to the overall economy, however, Russia's energy 
sector initially experienced a sizable decline coincident with 
the launch of Russia's transition from a centrally planned to a 
market-type economy. By 1997, Russia's primary energy 
production had plunged to a low point of 956.5 mtoe, a level 
only 71.6 percent of the peak output achieved in 1988 (of 
1,393.5 mtoe).
    However, Russia's aggregate primary energy production has 
risen for the third consecutive year in 2000 (+2.1 percent), 
representing a significant recovery after declining by 26.8 
percent in the period 1990-1997 during the initial period of 
Russia's difficult transition from a planned economy. The 
sizable increase registered in oil and coal production last 
year was tempered by a slight downturn in gas production.
    Broadly speaking, energy sector reforms over the past 
decade have typically lagged behind those in the economy at 
large. But increasingly, the outcome of general economic 
reforms will depend to a large extent upon the success of those 
in the energy sector. If properly managed, Russia's energy 
resources can become a major contributor to the general welfare 
and help accelerate the economic reform process; if poorly 
managed, it can easily hinder that process.
    Russia's principal energy policy document is the Energy 
Strategy of Russia to 2020, which was officially approved by 
the government in November 2000.\6\ The Energy Strategy states 
Russia's priorities for its long-term energy policy and the 
mechanisms for its implementation. This is the most recent in a 
series of energy policy documents laying out a strategy for the 
energy sector under the transition to a market economy, 
including its immediate predecessor, the Basic Guidelines for 
the Energy Policy of the Russian Federation to 2010 (approved 
in October 1995). The new Energy Strategy specifies the main 
trends, tasks, and objectives of energy policy to 2020. It 
states that the highest priority is the most efficient use of 
the country's fuel and energy resources so that the fuel and 
energy sector can be harnessed to improve the living standards 
of the population.
---------------------------------------------------------------------------
    \6\ Government of the Russian Federation, 2000.
---------------------------------------------------------------------------
    Similar to President Putin's overall economic strategy, 
Russia's Energy Strategy is based on the assumption that to 
continue social and economic reforms, to overcome the economic 
crisis, and to initiate stable development, Russia needs a 
strong state power. The document states that a strong state 
power in Russia means a democratic, law-based and active 
Federal state, and that the state's role is to become an 
efficient coordinator of the economic and social reforms, 
determine optimal purposes and parameters of national 
development, and create conditions and mechanisms for their 
implementation.
    The social and economic part of the Energy Strategy has 
been developed to address the following tasks: (1) to create 
acceptable living standards for all categories of the 
population; (2) to create a strong state and ensure human 
sovereignty; (3) to create an efficient and competitive 
economy; and (4) to ensure an honorable place for Russia in the 
world community. The document posits that this will not be 
possible unless long-term economic growth is ensured (minimum 
of 5 to 6 percent per year). To ensure such growth rates, the 
following should be implemented: (1) strengthening the economic 
functions of the state; (2) normalization of monetary and 
credit systems and restoration of budget equilibrium; (3) full-
scale capital renewal and rational structural policy; (4) 
development and implementation of publicly acceptable and 
socially responsible economic policies to ensure priority 
growth of the real income of the population; and (5) 
stimulation of the purchasing power of enterprises and 
population for products, goods, and services, especially those 
locally made.
    The development of the fuel-energy complex should meet the 
above stated parameters of the economic development of Russia. 
Thus, the Energy Strategy determines the demand of the country 
in fuel and energy required for economic growth, taking into 
account the expected structural, technological and territorial 
changes, and develops a forecast for the development of the 
fuel-energy complex and its main industries.
    Price and tax policy remains the linchpin of the mechanisms 
driving the Energy Strategy forward. The goal is to skillfully 
conduct price and tax policy in combination with anti-monopoly 
measures to keep the fuel and energy sector a major source of 
budget revenues and to alter the wasteful character of energy-
intensive branches of the Russian economy.

                               Oil Sector

                          crude oil production

    The Russian Federation (Russia) remains one of the world's 
major petroleum-producing countries, currently ranking third in 
the world behind Saudi Arabia and the United States. Since 
Russia also has accounted for about 90 percent (more or less) 
of the former Soviet oil output for several decades, when the 
former U.S.S.R. led the world in oil production between 1974 
(when it surpassed the United States) and 1991, so did Russia. 
Russia is also one of the leading oil exporters in the world 
and ranks among the world leaders in oil reserves, with an even 
greater oil potential.\7\
---------------------------------------------------------------------------
    \7\ Sagers, 1996.
---------------------------------------------------------------------------
    Russia's oil sector was particularly negatively affected by 
the launch of Russia's economic reforms and initially 
experienced a severe depression. By 1996, Russian crude oil 
production had plunged to only 301.2 mmt, a level barely half 
(52.9 percent) of the peak output achieved in 1987 (of 569.5 
mmt).\8\ In 1997, production actually turned around slightly, 
rising by 1.5 percent. Although the improving trend reversed in 
1998 (a year of financial crisis in Russia), as output 
experienced a slight dip, it then recovered again in 1999 and 
surged in 2000. Perhaps not so surprisingly, annual trends in 
Russia's GDP show a similar pattern.
---------------------------------------------------------------------------
    \8\ The energy production data cited in this paper for Russia as a 
whole or regional totals are usually taken from reports issued by the 
Russian State Statistics Committee (Goskomstat Rossii), while 
production data for individual companies or enterprises are taken from 
published statistical reports issued by the Ministry of Energy (i.e., 
the monthly bulletins Statistika, Dokumenty, Fakty or Itogi raboty 
Mintopenergo).
---------------------------------------------------------------------------
    The current upward swing in Russian crude oil production 
began in early 1999, and continued to gain momentum throughout 
2000. Overall for the year as a whole, Russian oil production 
was up by 6.0 percent, to 323.2 mmt.
    A number of elements were involved in producing the 
turnaround in Russian output, but given that the upturn began 
in the second quarter of 1999, clearly the major underlying 
driver for this recovery was the sharp rebound in international 
oil prices that occurred after March 1999, when the 
Organization of Petroleum Exporting Countries (OPEC) (in 
collaboration with some major non-OPEC producers such as 
Russia, Mexico, and Norway) agreed to reduce their oil output 
and exports to international markets. The resulting rise in 
world oil prices led to a substantial increase in revenues for 
the Russian producers, and allowed them to increase capital 
spending on upstream development. At the same time, production 
costs (in dollar-equivalent) for the Russian producers were 
reduced substantially in the wake of the sizable devaluation of 
the ruble associated with Russia's financial crisis of 1998, 
greatly increasing the sector's profit margins.
    Another dimension of the turnaround reflects a number of 
positive changes in the investment climate in the Russian oil 
industry that enabled this supply/investment response by the 
producers to take place. The combination of Vladimir Putin's 
accession to President in March 2000 together with the 
parliamentary elections of 1999 (substantially altering the 
composition of the state Duma, Russia's lower house of 
Parliament) have had a role in this. The policy directions 
taken by the Putin government toward the oil sector build on 
some important achievements that actually preceded Putin's 
accession to power, such as the beginning of tax reform 
(introduction of part 1 of the new Tax Code) and passage of the 
Amending and Enabling Laws to the Law on Production-Sharing (in 
early 1999).
    The strong surge in Russian oil output has been largely 
driven by high international oil prices that boosted the 
revenues of the Russian producers, which they plowed back into 
capital spending. Capital investment in the upstream oil sector 
in 2000 more than doubled from the 1999 level in real terms 
(+102.4 percent according to the Ministry of Energy), at 110.6 
billion rubles ($3.9 billion at the average exchange rate for 
the year).\9\ Of this, 34.5 billion rubles (31.2 percent of the 
total) was spent on drilling activity. Development drilling in 
the sector increased by a whopping 80.3 percent in 2000, to 
8,286,000 meters, and the number of new wells completed 
increased by 56.3 percent, to 3,405.
---------------------------------------------------------------------------
    \9\ The exchange rate does not reflect the true purchasing power of 
ruble expenditures in the upstream oil sector vis-a-vis the dollar. 
Real investment activity is much higher than indicated by the 
conversion of ruble outlays into dollars at the average exchange rate.
---------------------------------------------------------------------------
    The largest contribution to the higher production level in 
2000 continued to come from well work-overs, which reduced the 
number of idle wells to 31,940 by the end of the year (i.e., to 
only 22.5 percent of the total well stock compared to 24.2 
percent at the end of 1999). This combination of new wells and 
restarted old wells added over 19 mmt to annual production 
capacity in 2000.
    ``New oil,'' however, is also becoming noticeable again 
after virtually disappearing in the mid-1990s. A total of 43 
new fields were brought on stream during 2000, the largest 
annual number in almost two decades. These new fields 
contributed relatively little to aggregate production during 
the year (a mere 546,000 tons), but the contribution of all so-
called ``new fields'' (those that have been in production less 
than 5 years) \10\ was a more substantial 16.1 mmt in 2000, or 
5.0 percent of national production last year.
---------------------------------------------------------------------------
    \10\ Similarly, a total of 36 new fields produced their first oil 
in 1999. This included 18 new fields by the Russian oil majors, 15 by 
independent Russian companies, and 3 by foreign producers. In 1998, a 
total of 20 new small fields were brought on stream.
---------------------------------------------------------------------------
    In 2000, a total of 132 enterprises (companies) were 
producing oil in Russia according to Goskomstat; however, the 
bulk of these (110) are small, producing less than 1 mmt 
annually, and only 12 companies produce more than 10 mmt per 
year. Although the proportion is declining over time, the bulk 
of Russia's oil production is still produced by the large oil 
enterprises that previously were part of the former U.S.S.R. 
Ministry of Oil (95.5 percent in 1992 and 91.6 percent in 
2000).
    Gazprom remains the largest single producer outside these 
oil enterprises,\11\ but as production by joint ventures (JV) 
with ``foreign'' companies has surged, these have now become 
the largest component of production outside the traditional oil 
enterprises. At the same time, there has been a proliferation 
of other new types of oil producers, including Russian 
``independent'' (or private) companies and geological 
exploration enterprises.
---------------------------------------------------------------------------
    \11\ Gazprom's contribution to Russian petroleum output amounted to 
some 10.2 mmt in 1992 and by 2000 had almost returned to this level 
(10.0 mmt); i.e., Gazprom has produced 2.6 to 3.2 percent of the 
Russian total during the last decade. Much of this would be gas 
condensate, although Gazprom does produce some oil as well. Total 
output of gas condensate (at least that proportion of gas liquids 
output included in the crude petroleum production statistics; i.e., 
``lease'' condensate as opposed to ``plant'' condensate) in Russia was 
9.7 mmt in 1999 and 10.4 mmt in 2000, or about 3.2 percent of Russia's 
total annual petroleum (crude oil plus condensate) output.
---------------------------------------------------------------------------
    Among the various groups of producers, aggregate production 
rose substantially (+8.1 percent) for the largest and more 
important producing group, the large Russian vertically 
integrated companies (VICs); \12\ their combined aggregate 
output amounted to 296.3 mmt in 2000 (or 91.7 percent of total 
national output). Among the leaders in expanding production in 
2000 were: Rosneft (+6.3 percent); Surgutneftegaz (+14.2 
percent); Yukos (+11.4 percent); and Tyumen Oil Company (TNK), 
whose output was up by 23.4 percent.\13\ Russia's largest oil 
producer was Lukoil, at 62.2 mmt, with its acquisition of Komi-
TEK. The second-largest Russian producer is Yukos, at 49.5 mmt 
(following the consolidation of the Eastern Oil Company [VNK] 
into Yukos).
---------------------------------------------------------------------------
    \12\ The Russian oil industry was reorganized in the 1990s into a 
few large VICs which combine geological exploration, crude production, 
oil refining, and distribution and retailing of refined products in one 
integrated structure. These companies have also been largely 
privatized, although the share of federal government ownership in some 
of them remains quite sizable, and republic-level administrations also 
own sizable stakes in some of the ``regional'' VICs. Current plans call 
for the eventual sale of most of the remaining shares still held at the 
Federal level to raise funds for the budget. The interest in 
establishing a state-owned ``national'' oil company, championed 
periodically since 1995, has largely waned since the election of 
President Vladimir Putin in March 2000. Currently, the Russian oil 
sector includes 11 large VICs, which collectively accounted for 88.2 
percent of national crude production and 78.9 percent of total refinery 
throughput in 2000. The oil pipeline systems are not part of this 
``privatized'' structure, but so far remain largely state-owned (some 
shares have been distributed to employees and some plans for further 
privatization have been mooted); they function as service-for-fee 
carriers, serving all the various companies. The pipelines are 
administered by two entities. One, Transneft, operates the crude 
pipeline network, while the other, Transnefteprodukt, operates the 
product pipeline network.
    \13\ The TNK figure includes the takeover of Sidanko's 
Kondpetroleum and Chernogorneft (now TNK Nyagan and TNK Nizhnevartovsk, 
respectively).
---------------------------------------------------------------------------
    The output of the smaller, ``independent'' producers, which 
until 2000 had generally been far more dynamic than the large 
VICs, included 10.826 mmt produced by small Russian companies 
(+22.2 percent compared to last year), as well as 19.105 mmt 
officially credited to the foreign joint ventures (+4.6 percent 
versus last year), and 2.188 mmt produced by the Khar'yaga and 
Sakhalin-2 PSAs (production-sharing agreements). Thus, 
``foreign'' companies (the JVs and PSAs together) accounted for 
21.3 mmt in 2000, or 6.6 percent of Russia's total oil 
production last year.\14\
---------------------------------------------------------------------------
    \14\ The level of foreign involvement in JVs must be viewed with 
some caution. Many allegedly ``foreign'' partners are in fact Russian-
owned (although foreign-registered) companies, as they are not clearly 
identifiable international oil companies. The real role of Russian 
companies is likely to grow further, as some of them are buying out the 
original foreign JV partners.
---------------------------------------------------------------------------
    Although the immediate situation appears quite positive, 
many of the underlying fundamentals in the oil sector remain 
quite poor; the transition to a market-type economy has proven 
to be very difficult. Many of the economic and fiscal policies 
implemented tended to be highly unfavorable for the energy 
sector, particularly in the initial phases of the reform 
process, although policy has tended to become more rational 
over time. The fiscal burden on upstream operations was by and 
large based on revenues and not on net profit--and thus 
penalized exploration and production in high-cost environments 
(particularly applicable in the period previous to 1998 with 
the strong ruble). Also, domestic energy prices initially 
remained controlled while those for most other goods were 
liberalized (causing the oil sector's production costs to 
skyrocket with the high rate of inflation), taxes have remained 
oriented to budget (as opposed to investor) needs, the 
regulatory regimes need to be streamlined and clarified, and 
access to export markets continues to be restricted.
    At the same time, Russia's oil industry has undergone the 
most liberalization and commercialization within the entire 
energy sector. The breakdown of the old central command 
structures and de-monopolization under privatization, coupled 
with the proliferation of new producing entities, the formation 
of a quasi-market for oil domestically, the liberalization of 
prices, and the (partial) liberalization of exports, point to 
the tremendous changes that have occurred within this sector 
since 1991. The Russian Government has made considerable 
progress in clarifying the sector's administrative structure, 
establishing the level of competence of different levels of 
authority (Federal, regional, and local), and putting the 
sector on a firmer legal foundation. Nonetheless, all of these 
issues remain unsettled and much more still needs to be done. 
In fact, there was noticeable back-sliding on reform in the 
period after 1998, particularly in the area of exports, with 
administrative limitations again being imposed on crude and 
product exports.
    While the fundamental problem in the oil industry is an 
economic one, partly caused by the ongoing economic transition, 
objective technical factors are also important.\15\ Russia's 
prolific West Siberian oil province is very mature,\16\ 
although its depletion can be attenuated by proper reservoir 
management and development of small and difficult fields; at 
the same time, a new oil basin with reserves similar in size to 
West Siberia's is not on the horizon. Thus, the key factor 
determining Russia's level of oil production in the future 
essentially hinges on just how long West Siberia's current 
plateau of 200 to 220 mmt per year can be maintained, while new 
reserves are put into production in less mature provinces such 
as Timan-Pechora and Sakhalin.\17\ Longer term, new provinces 
such as East Siberia, the Pechora Sea, or the Russian sector of 
the Caspian, are likely to make sizeable contributions to the 
country's overall production profile.
---------------------------------------------------------------------------
    \15\ ``Osnovniye,'' 2000.
    \16\ West Siberia first faced a ``production crisis'' in 1983-1985. 
The downward trend then was reversed (albeit for only a couple of 
years) through a massive injection of financial and material resources. 
But after reaching an all-time peak of 418.6 mmt in 1988, West Siberian 
production then plunged to less than half this level by 1996.
    \17\ Sagers, 1996.
---------------------------------------------------------------------------
    Production costs and international oil prices are crucial 
considerations in the prospects for maintaining West Siberia's 
current production plateau. But it should be technically 
possible to attenuate West Siberia's maturation with the help 
of modern reservoir management and modern tertiary recovery 
techniques to maximize reservoir drainage, and formation and 
well treatment in less permeable reservoirs. Several alliances 
have been formed to this effect between Russian companies and 
Western service companies like Halliburton and Schlumberger, 
and these are beginning to show some positive results.\18\
---------------------------------------------------------------------------
    \18\ TNK signed an exclusive deal with U.S. Halliburton to provide 
sophisticated oilfield services for its fields in 1999, while Yukos has 
a similar arrangement with France's Schlumberger dating from 1998. 
According to McKinsey Report: Russian Oil (February 2001), the actual 
total factor productivity (the combined measure of labor and capital 
productivity) of the Russian oil industry is only about 30 percent of 
international levels. The main reasons for the productivity gap at the 
operational level are lower oil recovery (due mostly to less hydro-
fracturing and poor reservoir management techniques), and inefficient 
drilling because of low quality drill bits, cleaning muds, and cement 
being used.
---------------------------------------------------------------------------
    Water-flooding, which has been employed in West Siberia 
since the very beginning to quickly boost output to maximum 
levels, has resulted in an increasingly large water cut. By 
1990, the water cut was 76 percent for Russia as a whole, and 
72 percent for the West Siberian fields; the average had been 
only 50 percent as recently as 1976. Currently, water 
encroachment in Russia is 70 to 90 percent at nearly all of the 
large fields. Injection of (associated) gas (which also has the 
advantage of reducing gas flaring) has been slow to be 
introduced, still accounting for only 1.9 percent of Russian 
oil production in 1999. Conversely, the share of oil produced 
from free-flowing wells dropped from 51.8 percent in 1970 to 
only 12.0 percent by 1990, and by 1999 was down to 8.4 percent.

                              oil exports

    Russia is one of the largest oil exporters in the world, 
currently ranking second behind Saudi Arabia. In the peak year 
of 1988, Russia exported 256.5 mmt of crude beyond its borders, 
of which 132.1 mmt (51.5 percent) went to the other former 
Soviet republics. However, the amount of crude oil Russia has 
shipped to the rest of the former Soviet Union has declined 
dramatically since the break-up of the U.S.S.R. in 1991: in 
2000, Russia's crude oil exports to all countries amounted to 
144.5 mmt, but only 21.2 mmt (14.7 percent) was exported to the 
former Soviet republics (Table 1).\19\ In contrast, Russia's 
crude exports to countries outside the former Soviet Union were 
up by 11.6 percent in 2000, to 125.3 mmt, actually surpassing 
the previous peak of 124.4 mmt achieved in 1988.\20\
---------------------------------------------------------------------------
    \19\ This has been due to a combination of factors, including a 
decline in demand associated with the large contraction in economic 
activity, the financial difficulties of the refining sector in these 
republics, and the breakdown in inter-republican trade and payments 
mechanisms. In particular, Russia rapidly increased the prices being 
charged in inter-republican trade toward those prevailing on the world 
market after 1992, causing the importer-republics built up large 
payments arrears, and as a result, led Russia to withhold supplies and 
divert them to hard currency markets. Because of this leverage, non-
payments by the importing republics for oil have remained relatively 
modest in comparison with natural gas or electricity.
    \20\ In aggregate, Russia's crude exports in 2000 generated $25.319 
billion according to Goskomstat, or 178.8 percent more than in 1999. 
The average export price rose from $105.3 per ton in 1999 to $175.2 per 
ton in 2000. Exports to the non-Commonwealth of Independent States 
(CIS) generated $23.0 billion (an average of $179.9 per ton), while CIS 
exports generated $2.4 billion (an average of $139.7 per ton).
---------------------------------------------------------------------------
    Russia's international exports of crude oil had contracted 
sharply between 1988 and 1991 under the old Soviet Government, 
falling by 45.4 percent, from 124.4 mmt to only 56.5 mmt in 
1991. The Soviet Government had forced virtually the entire 
drop in domestic crude oil production into a reduction in 
exports. Since 1992, Russia's international exports have 
continued to rise with the marketization of the sector despite 
a host of administrative impediments and limits on exports.
    The East European countries (then including Eastern 
Germany) were traditionally the largest destination for Russian 
crude. The region as currently defined (i.e., without Eastern 
Germany) saw its Russian crude imports contract to as little as 
12.9 mmt in 1994, representing 14.5 percent of Russian 
international exports. This amount has since tripled, reaching 
36.3 mmt in 2000 (29.0 percent of Russia's non-former Soviet 
Union exports).

                                                    TABLE 1.--OIL BALANCE FOR THE RUSSIAN FEDERATION
                                                                [In million metric tons]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                         1990     1991     1992     1993     1994     1995     1996     1997     1998     1999     2000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Crude oil production.................................    516.2    462.3    399.3    353.9    317.8    306.8    301.2    305.6    303.3    305.2    323.2
Refinery throughput..................................    295.5    286.5    257.2    220.1    180.6    179.0    173.8    176.3    162.9    170.1    174.1
Direct use of crude/residual \1\.....................     10.5     20.0     11.1     16.7     15.0     12.4      6.3      8.6      9.7      6.1     10.9
Refined products consumption \2\.....................    250.6    228.7    216.5    176.6    138.7    137.9    121.2    121.6    113.3    120.3    112.6
Oil exports
    Crude oil........................................    219.9    173.9    141.7    127.6    126.8    122.3    125.6    126.8    137.1    134.5    144.5
        Foreign......................................     99.3     56.5     66.2     79.8     89.0     91.3    103.0    105.6    111.9    112.3    123.4
        Other republics..............................    120.6    117.4     75.5     47.8     37.8     31.0     22.6     21.3     25.2     22.2     21.2
    Refined products.................................     50.7     63.6     43.0     44.8     43.4     45.4     56.6     60.6     53.8     50.8     61.9
        Foreign......................................     37.9     41.6     25.3     34.3     38.0     42.1     55.0     58.4     51.2     47.8     58.4
        Other republics..............................     12.8     22.0     17.6     10.5      5.4      3.3      1.6      2.2      2.6      3.0      3.5
Oil imports
    Crude oil........................................     18.8     18.1     10.7     10.5      4.6      6.9      4.5      6.1      6.4      5.6      6.3
        Foreign......................................       --       --       --       --       --       --       --       --       --       --       --
        Other republics..............................     18.8     18.1     10.7     10.5      4.6      6.9      4.5      6.1      6.4      5.6      6.3
    Refined products.................................      5.8      5.8      2.3      1.3      1.5      4.3      4.0      5.9      4.1      0.9      0.4
        Foreign......................................      0.2      0.7      0.9      0.2      0.4      1.4      1.8      3.5      2.4      0.4      0.1
        Other republics..............................      5.6      5.1      1.4      1.1      1.1      2.9      2.3      2.3      1.8      0.5     0.3
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Balancing item.
\2\ Apparent consumption (production minus exports plus imports).


    Earlier, Eastern Europe's oil demand was declining, and 
they also sought to diversify their imports. More recently, oil 
demand has recovered, and these countries have found Russia to 
be an economical source of imports due to existing delivery 
infrastructure. The bulk of this oil arrives via the Druzhba 
Pipeline, which delivers crude to the Czech Republic, Slovakia, 
Hungary, Poland, and Eastern Germany, and occasionally, the 
former Yugoslav republics.
    The other major destination for Russia's crude is Western 
Europe. These countries took 54.3 mmt of crude from Russia in 
2000. The amount of Russian oil going to Western Europe has 
declined since peaking at 70.5 mmt (79.2 percent of Russia's 
total international exports) in 1994. Like Mexico and the North 
Sea, Russia/former Soviet Union represents a major source of 
non-OPEC oil. The presence of Russian/former Soviet Union oil 
has been a welcome addition to the West European market, 
helping to diversify sources from too heavy a reliance on the 
Gulf region and OPEC. Most of the West European countries 
purchase oil from the Russia, although typically it represents 
less than 10 percent of total oil supplies for any individual 
country.
    Russia's non-former Soviet Union crude exports in 2000 
included 112.4 mmt shipped out through the main Russian 
pipeline system operated by Transneft, plus another 12.9 mmt 
(10.3 percent of the total) exported via other routes, 
including railroad shipments and through other minor ports. The 
share of exports carried by these minor routes continues to 
ratchet upward, probably because the main means used by the 
Russian Government to limit exports is control over Transneft's 
pumping schedule. In 1999, Russia's exports outside the 
Transneft system amounted to 8.6 mmt (7.7 percent of the 
total).
    According to the Ministry of Energy, in 2000, Transneft 
moved a total of 314.8 mmt of crude in its pipeline system (5.1 
percent more than in 1999). It delivered 312.5 mmt, of which 
160.9 mmt was to Russian refineries, and 124.4 mmt of crude was 
shipped to export destinations outside the territory of the 
former Soviet Union (39.8 percent of the total shipped). In 
turn, this included 112.4 mmt of Russian crude and 11.7 mmt of 
transit crude (from Kazakhstan, Turkmenistan, and Azerbaijan), 
and another 0.35 mmt from Belarus that joined the pipeline 
system there on its way to Poland.
    Despite the fact that total flows in the Russian oil 
pipeline system are now much less than before because of the 
precipitous decline in Russia's crude oil production (Russian 
pipeline shipments declined by 43.3 percent between 1990 and 
2000, from 497.9 mmt to 294.6 mmt according to Goskomstat 
figures), constraints in Russia's crude oil pipelines have been 
a bottleneck since mid-1993.
    The key constraints are at the export ports and the 
pipelines supplying them, particularly at Novorossiysk, 
Russia's major oil export port on the Black Sea. The reason for 
the emerging export constraints is that previously a large 
portion of the total crude flow was dispersed to refineries 
across the former Soviet Union, and a substantial amount was 
delivered to Eastern Europe via the Druzhba Pipeline. But with 
the dramatic decline in oil demand in the former Soviet Union 
(and to a lesser extent in Eastern Europe), a much larger 
proportion of the total flow has become focused upon the small 
number of export ports that dispatch crude to other 
international markets. The former Soviet Union pipeline system 
was designed mainly to move crude to internal consuming 
centers, while international exports were of much less 
importance. As a result, much of the core system in the 
interior of Russia now has huge redundant capacity.
    Of Russia's own export shipments handled by Transneft in 
2000, 53.2 percent (59.8 mmt) moved out via marine ports and 
46.8 percent (52.6 mmt) moved out via the Druzhba Pipeline to 
Eastern Europe. Russia has made more of the marine terminal 
space, especially at Novorossiysk and Odessa, available for 
Caspian transit crude. The major marine terminals handled a 
total of 70.5 mmt in 2000, representing 56.7 percent of the 
overall total, while 53.9 mmt (43.3 percent) went out via the 
Druzhba Pipeline (Table 2). Compared to 1999, Druzhba shipments 
increased by only 1.6 percent while marine shipments increased 
by 13.6 percent. The large growth in marine shipments was 
mainly due to the new Butinge terminal in Lithuania, although 
all the other major terminals also handled more crude in 2000.
    The addition of the new Butinge terminal in Lithuania in 
mid-1999 added another 8 mmt of annual marine export capacity 
to the former Soviet Union pipeline system. Even so, 
collectively the overall capacity utilization at the major 
marine terminals was still almost 90 percent in 2000 (Table 2). 
There is some remaining spare capacity at Ventspils and 
Butinge. But substantial new capacity is expected to be 
available shortly, with both the Primorsk (Baltic Pipeline) and 
the Yuzhnaya Ozereyka (Caspian Pipeline Consortium) terminals 
slated for completion in 2001.
    The Druzhba Pipeline's aggregate capacity utilization is 
also quite high, increasing to 90 percent in 2000 (Table 2). 
However, the southern branch of the Druzhba (to the Czech 
Republic, Hungary, and Slovakia) remains underutilized, while 
the northern branch (to Poland and Germany) is now full. The 
increased flow in 2000 was concentrated entirely in the 
northern branch of the Druzhba that serves Poland and Eastern 
Germany.

                refinery operations and oil consumption

    The Russian Federation has a large refining sector, 
comprising 28 plants considered ``full fledged'' refineries. In 
addition to these petroleum refineries, Russia also has about a 
dozen other oil processing plants, including lube plants, 
oilfield topping plants, and specialized gas condensate 
processing facilities.
    The 28 main refineries had a total primary distillation 
capacity that the Ministry of Energy reported as 296 mmt at the 
beginning of 1999. Collectively, these facilities therefore 
operated at a capacity of only 58 percent in 1999 compared with 
87.5 percent as recently as 1990, even though almost 45 mmt of 
distillation capacity has been officially liquidated since 
1990. Utilization varies considerably from refinery to 
refinery. Clearly, with so much excess capacity and the 
likelihood that refinery runs are going to fall even lower and 
remain there for some time, a massive rationalization of 
refining capacity is in store. Much of the redundant refining 
capacity is concentrated in the Volga and Urals regions.

               TABLE 2.--FORMER SOVIET UNION CRUDE OIL EXPORTS BY EXPORT POINT (TRANSNEFT SYSTEM)
                                               [In thousand tons]
----------------------------------------------------------------------------------------------------------------
                                                                                                        Capacity
          Export point             1994      1995      1996      1997      1998      1999      2000     (mmt/yr)
----------------------------------------------------------------------------------------------------------------
Total (sum)....................    94,343    95,805   104,836   105,807   115,018   115,099   124,386
Ports (sum)....................    53,451    54,084    60,851    60,633    63,580    62,058    70,473
Capacity utilization (in             73.2      74.1      81.1      80.8      84.8      78.6      89.2         73
 percent)......................
     Russian oil (reported)....    50,474    51,439    57,056    58,281    58,762    53,735    59,822
     (Difference)..............     2,977     2,645     3,794     2,352     4,819     8,323    10,651
     Novorossiysk..............    30,003    29,018    31,706    31,090    32,870    33,066    37,363
    Capacity utilization (in         88.2      85.3      93.3      91.4      96.7      97.3      95.8         34
     percent)..................
         Russian crude.........    28,903    28,111    29,989    30,258    29,893    30,021    34,906
         Kazakh crude..........     1,100       906      1717       712       199       436     1,699
         Azerbaijan crude......        --        --        --       120     2,778     1,877       561
         Turkmen crude.........        --        --        --        --        --       731       198
     Ventspils.................    11,609    12,103    14,355    14,579    14,549    13,029    13,620
    Capacity utilization (in         64.5      67.2      79.8      81.0      80.8      72.4      75.7         18
     percent)..................
         Russian crude.........    10,952    11,520    14,258    14,574    14,549    13,029    13,620
         Kazakh crude..........       657       583        97         4         0         0         0
     Tuapse....................     4,407     4,431     4,652     4,778     6,107     5,149     5,699
    Capacity utilization (in         88.1      88.6      93.0      95.6     122.1     103.0     114.0          5
     percent)..................
         Russian crude.........     4,407     4,431     4,642     4,758     6,107     5,149     5,699
         Kazakh crude..........         0         0        10        20         0         0         0
     Odessa....................     7,432     8,532    10,138    10,186    10,054    10,265    10,724
    Capacity utilization (in         92.9     106.7     101.4     101.9     100.5     102.7     107.2          8
     percent)..................
         Russian crude.........     6,232     7,377     8,167     8,691     8,212     5,536     2,530
         Kazakh crude..........     1,200      1156      1971      1496     1,842     4,729     8,194
     Butinge...................        --        --        --        --        --       550     3,067
    Capacity utilization (in           --        --        --        --        --      13.8      38.3          8
     percent)..................
         Russian crude.........        --        --        --        --        --       550     3,067
Druzhba Pipeline (sum).........    40,892    41,722    43,985    45,174    51,438    53,040    53,913
    Capacity utilization (in         68.2      69.5      73.3      75.3      85.7      88.4      89.9         60
     percent)..................
     Russian oil (reported)....    38,808    39,706    41,381    42,879    49,117    49,927    52,573
     (Difference)..............     2,084     2,016     2,604     2,295     2,320     3,113     1,341
Druzhba Northern Route:              68.9      68.5      78.6      79.7      95.9     104.5     110.3         35
 Capacity utilization (in
 percent)......................
     Germany...................    17,276    15,873    17,670    16,766    18,898    20,024    20,403
         Russian crude.........    16,276    14,957    16,126    15,664    18,457    19,052    19,533
             To refineries.....  ........  ........    12,837    12,938    18,457    19,052    19,533
             To Rostock          ........  ........     3,288     2,726         0         0         0
             (export)..........
         Kazakh crude..........     1,000       917      1544      1103       441       972       871
     Poland....................     6,850     8,108     9,857    11,115    14,658    16,558    18,195
         Russian crude              6,066     7,339     9,171    10,225    13,551    14,416    17,845
         (shipments)...........
         Kazakh crude..........       500       519       385       490       725     1,791         0
         Belarussian crude.....       284       250       300       400       382       350       350
             To refineries.....  ........  ........  ........     9,921    13,273    14,408    16,217
             To Gdansk (export)  ........  ........  ........     1,194     1,385     2,150     1,978
Druzhba Southern Route:              67.1      71.0      65.8      69.2      71.5      65.8      61.3         25
 Capacity utilization (in
 percent)......................
     Czech Republic............     6,506     7,117     5,942     5,785     5,594     4,822     3,714
         Russian crude.........     6,306     6,928     5,692     5,785     5,265     4,822     3,714
         Kazakh crude..........       200       189       250         0       329         0         0
     Slovakia..................     4,971     5,058     5,303     5,335     5,711     5,555     5,506
         Russian crude.........     4,871     4,967     5,203     5,151     5,267     5,555     5,386
         Kazakh crude..........       100        92       100       184       444         0       120
     Hungary...................     5,289     5,565     5,213     6,172     6,577     6,081     6,095
         Russian crude.........     5,289     5,515     5,188     6,055     6,577     6,081     6,095
         Kazakh crude..........         0        50        25       118         0         0         0
                                --------------------------------------------------------------------------------
                Total Kazakh        4,100     3,828     6,001     4,122     3,980     7,928    10,883
                 shipments.....
                Total Kazakh        4,070     3,813     6,001     4,142     3,980     8,072   11,610
                 shipments
                 (reported)....
----------------------------------------------------------------------------------------------------------------
Note: Kazakh amounts by individual exit point are only approximate.


    Russia's refineries are not very sophisticated, with 
limited secondary processing capacity. Petroleum products are 
obtained mainly via straight-run distillation processes 
(primary refining), the method with the simplest technology and 
lowest costs; there is relatively little use of cracking or 
other secondary refining processes.
    Reflecting the lack of sophistication of the sector, the 
depth of refining is quite low. This indicator, defined as the 
share of premium products (essentially light products and 
lubes) in the output mix, was a mere 64.3 percent in 1998 for 
Russian refining overall compared with over 85 percent in 
advanced Western countries. Furthermore, this indicator 
deteriorated during the 1990s, falling from 65.0 percent in 
1991, although there has been some improvement since 1994 (when 
it dropped to 61.3 percent).
    The Energy Strategy to 2020 envisages substantial 
development of the oil refining industry through the 
construction and modernization of capacity, particularly the 
deepening of the refining process. Such reconstruction should 
also improve environmental conditions by reducing emissions as 
well as reducing the energy and material costs of production. 
The modernization is also aimed at improving the refining 
industry so that the quality of its products can be brought up 
to world standards. Thus, the Energy Strategy calls for the 
depth of refining to be increased to 75 percent by 2010 and 85 
percent by 2020. This is to be accomplished by a broad program 
of refinery modernization and the installation of additional 
secondary processing capacity, particularly new cracking 
facilities.
    The last decade saw a sharp plunge in refinery operations 
associated with the ongoing economic transition. Although 
Russia's refinery runs had been declining since 1980 (peak 
throughput in Russia was in 1980 at 325.2 mmt), during the 
1980s throughput only slowly drifted down. But beginning in 
1992, with the launch of economic reforms, crude runs by 
Russian refineries began to contract sharply. The decline 
lessened somewhat in 1995-1997, due partly to stabilization in 
internal refined product consumption, but mostly was due to a 
deliberate policy of fostering refined product exports. In 
1998, a year of economic crisis, throughput dropped rather 
sharply again, to 162.9 mmt; at that point, throughput was down 
to only 54.7 percent of what it was in 1990.
    The government had tried repeatedly during the 1990s to 
hold refinery throughput at much higher levels (in an effort to 
``fix'' consumption of refined products at existing levels and 
``stabilize'' the economy), but to little avail; it also was 
usually counterproductive. This was due to reasons largely 
having to due with the refineries' inability to pay much higher 
prices for crude and the financial insolvency of their 
customers. But this policy was more ``successful'' in 1999-2000 
as the government reined in crude exports and forced higher 
deliveries to the refineries. This was through a mechanism that 
required specified deliveries to domestic consumers to be met 
before producing companies were allowed access to Transneft's 
pipeline system for exports. As a result, refinery throughput 
rose in 1999-2000, reaching 170.1 mmt in 1999 and 174.1 mmt in 
2000.
    Longer term, the Energy Strategy envisages growth in 
refinery throughput to 220 to 225 mmt by 2015-2020. This volume 
is projected as providing 130 mmt of light products (gasoline, 
diesel, and kerosene) with the greater depth of refining 
anticipated. At the same time, production of mazut is 
anticipated to drop from 53 mmt currently to 30 mmt.
    While Russian refinery runs would normally be expected to 
rebound with the turnaround in product consumption as the 
overall economy re-expands, throughput of 220 to 225 mmt is 
probably economically unwarranted. First, aggregate product 
demand is currently less than 120 mmt, and is likely to grow 
fairly slowly over the coming two decades. Second, increased 
depth of refining should limit the need for higher throughput 
to provide sufficient light products. Third, the level of 
refined product exports, now running at 50 to 60 mmt annually, 
is likely to contract substantially as higher domestic crude 
acquisition prices and higher railroad transport tariffs erode 
profit margins on product exports. This is likely to result in 
throughput levels somewhat lower than now even by 2020.
    The Russian Federation is a large consumer of refined 
products. Aggregate apparent products consumption (throughput 
minus product exports plus product imports) peaked in 1987, at 
257.0 mmt. Following the launch of Russia's economic reform 
program in January 1992, bringing with it large declines in 
overall economic activity (GDP, industrial production, and 
transportation) combined with increases in (relative) fuel 
prices, consumption of refined products in Russia fell sharply. 
Overall consumption of refined products had contracted by 55.2 
percent by 1998, reaching 113.3 mmt. In 1999, however, buoyed 
by a stabilizing economy and administrative limits on product 
exports, apparent consumption of refined products increased by 
6.7 percent, to 120.9 mmt. In 2000, despite both continued 
limits on product exports and brisk economic growth, aggregate 
consumption of refined products dropped again, by 6.5 percent 
to 112.5 mmt. Russian statistics (from Goskomstat) report that 
gasoline consumption (sales/deliveries to the domestic market) 
in 2000 dropped by 4.8 percent, to 23.2 mmt; diesel fuel 
consumption increased by 5.1 percent, to 49.2 mmt; and residual 
fuel oil (mazut) consumption fell by 3.8 percent, to 41.9 mmt.
    With the transition to a market economy, oil ``demand'' is 
undergoing structural changes, both by sector and by product. 
The composition of aggregate economic output is shifting away 
from heavy industry toward services. An emerging middle class 
is leading to sharp increases in private car ownership and use. 
Thus, the importance of traditional consumers, such as industry 
and electric power, in overall oil consumption is declining, 
while the relatively limited development of trucking and 
private automobiles is being redressed. As a result, changes in 
demand clearly favor lighter products at the expense of 
residual fuel oil (mazut).
    Transportation is obviously the key sectoral component of 
the increased demand for light products. By 1999, the share of 
transportation had increased to about 50 percent of Russia's 
aggregate (civilian) petroleum product consumption, compared to 
39 percent in 1990. The share of electric power (powerplants 
and boilers) had dropped to about 20 percent, compared to 31 
percent in 1990. Similarly, industry's share had dropped as 
well, to about 18 percent, and agriculture's share had 
contracted to under 6 percent, about the same as the domestic 
sector (households and municipal use).

                               Gas Sector

                             gas production

    Russia is the world's leading gas producer. Russian 
production increased by nearly 8 times between 1970 and 1991, 
growing from 83.3 bcm to a peak of 642.9 bcm. During the 1990s, 
Russian gas production declined as the economy went into a 
tailspin, but the decline was surprisingly small given broader 
trends in the Russian economy. While Russian GDP declined by 
about 43 percent between 1990 and 1998 and aggregate industrial 
output plunged by about 56 percent, Russian gas output 
contracted by a mere 7.7 percent. Russian natural gas 
production has been able to virtually ``defy gravity'' and 
remain relatively stable because it was buoyed by surprisingly 
strong domestic consumption, which has been, in turn, a 
function of low prices and unusually easy payment terms.\21\ 
Another element that also supported the level of output was a 
large build-up in underground storage.
---------------------------------------------------------------------------
    \21\ Sagers, 1999.
---------------------------------------------------------------------------
    Russian gas production fell from a peak of 642.9 bcm in 
1991 to a low of 571.1 bcm in 1997, before recovering to 591.0 
bcm the following year. In 1999-2000, Russian production has 
declined slightly; in 2000, gas production declined by 1.1 
percent, to 584.2 bcm. The decline in output in 2000 occurred 
despite rising demand for gas, both within Russia and the 
former Soviet Union as well as in Europe (see below).
    The Russian gas industry is dominated by the Gazprom, the 
world's largest gas production, transmission, and exporting 
company. Gazprom, the successor of the old U.S.S.R. Ministry of 
the Gas Industry, is a privatized company, although still 
retaining a substantial Russian Government shareholding. In 
2000 Gazprom produced 89.5 percent of total Russian gas 
production; controlled virtually all the gas transported 
through Russia's high-pressure pipelines; controlled all gas 
exports outside the former Soviet Union; and provided about 20 
percent of Federal budget revenues and around 16 percent of 
Russia's total export revenues.
    Although the bulk of natural gas production within Russia 
is by enterprises of Gazprom, production outside Gazprom is 
becoming relatively more important. Traditionally, this was 
mainly comprised of associated gas recovered by oil producers. 
But an important trend in the last few years has been the 
appearance of new so-called ``independent'' gas producers that 
collectively now produce almost as much gas as the oil 
companies do.
    Also, Gazprom's production has fallen significantly in the 
last year or two--in 2000, by more than 20 bcm to 523.1 bcm--
giving rise to considerable speculation that a substantial and 
irreversible production decline is imminent for Russian gas.
    Gazprom produced 523.2 bcm in 2000 (89.6 percent of the 
Russian total), as its production declined by 4.1 percent 
compared to 1999. Gazprom cited the ``exhaustion of its main 
fields'' as the principal reason for the decline, combined with 
the lack of cash to invest in new fields. However, gas 
production by other entities increased in Russia; non-Gazprom 
output increased from 45.1 bcm in 1999 to 61.0 bcm (+35.3 
percent) in 2000. The major oil companies delivered marginally 
higher volumes of gas in 2000 (+4.5 percent, to 31.0 bcm), but 
the major increase (+232 percent, from 10.5 to 24.4 bcm) came 
from new, so-called ``independent'' gas producers, most 
noticeably the Itera group. Output by Itera's subsidiaries 
alone amounted to 18.0 bcm in 2000. Itera plans to increase 
output to 30 bcm in 2001.
    Over the next few years and well into the future, the 
Energy Ministry expects that Gazprom's share of Russian 
production will continue to contract. Thus, a key problem for 
Russia is establishing a workable regulatory framework to allow 
such ``independents'' easier access to Gazprom's pipeline 
network. This remains a major focus of the government's ongoing 
reforms of the so-called ``natural monopolies.''
    Gazprom complains that its ability to fund investment 
remains very limited because of low domestic prices and high 
non-payments by domestic and Commonwealth of Independent States 
(CIS) customers. Gazprom's plan is to hold its production in 
2001 at 523 bcm, and claims to have sufficient investment funds 
to ``support'' production at a level of about 530 bcm per annum 
after that. If correct, this would mean that any increases in 
production would have to come from non-Gazprom production; 
i.e., ``independent'' producers and joint ventures. Moreover 
given Gazprom's forecast decline for its fields currently in 
production (see below), it would also mean that a great deal of 
new capacity has to be brought on stream over the next two 
decades.
    Aggregate investment in the gas sector amounted to 90.5 
billion rubles in 2000 ($3.2 billion at the average exchange 
rate), a decline of 11.6 percent in real terms according to the 
Ministry of Energy. But it appears that investment spending 
picked up strongly in the second half of the year, a rather 
belated response to a substantial improvement in revenues and 
cash receipts for the sector in 2000. It appears that Gazprom 
was far more reticent to plow back its higher revenues into 
upstream investment than the oil companies were.\22\
---------------------------------------------------------------------------
    \22\ Gazprom reported that its investment outlays on various 
projects (not just in Russia) amounted to 101.2 billion rubles in 2000 
($3.6 billion) compared with 79.1 billion rubles ($3.2 billion) in 
1999.
---------------------------------------------------------------------------
    Gazprom's claims of insufficient cash to fund investment is 
becoming less and less credible as Gazprom's cashflow has been 
bolstered not only by rising international gas prices, but also 
by improved payments and higher prices domestically. Gazprom 
reported a profit of 60.7 billion rubles ($2.1 billion) in 2000 
as the company's total revenues jumped 63 percent, to 498.1 
billion rubles ($17.2 billion), with export revenues almost 
doubling to 294.3 billion rubles ($10.2 billion) and domestic 
sales increasing by about 20 percent, to 118.7 billion rubles 
($4.1 billion).
    In particular, the share of payments for gas by Russian 
consumers improved dramatically in 2000, from only about 63 
percent in 1999 to about 71 percent in 2000, and the share of 
cash in total payments improved from 53 percent in 1999 to 71 
percent. Combined with the domestic price increase that went 
into effect in May 2000 (of 20 percent), the sector's real cash 
receipts (sales volume  average price  
average percent payment  average percent payment in 
cash) in 2000 from domestic sales would be about double what 
they were in 1999. The outstanding arrears owed by Russian 
consumers for gas actually dropped in 2000, from 108.3 billion 
rubles at the beginning of the year to 81.4 billion rubles 
($2.8 billion) at the end of the year, a decline of 24.8 
percent, or $931 million. However, the debts owed by CIS 
countries increased by 14.8 percent in 2000, to a reported 58.0 
billion rubles ($2.0 billion).

                              gas exports

    Russia is the largest gas exporter in the world, shipping 
over 200 bcm beyond its borders since 1998 (217.1 bcm in 2000, 
or 37.2 percent of production), including 129.0 bcm to 
countries beyond the borders of the former U.S.S.R. and 88.1 
bcm to the former Soviet republics (Table 3).
    Between 1990 and 1996 (when they bottomed out), Russia's 
gas exports to the other former Soviet republics plunged by 
52.3 percent (Table 3). This sizable decline, from 153.2 bcm to 
73.0 bcm, was caused by two primary factors. First, demand for 
natural gas declined due to a substantial decrease in general 
economic (especially industrial) activity in these countries. 
Second, most of the importing republics amassed enormous debts 
for natural gas, making Russian suppliers anxious about 
delivering any more gas without payments being made. As of the 
end of 2000, Russia was owed 58 billion rubles ($2.0 billion at 
the average exchange rate for the year) by the other republics 
for natural gas (according to Russian statistics): Ukraine owed 
39.7 billion rubles ($1.4 billion); Belarus owed 6.0 billion 
rubles ($208 million); and Moldova owed 12.3 billion rubles 
($426 million).
    Russia exported 129.0 bcm in 2000 to destinations outside 
the former Soviet Union, including 38.6 bcm to Eastern Europe, 
80.1 bcm to Western Europe, and 10.3 bcm to Turkey. These non-
former Soviet Union exports increased by only 1.7 percent in 
volume terms in 2000 (Table 3); the bulk of this increment was 
actually realized to just one country, Turkey, as exports to 
both Eastern Europe and West Europe remained almost flat. 
Gazprom expects to export 135.0 bcm to countries outside the 
former Soviet Union in 2001, however, an increase of 4.7 
percent.
    With ``Russian'' gas exports to the former Soviet Union 
countries amounting to 88.1 bcm in 2000, this represented a 
sizable 13.3 percent increase compared to 1999 (Table 3). In 
turn, this was comprised of 4.8 bcm to the Baltic states and 
83.3 bcm to the CIS countries. Although some 23.3 bcm of this 
is evidently ``re-directed'' gas from other countries (or re-
exported gas), this can be considered to be ``Russian'' gas 
because of the role of Itera as the consignee, both on the 
import and export contracts. In 2001, ``Russian'' exports to 
the former Soviet Union should be much lower because of the 
switch in the structure of Ukraine's gas supplies. Gazprom 
reported that it expects to ship only 53.3 bcm of Russian gas 
to the CIS and Baltic states in 2001 (including both its own 
and ``independent'' exports), of which about 30 bcm will be to 
Ukraine.\23\
---------------------------------------------------------------------------
    \23\ The only ``Russian'' gas that Ukraine expects to receive in 
2001 is the in-kind payment (by Gazprom) for transit services; the 
remainder of its supplies are slated to come from Turkmenistan 
(although Itera remains the intermediary). But Ukraine's national oil 
and gas company Naftohaz Ukrainy expects to transit less gas in 2001 
than it did in 2000, and to therefore receive a smaller payment than 
expected. In 2000, it moved 123.5 bcm, of which 112.3 bcm was to Europe 
(outside the former Soviet Union), and 11.3 bcm to CIS countries. 
Although its contract with Gazprom calls for transit of 124.6 bcm in 
2001, Gazprom is making increasing use of the new pipeline through 
Belarus and Poland, and actual shipments through Ukraine are declining. 
Naftohaz Ukrainy projects that it may transit less than 110 bcm to 
Europe in 2001, and total transit may be less than 120 bcm.
---------------------------------------------------------------------------
    Ukraine remains the largest customer for Russian gas in the 
former Soviet Union. Russian customs statistics report that 
Russia exported only 39.7 bcm to Ukraine in 2000, while Ukraine 
itself claims that its gas imports amounted to 60.7 bcm, 
comprised of 27.9 bcm from Gazprom and 32.8 bcm from Itera. The 
27.9 bcm was what Gazprom paid for Ukraine's transit services, 
and the Itera imports would represent a combination of Turkmen 
imports arranged through Itera (1.9 bcm) as well as Itera's 
``own'' gas (from Russian or Turkmen sources).

                            gas consumption

    Despite the attention given Russia's international gas 
exports, natural gas is produced mostly for internal Russian 
consumption (representing 68.4 percent of production in 2000). 
Over the past 20 years, natural gas has made significant 
progress in replacing the previously most important sources of 
primary energy, coal and oil, in Russia's primary energy 
balance. In 1990, natural gas accounted for 43.1 percent of 
Russia's primary energy consumption, and by 2000, the share of 
gas had edged up to over half of total consumption at 52.2 
percent (Table 6).
    During the 1980s when the gas industry was growing so 
rapidly, the massive increments in gas supply were absorbed by 
directing most of it to a few very large industrial consumers, 
especially electric power stations, but also including iron and 
steel plants and nitrogenous fertilizer centers. This minimized 
the need for the construction of an extensive network of 
distribution lines to serve more dispersed consumers such as 
the housing and municipal sector (including households).
    Gas consumption (end-of-pipe deliveries) in Russia peaked 
at 409.0 bcm in 1991. Apparent gas consumption (including 
pipeline use) in Russia also peaked in 1991, at 468.7 bcm 
(Table 3). By 1997, with the declines in economic activity and 
some energy efficiency gains, apparent consumption of natural 
gas in Russia bottomed out at 377.5 bcm, down 19.5 percent 
compared to 1991, and actual deliveries to consumers dropped by 
19.3 percent between 1991 and 1997, bottoming out at 330.0 bcm; 
since then, apparent consumption has climbed back to 404.4 bcm 
by 2000, and actual deliveries to 347.1 bcm.
    Since the second half of the 1980s, electric power has 
accounted for the largest share of natural gas consumption in 
Russia. In 1990, out of 404.0 bcm of natural gas in total 
deliveries, electric power stations used 179.0 bcm, or 44.3 
percent. In 2000, electric power took 136.4 bcm, or 39.2 
percent of all sales to domestic consumers.

                                                    TABLE 3.--GAS BALANCE FOR THE RUSSIAN FEDERATION
                                                                [In billion cubic meters]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                         1990     1991     1992     1993     1994     1995     1996     1997     1998     1999     2000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Gas production.......................................    640.6    642.9    640.4    617.6    606.8    595.4    601.5    571.1    591.0    590.7    584.2
Gas consumption (total apparent).....................    460.7    468.7    454.7    453.2    424.4    408.4    409.5    377.5    390.8    389.8    404.4
    Deliveries.......................................    404.0    409.0    395.3    382.1    348.0    339.0    336.8    330.0    331.6    339.9    347.1
    Pipeline use/changes in storage \1\..............     56.7     59.7     59.4     71.1     76.4     69.4     72.7     47.5     59.2     49.9     57.3
        Pipeline use and losses (reported)...........     63.6     63.5     59.6     57.1     56.3     54.2     56.3     47.7     53.0     53.0     51.0
        Change in storage (residual).................     -6.9     -3.8     -0.2     14.0     20.1     15.2     16.4     -0.2      6.2     -3.1      6.3
Gas exports..........................................    249.7    173.0    195.3    171.0    184.4    190.6    196.5    198.4    202.5    204.5    217.1
    Foreign..........................................     96.5     90.0     88.9     92.7    105.8    117.4    123.5    116.7    120.5    126.8    129.0
    Other republics..................................    153.2     83.0    106.4     78.3     78.6     73.2     73.0     81.7     82.0     77.7     88.1
Gas imports..........................................     70.1     13.8      7.0      6.6      2.0      3.6      4.5      4.9      2.3      3.6     37.3
    Foreign..........................................       --       --       --       --       --       --       --       --       --       --       --
    Other republics..................................     70.1     13.8      7.0      6.6      2.0      3.6      4.5      4.9      2.3      3.6     37.3
        Kazakhstan...................................  .......  .......      3.9      3.5      1.6      3.2      2.0      2.7      2.3      3.6      5.3
        Turkmenistan.................................  .......  .......      3.1      3.1      0.3      0.3      1.9      1.9       --       --     29.1
        Latvia.......................................  .......  .......       --       --       --       --      0.7      0.3  .......  .......      0.6
        Uzbekistan...................................  .......  .......  .......  .......  .......  .......  .......  .......  .......  .......     2.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Balancing item.

    Industry remains the second largest consumer of natural gas 
in Russia. In 1990, Russian industry used 165.7 bcm of natural 
gas (41.0 percent of the total), primarily in chemicals, 
machine-building and metalworking, ferrous metallurgy, and the 
oil and gas extraction sector. These four sectors accounted for 
over 71 percent of all industrial consumption in Russia in 
1990, or almost 29 percent of total gas deliveries at that 
time. But as industrial activity contracted with the 
transition, the share of industry in Russian gas consumption 
also declined, at least through 1998, bottoming out that year 
at 94.0 bcm, representing 28.4 percent of total consumption.
    In 1990, the volume of gas used in the municipal sector and 
housing reached 42.3 bcm, or 10.5 percent of total Russian gas 
deliveries. Since 1990, the relative importance of the 
municipal sector has climbed as industrial consumption has 
declined, as the amount used by the housing and municipal 
sector has slowly increased. Its share had climbed to 27 to 28 
percent by 1999-2000, actually rivaling that of industry.

                              Coal Sector

    Russian (gross) coal production declined by 41.3 percent 
between 1990 and 1998, from 395.3 mmt to 232.2 mmt, largely 
reflecting the contraction in consumption with the transition-
related economic decline. However, production did turn around 
in 1999 and 2000, reaching 257.9 mmt in 2000. In 2000, this was 
comprised of 171.7 mmt (66.6 percent of the total) of ``hard'' 
coal (i.e., of bituminous or anthracite rank) and 86.2 mmt 
(33.4 percent) of lower-rank lignite.
    The bulk of Russian coal (over 80 percent) is produced in 
Siberia, far from the main energy-consuming centers of the 
country in European Russia. The principal producing basins 
include: the Kuznetsk Basin (in West Siberia), with an output 
of 114.0 mmt in 2000; the Kansk-Achinsk Basin (in East 
Siberia), with an output 39.9 mmt in 2000; the Pechora Basin 
(in northern European Russia), with an output of 18.4 mmt in 
2000; and South Yakutia (Far East), with an output of 10.1 mmt 
in 2000.
    Not surprisingly, the principal areas of increase in 2000 
were the Kuznetsk Basin in West Siberia (+4.6 percent) and the 
Kansk-Achinsk Basin in East Siberia (+9.8 percent); the older 
producing areas in European Russia did not do quite as well. 
These two large Siberian basins now account for 61.2 percent of 
national coal production. Although underground-mined coal 
expanded in 2000 (by 1.6 percent), coal mined in open-pits 
expanded by 4.2 percent, raising the share of open-pit-mined 
coal to 64.6 percent.
    The expansion in coal output in 2000 was heavily driven by 
rising export demand, although internal (apparent) consumption 
was up slightly as well. Russia's exports of coal to 
international markets (beyond the territory of the former 
Soviet Union) grew quite rapidly in 2000, jumping by 69.8 
percent, to 37.3 mmt (Table 4). Russia's coal exports to the 
former Soviet Union countries were up as well, although more 
moderately (+6.6 percent), to 6.1 mmt.

                                                    TABLE 4.--COAL BALANCE FOR THE RUSSIAN FEDERATION
                                                                [In million metric tons]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                         1990     1991     1992     1993     1994     1995     1996     1997     1998     1999     2000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Coal production......................................    395.3    353.3    337.3    305.0    270.9    262.2    255.0    244.4    232.2    249.1    257.9
Coal consumption (apparent)..........................    398.4    361.1    337.5    305.0    274.9    251.2    249.5    237.3    223.7    237.4    239.9
    Coal deliveries to consumers (reported)..........       ND       ND       ND       ND    272.6    259.0    205.6    197.8    196.4    210.0    205.8
Coal exports.........................................     49.2     37.4     40.5     28.7     23.3     29.6     25.6     22.9     23.5     27.7     43.4
    Foreign..........................................     20.0     17.5     18.1     20.2     17.6     21.0     18.5     18.1     18.3     22.0     37.3
    Other republics..................................     29.2     19.9     22.4      8.5      5.7      8.5      7.1      4.8      5.2      5.7      6.1
Coal imports.........................................     52.3     45.2     40.7     28.7     27.3     18.5     20.1     15.8     14.9     16.1     25.4
    Foreign..........................................       --       --       --       --       --      1.0      0.7      1.1      0.3      0.1      0.0
    Other republics..................................     52.3     45.2     40.7     28.7     27.3     17.5     19.3     14.7     14.7     16.0    25.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
ND--No data.


    This strong export performance reflects not only the effect 
of higher prices (the average export price for Russian coal in 
December 2000 was $28.3 per ton [$26.9 per ton for non-CIS and 
$38.8 per ton for CIS sales] compared with $15.4 per ton in 
December 1999), but also the benefit from the sizable reduction 
in costs achieved with the devaluation of the ruble in 1998. 
These have made Russian coal exports much more profitable for 
the producers and highly competitive in export markets.
    Reflecting rising demand from the strong economic rebound 
in 2000, Russia's coal imports surged as well, increasing by 
58.5 percent, to 25.4 mmt (Table 4). Most of this coal is 
imported from Kazakhstan. Thus, apparent coal consumption in 
Russia also grew, reflecting the expansion in economic activity 
and expanded thermal electricity generation. Apparent 
consumption in Russia amounted to 239.9 mmt in 2000, up 1.0 
percent compared to 1999. However, reported deliveries to 
consumers actually declined, dropping by 2.0 percent, to 205.8 
mmt. Consumption mainly increased in electric power stations 
(+8.8 percent, to 135.2 mmt), coking/metallurgy (+3.6 percent, 
to 42.1 mmt), and the municipal sector (+9.6 percent, to 13.0 
mmt).
    Despite the turnaround in output in 1999-2000, Russian coal 
production in PlanEcon's energy forecast is projected to slowly 
decline over the next two decades (see below). In contrast, the 
Russian Energy Strategy envisions coal production rising to 320 
mmt in 2010 and over 400 mmt in 2020. In the Strategy, major 
technological breakthroughs are postulated in production, 
processing and transportation that result in declining costs, 
and therefore end-user prices, of coal. This is viewed as 
making coal a cost-effective energy choice for consumers in 
European Russia.
    The Russian coal-mining sector has been only slowly 
transformed in the last 5 years or so as the government has 
pressed forward on a difficult restructuring program under the 
impetus of the World Bank. In 2000, the sector included about 
65 coal producers, including 60 already corporatized as coal-
mining companies (not including subsidiaries), as well as 5 
producers still organized as state enterprises; these companies 
worked 106 open-pit mines and 114 underground mines.\24\ Three 
of the more prospective companies were privatized in 2000, 
reducing the number of companies in which the federal 
government still holds a majority of shares to 24.
---------------------------------------------------------------------------
    \24\ During most of the 1990s (until December 1997), operational 
responsibility for the Russian coal-mining sector rested with a central 
body known as the Russian Coal Company or Rosugol. Rosugol was 
disbanded in connection with the agreement on the distribution of loans 
and credits from the World Bank for coal sector restructuring.
---------------------------------------------------------------------------
    As a result of the ongoing restructuring program for the 
sector, over the 1994-2000 period, a total of 134,200 workers 
have been shed, of which 23,500 were let go in 2000, and about 
170 of the worst mines have already been closed. Because of 
this, productivity has been rising (in 2000, this improved to 
108 tons per worker per month), and with higher domestic and 
international coal prices in 2000, has substantially reduced 
the need for direct government subsidies. But the government 
still provided ``selective assistance'' to 70 mines in 2000. 
The Ministry of Energy's program for 2001 calls for subsidies 
of 8 billion rubles ($270 million), of which it would like to 
direct 3.1 billion rubles (38.5 percent) to investment projects 
rather than the closures and social payments that have 
dominated up to now. What has also improved the finances of the 
sector is the improved situation for payments by consumers. 
Over the first 11 months of 2000, consumers actually paid for 
86.2 percent of the coal they received, of which 46 percent was 
in cash. In January 2000, this had been only 54 percent and 38 
percent, respectively.

                         Electric Power Sector

                         electricity production

    Electricity generation in Russia closely follows 
consumption trends; only a relatively small proportion of 
electricity production is exported. As the economy slowed in 
the late Soviet period, generation increases started to slow 
dramatically in the latter half of the 1980s, and began to 
decline in 1991. Then with the transition-related difficulties 
of the 1990s, electricity production fell sharply. By 1998, 
when aggregate production bottomed out at 827.2 billion 
kilowatt-hours (kWh), output had declined by 23.6 percent from 
the 1990 peak of 1,082.2 billion kWh. Since then, output has 
risen slightly with economic re-expansion, reaching 878.1 
billion kWh in 2000 (Table 5). Production in 2000 was comprised 
of 66.3 percent from thermal stations, 18.8 percent from hydro-
stations, and 14.9 percent from nuclear stations.
    Thermal generation in Russia increased by 3.2 percent in 
2000, to 582.3 billion kWh. At the same time, primary 
electricity generation grew substantially, as nuclear 
generation increased by 8.8 percent, to 130.5 billion kWh, and 
hydro-electric generation increased by 2.7 percent, to 165.3 
billion kWh.
    The increased requirement for thermal generation put 
Unified Energy Systems of Russia (UES), the electricity utility 
which runs most of the Russia's thermal plants (see below), in 
a tough situation because Gazprom periodically threatened to 
reduce gas supplies last year, citing non-payments. However, 
UES actually ended up consuming more gas in 2000 than in 1999 
(136.4 bcm vs. 134.1 bcm) as well as consuming more coal (132.5 
mmt vs. 121.8 mmt). UES' fuel mix for thermal generation in 
2000 shifted only slightly away from gas: to 66 percent gas, 
28.6 percent coal, and 5.4 percent oil (residual fuel oil); 
this compares with 67.5 percent gas, 26.0 percent coal, and 6.5 
percent oil in 1999.

                        electricity consumption

    Electricity consumption in Russia started to fall in 1991 
as the economy began the transition. The drop in (gross) 
electricity consumption (measured as production minus net 
exports) continued through 1998, when it bottomed out at 809.1 
billion kWh, 24.7 percent less than the peak of 1,073.9 billion 
kWh achieved in 1990. Following the recent economic turnaround, 
consumption increased in both 1999 and 2000.

                                                TABLE 5.--ELECTRICITY BALANCE FOR THE RUSSIAN FEDERATION
                                                               [In billion kilowatt-hours]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                         1990     1991     1992     1993     1994     1995     1996     1997     1998     1999     2000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total production.....................................  1,082.2  1,068.2  1,008.5    956.6    875.9    862.1    847.2    834.1    827.2    846.2    878.1
    Thermal stations.................................    797.1    780.1    716.3    662.6    601.1    586.4    583.6    568.3    566.3    563.3    582.3
    Hydro-stations...................................    166.8    168.1    172.6    175.0    177.0    176.4    154.8    157.5    158.7    160.9    165.3
    Nuclear stations.................................    118.3    120.0    119.6    119.0     97.8     99.3    108.8    108.3    102.2    122.0    130.5
Exports (-)..........................................     43.3     47.2     44.0     43.4     41.7     38.0     31.8     26.8     26.4     22.5     14.8
Imports (+)..........................................     35.0     35.1     27.7     24.7     22.2     18.4     12.3      7.1      8.3      8.4      1.6
Apparent consumption.................................  1,073.9  1,056.1    992.2    937.9    856.4    842.5    827.7    814.4    809.1    832.1    864.9
Losses and self-use..................................    154.6    153.4    149.7    142.0    160.6    167.0    164.1    161.6    160.2    163.9       ND
    Transmission losses..............................     84.2     83.9     84.1     79.8     73.0     71.9     70.6     69.6     69.0     70.6       ND
    Power station use and losses.....................     70.4     69.5     65.6     62.2     87.5     95.1     93.5     92.0     91.3     93.4       ND
Domestic deliveries..................................    919.3    902.7    842.5    795.9    695.8    675.5    663.6    652.8    648.9    668.2       ND
    Industry and construction........................    574.3    552.5    505.3    450.4    359.5    345.1    331.4    329.4    320.7    336.9       ND
    Agriculture......................................     96.4    103.4    102.9    103.8     97.7     88.6     85.9     78.1     75.0     72.0       ND
    Transportation...................................    103.8     96.7     86.8     76.7     68.4     65.2     64.9     63.5     60.0     60.6       ND
    Housing/municipal sector (urban).................    144.8    150.1    147.5    165.0    170.3    176.6    181.4    181.8    193.1    198.6       ND
    Industry (including power stations)..............    644.7    622.0    570.9    512.6    447.0    440.2    424.9    421.4    412.0    430.3      ND
--------------------------------------------------------------------------------------------------------------------------------------------------------
ND--No data.


    The decline in electricity consumption during the period 
was much less than the overall decline in economic activity. 
This reflects a combination of several factors, including the 
relatively slow reform and commercialization of the sector 
(manifestations of which are low end-user prices and high 
levels of non-payments) as well as a high proportion of 
``overhead'' or ``fixed'' consumption; i.e., consumption that 
occurs irrespective of direct production or economic activity. 
For example, a factory must be lighted and the assembly line 
turned on regardless of whether it produces only one item or a 
hundred.
    According to the Ministry of Energy, (gross) electricity 
consumption rose in 2000, although only by 3.7 percent, to 
864.9 billion kWh.\25\ This indicates that the electricity 
intensity of the aggregate economy (kWh consumed per unit of 
GDP) is improving somewhat as the economy re-expands; i.e., the 
inverse situation of what occurred earlier in the decade as GDP 
declined.
---------------------------------------------------------------------------
    \25\ Net exports of electricity from Russia can thus be calculated 
as the difference between reported production and consumption in 2000 
at 13.2 billion kWh, down from 14.1 billion kWh in 1999. Russia's 
exports of electricity (invoiced) in 2000 were reported as 14.849 
billion kWh by Goskomstat, a decline of 38.5 percent from 15.346 
billion kWh in 1999 (although total exports in 1999 amounted to 22.5 
billion kWh). Thus, imports in 2000 would be 1.6 billion kWh.
---------------------------------------------------------------------------
    The growth in Russian electricity consumption in 2000 
occurred despite a much tougher payment policy by UES. Driven 
by the need to come up with sufficient cash to pay for its fuel 
deliveries (especially of gas), UES was willing to cut off non-
payers, even if they were entire regions or major enterprises 
or even key defense facilities. With the tougher approach, UES 
had lifted the share of payments by Russian consumers to 100 
percent by the end of the year, with the share of cash in these 
payments increasing to 74.2 percent.
    Final electricity consumption (actual deliveries to 
consumers) declined by 29.4 percent between 1990 and 1998, from 
919.3 billion kWh to a low point of 648.9 billion kWh. In 1999, 
final consumption increased to 668.2 billion kWh (Table 5). 
Final consumption fell slightly more than apparent electricity 
consumption because of a slower rate in the fall of electricity 
use at power plants and transmission losses.
    Electricity consumption in Russia has been dominated by the 
industrial sector (particularly heavy industry), with a 
correspondingly small share by the residential and commercial 
sector. Whereas electricity consumption patterns shifted away 
from industry to the commercial and residential sectors in 
other countries over the course of their development, the 
Soviet development experience remained fixated upon 
industrialization, with the result that there was relatively 
little shift in this regard in Russia through the 1980s. In 
1990, the industrial sector still consumed 60.4 percent of 
total final electricity consumption, while the residential 
sector accounted for a mere 8.4 percent; combined, residential-
commercial users (the domestic sector) still accounted for only 
18.9 percent of total final electricity consumption in 1990.
    But such a shift is evident during the ongoing re-
orientation of economic activity under the transition to a 
market-type economy. During the 1990s the sectors experiencing 
the greatest decline in electricity use have been industry and 
transport. Industrial electricity consumption (including the 
construction sector) fell by 41.3 percent between 1990 and 
1999, dropping its share of final consumption to 50.4 percent 
in 1999. Industrial electricity consumption finally turned 
around in 1999 with the industrial recovery. In contrast, 
electricity consumption in the household and commercial-
municipal sector generally has been rising throughout the 
transition period. The combined share of the domestic sector 
(households-commercial users) in final consumption in 1999 was 
29.7 percent.

                        organizational structure

    The Russian electricity sector is now administered and run 
by three key entities: the large joint-stock company known as 
RAO UES (Russian Joint-Stock Company of the Unified Energy 
Systems of Russia); the 72 regional distribution companies (the 
energos); and the nuclear power operator, Rosenergoatom, which 
has exclusive responsibility for the nuclear stations (except 
for the Leningrad nuclear station which operates separately).
    The government's organizational plan for the electric power 
sector laid out in 1992-1993 intended for each of the 
distribution companies to operate in the context of a Russian 
electricity ``market,'' both generating electricity themselves 
from their own smaller stations as well as buying power from 
the large stations (independent producers) to supply their 
customers if needed or selling power into the grid if they 
generated a surplus. One of RAO UES' major tasks was to arrange 
a ``Federal wholesale electricity market'' (FOREM) through its 
operation of the transmission system. As dispatcher and 
operator of the high-voltage grid, it plays a crucial role in 
maintaining system stability and wheeling electricity to 
deficit power networks from those with a surplus. The Central 
Dispatch Office, which coordinates the seven regional power 
pools of the RAO UES network, was corporatized, with 100 
percent of its statutory capital owned by RAO UES. The various 
regional dispatch offices (for each regional power pool) are 
subsidiaries of RAO UES as well.
    RAO UES was organized and officially registered as a joint-
stock company on December 31, 1992. It essentially absorbed 
many of the enterprises and activities of the former Rosenergo 
``concern,'' the successor of the old U.S.S.R. Ministry of 
Electric Power. At that time, the Russian Government planned to 
hold onto 51 percent of the new holding company's shares 
(although up to 30 percent was planned to eventually be 
transferred to local administrations, and currently the 
regional administrations vote 30 percent of the government 
shares in the energos), 21 percent was sold to employees of the 
enterprises that comprise the company both for privatization 
checks and for cash, and 15.1 percent was distributed to the 
population through check auctions (in February and June 1994), 
while another 7.1 percent was reserved for cash sale or 
auction. By early 2000, the government's stake in RAO UES had 
been reduced to 52.7 percent, with about 22 percent purchased 
by foreign institutional investors, about 6 percent in 
preferred (non-voting) shares in the hands of employees, and 
the remainder held by Russian institutional investors and 
individuals.
    The local distribution companies, or energo, were 
incorporated into the RAO UES holding as ``daughter'' 
subsidiaries; RAO UES was intended to hold a 49 percent stake 
in each energo (on behalf of the state). Thus, RAO UES was 
given broad control over the sector and was intended to 
represent the government's interests in the power sector. 
However, due to several structural factors, RAO UES has been 
unable to effectively exert its control and manage these 
widespread assets successfully. This largely reflects the fact 
that RAO UES bears the ministerial administrative legacy from 
its Soviet predecessor plus the conflict between its role as a 
commercial company and that of a state-owned managerial body 
for the sector; an additional factor is that with the changes 
in the operating environment since 1990, it is simply too 
difficult for RAO UES to effectively manage the entire sector.
    Many energos, supported by local government 
administrations, have taken a more independent line, with 
particularly strong opposition coming from the surplus power 
regions that objected to having valuable generating assets 
taken from them. As a result, various compromises have been 
reached. Still, for most of the energos, RAO UES did receive a 
46 to 51 percent stake (giving it a majority of votes depending 
upon the particular composition of preferred versus common 
shares for each energo), and it has a 100 percent stake in 8 
others, while in only two it holds no shares.
    In turn, the energos include within their structure the 
smaller electric power stations (of less than 1,000 MW for 
thermal stations or less than 300 MW for hydro-stations), 
comprising about 480 stations. The energos own 118 GW of 
capacity, but operationally retain roughly 135 GW (about 63 
percent of the Russian total), including about 65 GW of heat-
and-power stations (TETs) and 30 GW of smaller thermal and 
hydro plants. Each of the smaller stations is, in turn, a 
``daughter'' company of the local distribution company; i.e., 
it is itself a joint-stock company with 49 percent of its 
shares owned by the larger distribution company.
    While a large component of RAO UES' holdings is comprised 
of the regional distribution companies (almost 60 percent of 
its charter capital lies in its holdings of the energos), this 
is not the only component. RAO UES also holds the large 
(independent) stations \26\ as well as the bulk of the high-
voltage transmission grid system (over 330 kV) and some 
auxiliary operations, such as research institutes, design 
bureaus, and construction enterprises. Thus, RAO UES has been 
described as the world's largest holding structure.
---------------------------------------------------------------------------
    \26\ The scheme establishing RAO UES intended to strip the largest 
thermal stations (over 1,000 MW) and hydro-electric stations (over 300 
MW) out of the energos where they previously had been administered, and 
put them in RAO UES' hands, which together with RAO UES' control of the 
high-voltage transmission grid, would lead to the formation of a 
wholesale electricity market among the regions. With the loss of the 
large stations, few of the energos would be self-sufficient in 
electricity.
---------------------------------------------------------------------------
    Russia's 51 larger stations (hydro-electric stations [GES] 
of more than 300 MW and thermal stations of more than 1000 MW) 
were supposed to be separated from the energos and were 
initially intended to become ``daughter'' companies within the 
RAO UES holding. These 51 stations (comprising a total of 96 GW 
or 45 percent of Russian total installed capacity), despite 
being incorporated into RAO UES, are described as being 
``independent'' power producers.
    Similar to what happened among the energos, however, not 
all the stations followed the national scheme. Only 23 of these 
stations are wholly under RAO UES (comprising 41 GW), while 9 
stations (comprising 16 GW) are ``leased'' back to the local 
energos and 17 either remained with the energo, became an 
energo ``daughter'' company like the smaller stations, or were 
privatized under regional programs. Of these 17, 4 were 
privatized by the (autonomous) republics; 4 were 
``incorporated'' by local authorities; and 5 were 
``incorporated'' under different decrees or rules. In other 
cases, special purchase rules for the output of these stations 
has been agreed, further limiting the benefits to RAO UES from 
ownership. Thus, in a variety of ways, control over many of 
these larger stations has not remained with RAO UES as 
intended, but has often slipped back to the energos.
    The nuclear stations also supply electricity to the network 
independently (their output is purchased both by RAO UES as 
well as by some of the energos directly). They are under the 
administration of the Russian Ministry of Nuclear Power, 
Minatom, or more properly, the government holding company under 
that ministry known as Rosenergoatom (except for the Leningrad 
station, which operates independently).
    The Russian electric sector remains in a state of flux, and 
since the existing organizational structure creates a number of 
problems for the system in terms of operation and management, 
it is slated to undergo additional changes. A general 
restructuring plan for the sector was recently approved by the 
government, more or less along the lines of an earlier proposal 
mooted by Anatoly Chubais, the chief executive of RAO UES. The 
key elements of the plan envision the central government 
holding (RAO UES) divesting itself of generation and 
distribution assets, and refocusing its activities on the 
``natural monopoly'' element of transmission. Change will be 
difficult, however, both because of the effective 
decentralization that has occurred and because the power sector 
has become extremely politicized at both the national and 
regional levels.

     The Russian Federation's Primary Energy Balance in Long-Term 
                              Perspective

    The main trends, tasks, and objectives of energy policy to 
2020 are embodied in Russia's recently approved Energy Strategy 
of Russia to 2020.\27\ This is the most recent in a series of 
energy policy documents laying out a strategy for the energy 
sector and mechanisms for its implementation under the 
transition to a market economy. Its immediate predecessor was 
the Basic Guidelines for the Energy Policy of the Russian 
Federation to 2010 (approved in October 1995).
---------------------------------------------------------------------------
    \27\ Government of the Russian Federation, 2000.
---------------------------------------------------------------------------
    A major difference between the 1995 and 2000 documents is 
their macro-economic contexts. In 1995, Russia's economy was 
still contracting, and the reduction in primary energy 
requirements concomitant with that was largely viewed as a 
factor facilitating the task of supplying the country with 
energy and allowing foreign exchange to be generated by 
exporting the surplus. In contrast, the 2000 Strategy is set 
against a background of a resurgent economic growth, and its 
focus is mainly upon meeting the growing energy needs of a re-
expanding economy. There is an overarching concern that, given 
the poor state of the Russian energy sector, it may not be able 
to meet the increasing energy demand nor provide the vital 
exports needed to sustain the economic transformation. Thus, 
even more so than in the past, the 2000 Energy Strategy 
emphasizes improvements in energy efficiency and reform of 
energy pricing structures as principal mechanisms.
    The new Energy Strategy's projections for energy supply to 
2020 are based on a major change in energy policy outlook given 
the concern of an energy security risk from a deemed too high 
dependence on natural gas. The Strategy envisages a change in 
the fuel mix such that the share of natural gas in total 
primary energy consumption will decrease from levels of about 
50 percent in the late 1990s to 42 to 45 percent in 2020. In 
its place, the share of coal is planned to increase from 11 to 
12 percent in 1998 to 22 percent in 2010 and 21 to 23 percent 
in 2020. Nuclear energy is also slated to increase, expanding 
to 6 percent in 2020 from current levels of 5 percent, while 
oil's share in primary energy consumption will remain 
practically unchanged.
    The Strategy projects primary energy production in Russia 
in 2020 at 1,525 to 1,740 million tons of coal-equivalent 
(1,068 to 1,218 mtoe), primary energy consumption in 2020 at 
2,090 to 2,325 million tons of coal-equivalent (1,464 to 1,628 
mtoe), and net energy exports at 565 to 585 million tons of 
coal-equivalent (396 to 410 mtoe).
    In contrast, PlanEcon's current energy forecast for 
Russia\28\ projects a substantially different picture for 2020, 
with a higher level of aggregate energy production, a lower 
level of consumption, and a higher level of exports. By 2020, 
PlanEcon's current energy forecast\29\ projects total output of 
primary energy in Russia at 1.446.3 mtoe, 10.7 percent above 
the 1990 level, and 46.7 percent higher than the 2000 figure 
(Table 6).
---------------------------------------------------------------------------
    \28\ Sagers and Movit, 2001.
    \29\ Sagers and Movit, 2001.
---------------------------------------------------------------------------
    In the PlanEcon forecast, coal production is expected to 
eventually resume its long-term secular decline; oil output is 
expected to continue to recover (albeit slowly); and gas 
production should be able to turn around shortly, due both to 
improvements in the domestic investment climate (reflecting 
higher prices and toughening payment conditions) and to more 
buoyant demand from expanding economic activity in the region. 
Thus, natural gas is expected to remain the largest component 
of Russia's energy production. The share of natural gas in 
primary energy output rose to 47.9 percent in 2000, and is 
projected to reach 58.3 percent by 2020.
    Over the entire 2000-2020 period, aggregate primary energy 
output in Russia is projected to increase at an annual average 
rate of about 1.9 percent. While output of crude oil and 
natural gas is projected to rise considerably over the next 20 
years, primary electricity production is anticipated to remain 
more or less stagnant (due mainly to high capital costs), and 
coal output (in energy equivalent terms) is expected to resume 
its long-term slide as rising extraction costs and prohibitive 
transport charges erode its markets.

                                                  TABLE 6.--PLANECON'S FORECAST OF THE PRIMARY ENERGY BALANCE OF THE RUSSIAN FEDERATION TO 2020
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             1990     1991     1992     1993     1994     1995     1996     1997     1998     1999     2000     2005     2010     2015     2020
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Production (mtoe)........................................  1,306.1  1,233.4  1,157.8  1,071.7  1,011.8    991.2    982.8    956.5    961.4    977.4    997.8  1,081.4  1,229.8  1,364.1  1,446.3
Shares (in percent):
    Coal.................................................     14.5     13.5     13.8     13.5     12.8     12.8     12.5     12.3     11.5     12.3     12.5     11.3      9.6      8.6      7.8
    Oil..................................................     39.5     37.4     34.2     32.1     31.2     31.0     30.6     32.0     31.5     31.2     32.4     33.7     31.9     30.3     29.3
    Natural gas..........................................     40.1     42.6     45.3     47.2     49.1     49.1     50.1     48.8     50.3     49.4     47.9     48.6     53.0     56.2     58.3
    Primary electricity..................................      4.8      5.3      5.7      6.2      6.2      6.4      6.1      6.3      6.2      6.6      6.8      6.0      5.2      4.7      4.5
    Other................................................      1.1      1.2      1.0      1.0      0.7      0.7      0.6      0.6      0.5      0.5      0.5      0.3      0.2      0.2      0.1
Consumption (mtoe).......................................    905.9    905.0    814.8    768.9    692.9    667.9    640.2    609.9    606.9    622.0    634.2    679.0    745.7    829.4    880.9
Shares (in percent):
    Coal.................................................     20.5     18.4     19.0     18.5     18.7     18.1     18.2     18.3     17.2     18.0     17.6     19.1     16.9     15.6     13.8
    Oil..................................................     29.5     29.4     26.5     23.4     21.8     22.1     19.8     21.2     20.1     20.2     19.3     18.4     17.5     15.1     18.5
    Natural gas..........................................     41.6     43.7     45.4     48.6     50.1     50.0     52.3     50.3     52.7     51.3     52.2     52.8     57.1     43.3     60.6
    Primary electricity..................................      6.8      7.0      7.6      8.1      8.4      8.8      8.7      9.2      9.3      9.8     10.2      9.1      8.1      7.4      6.9
    Other................................................      1.6      1.6      1.5      1.4      1.1      1.1      1.0      0.9      0.7      0.8      0.7      0.6      0.4      0.5      0.2
Net exports (mtoe).......................................    400.2    328.4    343.0    302.8    318.9    323.3    342.5    346.7    354.4    355.4    363.6    402.5    484.1    534.7    565.3
    Coal.................................................      3.4     -0.0      4.4      2.9      0.4      6.3      6.7      5.7      6.4      8.3     13.0     -7.5     -8.0     -8.6     -8.2
    Oil..................................................    249.2    195.4    180.0    164.2    164.8    159.3    174.4    176.3    181.1    179.5    200.5    239.4    262.0    267.4    260.4
    Natural gas..........................................    146.9    130.3    154.0    131.4    149.3    153.2    157.0    160.2    163.8    164.4    147.1    167.0    226.1    271.9    308.5
    Primary electricity..................................      0.6      2.8      4.6      4.3      4.5      4.5      4.5      4.5      3.1      3.2      3.0      3.5      4.0      4.1     4.6
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Note: Historical figures through 2000.


    Nonetheless, oil is projected to see a slight decline in 
its share of primary energy production, despite steadily rising 
output. This is because longer term, it is uncertain if the 
investment needed by the sector to sustain and expand oil 
output will continue to be forthcoming. The single most 
important determinant of oil investment is the tax regime, so 
the longer term prospects for Russian oil production are 
largely dependent upon tax reform. In its present form, the 
Russian oil taxation system has several major defects. The main 
problem is that it depends excessively on revenue- or volume-
based rather than profit-based taxes. Until the circumstances 
of extraordinary high international prices and low production 
costs in 1999-2000, the existing Russian tax system resulted in 
unacceptable returns on virtually all categories of investment.
    Yet, maintaining the recovery in the oil sector depends 
heavily on investment to replace the declining volumes of 
``flowing oil.'' The Duma is slated to act on tax reforms for 
the oil sector in 2001, and the remaining normative acts needed 
to complete Russia's regime for production-sharing agreements 
for oil and gas production, are also slated to be completed as 
well. These measures should allow investment in the oil sector 
to continue to rise. Combined with improved effectiveness in 
the sector's application of investment resources, this should 
assure a steadily rising volume of ``new oil'' sufficient to 
more than offset the decline of ``flowing oil.''
    Thus, Russian oil production is projected to continue to 
rise over the forecast period by PlanEcon, although growth is 
expected to slow over time. During the next decade, oil output 
is projected to expand steadily at about 1.5 percent per year 
before slowing to about 0.5 percent per year in the period 
2016-2020. Russian oil production is projected to grow at an 
average rate of 1.4 percent per year over the entire 20 year 
period to 2020, to reach 392.7 mmt in 2010, and then 423.2 mmt 
by 2020.
    The official Russian Energy Strategy to 2020 envisions oil 
output at 335 mmt in 2010 and 360 mmt in 2020, an average 
annual rate of growth over the 20 year period of only 0.5 
percent. The Strategy estimates that to reach these production 
targets, investments of $42 billion (expressed in constant 
ruble equivalent compared to 1999) will need to be mobilized 
over the next decade, and another $80 billion will be needed in 
the following decade. This is an average of $6 billion per year 
over the 20 year period compared with the 1999 investment level 
valued at $2.0 billion (see above).
    In general, these Russian estimates of investment 
requirements seem reasonable with the Strategy's oil production 
forecast. However, the overall oil production forecast seems 
far too conservative given what was achieved in 2000 (e.g., 
higher investment, expanded drilling, more new fields) and the 
changes in the investment climate that are likely to be 
realized over the next few years.
    In contrast, natural gas production in Russia is largely 
dependent upon developments in consumption. Despite Gazprom's 
current worries over its ability to produce gas in the near 
term, in PlanEcon's view, the decline in Russia's gas output is 
largely an organizational/institutional issue related to the 
lack of incentives to invest rather than a question of reserves 
or even the capacity to mobilize investment. Thus, with the 
current direction of reforms in the gas sector (albeit quite 
modest), production is likely to be able to turn around 
relatively quickly to support rising gas demand, although 
growth will still remain fairly moderate. It will be driven 
upward by a combination of internal consumption needs and 
export demand in the former Soviet Union countries and non-
former Soviet Union. PlanEcon projects Russian gas output in 
2005 at 642.6 bcm, expanding to 797.0 bcm in 2010 and 1,030 bcm 
in 2020; gas output growth is forecast to average 2.9 percent 
per annum over the 20 year period.
    In contrast, the Russian Energy Strategy, because of its 
goal of diminishing the domestic economy's reliance on gas, 
projects gas output at only 655 bcm in 2010 and a mere 700 bcm 
in 2020. The average annual growth rate envisioned in the 
Strategy for gas production is thus a mere 0.9 percent over the 
20 year period. The expanded production is largely geared 
toward higher exports, while domestic consumption is envisioned 
as remaining relatively flat over the next two decades.
    Clearly, such limited expansion would be favorable for 
Gazprom, as the organization is not really challenged in 
achieving this output. Such a situation that is essentially 
non-threatening to Gazprom's current dominance in the Russian 
gas sector.
    In fact, the Strategy reflects Gazprom's current 
sensibilities, and projects output from Gazprom's three main 
producing fields (Urengoy, Yamburg, and Medvezh'ye) to decline 
from the current level of output (400 bcm) to a mere 87 bcm by 
2020, necessitating a relatively high level of investment in 
replacement production capacity. Such a high rate of decline 
for the main fields (-7.2 percent per annum on average) seems 
excessive given the past experience with the large fields 
exploiting West Siberia's Cenomanian reservoirs. PlanEcon's 
forecast for Russian gas production envisions a much lower rate 
of decline in Gazprom's main existing fields (3.1 percent per 
annum on average), but nonetheless requires a substantial 
expansion of ``new gas'' (775 bcm by 2020). To achieve this, 
organizational/institutional changes will be needed in the 
Russian gas sector to support the development of more gas 
outside Gazprom (by so-called ``independents'').
    Russian coal production, in energy equivalent terms, is 
projected by PlanEcon to slowly decline over the forecast 
horizon (-0.5 percent per year on average). In contrast, the 
Energy Strategy envisions coal production rising to 320 mmt in 
2010 and over 400 mmt in 2020. In the Strategy, major 
technological breakthroughs are postulated in production, 
processing and transportation that result in declining costs, 
and therefore end-user prices, of coal. Such a view seems quite 
unrealistic, however.
    The projected level of primary electricity production in 
the current PlanEcon forecast envisions the completion of six 
new (1,000 MW) nuclear units during the forecast period, 
including four before 2005. The recently approved Energy 
Strategy calls for the completion of five new units (which were 
already well advanced in construction during the Soviet period) 
before 2005, identifying these as the cheapest generating 
capacity (in costs per MW or per kWh) that Russia could bring 
on stream. PlanEcon concurs in this assessment mainly because 
of the sizable investment that has already been sunk into these 
units, particularly recently; the first of these units (Rostov 
No. 1, a VVER-1000) was started up in February 2001. Commercial 
generation of power at the new unit is expected to occur in 
October 2001.
    However, PlanEcon does not consider the Strategy's longer 
term plans for further nuclear expansion beyond these initial 
units to be realistic. The Strategy calls for 12 GW of new 
nuclear capacity (12 units) to be installed by 2010, pushing 
installed capacity to 33.2 GW and nuclear generation in the 
country up to 220 billion kWh, to be followed by further 
expansion and modernization of older units that would boost 
installed capacity to 48.4 GW in 2020, producing 320 billion 
kWh (19.8 percent of the Strategy's projected total for 
electricity generation). In comparison, Russia's nuclear 
stations produced 130.5 billion kWh in 2000, or 14.9 percent of 
total production. PlanEcon's forecast projects nuclear 
generation of only 106 billion kWh in 2020 (8.2 percent of 
total generation), largely because of the retirement of 13.2 GW 
of nuclear capacity over the 20 year period, which is only 
partially offset by the installation of the 6.0 GW of new 
nuclear capacity.
    In thinking about the long-term outlook for the Russian 
Federation's primary energy balance, one of the most important 
factors in a functioning marketized economy (which Russia hopes 
to become) is energy demand. In turn, one of the most important 
demand drivers is the path of aggregate economic activity 
(GDP).
    PlanEcon projects that Russia's economic re-expansion will 
continue in the future, although at a much slower rate than in 
2000 (at least initially)--GDP growth is projected to average 
3.8 percent per year in 2001-2005 and 4.6 percent in 2006-2010, 
before accelerating to 5.5 percent in 2011-2015. But in the 
subsequent 5 year period (2016-2020), economic growth is 
projected to slow to 3.5 percent per annum on average. Average 
GDP growth over the 20 year period is projected at 4.4 percent.
    Two factors that will slow growth in the near term is 
rising domestic prices for energy and transportation and 
tougher payment conditions (particularly for electricity and 
gas). These developments, overdue since the 1998 devaluation 
that depressed these regulated prices in real terms, will 
reduce the profitability of many traditional, Soviet-style 
activities (particularly in industry). These were resuscitated 
and given a second lease on life by the tumultuous events of 
1998. Nonetheless, economic growth is anticipated to remain 
fairly strong throughout the forecast period, although there 
remains a high degree of uncertainty in the pace of economic 
reform and the underlying economic policies that will be 
pursued by the Russian Government under President Vladimir 
Putin. Not surprisingly, the official Russian Energy Strategy 
envisions even more rapid growth than this, with average annual 
growth rates in the range of 5.5 to 6.2 percent.
    But because a fairly rapid pace of structural change in the 
Russian economy would be commensurate with such high rates of 
economic growth (together with other adjustments), PlanEcon 
projects that the growth in primary energy consumption will lag 
well behind the trend in aggregate economic activity. Primary 
energy consumption is projected to rise at an average rate of 
only 1.7 percent per year over the 20 year period. While the 
energy intensity of the Russian economy in 2000 was 
considerably higher than in the Soviet period, improvements in 
the energy efficiency of the economy have occurred in the last 
few years, and this pattern is expected to continue by 
PlanEcon, perhaps even at a more rapid rate. The improvement in 
energy efficiency in the economy is projected in the range of 
2.0 to 3.3 percent per year over the 20 year period by 
PlanEcon, averaging about 2.7 percent per annum. In the final 
period of the forecast (2015-2020), the aggregate energy 
elasticity (the rate of change in energy consumption per the 
rate of change in GDP) is projected to decline to a value 
closer to recent Western historical experience (i.e., to 0.3 to 
0.4). Thus, by 2020, aggregate energy intensity is projected to 
decline to 64.4 percent of the 1990 level.
    The official Energy Strategy is even more aggressive in 
projecting energy savings potential in the economy. Despite 
postulating much higher underlying economic expansion (see 
above), it projects that primary energy consumption will grow 
an average of only 1.3 percent per year between 2000 and 2020.
    The shares of individual fuels in meeting aggregate primary 
energy needs in Russia changed significantly over the course of 
the 1990s, and PlanEcon believes that they will continue to 
change in similar directions over the next two decades. The 
share of natural gas has risen from 41.6 percent in 1990 to 
52.2 percent in 2000. By 2010, we project the share of gas will 
be up to 57.1 percent, and that it will rise further, to 60.6 
percent, by the end of the forecast horizon in 2020. Most of 
the gain in the share of gas takes place at the expense of 
coal. From a share of 20.5 percent in 1990, coal had already 
experienced a decline in importance to a low point of 17.2 
percent of total primary energy consumption by 1998, before 
rebounding to 18.0 percent in 1999 and 17.6 percent in 2000. 
PlanEcon forecasts that coal's share of the total will rise 
again in 2001, to 19.9 percent, before heading back down to 
19.1 percent in 2005, with a further drop by the end of the 
forecast, to only 13.8 percent by 2020.
    The Energy Strategy envisions a very different picture. The 
Ministry of Energy, the Strategy's principal author, thinks 
that energy consumption has become too unbalanced in favor of 
gas. In particular, the Strategy calls for greater use of coal 
and nuclear power to meet the increased demand for electricity. 
The Strategy projects a decline in the share of gas in Russian 
primary energy consumption to about 40 percent by 2020, led by 
a decline in the share of gas in fuels use by the electric 
power sector from the current 62 percent to 51 percent by 2020. 
Concomitantly, according to the Strategy, the share of coal in 
primary energy consumption will rise slightly over the 20 year 
period, to about 22.5 percent by 2020.
    PlanEcon's view is that coal and nuclear are not only 
intrinsically much more expensive than gas, but also come with 
enormous environmental liabilities. Therefore with huge 
reserves of relatively economic and clean natural gas, PlanEcon 
forecasts that Russia's reliance on coal for power generation 
and process heat is likely to wane further. The declining 
relative importance of metallurgy in the country's aggregate 
economic output should also serve to reduce the share of coal 
in primary energy consumption as well.
    PlanEcon anticipates that the share of oil/petroleum 
products in meeting primary energy consumption will decline 
further before rebounding slightly by 2020. Although demand for 
motor fuels will increase as the Russian economy is 
increasingly motorized and the fleet of cars and trucks 
continues to grow, this will be partially offset by the 
retirement of the sizable fleet of less fuel-efficient 
gasoline-powered trucks and the improvement in the fuel 
efficiency of vehicles more generally. Additionally, 
restructuring away from heavy industry will further depress 
demand for residual fuel oil (mazut) under industrial boilers, 
while mazut as well as coal will face heavy competition from 
less expensive natural gas. The share of petroleum products has 
fallen from 29.5 percent in 1990 to only 19.3 percent by 2000. 
Over the forecast period the share of petroleum products is 
projected to decline to 17.5 percent in 2010 and 15.1 percent 
in 2015 before rising to 18.5 percent in 2020.
    The projection of primary energy production and consumption 
also provides a forecast for their difference, or net energy 
exports for Russia. Russian net energy exports reached a trough 
in 1993 at 302.8 mtoe, a decline relative to 1990 of 24.4 
percent. The greatest share of the decline took place in net 
exports of oil, as the lack of investment resources and the 
impact of the general economic decline fell heavily on the oil 
extraction sector. Net oil exports in 1993 were at only 65.9 
percent of the 1990 level, and were even further below the peak 
reached in the late 1980s.
    Net oil exports are now expected to surpass the 1990 level 
(of 249.2 mtoe) already in 2008, and reach a peak of 267.4 mtoe 
in 2015 before dropping slightly over the ensuing 5 years to 
260.4 mtoe in 2020. The expansion of Russian oil output is 
anticipated to decline over time, causing a decline in net 
exports at the end of the forecast because of higher growth in 
demand projected at that time (i.e., 2.3 percent per year in 
2016-2020) when restructuring of mazut and low-octane gasoline 
consumption is of less consequence.
    Net exports of natural gas have remained constrained during 
most of the 1990s by the lack of absorption capacity by 
customers in international markets (primarily Europe) and 
elsewhere in the CIS. Partly because of limited demand growth 
in the importing countries (as well as institutional barriers 
to mobilizing investment to expand production in Russia), net 
exports of gas remained stagnant at around 150 to 160 mtoe (180 
to 200 bcm) in the late 1990s. But with continued inroads by 
gas in displacing coal and mazut in the CIS and Eastern Europe 
and modest expansion of West European and Turkish demand for 
Russian gas, net exports of gas are projected to rise rather 
steadily in the later periods. Some new markets are also likely 
to be pioneered in Asia as well for Russian gas from Sakhalin 
and perhaps East Siberia as well. Net gas exports are forecast 
to reach 308.5 mtoe (377.1 bcm) by 2020, 2.2 times the level 
that characterized the low point of 1991.
    PlanEcon anticipates that Russia will not retain its 
position as a small net exporter of both coal and electricity. 
The net surplus for coal is expected to become a slight net 
deficit already in 2001, and the gap will steadily expand over 
the next two decades. Russia's own exports of coal to the non-
former Soviet Union are expected to be more than offset by 
rising imports of coal from Kazakhstan. But a small net trade 
surplus in electricity is projected to remain over the 2000-
2020 period.

                               References

Goskomstat Rossii (Gosudarstvennyy komitet Rossiyskoy 
        Federatsii po statistike), Sotsial'no-ekonomicheskoye 
        polozheniya Rossii 2000 god, Moscow: 2001.
Goskomstat Rossii, Sotsial'no-ekonomicheskoye polozheniye 
        Rossii 1999 god, Moscow, 2000.
Goskomstat Rossii, Rossiyskiy statisticheskiy ezhegodnik, 
        statisticheskiy sbornik, Moscow: 2000.
Goskomstat Rossii, Rossiyskiy statisticheskiy ezhegodnik, 
        statisticheskiy sbornik, Moscow: 1999.
Goskomstat Rossii, Promyshlennost Rossii, statisticheskiy 
        sbornik, Moscow, 1995.
Government of the Russian Federation, Energy Strategy of Russia 
        for the Period to 2020: Main Provisions, Moscow, 
        November 2000.
GVTs Energetiki, Itogi raboty Mintopenergo Rossii 1999 god, 
        Moscow: 2000.
GVTs Energetiki, Itogi raboty Mintopenergo Rossii 1998 god, 
        Moscow: 1999.
McKinsey Report: Russian Oil, February 2001.
Mintopenergo (Ministerstvo Topliva i Energetiki Rossiyskoy 
        Federatsii) and IPROEnergo (Assotsiatsiya institut 
        pravovykh osnov energoeffektivnosti), Toplivo i 
        energetika Rossii, Moscow: 1999.
Mintopenergo (Ministerstvo Topliva i Energetiki Rossiyskoy 
        Federatsii) and IPROEnergo (Assotsiatsiya institut 
        pravovykh osnov energoeffektivnosti), Toplivo i 
        energetika Rossii, Moscow: 1998.
``Osnovniye kontseptual'niye polozheniya i razvitiya 
        neftegazovogo kompleksa Rossii'' (Basic Concepts for 
        the Progress and Development of the Oil and Gas Complex 
        of Russia), Neftegazovaya Vertikal', 1: January 2000 
        (Web address: ww.ngv.orc.ru).
Sagers, Matthew J., and Charles Movit, ``Projected Developments 
        in the Primary Energy Balances of the Former Soviet 
        Republics to the Year 2020, `` in PlanEcon Energy 
        Outlook. Washington, DC: PlanEcon, Inc., July 2001.
Sagers, Matthew J., Valeriy A. Kryukov, and Vladimir V. Shmat, 
        ``Resource Rent from the Oil and Gas Sector and the 
        Russian Economy,'' Post-Soviet Geography, 36, 7: 389-
        425, September 1995.
Sagers, Matthew J., ``The Russian Gas Industry in 1998 and 
        Prospects for the Future,'' in PlanEcon Energy Outlook. 
        Washington, DC: PlanEcon, Inc., April 1999, 147-217.
Sagers, Matthew J., ``Russian Crude Oil Production in 1996: 
        Conditions and Prospects,'' Post-Soviet Geography and 
        Economics, 37, 9: 523-587, November 1996.








     AGRICULTURAL REFORM: MAJOR COMMODITY RESTRUCTURING BUT LITTLE 
                          INSTITUTIONAL CHANGE



                         By William Liefert \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   253
Introduction.....................................................   254
Main Elements of Agricultural Reform.............................   255
How Reform Has Changed Agricultural Production, Consumption, and 
  Trade..........................................................   257
    The pre-reform Soviet agriculture and food economy...........   258
    Price liberalization.........................................   260
    Trade liberalization.........................................   262
    Fall in output was inevitable part of market reform..........   263
    Current support and trade policies...........................   264
    Effects on U.S. agricultural trade...........................   265
    Consumption and food security concerns.......................   266
Farm Restructuring and Institutional Market Infrastructure.......   268
    Private farms................................................   268
    Household plots..............................................   271
    Former state and collective farms............................   272
    New agricultural operators and a new spirit of enterprise?...   274
Could Reform Turn Russia into a Major Grain Exporter?............   276
Conclusion.......................................................   278
References.......................................................   280
                                Summary

    Economic reform in Russia has substantially changed the 
volume and commodity mix of agricultural production, 
consumption, and trade. The main development has been the large 
drop in output, with the livestock sector being particularly 
hard hit. During the 1990s livestock output and animal 
inventories both fell by about half. However, the production 
decline has been an inevitable part of market reform, as the 
hefty Soviet-era subsidies to agriculture dropped severely. The 
contraction of the livestock sector has ended the large imports 
of grain and soybeans needed during the Soviet period as animal 
feed. On the other hand, imports of meat and other high value 
products have increased. These changes have affected U.S. 
agriculture, as Russia has become the top foreign market for 
U.S. poultry, in some years taking nearly half of all poultry 
exports.
---------------------------------------------------------------------------
    \1\ William Liefert is a Senior Economist with the Economic 
Research Service (ERS), U.S. Department of Agriculture (USDA). The 
author thanks Stefan Osborne, Bryan Lohmar, Zvi Lerman, and Mary Anne 
Normile for helpful comments, though he bears full responsibility for 
any remaining shortcomings. The opinions expressed in this paper are 
the author's alone and do not in any way represent official USDA views 
or policies.
---------------------------------------------------------------------------
    Institutional change, which involves farm restructuring and 
creation of the commercial and public infrastructure that a 
market-oriented agricultural economy needs, has been 
disappointingly slow. Private farms account for only 2 to 3 
percent of agricultural output, while the former state and 
collective farms continue to dominate the organizational 
structure of agriculture. Although officially reorganized, with 
many becoming ``joint stock companies,'' these farms have not 
substantially changed their systems of management and internal 
incentives inherited from the Soviet period. No federal 
legislation exists that allows genuine private ownership of 
agricultural land, which precludes development of a land 
market. In the absence of major institutional reform in 
agriculture, productivity growth in the sector during the 
transition period has been negligible at best.

                              Introduction

    This paper surveys developments within the Russian 
agricultural economy since reform began in the early 1990s.\2\ 
The paper focuses on two main questions: how has reform changed 
the commodity volumes and structure of Russian agriculture 
(production, consumption, and trade), and how has the 
institutional reform of Russian agriculture progressed? 
Institutional reform involves such matters as farm level 
restructuring and creation of the commercial and public 
infrastructure that a market-oriented agricultural economy 
needs.
---------------------------------------------------------------------------
    \2\ The paper draws heavily on a forthcoming ERS study (Liefert and 
Swinnen) that examines how reform has changed agricultural production, 
consumption, and trade in the transition economies of the former Soviet 
bloc. Another forthcoming ERS study (Cochrane et al.) focuses on how 
reform in the transition economies has specifically restructured the 
livestock sector. Sources on Russian agricultural developments during 
transition include ERS (annual to 1996, 1997, and 1998), OECD (annual), 
and OECD (1998). Much of the data presented in the paper are from ERS 
and Organization for Economic Cooperation and Development (OECD) 
databases.
---------------------------------------------------------------------------
    The major commodity-related development during transition 
has been the large fall in production, especially in the 
livestock sector. Total agricultural output has declined by 40 
percent compared to the pre-reform period, and production of 
livestock goods about 50 percent. The drop in output is 
important for U.S. policymakers and agricultural interests, for 
three main reasons. The first is that it has strongly affected 
U.S. agricultural exports. During the Soviet period, the 
U.S.S.R. was a major importer of U.S. grain, soybeans, and 
soybean meal, used primarily as animal feed for the country's 
growing livestock herds. The severe downsizing of the livestock 
sector in Russia (as well as in the rest of the former 
U.S.S.R.) during transition has largely terminated these 
imports. Russia is now importing substantial amounts of meat 
and other livestock products, especially poultry. Consequently, 
Russia has become the largest foreign market for U.S. poultry, 
in some years taking nearly half of all poultry exports.
    Another reason commodity developments are important for the 
United States concerns policy advising and technical 
assistance. The Russian agricultural establishment argues that 
the contraction of agriculture, especially that of the 
livestock sector, is a catastrophe for the country, and that 
state policy toward agriculture should focus on returning 
output to pre-reform levels. To accomplish this goal, 
agricultural interests lobby for a substantial increase in 
subsidies and trade protection for the sector, as well as other 
policy interventions into agricultural markets that would be to 
the sector's advantage, such as raising prices for agricultural 
output relative to input prices. The United States, as well as 
the European Union (EU) and international organizations such as 
the World Bank and European Bank for Reconstruction and 
Development (EBRD), have been heavily involved in policy 
advising and technical assistance with Russian agriculture. 
Therefore, it is important that the Russian agricultural 
establishment and advising Western bodies generally agree on 
the explanations as to why the main reform-related developments 
within the sector have occurred, the drop in output being at 
the top of the list.
    The third reason the United States should be concerned 
about Russian agricultural commodity developments is that the 
drop in production and consumption during transition has raised 
questions about Russia's food security. Both the United States 
and EU have responded by providing Russia with food aid (most 
recently in 1999-2000).
    The paper is organized as follows. The first section 
examines the main elements of Russian agricultural reform. The 
next section examines how reform has changed Russian 
agricultural production, consumption, and trade, highlighting 
the role that price and trade liberalization played in 
commodity restructuring. Subsections discuss how the 
restructuring has affected U.S. agricultural trade, the current 
status of Russian support and trade protection for agriculture, 
and the consequences of commodity restructuring for food 
consumption and food security.
    The next section examines institutional developments, in 
particular farm restructuring and creation of market 
infrastructure for agriculture during transition. The focus 
concerning farm restructuring is on the three major types of 
agricultural producers--private farms, household plots, and the 
former state and collective farms. The section concludes by 
looking at new types of agricultural producers--large 
vertically integrated agri-food enterprises--which some Russian 
agricultural specialists believe could be a progressive force 
in Russian agriculture, perhaps raising productivity and 
injecting a stronger entrepreneurial spirit into the sector. 
The paper's last section examines the possibility that 
effective reform could turn Russia into a major exporter of 
grain, as some Western specialists forecasted at the beginning 
of transition.

                  Main Elements of Agricultural Reform

    Agricultural reform in Russia has involved four main 
elements: (1) market liberalization; (2) farm restructuring; 
(3) reform of upstream and downstream operations; and (4) 
creation of supporting market infrastructure. Market 
liberalization involves removing government controls over the 
allocation of resources and output, thereby allowing the market 
to become the main means of allocation. It includes the key 
reform policies of liberalizing prices and trade and 
eliminating subsidies to agricultural producers and consumers. 
By changing prices, incomes, and other key monetary values that 
influence the market decisions of producers and consumers, 
market liberalization has resulted in major changes in the 
commodity volume and mix of countries' agricultural production, 
consumption, and trade. Liberalization and its effects thereby 
mainly address the question of what goods are produced and 
consumed in the agricultural economy. Market liberalization 
also links the macro-economy to agriculture. Macro-developments 
such as inflation and movement in the exchange rate affect the 
key variables (prices, consumer income) that drive agricultural 
markets.
    Farm restructuring changes the nature or system of 
production at the level of the actual producer. It involves how 
farms are owned, organized, and managed, that is, how goods are 
produced. Key policies are privatization and land reform, which 
directly affect incentives for using labor and other resource 
inputs.
    Market liberalization and farm restructuring affect output 
and consumption in different ways. Market liberalization 
changes the mix of goods produced and consumed in a way that 
better satisfies consumers' desires for goods, but without any 
necessary improvement in the system or technology of 
production. Farm restructuring entails changes by producers in 
the nature of production that could increase productivity. This 
would allow more output to be produced from a given amount of 
input, which would increase the total quantity of goods 
available for consumption.\3\
---------------------------------------------------------------------------
    \3\ Another way of explaining how market liberalization and farm 
restructuring differently affect the economy is with the concepts of 
(1) allocative efficiency and (2) technical efficiency and 
technological change. By changing the mix and distribution of output in 
a way that better satisfies consumers' desires, market liberalization 
increases allocative efficiency. The gains to consumers occur without 
any necessary improvement in the economy's overall (or any sectoral) 
production function. Conceptually, market liberalization results in 
movement along the economy's existing production possibilities 
frontier. By allowing more output to be produced from a given amount of 
input, farm restructuring increases technical efficiency. The move by 
underachieving farms to the best domestically available production 
practices results in movement from within an economy's production 
possibilities frontier to the frontier. If the improvement occurs 
because farms move to a new superior system or technology of 
production, the farm restructuring spawns technological change. This 
shifts the production possibilities frontier out.
---------------------------------------------------------------------------
    Market liberalization and farm restructuring are 
nonetheless interrelated. The main way is that market 
liberalization can help motivate farm restructuring. The desire 
to increase profit, or the fight just to stay in business, can 
spur producers to reduce costs by changing their system of 
production. The pressures from market competition are the key 
to the relationship. However, market liberalization by itself 
will not inevitably lead to farm restructuring--producers must 
still make the actual changes in how they produce.
    The third element of agricultural reform is transforming 
upstream and downstream operations. Upstream activities concern 
the supplying of agricultural inputs, while downstream 
activities cover storage, transportation, processing, and 
distribution. The transformation of these previously state-run 
operations that were well-integrated into the planned economy 
into privatized, market-oriented, and competitive enterprises 
not only would improve their productivity and performance, but 
also help farms improve theirs.
    The fourth element of agricultural reform is the creation 
of supporting market infrastructure. This involves establishing 
the institutions and services, whether commercially or publicly 
provided, that a well-functioning market-oriented agricultural 
economy needs. These include systems of agricultural banking 
and finance, market information, and commercial law that can 
clarify and protect property, enforce contracts, and resolve 
disputes. Development of market infrastructure and the 
transformation of upstream and downstream operations are 
closely related, and in some respects might be hard to separate 
from each other. For example, in many isolated regions within 
Russia, the collapse of the planned economy has deprived farms 
(especially small ones) of any channels for obtaining inputs, 
or for selling, storing, or processing their output. In other 
words, upstream and downstream linkages, as well as the market 
infrastructure (such as market information) that could allow 
farms to find new linkages, are completely lacking.
    The four elements of agricultural reform identified in this 
paper are roughly comparable to the taxonomy of reform elements 
developed by the World Bank (Csaki and Nash, 2000) for 
agriculture in all transition economies of the former Soviet 
bloc. The World Bank reform elements are (1) price and market 
liberalization; (2) land reform and privatization; (3) 
privatization and reform of agro-processing and input supply 
enterprises; (4) rural finance; and (5) institutional reforms 
(largely involving public services). Market liberalization 
corresponds to World Bank element No. 1, farm level 
restructuring to World Bank element No. 2, reform of upstream 
and downstream operations to World Bank element No. 3, and 
market infrastructure to World Bank elements Nos. 4 and 5.

 How Reform Has Changed Agricultural Production, Consumption, and Trade

    Since reform began in the early 1990s, Russian agriculture 
has experienced major commodity restructuring--that is, major 
changes in the commodity volume and mix of agricultural 
production, consumption, and trade. The main feature of the 
restructuring has been a substantial drop in agricultural 
production, especially in the livestock sector (Table 1).\4\ 
During the 1990s meat production, as well as livestock 
inventories, fell by about half.
---------------------------------------------------------------------------
    \4\ For data on Russian agricultural production and trade, as well 
as analysis of issues involving Russian agriculture, see the briefing 
rooms on Russia at the ERS Web site www.ers.usda.gov. ERS briefing 
rooms also exist for agriculture in the other transition economies of 
Ukraine, Hungary, and Poland.
---------------------------------------------------------------------------
    The data in the table are based on countries' official 
production numbers, which exaggerate the decline in output. In 
the pre-reform period farms had an incentive to overstate their 
production in order to look better with respect to output 
performance, while in the transition period farms have an 
incentive to understate production, in order to avoid taxes and 
buttress their argument that they need more state support. 
Also, the difficulty of measuring output by private and 
household producers adds to the undercounting of transition 
production. Yet, even if not wholly accurate, the official 
numbers clearly show a large decline in output. The downsizing 
of the sector has also coincided with a major drop in 
consumption of livestock products (Table 2).
    Table 1 shows that the drop in agricultural production has 
been part of an economywide decline in output. Given that 
Soviet planners favored production of capital goods over 
consumer products, one should not be surprised that the 
elimination of central planning strongly hit industrial 
production (especially heavy industry such as metallurgy and 
chemicals). However, since foodstuffs are the most fundamental 
of consumer purchases, a major decline in agricultural 
production might seem counterintuitive. Yet, the main reason 
agricultural output has fallen in Russia during the transition 
period is the same as why industrial output and gross domestic 
product (GDP) have declined--consumers' desires for goods have 
replaced planners' preferences as the dominant force in 
determining what goods are produced, consumed, and traded. As 
with heavy industry, the contraction and commodity 
restructuring of agriculture in Russia has been an inevitable 
part of market reform.

                     TABLE 1.--CHANGES IN PRODUCTION
------------------------------------------------------------------------
                                                              Production
                         Commodity                              index
------------------------------------------------------------------------
 Aggregate:
     Total agriculture.....................................           60
        Total crops........................................           69
        Total livestock products...........................           52
    Total industry.........................................           50
    Gross domestic product (GDP)...........................           61
Crops:
    Grain..................................................           61
    Sunflowerseed..........................................          106
    Sugar beets............................................           40
    Potatoes...............................................           93
    Vegetables.............................................          101
Livestock products:
    Meat...................................................           48
    Milk...................................................           61
    Eggs...................................................           68
Livestock inventories:
    Cattle.................................................           53
    Pigs...................................................           45
    Poultry................................................          56
------------------------------------------------------------------------
Note: The production index gives average annual production (or
  inventories) over 1997-1999 relative to average annual production (or
  inventories) over 1986-1990, with 1986-1990 = 100.
Source: USDA.


    Agricultural production has dropped severely in almost all 
the transition economies of the former Soviet bloc, though 
particularly in the countries of the former U.S.S.R. In most 
transition economies, total agricultural output fell during the 
1990s by 25 to 50 percent. The ensuing explanation for the 
sector's downsizing applies to a fair degree to all these 
countries. To examine the downsizing of Russian agriculture, 
one must first explore certain features of the pre-reform 
Soviet agricultural economy.

           the pre-reform soviet agriculture and food economy

    In the late 1960s the leadership of the Soviet Union 
decided to increase production of livestock goods, a policy the 
East European countries of the Soviet bloc generally followed. 
Consequently, from 1970 to 1990 livestock herds and output in 
these countries grew by 40 to 60 percent. For example, in the 
former U.S.S.R., Poland, and Hungary, meat production in 1990 
was higher than in 1970 by 63, 43, and 57 percent (Economic 
Research Service (ERS) databases). The rise in feed 
requirements caused by the growing herds stimulated the crop 
sector. In the late 1980s the average annual output of feed 
grain in the former U.S.S.R. was up by about half compared to 
the late 1960s. The feed requirements of the former U.S.S.R. 
were so great that the country also became a substantial 
importer of grain, soybeans, and soybean meal, much from the 
United States (Table 3).

                            TABLE 2.--PER CAPITA CONSUMPTION OF FOODSTUFFS BY COUNTRY
                                                 [In kilograms]
----------------------------------------------------------------------------------------------------------------
                                                                                                   Great
              Foodstuff               Poland  Hungary  Romania  Russia  Ukraine  U.S.A.  Germany  Britain  Japan
----------------------------------------------------------------------------------------------------------------
1990:
  Meat..............................     73     101        74       75       68    113       96      72      38
  Milk (excluding butter)...........    230     178        99   \1\ 18  \1\ 184    256      224     227      65
  Cereals...........................    145     148       173        4  \1\ 164    109       94      93     133
  Potatoes..........................    144      58        59   \1\ 16      131     55       81     105      25
                                                                     4
                                                                   106
1997:
  Meat..............................     66      84        50       48       32    117       83      73      42
  Milk (excluding butter)...........    204     156       179      145      156    254      236     234      68
  Cereals...........................    157     113       205      156      160    116       83      95     118
  Potatoes..........................    136      66        82      125      126     62       79     113      26
----------------------------------------------------------------------------------------------------------------
\1\ Figure for entire U.S.S.R.
Source: United Nations Food and Agriculture Organization.



    TABLE 3.--AGRICULTURAL IMPORTS BY THE FORMER U.S.S.R. AND RUSSIA
                         [In thousands of tons]
------------------------------------------------------------------------
                                          Former U.S.S.R.       Russia
              Commodity              -----------------------------------
                                       1986-1990   1995-1998   1995-1998
------------------------------------------------------------------------
Total imports:
    Grain...........................      35,720       2,150       2,860
    Soybeans and soybean meal \1\...       4,500         850         190
    Meat............................         810       1,970       1,670
Imports from the United States:
    Grain...........................      13,700         660         190
    Soybeans and soybean meal \1\...       1,720         160          20
    Meat............................           2       1,200        990
------------------------------------------------------------------------
\1\ In soybean equivalent.
Note: Figures give average annual values over the period. Imports by the
  former U.S.S.R. in 1995-1998 are from beyond the region, while imports
  by Russia for 1995-1998 are from both beyond and within the former
  U.S.S.R.
Source: USDA.

    By 1990 per capita consumption of livestock products and 
foodstuffs in general in the pre-reform transition economies 
compared favorably to levels in many Organization for Economic 
Cooperation and Development (OECD) nations (Table 2). Since per 
capita GDP in the U.S.S.R. and Eastern Europe was at most only 
half the OECD average, these countries were producing and 
consuming high-cost livestock products at a much higher volume 
than one would expect based on the countries' real income. This 
``achievement'' came at a price, as large state subsidies, to 
both producers and consumers, were necessary to maintain the 
high levels of production and consumption. For example, by 1990 
direct budget subsidies to the agriculture and food economy in 
the U.S.S.R. equaled about 10 percent of GDP, with the bulk 
going to the livestock sector. The subsidies created price 
gaps, whereby the prices paid to producers exceeded those 
charged to consumers. In the late 1980s agricultural producer 
prices in the aggregate exceeded consumer prices by about 75 
percent (Liefert and Swinnen).
    A major feature of the pre-reform Soviet food economy was 
that consumer prices for foodstuffs were set so low that output 
could not satisfy all the demand generated by the prices. In 
the pre-reform period long lines of shoppers and bought-out 
food stores were commonly interpreted in both the Soviet Union 
and the West as signs of major food shortages. However, low 
state-set consumer prices that overly stimulated demand were 
the main cause of these ``market shortages,'' rather than 
inadequate supplies of foodstuffs in volume terms (as the 
inter-country comparison of consumption in Table 2 shows).

                          price liberalization

    The lead policy of economic reform in Russia was price 
liberalization. This involved the corollary policy of reducing 
or eliminating state budget subsidies needed to maintain the 
gaps between prices paid to producers and prices charged to 
consumers. The result was that the market became the dominant 
force in determining prices and the quantities of goods 
produced and sold. The fall in producer prices from ending the 
price gap lowered production.
    Price liberalization had two other more indirect but 
nonetheless significant effects on markets for agricultural 
products. These came from the drop in consumer income and the 
deterioration in the terms of trade for agriculture that 
accompanied the liberalizing of prices. The freeing of prices 
led to high economywide inflation, in the early reform years in 
the hundreds of percent annually. The massive inflation 
substantially reduced consumers' real income, and 
correspondingly purchasing power, as prices economywide rose by 
a greater percent than wages and salaries. By the late 1990s 
real per capita income in Russia was only about half the level 
of 1990 (PlanEcon). The income decline reflects not only the 
drop in pay for workers who kept their jobs, but also the rise 
in unemployment during the transition period.
    The degree to which changes in real income affect the 
market for a specific foodstuff depends on how sensitive demand 
is to income variations (income elasticity of demand). Among 
foodstuffs, demand for livestock products is relatively 
sensitive to changes in income (income elastic). This means 
that declining income particularly hurt the livestock sector. 
The fall in demand cut production further. The downsizing of 
the livestock sector also lowered demand for animal feed (feed 
grains and oilseeds), and thereby upset those markets. Since 
the bulk of grain output in Russia is used as animal feed (as 
in most countries), the contraction of the livestock sector 
largely drove the decrease in grain production, rather than a 
decline in human demand for grain products.
    In fact, for certain foods, such as bread and potatoes, 
demand can rise rather than fall when income decreases 
(inferior goods). Table 2 shows that during the transition, 
consumption of cereals in Russia has remained generally steady 
while potato consumption has increased, suggesting that in 
Russia potatoes might be inferior goods.
    The second way price liberalization affected agricultural 
markets was on the supply side, by raising the real prices for 
agricultural inputs. In the inflation following price 
liberalization, prices for agricultural inputs rose by a much 
greater percentage than prices for agricultural output. This 
increased the real prices producers had to pay for inputs, or 
in other words, worsened producers' terms of trade. In Russia, 
agriculture's terms of trade declined during the 1990s by about 
75 percent. For example, in Russia in 1992, wheat producers on 
average had to sell 0.3 tons of output to purchase one ton of 
nitrogen fertilizer. In 1997 they had to sell 1.4 tons of wheat 
(Russian Federation, 1998). Higher input prices decreased the 
amount of inputs used in production, which reduced output 
further. For example, in Russia from 1990 to 1997, fertilizer 
use per hectare fell 80 percent, from 88 to 16 kilograms 
(Russian Federation, 2000).
    Price liberalization could result in input prices rising 
relative to output prices for two reasons. The first is that in 
the pre-reform period prices for inputs were set lower relative 
to their production cost than were prices for output. When 
prices were then freed, prices for inputs had to rise more than 
prices for output to reach the value of the real cost of 
production. Such price-setting behavior means that in the pre-
reform period producers were subsidized not only through direct 
budget subsidies, but also indirectly through the price system.
    The second possible reason input prices could rise relative 
to output prices involves not just market liberalization but 
also the market structure for suppliers of agricultural inputs. 
In the pre-reform period farms were typically dependent for the 
supply of any particular input on just a few, and perhaps only 
one, large state distributor(s). During the early reform years, 
markets were liberalized and the input distributors privatized 
without the latter being broken up into smaller competing 
units. During the transition period farms have accused the 
large suppliers of using their monopoly-type market power 
inherited from the Soviet period to charge higher prices than 
would be possible if a number of smaller competitive suppliers 
existed, prices that exceed the input producers' costs of 
production.
    Although this problem has probably existed to some degree, 
gauging the degree of the problem is difficult. In Russia, 
local authorities continue to help the large former state and 
collective farms obtain inputs, often at below market prices, 
in return for the farms' willingness to sell them a certain 
amount of output at agreed-upon prices. Since the prices of 
both inputs and output exchanged in these deals often deviate 
from existing market prices, it is difficult to determine 
whether farms are on net gaining or losing from the 
arrangement. Given that Russian regional governments have been 
paternalistic toward their local agriculture, fearing that 
defunct farms would create unemployment and food security 
problems, they have probably not used this relationship much to 
farms' disadvantage.

                          trade liberalization

     The second major reform policy that affected commodity 
restructuring in agriculture was trade liberalization. When 
Russia liberalized trade, domestic producer prices for most 
agricultural goods lay above world market prices (OECD, 1998). 
This was yet another way that the pre-reform system subsidized 
Russian agriculture--setting domestic producer prices above 
world prices. The fall in prices to world levels during the 
transition period further reduced agricultural production.
    The Soviet Union was a major agricultural importer of 
products from outside the Soviet bloc (with most of the imports 
going to Russia). The main imports included feed grain, 
soybeans, and soybean meal, needed to feed the growing 
livestock herds. The reform-driven contraction of the livestock 
sector has severely reduced these imports (Table 3).\5\ Instead 
of importing feed to maintain their expensive livestock herds, 
Russia and the other countries of the former U.S.S.R. are now 
importing meat and other livestock products directly. From the 
second half of the 1980s to the period 1995-1998, average 
annual meat imports by the countries of the former U.S.S.R. 
rose by about 125 percent (Table 3), with Russia taking the 
bulk.\6\
---------------------------------------------------------------------------
    \5\ This point takes issue with the criticism commonly made of the 
Soviet Union that it could not even feed itself. Rather than allaying 
food shortages, the imports of animal feed were used to maintain 
artificially high levels of livestock production and consumption.
    \6\ The reason the data in Table 3 stop at 1998 is that in 1999 and 
2000 the United States and EU gave Russia substantial food aid. The 
official Russian foreign trade data do not distinguish between 
commercial imports and food aid, and separating out the two categories 
of inflows would be overly difficult.
---------------------------------------------------------------------------
    The switch by Russia during transition from being a major 
importer of animal feed to a major importer of meat and other 
livestock products suggests that the country has a comparative 
disadvantage in the production of livestock products relative 
to animal feed; that is, it produces meat and other livestock 
products at a higher cost than it produces animal feed, 
relative to world market prices. Liefert (1994) supports this 
conclusion. He finds that at the end of the Soviet period, the 
U.S.S.R. had a general comparative disadvantage in agricultural 
goods vis-a-vis industry, and within agriculture a comparative 
disadvantage in meat production compared to grain. That 
agricultural trade during the Soviet period appears to have 
been inconsistent with comparative advantage shows the extent 
to which trade was driven by policy rather than economic 
rationality. Liefert (forthcoming) finds that in the late 
1990s, despite the major production and trade adjustments that 
had occurred during almost a decade of transition, Russia 
continued to have a comparative disadvantage in meat production 
vis-a-vis grain.
    In addition to meat, Russia's main agriculture and food 
imports include other high-value products such as fruit, 
processed foods, beverages, and confectionary products, as well 
as the bulk crop sugar (mainly from Ukraine). A negligible 
agricultural exporter, Russia has maintained a large trade 
deficit in agriculture (Table 4).

                                      TABLE 4.--AGRICULTURAL TRADE BALANCE
                                          [In billions of U.S. dollars]
----------------------------------------------------------------------------------------------------------------
                                                       1992    1993    1994     1995     1996     1997     1998
----------------------------------------------------------------------------------------------------------------
 Total trade
    Imports.........................................   $9.62   $5.95   $10.7   $13.18   $11.56   $13.36   $10.27
    Exports.........................................    1.65    1.67    2.78     2.67      3.2     2.48      2.2
    Net imports.....................................    7.97    4.28    7.92    10.51     8.36    10.88     8.07
Trade with the United States
    Imports.........................................    1.13    1.22    0.65     1.03     1.33        2     0.83
    Exports.........................................    0.02    0.02    0.02     0.02     0.04     0.03     0.03
    Net imports.....................................    1.11     1.2    0.63     1.01     1.29     1.97     0.8
----------------------------------------------------------------------------------------------------------------
Source: USDA and OECD.


          fall in output was inevitable part of market reform

    The analysis shows that commodity restructuring in Russia 
has been an inherent part of market liberalizing reforms. Price 
and trade liberalization substantially changed prices and 
incomes--the two main factors on which producers and consumers 
base their decisions to produce, buy, and sell goods. Changes 
in these variables in turn induced major changes in 
agricultural production, consumption, and trade. The decline in 
output, particularly in the livestock sector, was inevitable. 
Price liberalization caused output for a typical good to fall 
for three reasons--elimination of the gap between producer and 
consumer prices, the drop in consumer income, and the rise in 
inputs' real prices, with the last two effects occurring from 
economywide price liberalization. Trade liberalization added a 
fourth reason production could drop, since world prices lay 
below domestic producer prices for most agricultural goods.
    A parallel way of explaining why reform has reduced output 
is by identifying how the pre-reform system directly and 
indirectly subsidized agriculture, and how price and trade 
liberalization caused production to drop by eliminating these 
subsidies. The three main types of subsidies were direct budget 
subsidies from the government (which maintained the gap between 
producer and consumer prices), the domestic price system which 
kept prices for agricultural inputs low relative to producer 
output prices and the real costs of production, and the price 
and trade system which kept domestic producer prices above 
world trade prices.
    That the decline in agricultural output has been a 
necessary consequence of market liberalization means that the 
change in output is an unsuitable indicator of the success of 
agricultural reform. The degree to which output has fallen in 
individual countries is largely a measure of the extent to 
which agriculture in the pre-reform period was subsidized, 
planners' preferences for goods deviated from consumers' 
preferences, and the structure of countries' production and 
foreign trade differed from that based on comparative 
advantage.\7\
---------------------------------------------------------------------------
    \7\ Although examining why industrial output has also fallen during 
the transition period is beyond the scope of this report, the general 
reasons are the same as those given for agriculture. Planners' desires 
for goods dominated over those of consumers, industrial production was 
subsidized (especially in heavy industry), and production and trade 
were not driven by countries' comparative advantage vis-a-vis the world 
market. Thus, industry also was an overexpanded sector of the economy.
---------------------------------------------------------------------------

                   current support and trade policies

    Although the various types of direct and indirect subsidies 
to Russian agriculture steadily diminished during the 1990s, 
state support to agriculture has not been wholly eliminated. 
Relative to agriculture's share in GDP of 7 percent, budget 
subsidies by the federal government are low, comprising less 
than 2 percent of the federal budget, and just a fraction of 1 
percent of GDP. However, as federal subsidies to agriculture 
diminished during the decade, subsidies by regional and local 
governments increased, such that in the aggregate they 
currently exceed total federal budget support. Regional 
governments are concerned about both the local food security 
and employment consequences of falling output and unprofitable 
farms within their jurisdictions. With their growing support to 
agriculture, local governments have gained influence over 
farms. As mentioned earlier, they typically help their farms 
obtain inputs, often at low or subsidized prices, in return for 
the farms' willingness to sell them output at agreed-upon 
prices.
    Farms are also subsidized indirectly by the recurring 
policy of writing off of debt. Farms habitually receive ``soft 
credits,'' either from state or quasi-state lenders, which are 
usually written off. During the 1990s most Russian former state 
and collective farms were unprofitable (currently about 50 
percent are), and yet virtually none have gone bankrupt and 
closed down. That unprofitable farms can keep functioning means 
that their creditors (both input suppliers and lenders) 
indirectly subsidize them by either not calling in debt or 
eventually abolishing it.
    Foreign trade policy in agriculture currently is not overly 
protectionist. Import quotas do not exist, with the exception 
of sugar (directed mainly at Ukraine). Import tariffs for most 
agricultural goods range between 10 and 20 percent, with 30 
percent being the maximum. Some exports are also restricted, in 
particular sunflowerseed. Sunflowerseed exports are taxed, 
mainly to keep domestic output within the country to help 
national processors (crushers) suffering from excess capacity.
    The dismantling of the state monopoly over foreign trade, 
and the array of prices and trade controls that were part of 
the monopoly, has substantially narrowed the gap between world 
and domestic producer prices for agricultural goods. As a 
result, the indirect subsidy to Russian agricultural producers 
during the Soviet period from receiving prices above world 
trade prices has declined significantly.\8\
---------------------------------------------------------------------------
    \8\ For detailed discussion and data concerning support to Russian 
agriculture during the transition period, see OECD 1998.
---------------------------------------------------------------------------
    However, agricultural trade restrictions have been stronger 
at the regional rather than federal level. Regional and local 
governments commonly restrict outflows of agricultural output 
from their jurisdiction. This hinders not only export beyond 
the borders of Russia, but also agricultural trade within the 
country. The most benign-possible reason for the flow 
restrictions is that regional authorities wish to protect their 
own consumers by ensuring that local supplies are adequate. The 
most malign-possible reason is corruption, as officials might 
exploit the regional price differences created by these 
restrictions to earn easy profits. Such controls work to 
segment regional markets from each other, as well as cut 
regional markets off from the world market. Without these 
restrictions Russian agricultural exports probably would not be 
much higher, but imports would be lower. The controls prevent 
regional output from reaching the large cities, such as Moscow 
and St. Petersburg, where domestic output competes with 
imports.
    Russia began its negotiations for accession to the World 
Trade Organization (WTO) in 1994, and could finally gain 
admission within the next few years. The two main areas of 
negotiation concern market access (involving import 
restrictions such as tariffs and quotas) and domestic support. 
Compared to most other countries (whether in the WTO or not), 
the levels of Russia's current tariffs and domestic support to 
agriculture are neither particularly high nor low. Although 
Russia's negotiated terms of entry could reduce these amounts a 
bit, the effect on import volumes might not be substantial, at 
least in the near term. However, WTO accession would bind the 
country to maximum allowable levels of tariffs and domestic 
support, which would prevent Russia from raising the levels in 
the future.
    Accession would also facilitate the development of a 
transparent, rules-based, and predictable trading system, the 
lack of which is probably the biggest current impediment to 
trade. For example, Russia has used arguments concerning health 
and safety to restrict imports of poultry from the United 
States. By binding Russia to the WTO's Agreement on the 
Application of Sanitary and Phytosanitary Measures, accession 
would require that any Russian complaints raised on this issue 
comply with WTO rules and procedures. A potential problem 
concerning WTO rules' enforcement for Russia, though, is the 
proliferation of support and controls by regional and local 
governments (such as the bans on outflows). Although these 
measures might conflict with WTO rules and commitments (just as 
they often violate Russian federal law), enforcing WTO 
disciplines at such decentralized levels of government could be 
difficult.\9\
---------------------------------------------------------------------------
    \9\ For further discussion of Russia's WTO accession involving 
agriculture, see Liefert (1997).
---------------------------------------------------------------------------

                   effects on u.s. agricultural trade

    The Soviet Union was a major market for U.S. grain, 
soybeans, and soybean meal (Table 3). The reform-driven changes 
in agricultural production and trade in Russia and the other 
countries of the former U.S.S.R. have strongly affected U.S. 
agricultural trade. U.S. exports of the above commodities to 
the region have fallen substantially (Table 3). However, the 
United States has moved from exporting almost no meat to the 
region in the pre-reform period to being a major meat exporter. 
The bulk of the exports are poultry, with most going to Russia. 
Since the changes in Russian agricultural trade are being 
driven by the economic fundamentals of comparative advantage, 
rather than any short-run ``disruptions of transition,'' the 
changes in the volume and structure of U.S. agricultural 
exports to Russia and the rest of the former U.S.S.R. region 
are not likely to be reversed in the foreseeable future.
    During the second half of the 1990s, Russia took nearly 
half of all U.S. poultry exports. Poultry accounted for about 
three-fourths of all U.S. agriculture and food exports to 
Russia in value terms, and imported poultry (mainly from the 
United States) provided over half of all poultry consumed in 
Russia. Other U.S. agricultural exports include red meat and 
processed foods. As the United States imports virtually no 
agricultural products from Russia, during the 1990s it ran an 
agricultural trade surplus with the country annually averaging 
about $1 billion (Table 4).
    Russia's financial crisis that hit in August 1998 severely 
cut the country's agricultural imports, seriously hurting U.S. 
exports. One of the main consequences of the crisis was 
depreciation of the ruble vis-a-vis the U.S. dollar and other 
major Western currencies by about 75 percent, as the exchange 
rate quickly fell from about 6 rubles to the dollar to 25 
rubles. In the fourth quarter of 1998, total Russian 
agricultural imports were down by about 80 percent compared to 
the previous year, and by 2000 had recovered to only half the 
pre-crisis level. U.S. agricultural exports (again especially 
poultry) to Russia crashed in late 1998, though have since 
steadily rebounded. By early 2001 U.S. poultry sales to Russia 
were close to pre-crisis levels (230,000 metric tons in the 
first quarter of 2001).
    In 2001 and 2002 U.S. meat exports to Russia might also 
benefit from the outbreak of both mad cow disease (Bovine 
Spongiform Encephalopathy, or BSE) and foot-and-mouth disease 
in the EU. The EU has been Russia's main source of imported 
beef and pork. In early 2001 Russia, along with other countries 
such as the United States and Canada, banned the import of all 
EU meat (though poultry was later allowed). In 1999 and 2001 
Russia also forbade imports of pork from China, because of 
foot-and-mouth disease outbreaks there. Although it is unclear 
how long the meat import embargoes imposed by Russia will last, 
the bans, as well as lingering Russian suspicion concerning 
imported meat from the EU and China, could provide U.S. beef 
and pork producers with at least a short- to medium-term 
opportunity to expand exports.

                 consumption and food security concerns

    The drop in agricultural production during reform has 
coincided with a fall in consumption of livestock products 
(Table 2). In discussing food security in Russia, the Western 
media commonly give the decline in agricultural output and 
consumption as evidence that transition has seriously worsened 
food security. Although transition has created a food security 
problem, the cause of the problem is not the drop in 
agricultural output, nor is it more generally insufficient food 
supplies. As mentioned earlier, before reform, Russia had high 
per capita levels of consumption of most foodstuffs, including 
meat and other high-value livestock products, compared with 
even rich OECD nations. The best evidence of the adequate 
availability of foodstuffs during transition is that, even with 
food supplies and consumption being relatively high in the pre-
reform period, consumption of staple foods such as cereals and 
potatoes has remained steady or even risen (Table 2). 
Consumption of high-value livestock products has fallen during 
transition. As mentioned before, however, per capita GDP in 
Russia and the rest of the U.S.S.R. before reform was at most 
only half the OECD average. Consumption of ``luxury'' livestock 
products has therefore declined during transition to levels 
more consistent with the country's real income.
    Reform has threatened food security in Russia not because 
of inadequate overall supplies of foodstuffs, but because of 
problems involving access to food for segments of the 
population and certain regions within the country. The 
inflation and rising unemployment of the transition period 
increased poverty, such that food became less affordable to a 
growing share of the population. The groups most vulnerable to 
poverty are those dependent on the state welfare system for 
their income (such as pensioners), which has declined in real 
terms because of inflation, and workers who have lost their 
jobs or suffered a decline in their real wages, largely because 
they are (were) employed by industries producing goods for 
which demand has dropped during reform. Reports suggest that as 
much as 30 percent of the Russian population might be living 
below the poverty level.
    In addition, as discussed earlier, agricultural surplus-
producing regions commonly restrict the outflow of foodstuffs. 
Whether the authorities' motive is to protect their consumers 
by strengthening local supplies or to benefit corruptly from 
the price arbitrage opportunities created by the restrictions, 
the controls can prevent food-deficit regions from obtaining 
needed supplies.
    In 1999-2000, Russia received substantial food aid from the 
United States and EU. U.S. aid for the 2 years totaled over 3 
million metric tons (mmt) of commodities worth about $1.1 
billion, while the EU gave 1.8 mmt, worth almost $0.5 billion. 
Most of the U.S. and EU aid was targeted to food deficit 
regions, while some of the U.S. aid was distributed by private 
voluntary organizations to the poor and elderly.\10\
---------------------------------------------------------------------------
    \10\ One of the motivating factors in the large aid to Russia was 
worry about the effects on food availability of Russia's economic 
crisis of 1998. As discussed earlier in the report, the crisis 
substantially depreciated the Russian ruble vis-a-vis Western 
currencies. By raising the price of imported foodstuffs, the 
depreciation cut food imports in half. It has been a commonly held 
belief during the transition that Russia imports over half of its food. 
If true, the large drop in imports following ruble depreciation could 
by itself threaten food security. However, the Economic Research 
Service of USDA has calculated that even before Russia's crisis, 
imports accounted for only about a fifth of the country's total food 
consumption. Poultry (mainly from the United States) was the only major 
foodstuff for which imports have been providing over half of domestic 
consumption. Imports do account, though, for over half of the food 
consumed in major cities such as Moscow and St. Petersburg. 
Extrapolating the experience of the big cities to the entire country 
might explain how the misconception developed concerning the importance 
of imports to total national food supplies (see Liefert and Liefert, 
1999).
---------------------------------------------------------------------------
    These distribution policies reflect the wisdom of targeting 
food aid to needy social groups and regions. Such distribution 
will not only have the strongest possible humanitarian effect, 
but also limit any potential harm to agricultural producers. 
Funneling food aid to the poor who have reduced purchasing 
power and to food deficit regions where food prices are high 
will minimize the injury that food aid can cause agricultural 
producers by depressing prices.
    The reform-driven drop in agricultural production and 
consumption in Russia is part of the economywide reallocation 
of resources away from producing and consuming goods favored by 
planners and the political elite to goods favored by consumers. 
It might seem surprising to describe foodstuffs as goods more 
favored by planners than consumers. Yet, as previously 
discussed, the high levels of agricultural production and 
consumption of foodstuffs during the pre-reform period required 
large direct and indirect subsidies to both producers and 
consumers. Once market liberalization and the decline in 
subsidies resulted in foodstuffs reflecting the full cost of 
their production, consumers switched from buying high value 
livestock products to other goods and services. Reform has in 
fact created entirely new goods, and in particular services, 
which consumers were starved of under the old regime and to 
which demand has turned during reform. Some of the worry in 
both Russia and the West about declining food production and 
consumption during reform has been based on the misconception 
that by their very nature, foodstuffs must be more favored by 
consumers than planners, such that the general public must on 
net inevitably suffer if reform reduces consumption.

       Farm Restructuring and Institutional Market Infrastructure

    This paper argued earlier that because the contraction of 
agricultural output has been an inherent part of market reform, 
output is a misleading indicator of reform progress within the 
sector. A more appropriate indicator is growth in productivity, 
that is, farms' ability to produce more output from a given 
amount of inputs. Productivity growth would increase farm 
output and profitability, improve the cost-price 
competitiveness of Russian production vis-a-vis the world 
market (which in the Russian context mainly means competing 
better against imported foodstuffs in the country's large urban 
markets), and save resources that could move out of agriculture 
to produce goods in other sectors of the economy.
    The changes in Russian agriculture that could raise 
productivity must come in the major areas of agricultural 
reform (other than market liberalization) identified at the 
start of the paper--farm restructuring, changes in upstream and 
downstream operations, and development of institutional 
infrastructure. However, progress in these areas to date has 
been disappointing, from the point of view of both the actual 
changes made and improved productivity performance. 
Developments will be examined from the point of view of the 
three main types of agricultural producers during the 
transition period: private farms, household plots, and the 
former state and collective farms.

                             private farms

    At the start of reform many Russian agricultural reformers 
hoped that private farms would be the vanguard of successful 
market-driven reform of agriculture. By 1995 about 280,000 
private farms existed in Russia, comprising 5 percent of all 
farmland, and producing 2 percent of total agricultural output 
(Table 5). The average size of the farms in 1995 was 43 
hectares (106 acres).

                                              TABLE 5.--SHARE IN AGRICULTURAL OUTPUT OF DIFFERENT PRODUCERS
                                                                      [In percent]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                           Private farms                   Household plots \1\         Former state and collective farms
                    Commodity                   --------------------------------------------------------------------------------------------------------
                                                  1995   1996   1997   1998   1999   1995   1996   1997   1998   1999   1995   1996   1997   1998   1999
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total output...................................    1.9    1.9    2.4    2.1    2.5   47.9   49.1   51.1   59.2   57.2   50.2   49.0   46.5   38.7   40.3
Grain..........................................    4.7    4.6    6.2    6.8    7.1    0.9    0.8    0.8    0.9    0.9   94.4   94.6   93.0   92.3   92.0
Sunflowerseed..................................   12.3   11.4   10.8   10.9   12.6    1.4    1.6    1.4    1.5    1.3   86.3   87.0   87.8   87.6   86.1
Sugar beets....................................    3.5    3.3    3.5    4.0    5.4    0.6    0.7    0.8    0.8    0.8   95.9   96.0   95.7   95.2   93.8
Potatoes.......................................    0.9    0.9    1.0    1.0    1.0   89.9   90.2   91.3   91.2   92.0    9.2    8.9    7.7    7.8    7.0
Vegetables.....................................    1.3    1.1    1.5    1.8    2.1   73.4   76.8   76.3   79.6   77.0   25.3   22.1   22.2   18.6   20.9
Meat \2\.......................................    1.5    1.7    1.6    1.6    1.7   48.6   51.6   55.9   56.9   59.4   49.9   46.7   42.5   41.5   38.9
Milk...........................................    1.5    1.5    1.5    1.6    1.7   41.4   45.4   47.2   48.3   49.7   57.1   53.1   51.3   50.1   48.6
Eggs...........................................    0.4    0.4    0.4    0.4    0.4   30.2   31.2   30.4   30.1   29.4   69.4   68.4   69.2   69.5  70.2
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Includes garden plots.
\2\ Liveweight (before slaughter).
Source: Russian State Committee for Statistics.


    Since 1995 private farming has not grown by much, in terms 
of either number of farms or the farms' share in total output 
(though average farm size has increased to 58 hectares). A 
number of serious impediments exist to their growth and 
prosperity. Although these obstacles hurt all types of 
agricultural producers to some degree, they are the most vexing 
for private farms. One impediment is the absence of full 
private ownership rights in agricultural land. A 1993 
Presidential Decree sanctioned private property in farmland. 
This has allowed individual farmers to obtain and use farmland 
for private gain, as well as de facto pass the land on to their 
heirs. Most private farmers acquired their land in two ways. 
The first was the reorganization of former state and collective 
farms in 1993, whereby farm members were given shares of land 
which they could choose to farm individually. The second way 
was purchasing land from the state land reserve, which was 
created at the beginning of reform from land taken from former 
collective farms.
    However, private farmers do not fully own their land, and 
can only sell it back to the state land reserve. Also, 
foreigners cannot purchase farmland. What is most lacking is 
federal legislation passed by the Duma which gives individuals 
full legal title to farmland, which they could sell to others. 
The Yeltsin Administration pushed for legislation that would 
allow full private property in farmland, and it appears that 
some in the Putin Administration also support such a position. 
However, the Duma, in which conservative agrarian interests 
have been strong throughout the transition period, has 
consistently opposed such legislation. In June 2001 a law in 
the Duma passed its first reading (three ``readings'' are 
necessary to become law) that would allow private ownership of 
land. However, the law sidesteps the issue of ownership of 
agricultural land, by stating that agricultural land will be 
handled in future legislation. If no federal legislation is 
passed in the near to medium term that specifically addresses 
the question of farmland, regional (oblast) legislation would 
probably determine the specific conditions of its ownership and 
use. Although some regions have passed liberal legislation 
concerning agricultural land, others have enacted very 
conservative laws that deny private ownership.
    The mass of conflicting federal and regional laws and rules 
concerning farmland has had the collective effect of preventing 
the development of an agricultural land market. One negative 
consequence of the absence of private ownership of farmland and 
a land market is that farmers cannot use their land as 
collateral for debt. Current law in fact prohibits farms from 
mortgaging their land. This makes it virtually impossible for 
them to obtain commercial loans. A second negative effect is 
that without the security of full ownership, farmers have 
reduced incentive to invest in developing their land.
    Other major impediments to the development of private 
farming concern the third and fourth major elements of Russian 
agricultural reform identified at the start of the paper--
upstream and downstream linkages and supporting market 
infrastructure. Upstream and downstream linkages and market 
infrastructure have all been weak during the transition period. 
During the Soviet era farms received inputs directly from the 
state and also gave their output directly to the state 
distribution system. Private farmers, however, must secure 
inputs for themselves and also market their output. The 
commercial channels for doing so were non-existent at the start 
of reform, and grew only slowly during the 1990s.
    Private farmers not only need to establish these key 
linkages, but they also need supporting commercial and public 
institutions and infrastructure that a market-oriented 
agricultural economy requires. They in particular need a 
financial system that allows fast, affordable access to 
capital, a system for quick and inexpensive dissemination of 
market information (where can one buy and sell, and at what 
price?), and a strong system of commercial law that protects 
property and enforces contracts. Infrastructure and services in 
all these areas are weak. Virtually no system of private 
commercial finance exists for agriculture. A recent publication 
on Russia's agro-food economy (Wehrheim et al., 2000) argues 
that undeveloped institutions and infrastructure are the main 
problem facing the sector. The absence of this infrastructure 
increases the risks and transaction costs of doing business.
    Another endemic problem in Russia that raises transaction 
costs is extortion and bribery, a consequence largely of the 
dysfunctional legal system. The problem is particularly serious 
for sellers of agricultural products. The easily identifiable 
and perishable nature of their output makes them vulnerable to 
vandalism by extortionists or corrupt officials who want to 
punish those who thwart them. In addition to poor institutional 
infrastructure, private farmers (like the entire sector) are 
plagued by deficient physical infrastructure. Although storage 
is inadequate, the main weakness is transportation, 
particularly the poor road system.
    Yet another major impediment to the development of private 
farming is resistance by the farmers' parent farms. The 
managers of the former state and collective farms do not 
support, and often actively oppose, having their workers spin 
off private farms. Weak institutional infrastructure and 
upstream and downstream linkages increase private farmers' 
vulnerability vis-a-vis their parent farms, for it makes them 
dependent on the farms for obtaining inputs and marketing their 
output.

                            household plots

    As during the Soviet period, households on the former state 
and collective farms have small plots that they can 
independently cultivate. The plots average no more than half a 
hectare in size (about one acre). Yet, as during the Soviet 
period, they produce a disproportionate share of the country's 
agricultural output. The share has steadily risen during the 
transition period (mainly because output by the former state 
and collective farms has dropped), such that they now account 
for more than half of all production (Table 5). The plots 
produce mainly livestock products, potatoes, and vegetables, 
and virtually no bulk crops, such as grain and oilseeds. The 
households typically consume part of their output themselves 
and sell the rest, usually directly to consumers at local 
farmers' markets. During the reform period there has also been 
growth in output by garden plots tended by the general 
population.
    The household plots' disproportionate share in output 
raises the question of whether they could serve as the 
foundation for developing a market-oriented agricultural system 
based on privately owned household farms. The plots' 
achievement, however, is deceiving. A major reason for their 
``success'' is their strongly symbiotic (parasitic?) 
relationship with their parent farms, through which the 
plotholders obtain inputs (such as animal feed) inexpensively 
or for free. Despite the official statistics which identify the 
share of these plots in total farmland as only 3 percent, the 
plotholders also use some of their parent farms' land for their 
own purposes. The amount of land they actually utilize could be 
as high as 10 to 15 percent of the total (OECD, 2001). If the 
plots were wholly privatized, they would face the same 
challenges as the struggling private farms described earlier, 
in particular the problem of obtaining inputs through 
commercial means.
    The plotholders would face these hurdles with the 
additional handicap of being much smaller than existing private 
farms. Even if the plots increased in area tenfold, they would 
still be very small. Russia could end up with a situation 
similar to Poland, the only country of the Soviet bloc that had 
small peasant-run farms, where farms currently average about 8 
hectares in size (20 acres). The unproductivity of such a 
scenario is shown by the fact that agriculture in Poland 
accounts for only 5 percent of the country's GDP, but has 25 
percent of the labor force. Small plots in Russia would in 
particular suffer from diseconomies of scale in producing bulk 
crops, which require heavy machinery for planting and 
harvesting. Although the productivity of Russia's household 
plots demonstrates the beneficial effect on incentives from 
giving farmers the freedom to farm for their own gain, such a 
system of small non-capitalized plots would be technologically 
and organizationally pre-modern in nature.

                   former state and collective farms

    The dominant agricultural producers in Russia (if not in 
terms of total output, then in institutional structure and 
influence) continue to be the former state and collective 
farms. They hold about 85 percent of all farmland and produce 
about 40 to 45 percent of total agricultural output (Table 
5).\11\ They account for most bulk crop production. In 1993 the 
state and collective farms of the Soviet era were forced 
officially to reorganize. Many became ``joint stock 
companies,'' while others became some sort of cooperative or 
collective association. As joint stock companies, the farms 
issued vouchers to all workers and managers, which gave them a 
claim to a share in the farms' land and other assets. 
Individuals could use these vouchers to obtain land to work as 
private farmers.
---------------------------------------------------------------------------
    \11\ Because the former state and collective farms produce most of 
the country's bulk crops, their output volumes are sensitive to the 
weather. A major reason these farms' share in total agricultural output 
slips in 1998-1999 to only about 40 percent is because poor weather 
caused low harvests, especially of grain. The statement that these 
farms currently account for about 40 to 45 percent of total output 
assumes average weather conditions.
---------------------------------------------------------------------------
    With the collapse of central planning, farm managers were 
given the freedom and responsibility to make their own 
production decisions, obtain inputs, and market their output. 
As a result, their position within the farms strengthened 
considerably. Farm management has been conservative during the 
reform period, such that little real change has occurred 
concerning farm organization, administration, and the system of 
internal work incentives. Farm productivity has increased only 
negligibly, if at all. Lerman et al. (2001) calculate that 
during 1992-1997, total factor productivity in Russian 
agriculture rose only 7 percent (in total over the period, not 
annually). Voigt and Uvarovsky (2001) compute that during 1993-
1998, total factor productivity on the former state and 
collective farms fell 15 percent (in total). Both Sedik et al. 
(1999) and Voigt and Uvarovsky (2001) find that technical 
efficiency on the former state and collective farms, which 
measures the productivity performance of farms relative to the 
most productive farms in the country, has fallen during the 
transition period. This means that farms in general have moved 
further away from, rather than closer to, the best possible 
production practices within the country.
    Because of the unlikelihood that private farming as 
previously described will flourish in the near to medium term, 
the ``reorganized'' former state and collective farms will 
probably continue to dominate agriculture in the foreseeable 
future (say the next 10 years). What are the chances that these 
farms will evolve into more dynamic and productive enterprises?
    The farms face some major handicaps inherited from the 
Soviet period in changing their nature and behavior. One is 
that during the Soviet era farms did not specialize in 
production. Although very large (state farms averaged about 
38,000 acres and collective farms 15,000 acres), they usually 
produced dozens of commodities. If a farm had the capability to 
produce a certain agricultural good, it usually did. Such non-
specialization contrasted sharply with industrial policy during 
the Soviet period, whereby a huge enterprise might be the 
country's sole producer of a major product. The growing 
influence of local government over farms during the reform 
period has reinforced the tendency to diversify rather than 
specialize in production, as local governments worry about food 
security. Greater specialization would reduce farms' production 
costs by allowing them to capture economies of scale.
    Another handicap is the farms' tradition of providing 
social welfare services for their workers, which includes 
health, education, housing, and entertainment. Although the 
quality of these services has declined during the reform 
period, the general obligation remains. According to a farm 
survey, these services increase farms' total costs by 10 to 30 
percent (Uzun, 2001). Yet another handicap is the relationship 
household plotholders have vis-a-vis their parent farms, by 
which the former obtain inputs at the latter's expense. 
According to the same farm survey, this relationship raises 
farms' costs by another 20 percent (Uzun, 2001). Non-
specialization in production, provision of welfare benefits, 
and service as a conduit for free inputs to plotholders all 
impede farms' ability to become market-oriented profit-
maximizing and cost-minimizing producers.
    In addition to reducing the burdens just identified, there 
are two general ways farms could become more efficient and 
productive. The first would simply be to shed existing 
unproductive inputs, especially labor. The relative 
unproductivity of agricultural labor is shown by the fact that 
agriculture currently accounts for about 7 percent of GDP, but 
has 14 percent of the country's total labor force. (In 
comparison, agriculture's share in the labor force in the 
United States is only about 2 percent--which is also primary 
agriculture's share in U.S. GDP--and in the EU 5 percent.) Poor 
labor productivity in Russia keeps production costs high and 
farm wages and income low.
    An advantage of raising productivity by shedding labor is 
that it does not require a change in the existing system or 
technology of agricultural production. The drawback is that it 
requires economic developments outside of agriculture. The rest 
of the economy must grow in order to generate new jobs for 
agricultural workers.\12\ Local governments resist attempts by 
farms to pressure workers to leave, out of fear it will add to 
unemployment. The collapse of the national social welfare 
system during the transition period also discourages workers 
from leaving the farm. Workers are understandably reluctant to 
face the prospects of both unemployment and a social welfare 
system inferior to that they currently enjoy.
---------------------------------------------------------------------------
    \12\ More generally, Lerman (1999, 2000) finds a correlation 
between GDP growth in transition economies and growth in agricultural 
output. GDP growth not only increases the quantity of agricultural 
inputs available to farms, but also helps develop the agricultural 
services and commercial infrastructure that farms need to function and 
reduce operational and transaction costs.
---------------------------------------------------------------------------
    The second way farms could increase productivity would be 
from genuine farm restructuring--that is, a major improvement 
in how farms are managed and internally motivated, which would 
increase the incentives to use resources more productively. 
Throughout the transition period, farm management has opposed 
such major changes, while the agricultural establishment in 
general has defended the existing system.
    Rather than advocating major systemic reform of 
agriculture, managers and agricultural policymakers argue that 
improvement should come in two different ways. The first way is 
by restoring the various types of support that existed during 
the Soviet period, such as direct government subsidies to 
agriculture and high output prices relative to input prices. 
The main complaint of agriculture during the reform period is 
that the deterioration in its terms of trade has made inputs 
unaffordable. The second way is by acquiring superior Western 
technology. Yet, unless major improvements are made in the 
systemic nature of agriculture (effective farm level 
restructuring supported by the necessary institutional 
infrastructure), Russian agriculture might not effectively use 
the superior material technology and therefore fail to raise 
productivity.
    The reason the Russian agricultural establishment has 
resisted major reform is probably some combination of a genuine 
belief that the main problems in agriculture are not systemic 
in nature, and that major systemic changes would threaten their 
power and privileges. This writer is in fact sympathetic to the 
argument that Russian agriculture lacks the mentality necessary 
to implement major reform. The Russian agricultural 
establishment appears to be stunned by the huge contraction of 
the sector, particularly the halving of livestock operations. 
Adding to the shock is the mindset inherited from the Soviet 
period whereby the main goal and performance indicator of 
economic activity was rising output (rather than growing 
productivity or consumer satisfaction).

       new agricultural operators and a new spirit of enterprise?

    There is evidence that some new forms of farm organization 
and ``agricultural operators'' are emerging in the country 
(Rylko, 2001). A feature of these new producers is that they 
are very large (around 36,000 hectares, or 85,000 acres, on 
average), and often are vertically integrated enterprises, 
combining primary production, processing, and distribution. 
Most of these new operations have not evolved from the former 
state and collective farms, but rather have been created by 
entities outside of primary agriculture, such as banks, input 
suppliers, agro-processors, or industrial enterprises. The 
apparent motive for the move into primary agriculture is that 
they think it will profitably complement their existing 
business (such as input supply or processing). Uzun (2001) 
finds that the most successful of the former state and 
collective farms are also very large, the hypothesis (backed by 
some evidence) being that they have lower per unit costs of 
production from economies of scale. Uzun argues that one reason 
these farms are successful is that they specialize in 
production much more than most former state and collective 
farms.
    Nonetheless, the evidence is too new and slight to argue 
that these new operators and large former state and collective 
farms are the wave of the future. Yet, it is telling that the 
most dynamic new types of farm organization in Russia involve 
large and integrated enterprises, rather than smaller family-
type farms.
    Is there any recent evidence that Russian agricultural 
performance in the aggregate is improving, perhaps because of 
the benign influence of these new types of producers? The 
economic crisis of 1998 provided a good test of Russian 
agriculture's ability to respond to opportunities to expand 
output. The extreme depreciation of the ruble following the 
crisis severely cut imports and raised agricultural producer 
prices expressed in domestic currency. A large Russian 
production response would show that market incentives and 
mechanisms were working reasonably well.
    However, it appears that agricultural output has responded 
to this opportunity only mildly. Although total agricultural 
output increased in 1999 and 2000 by 3 and 5 percent, this was 
mainly because weather improved in those years over the 
terrible weather year of 1998 (which produced Russia's lowest 
grain harvest in decades). In 2000 total agricultural 
production was still 4 percent lower than in 1997 (admittedly a 
very good weather year).
    The change in production of livestock products is a better 
indicator of response than the change in crops, given that 
Russia is a larger importer of livestock products compared to 
crops and that livestock output is not so vulnerable to the 
weather. In 1999 livestock production declined 4 percent, while 
aggregate output in 2000 was roughly unchanged. The 2000 
performance in fact represents some progress, since it was the 
first year since reform began that livestock output did not 
fall. Other positive indicators in 2000 were that farm 
profitability improved (the number of unprofitable farms fell 
from 54 percent to 48 percent), and output of agricultural 
inputs rose (Serova, 2001).
    All this evidence supports the conclusion that the isolated 
effect of major ruble depreciation on agricultural output has 
been positive, though not robust. Some Russian agricultural 
specialists believe more generally that in the last couple 
years an improvement has occurred in the attitude and behavior 
of agricultural enterprises (farms and processors). Enterprises 
better understand and accept the challenges (and opportunities) 
of producing for a market-driven economy, and thereby are 
becoming more concerned about productivity, cost minimization, 
marketing, and the need to be self-financing.\13\ Such opinion 
provides some basis for optimism, though it is unclear how 
prevalent and deep the changed behavior is. In its most recent 
review of Russian agriculture, the OECD (2001) argues that any 
current upturn in the sector might be a response more to short-
run and reversible favorable developments, such as good weather 
and ruble depreciation, rather than to any major improvement in 
business mentality or behavior.
---------------------------------------------------------------------------
    \13\ This information is based mainly on the author's recent 
conversations with agricultural specialists in Russia.
---------------------------------------------------------------------------
    This writer believes that it is still too early to conclude 
that a definite improvement has taken place in the attitude and 
performance of Russian agricultural producers. Although 
productivity growth is needed to make Russian agriculture 
profitable and competitive, the motivation within the sector to 
make the necessary systemic changes to raise productivity still 
appears rather weak. Motivation could be imposed on the sector 
from outside by the state enforcing a genuine ``hard budget 
constraint.'' This would involve ending soft credits and 
requiring farms punctually to pay all debts, that is, to become 
genuinely self-financing. However, the agricultural 
establishment and local governments resist this, and no other 
force pushes for it. As a result, although most farms have been 
unprofitable during the 1990s, hardly any have gone bankrupt, 
as they muddle on with de facto subsidies from soft credits. 
Almost all farms continue to function despite a huge sectorwide 
drop in production, and with agriculture still employing almost 
as much labor as in the pre-reform period.

         Could Reform Turn Russia into a Major Grain Exporter?

    When Russia began economic reform in the early 1990s, U.S. 
agricultural interests worried that reform might not only 
eliminate the large U.S. exports of grain and soybeans to the 
country, but also turn Russia into a major grain exporter. 
Using forecasting models, Liefert et al. (1993) and Tyers 
(1994) predicted that if reform succeeded in significantly 
raising agricultural productivity in Russia, the country would 
become a major grain exporter, perhaps up to 20 million tons a 
year.\14\ Johnson (1993) argued that by simply reducing waste 
and thereby raising utilizable output of grain, which is one 
form of productivity growth, Russia could have exportable 
surpluses.
---------------------------------------------------------------------------
    \14\ The forecast by Liefert et al. was for the former U.S.S.R. in 
the aggregate, though it would be unlikely that the region could become 
a major grain exporter if Russia were not exporting.
---------------------------------------------------------------------------
    The reason Russia has not become a grain exporter is that 
the farm level restructuring and creation of supporting 
infrastructure that would raise productivity have not occurred. 
This means that the forecasters were not necessarily wrong in 
their predictions, since their forecasts were based on the 
general premise (fleshed out with specific assumptions) that 
ambitious and effective reform would be pursued.
    However, even if reform succeeded in raising productivity 
in grain production, this might be insufficient to move Russia 
toward grain exports. The forecasting studies just identified 
examined the effect of reform within the agricultural economy 
alone. The studies correctly forecast that the isolated effect 
of productivity growth in grain would be to improve the trade 
balance in the product. Productivity growth would stimulate 
exports by reducing per unit costs of production, thereby 
making domestic output more price competitive vis-a-vis imports 
and the world market--in other words, the productivity growth 
would improve Russia's comparative advantage in the product.
    Assume, though, that reform raises productivity uniformly 
throughout the economy (for all inputs used to produce all 
goods), say by 50 percent. Because of the inverse relationship 
between productivity growth and costs of production, production 
costs for all goods would fall also by a uniform percentage. 
(Under standard assumptions, the per unit costs would drop by 
one-third.) Since comparative advantage depends on relative 
costs and prices, Russia's structure of comparative advantage 
would not change. If Russia were a relatively high cost 
producer of grain before the uniform productivity increase, it 
would remain a relatively high cost producer, because per unit 
costs for all goods would change by the same percentage. This 
means that if Russia were a net importer of grain or any other 
good before the productivity growth, it would be economically 
profitable for the country to continue importing the good.\15\
---------------------------------------------------------------------------
    \15\ Conceptually, productivity growth would shift the domestic 
supply curve for grain to the right, thereby increasing output. 
However, by lowering the production cost of all goods by a uniform 
percentage, the productivity rise should appreciate the country's 
currency (under standard assumptions by an amount equal to the 
productivity growth). The appreciation would lower the good's world 
price expressed in domestic currency. The drop in price would increase 
domestic consumption and reduce domestic production. Thus, the 
country's trade deficit in the good might change little. Liefert (1994) 
examines the relationship between productivity growth and comparative 
advantage, particularly as applied to transition economies.
---------------------------------------------------------------------------
    An example of this general point is that ever since Great 
Britain repealed the Corn Laws in the middle of the 19th 
century which opened the country up to free trade, it has been 
a major importer of agricultural goods. Over the past 150 years 
Britain has had significant productivity growth in agriculture 
in absolute terms. However, because productivity growth has 
occurred throughout the economy, Britain remains a high cost 
producer of agricultural goods relative to other goods it 
produces, and thereby has continued as a large agricultural 
importer.
    If Russia currently does not have a comparative advantage 
in grain, as appears to be the case, it can develop a 
comparative advantage and thereby become a major exporter only 
if productivity growth in grain production exceeds that in most 
other areas of the economy. The southern half of the European 
part of the former U.S.S.R. has highly favorable natural 
conditions for agriculture, particularly grain production--
excellent soil and climate and generally adequate (though 
inconsistent) precipitation. Once that region, which covers 
Ukraine and southern European Russia, adopts world-standard 
production technology, creates reasonably efficient systems of 
farm organization and management, and builds institutional 
infrastructure to service agriculture properly, it will most 
likely have a comparative advantage in production of grain and 
various other crops, such that it should be a major exporter. 
This would be consistent with the region's history of being a 
large grain exporter. However, during the transition period, 
agriculture has been one of the most conservative and anti-
reform sectors in Russia (as well as Ukraine), and there is no 
firm evidence that it will become significantly more 
progressive during the next 10 to 15 years (the new farm 
operators notwithstanding). Thus, during at least this time 
frame, the likelihood that agriculture will outperform the rest 
of the economy in productivity growth to become a major 
exporting sector appears dim.\16\
---------------------------------------------------------------------------
    \16\ Using a forecasting model for Russian agriculture, the 
Economic Research Service of the USDA predicts that during the next 10 
years Russia remains a net grain importer (though of only a couple 
million tons a year). The forecasts are based on assumptions that 
productivity growth in the grain sector, as well as throughout 
agriculture, is slight (ERS, 2001).
---------------------------------------------------------------------------

                               Conclusion

    During the transition period, Russian agricultural output 
has fallen in volume terms by 40 percent. The livestock sector 
has been hit the hardest, with production and animal 
inventories both down by about half. The decline in 
agricultural production, however, has been an inevitable 
consequence of market reform. The main reason for the output 
drop is that consumers' desires for goods have replaced those 
of planners and the political leadership as the dominant force 
in determining what goods are produced and consumed. The 
policies that engineered the switch from planners' to 
consumers' preferences as the driving force of production and 
consumption were price and trade liberalization. These policies 
reduced or eliminated the array of Soviet-era subsidies to 
agriculture that maintained artificially high levels of 
production and consumption. Agriculture was subsidized three 
general ways: (1) through direct budget subsidies from the 
government; (2) through the domestic price system whereby the 
prices farms had to pay for inputs were set low relative to 
output prices and to the real costs of production; and (3) 
through a price support system whereby the prices agricultural 
producers received for their output were kept above world trade 
prices.
    The restructuring of agricultural production and 
consumption has strongly affected U.S. agricultural exports. 
The Soviet Union was a large importer of grain, soybeans, and 
soybean meal, needed to feed growing livestock herds, with the 
United States being a major supplier. The contraction of the 
livestock sector has pretty much ended these imports. In their 
place, Russia has been importing substantial amounts of meat. 
These changes have strongly affected U.S. agriculture, as 
Russia has become the largest foreign market for U.S. poultry. 
Research at the Economic Research Service of the U.S. 
Department of Agriculture (USDA) shows that the switch from 
importing animal feed to maintain a large livestock sector to 
importing meat and other livestock products is consistent with 
Russia's comparative advantage in agriculture--that is, the 
country produces livestock goods at a relatively higher cost 
than it produces animal feed.
    The production decline has been accompanied by a fall in 
consumption of many foodstuffs, particularly livestock products 
such as meat and milk. This has raised concerns about food 
security. Although transition has created a food security 
problem for Russia, the cause of the problem is not the drop in 
agricultural output, nor is it more generally insufficient food 
supplies. Before reform Russia had high per capita levels of 
consumption of most foodstuffs, compared even to rich OECD 
countries. Although consumption of expensive livestock products 
has dropped, consumption of staple foods such as bread and 
potatoes has remained steady or even increased.
    Reform has threatened food security because of problems 
involving access to food. Reform has increased the number of 
poor who lack the purchasing power to sustain adequate diets. 
Also, impediments to the flow of foodstuffs within the country 
have prevented food-deficit regions from obtaining supplies 
from surplus-producing areas.
    That the fall in agricultural production has been a 
necessary part of market reform shows that output is an 
inappropriate indicator of reform progress. Better performance 
indicators for Russian agriculture are productivity growth 
(getting more output from a given amount of inputs) and cost 
reduction. In addition to increasing output, productivity 
growth would make domestic production more price competitive 
vis-a-vis the world market, and free up resources that could be 
used to produce goods in other sectors of the economy (such as 
the fast-growing service sector).
    Productivity growth and cost reduction could be achieved 
two main ways. The first is through effective farm 
restructuring, which involves changing farms' internal systems 
of organization, management, and incentives for workers. The 
second is by reducing transaction costs for farms and 
enterprises by creating the institutional infrastructure that a 
market-oriented agricultural system needs. Necessary 
institutional infrastructure includes systems of rural banking 
and finance, market information, and commercial law that can 
clarify and protect property, enforce contracts, and resolve 
disputes. This infrastructure would also strengthen the 
upstream and downstream linkages that connect agricultural 
producers to their input suppliers and output processors and 
distributors.
    To date, progress in farm restructuring and growth of 
institutional infrastructure has been disappointingly slow. 
Private farming has not taken off, and currently accounts for 
only 2 percent of agricultural output. A major reason is that 
the mass of conflicting laws concerning the use of agricultural 
land does not allow for full private ownership of land, which 
prevents development of an agricultural land market. This hurts 
private farmers' incentives to invest in their land, as well as 
their ability to get loans, since they cannot use land as 
collateral. Russian agricultural producers in general, but in 
particular private farmers, have also suffered from the fact 
that commercial and public institutional infrastructure for 
agriculture remains very undeveloped.
    The household plots maintained by workers on the former 
state and collective farms now produce over half of the 
country's total agricultural output (mainly livestock goods, 
potatoes, and vegetables). A major reason for the plots' 
``success,'' however, is their symbiotic relationship with 
their parent farms, which allows plotholders to obtain inputs 
inexpensively or for free. Without this crutch, the plots would 
face all the challenges of private farms, with the added 
handicap of being only a fraction of their size.
    The former state and collective farms continue to dominate 
the organizational structure of Russian agriculture. Although 
forced in 1993 officially to reorganize, with many becoming 
``joint stock companies'' owned by their workers, the farms 
have done little to change how they internally operate. Farm 
managers and the agricultural establishment generally oppose 
systemic changes in agriculture, probably from some combination 
of a genuine belief that the main problems in Russian 
agriculture are not systemic in nature, and fear that major 
changes would threaten their power and privileges. Most farms 
have been unprofitable throughout the transition period, and 
get by largely from continued soft loans from either state or 
quasi-state lenders that are eventually written off.
    Some new types of producers are appearing in Russian 
agriculture, in particular large vertically-integrated 
enterprises, often created by input suppliers or processors. 
Some Russian agricultural specialists argue that farms and 
processors in general are becoming more reconciled to the 
challenges and opportunities of producing for a market economy, 
and thereby are growing more concerned about productivity, cost 
reduction, and marketing. However, the evidence is still too 
slight to conclude that these new producers, and attitudes, 
represent the future of Russian agriculture, and that they will 
lead to a substantial improvement in agricultural performance. 
If such improvement is not forthcoming, the main consequence 
for U.S. agriculture is that Russia will not become a major 
agricultural exporter, and will likely continue as a big meat 
importer.

                               References

Cochrane, Nancy J., coordinator. Livestock Production in 
        Transition. Economic Research Service, USDA, 
        Agriculture Economic Report (forthcoming).
Economic Research Service (ERS), USDA. Former USSR, 
        International Agriculture and Trade Reports, annual 
        1992-1996.
Economic Research Service, USDA. Newly Independent States and 
        the Baltics, International Agriculture and Trade 
        Reports, May 1997.
Economic Research Service, USDA. Transition Economies, 
        International Agriculture and Trade Reports, May 1998.
Economic Research Service, USDA. USDA Agricultural Baseline 
        Projections to 2010. Staff Report WAOB-2001-1, Feb. 
        2001.
Johnson, D. Gale. ``Trade Effects of Dismantling the Socialized 
        Agriculture of the Former Soviet Union.'' Comparative 
        Economic Studies 35, 4:21-31, Winter 1993.
Lerman, Zvi. ``Land Reform and Farm Restructuring: What Has 
        Been Accomplished to Date.'' American Economic Review 
        89, 2:271-275, May 1999.
Lerman, Zvi. ``From Common Heritage to Divergence: Why the 
        Transition Economies are Drifting Apart by Measures of 
        Agricultural Performance.'' American Journal of 
        Agricultural Economics 82, 5:1140-1148, Nov. 2000.
Lerman, Zvi, Yoav Kislev, Alon Kriss, and David Biton. 
        ``Agricultural Output and Productivity in the Former 
        Soviet Republics.'' Presented at Meeting of the 
        American Agricultural Economics Association, Chicago, 
        ILL, August 2001.
Liefert, William M. ``Economic Reform and Comparative Advantage 
        in Agriculture in the Newly Independent States. 
        American Journal of Agricultural Economics 76, 3:636-
        640, August 1994.
Liefert, William M. ``NIS and Baltic Countries Look to Join the 
        WTO.'' Agricultural Outlook, Economic Research Service, 
        USDA, Nov. 1997, pp. 26-30.
Liefert, William M. ``Comparative (Dis?)Advantage in Russian 
        Agriculture.'' American Journal of Agricultural 
        Economics (forthcoming).
Liefert, William M., Robert B. Koopman, and Edward C. Cook.'' 
        Agricultural Reform in the Former USSR.'' Comparative 
        Economic Studies 35, 4:49-68, Winter 1993.
Liefert,William M., and Olga Liefert. ``Russia's Economic 
        Crisis: Effects on Agriculture.'' Agricultural Outlook, 
        ERS, USDA, June 1999, pp. 15-18.
Liefert, William M., and Johan F.N. Swinnen. Changes in 
        Agricultural Markets in Transition Economies. Economic 
        Research Service, USDA, Agriculture Economic Report 
        (forthcoming).
OECD. Agricultural Policies in Transition Economies: Monitoring 
        and Evaluation, annual 1993-1997 (with slight variation 
        in yearly titles).
OECD. Agricultural Policies in Emerging and Transition 
        Economies, annual 1998-2001.
OECD. Review of Agricultural Policies: Russian Federation, 
        1998.
PlanEcon. Review and Outlook for the Former Soviet Republics, 
        Washington, DC, annual.
Rylko, Dmitri N. ``New Agricultural Operators, Input Markets, 
        and Vertical Sector Coordination.'' Presented at 
        Workshop on Russian Agricultural Input Markets, 
        Golitsino, Russia, July 2001.
Russian Federation, State Committee for Statistics. Rossiiskii 
        Statisticheskii Ezhegodnik (Russian Statistical 
        Yearbook), Moscow, annual.
Sedik, David J., Christian S. Foster, and William M. Liefert. 
        ``Economic Reforms and Agriculture in the Russian 
        Federation, 1992-1995.'' Communist Economies and 
        Economic Transformation 8, 2:133-148, 1996.
Sedik, David J., Michael Trueblood, and Carlos Arnade. 
        ``Corporate Farm Performance in Russia, 1991-1995: An 
        Efficiency Analysis.'' Journal of Comparative Economics 
        27, 3:514-533, Sept. 1999.
Serova, Eugenia. ``Russia: Agri-Food Sector in 2000.'' 
        Presented at OECD Global Forum on Agriculture, Paris, 
        April 2001.
Tyers, Rod. Economic Reform in Europe and the Former Soviet 
        Union: Implications for International Food Markets. 
        Washington, DC: International Food Policy Research 
        Institute, Research Report 99, 1994.
Uzun, V.Y. ``Organizational Types of Agricultural Production in 
        Russia.'' Presented at Workshop on Russian Agricultural 
        Input Markets, Golitsino, Russia, July 2001.
Voigt, Peter, and Vladimir Uvarovsky. ``Developments in 
        Productivity and Efficiency in Russia's Agriculture: 
        The Transition Period.'' Quarterly Journal of 
        International Agriculture 40, 1:45-66, 2001.
Wehrheim, Peter, Klaus Frohberg, Eugenia Serova, and Joachim 
        von Braun, editors. Russia's Agro-food Sector: Towards 
        Truly Functioning Markets. Dordrecht, Netherlands: 
        Kluwer Academic Publishers, 2000.








                 Human Capital and the Social Contract




                RUSSIA'S DEMOGRAPHIC AND HEALTH MELTDOWN



                         By Murray Feshbach \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   283
Introduction.....................................................   284
Demographic Markers..............................................   285
Fertility........................................................   288
Migration........................................................   289
Mortality........................................................   290
HIV/AIDS.........................................................   290
Other Health Status Issues.......................................   297
Some Positive Signs..............................................   299
Selected Environmental Health Issues.............................   301
Foreign Assistance and Unmet Needs...............................   304
                                Summary

    The demographic and health meltdown in Russia during the 
first half of the 21st century is based on trends already 
evident or emerging. The overall population and health decline 
starts with children born to women with poor reproductive 
health, and proceeds to high premature mortality of Russian 
males.
---------------------------------------------------------------------------
    \1\ Dr. Murray Feshbach is currently a Senior Scholar at the 
Woodrow Wilson International Center for Scholars of the Smithsonian 
Institution. He began work in October 2000 on policy implications of 
the population, health and environmental problems in Russia. He retired 
as Research Professor Emeritus from Georgetown University in July 2000. 
During this period he spent much of 1986-1987 as Sovietologist-in-
Residence at NATO headquarters in Brussels, Belgium, working directly 
for Lord Carrington, Secretary-General. Prior to Georgetown University, 
he was Chief of the U.S.S.R. Population, Employment and Research and 
Development Branch, Foreign Demographic Analysis Division, U.S. Bureau 
of Census, until his retirement in 1981 from this organization. He 
joined the Census Bureau in 1957 after several years working on the 
Soviet Economy Project at the National Bureau of Economic Research, in 
New York, during 1955 to 1956.
    This paper is a revised, enlarged and edited version of ``Russian 
Population Meltdown,'' Wilson Quarterly, volume XXV, no. 1, Winter 
2001, pp. 15-21. Also see, Murray Feshbach and Alfred Friendly, Jr., 
Ecocide in the U.S.S.R., Health and Nature Under Siege, New York, Basic 
Books, 1992 and Murray Feshbach, Ecological Disaster, Cleaning up the 
Hidden Legacy of the Soviet Regime, New York, Twentieth Century Books, 
1995.
---------------------------------------------------------------------------
    Human immunodeficiency virus (HIV)/acquired 
immunodeficiency syndrome (AIDS) and its co-infection with 
tuberculosis are now in early but virulent stages. If present 
trends continue, these infections will have an increasingly 
negative effect on life expectancy and overall health of the 
Russian population. Mental retardation of the young adds 
another severely negative factor to future Russian health. 
Accumulative consequences of this demographic and health 
meltdown will be deterrence of an economic revival, reduction 
of military capabilities and dampening of morale of the 
populace. Migration into Russia is not likely to fully offset 
the effects of this demographic and health decline. Only large-
scale Chinese in migration would stem the decline of the 
Russian population.

                              Introduction

    In his first annual presidential address to the Russian 
people on July 8, 2000, President Vladimir Putin listed the 16 
``most acute problems facing our country.'' Number one on the 
list, topping even the country's economic condition and the 
diminishing effectiveness of its political institutions, was 
the declining size of Russia's population. Putin put the matter 
bluntly. The Russian population is shrinking by 750,000 every 
year, and thanks to a large excess of deaths over births, and 
insufficient migration to compensate for the mortality/birth 
ratio, it looks likely to continue dropping for years to come. 
If the trend is not altered, he warned, ``the very survival of 
the nation will be endangered.''
    Unfortunately, even Putin's grim reckoning of the numbers, 
based on official projections made by the State Statistical 
Agency, may understate the dimensions of the calamity 
confronting his country. Its birthrate has reached 
extraordinarily low levels, while the death rate is high and 
rising. The incidence of HIV/AIDS, syphilis, tuberculosis, 
hepatitis C, and other infectious diseases is soaring, even as 
the Russian health care system is vastly underfunded and 
insufficient for the need. Perhaps 40 percent of the nation's 
hospitals and clinics do not have hot water or sewage. Seventy-
five percent or more of pregnant women suffer a serious 
pathology during their pregnancy, such as sepsis, toxemia, or 
anemia.
     Only about 25 percent of Russian children are born 
healthy. At the same time, the infant mortality rate had 
significantly declined, at least according to official 
statistics in the last 5 years, but increased again in 2000. 
The leading Russian pediatrician Aleksandr Baranov estimates 
that only 5 to 10 percent of all Russian children are healthy, 
a much lower proportion than the official figure.
     As if these challenges were not enough, Russia bears the 
burden of decades of environmentally destructive practices that 
have a direct, harmful impact on public health. Their legacy 
includes not just conventional pollution of the air and water 
but serious contamination around many nuclear and chemical 
sites throughout the country. In Dzerzhinsk and Chapayevsk, 2 
of the 160 ``military chemical cities'' that produce chemicals 
for the military-industrial complex, the rate of spontaneous 
abortions or miscarriages is 15 to 34 percent of conceptions--a 
strong indication of chromosomal aberrations induced by the 
local environment. Yet a weakened Russia lacks the means to 
contain ongoing pollution or to begin the monumental task of 
environmental cleanup. The decline in the size of the Russian 
population, and in Russians' general health, vastly increases 
the difficulty of creating the economic wealth upon which such 
a cleanup--and so much else--depends.
    It is not only compassion that should arouse the concern of 
the West. While some may cheer the weakening of this sometimes 
less-than-friendly power, still armed with large numbers of 
nuclear, biological, and chemical weapons, Russia's decline 
raises the twin prospects of political disintegration and 
subsequent consolidation under an authoritarian leader overtly 
hostile to Western interests. The nation's problems, in any 
event, can no longer be thought of as somehow only its own. An 
unclassified U.S. national intelligence estimate warned that 
the global rise of new and re-emergent infectious diseases will 
not only contribute to social and political instability in 
other countries but ``endanger U.S. citizens at home and 
abroad.'' \2\ All new cases of infectious diseases (including 
HIV/AIDS at about 42,000 per year) in the United States have 
nearly doubled, to some 170,000 annually, since 1980. In 
Russia, the numbers of major diseases have increased many 
multiples. For example, new incidence of HIV/AIDS, officially 
recorded as 1,000 new cases in 1995, was over 56,000 by the end 
of 2000; all epidemiologists and commentators in Russia and at 
UNAIDS believe this number is actually 5 to 10 times higher. 
And radioactive contamination from Russia's deteriorating 
weapons stockpiles, its decommissioned (but not unloaded) 
nuclear rods and reactor compartments from submarines, and from 
sunken ships and submarines such as the Lenin nuclear 
icebreaker and the Kursk nuclear submarine, poses a threat of 
unknown dimensions, particularly to the nearby Scandinavian 
countries.
---------------------------------------------------------------------------
    \2\ Issued by the National Intelligence Council, as: Global 
Infectious Disease Threats to the United States, Washington, DC, 2000, 
60 pp.
---------------------------------------------------------------------------

                          Demographic Markers

    The broad outlines of Russia's looming demographic decline 
can be sketched in stark terms. Russians are dying at a 
significantly faster rate than they are being born. Even in 
Germany and Italy, which also record more deaths than births, 
the difference is only about 10 percent. In Russia deaths have 
exceeded births by a multiple of 1.8 to 2.0 since the early 
1990s (Figure 1). In 2000, the number of births in Russia was 
1,259,400, while the number of deaths was 2,217,100--both 
increasing compared to 1999. The net natural increase declined 
more than the previous year because deaths increased even more 
than births.\3\ From the regional point of view, births 
increased in 70 regions, while deaths increased in 78 of the 89 
administrative-territorial units. Nonetheless, deaths still 
exceeded births by 1.8 times in 2000, the same disparity as in 
1999. In the first 4 months of 2001, the population shrank, by 
308,800 persons, to 144,500,000 (including net migration), 
according to Interfax News Agency, on June 22, 2001. If this 
were to continue throughout the year, the net decline in the 
population of Russia, would be over 900,000 persons, a number 
150,000 greater than the one Putin cited in his speech only 1 
year earlier. By age group, the decline during the period 2000 
to 2016 of persons younger than 16 will be over 8 million, from 
29,044,400 to 19,871,600, or by 32 percent; Goskomstat's 
projection for the working age population (16- to 59-year-old 
males and 16- to 54-year-old females, inclusive) will drop by 
6.4 million persons over the first 15 years of the period, from 
86,359,400 to 79,967,900 at the beginning of 2016, or by 7 
percent.
---------------------------------------------------------------------------
    \3\ Goskomstat, online Web site: www.gks.ru, February 2001, under 
the rubric ``Sotsial'no-ekonomicheskoye polozheniye v Rossii.'' Also 
see footnote 4.

---------------------------------------------------------------------------
                FIGURE 1._HOW RUSSIA COMPARES, 1980-1999

[GRAPHIC] [TIFF OMITTED] T6171.027


    As negative as Putin's declaration was, it was based on the 
relatively optimistic projections of the State Statistical 
Agency, Goskomstat. This scenario assumes a small decrease in 
the total fertility rate beginning in 2000, a small increase in 
the mortality rate, and a large decrease in net in-migration. 
But only the latter projection is remotely plausible. However, 
if one expects large numbers of Chinese and/or illegal migrants 
from Afghanistan, China, Kurdistan, Southeast Asia and others 
to contribute to the economy, and settle in as residents, this 
could change markedly. As noted later, one leading migration 
specialist expects a significant number of legal Chinese 
migrants to settle into the east of the country; the political 
and social implications may be very serious; the economic 
consequences could be very positive.\4\
---------------------------------------------------------------------------
    \4\ Predpolozhitel'naya chislennost naseleniya Rossiyskoy 
Federatsii do 2016 goda (Statisticheskiy byulleten), Moscow, 1999, pp. 
113 and 144. All projections from this source use the medium variant. 
This variant incorporates an assumption that total fertility rates in 
Russia will approximate those of western countries over a period of 
time (i.e., be lower than currently), that mortality will decrease in 
the first year of life, and that migration will be small from 
``Russian-speaking diaspora'' in Belorussia, Ukraine, Baltic States and 
Moldavia, and only a slow ``repatriation'' from the remaining CIS 
countries. Ibid., p. 5.
---------------------------------------------------------------------------
    By 2050, I believe, Russia's population will shrink by one-
third. In other words, it will drop from 144.7 million at the 
beginning of 2001 to about 100 million, a blow that even a 
stable, prosperous country would have difficulty sustaining. 
The draft version of the United Nations'  World Population 
Prospects. The 2000 Revision. Highlights, (ESA/P/Wp.165, 28 
February 2001, table 15), projects a drop of 41,233,000 for 
Russia between 2000 and 2050, the largest in absolute terms for 
any country included in the report. Based on the medium variant 
projection this would yield a figure of 104,258,000. The next 
largest decline, in absolute terms, occurs in Ukraine 
(-19,609,000), and then Japan (-17,876,000). Italy and Germany 
are expected to witness declines of 14.5 million and 11.2 
million, respectively, over the same half century. However, in 
relative terms only four countries exceed the relative decline 
(of 28.3 percent) in the Russian Federation--Estonia (46.1 
percent), Bulgaria (43.0 percent), Ukraine (39.6 percent), and 
Georgia (38.8 percent) and Guyana (33.7 percent)--all except 
one, in the eastern European region.\5\ Many western European 
countries also are projected to experience population declines, 
but not nearly as severe as that in Russia. While I believe 
that the assumption of relatively stable or improving 
mortality, and of an improvement in total fertility rate, as 
assumed in the United Nations (UN) projection are not likely I 
understand that any projection of 5 decades is at hazard to 
begin with. But the evidence presented below would seem to 
indicate that a lower variant projection would be more 
realistic in Russia than even the decline projected by the 
medium variant.
---------------------------------------------------------------------------
    \5\ UN Population Projections, Revision 2000, table 15.
---------------------------------------------------------------------------
    My projections, growing from a model developed for West 
Germany by the Population Reference Bureau, are less 
apocalyptic than those of various Russian officials, Duma 
members, and demographers. A new study produced under the 
auspices of the Institute of Social and Political Research of 
the Russian Academy of Sciences, for example, predicts that the 
Russian population will decline to between 70 and 90 million by 
2045. If one takes the annual 750,000 decrease noted by Putin 
and multiplies it by 50 years, the result is a drop in 
population of 37.5 million persons, to a net total of 108 
million--not far from my estimate of 100 million.
    A model used by Dr. Yuri Komarov, former head of the 
Medical and Socio-Economic Information Institute of the Russian 
Ministry of Health, developed a projection of 94 million 
population in 2050. Dr. Nataliya Rimashevskaya, Director of the 
Institute of Socio-Economic Problems of the Population of the 
Russian Academy of Science, projected a population of 55 
million in 2050 (this probably should have been indicated as 
the projected population in the year 2075 as other individual 
Russian demographers have projected). Anatoliy Vishnevskiy and 
Yevgeniy Andreyev (head of the Demographic and Human Ecology 
Center of the Institute of Scientific Forecasting and 
Laboratory Chief at the Center, respectively), published 
another set of projections in the January 2001 issue of Voprosy 
ekonomiki. In the worst case scenario, that is, a continued 
drop in births and increases in deaths, with zero net in-
migration, the result is 86.5 million population in 2050. The 
better case scenario, with a rise in the total fertility rate 
to two children per woman (which is very unlikely, as they also 
indicate) and no change in mortality rates (also very unlikely, 
as noted below) yields only 94.5 million.\6\ The United Nations 
Revision 2000, cited above, projects a high of 113 million in 
2050, 104 million as the medium projection, and 96 million as 
the low variant. (Personal communication from a staff member of 
the UN Population Division.) Thus, a decline of some 45 to 50 
million over the first half of the century is not out of line 
with many other projections.
---------------------------------------------------------------------------
    \6\ Anatoliy Vishnevskiy and Yevgeniy Andreyev, Voprosy ekonomiki, 
January 2000, p. 33.
---------------------------------------------------------------------------
    The U.S. population, meanwhile, is projected by the U.S. 
Bureau of the Census to grow from today's 285 million to 396 
million in 2050, a level almost four times the UN-projected 
Russian population.

        TABLE 1.--NUMBER OF FEMALES, AGES 20-24, 25-29, AND 20-29
------------------------------------------------------------------------
                   Year                       20-24     25-29     Total
------------------------------------------------------------------------
2000 (As of September 1)..................     5,415     5,118    10,533
2003......................................     5,728     5,311    11,040
2006......................................     5,988     5,539    11,527
2010......................................     5,827     5,923    11,750
2013......................................     4,681     6,069    10,751
2016......................................     3,721     5,527     9,247
2019......................................     3,539     4,258     7,797
2022......................................     3,592     3,589     7,181
2025......................................     3,742     3,536     7,279
2029......................................     3,914     3,681     7,595
2032......................................     3,886     3,839     7,725
2035......................................     3,721     3,917     7,638
------------------------------------------------------------------------


    In broad demographic terms, one can say that Russia's 
population is being attacked by two pincers. On one side is the 
fertility rate, which has been falling since the early 1980s. 
Russian women now bear little more than half the number of 
children needed to sustain the population at current levels. In 
absolute terms, the number of annual births has dropped by 
half, to 1.2 million in 2000, since reaching a high of 2.5 
million in 1983. Due to Russia's rising mortality rates, 
fertility would need to reach 2.15 births per woman just to 
reach the simple population replacement level. As of 1999, 
however, the total fertility rate stood at 1.17 births per 
woman (the total fertility rate for 2000 has not yet been 
published (early July 2001), but is likely no higher than 1.20, 
or may even be as low as 1.10). That is to say, Russian women 
bear an average of 1.17 children over their entire fertile 
life, ages 15 to 49. Fertility would need to rise by some two-
thirds to reach the replacement level of 2.1 to 2.15, at 
current mortality levels; that is, over 750,000 additional 
births per year.

                               Fertility

    Some Russian demographers take comfort from the fact that 
their country is not entirely alone, since deaths exceed births 
in a number of European countries. But in countries such as 
Germany and Italy, the net ratio is close to 1.1 deaths to 
every birth. In Russia, deaths exceeded births by 929,600 in 
1999, a ratio of 1.8 to 1. If health trends and environmental 
conditions are not dramatically changed for the better, Russia 
could see two or more deaths for every birth in the not-too-
distant future.
    Goskomstat's projection points to an increase in fertility 
from 1.184 in 1999 up to 1.205 in the year 2000, then a 
continual decline to 1.160 by 2015.\7\ In the UN Revision 2000 
projection, the anticipated total fertility rate is slightly 
higher than Goskomstat's, and will be 1.18 in the period 2010-
2015. It rises to 1.36 in 2020-2025, and only in 2045-2050, 
does it reach to 1.75 children per woman (let alone to 2.1 or 
2.15). Goskomstat's projection likely is based on a hopeful 
extrapolation of trends at the end of the 1990s, but neither it 
nor the UN projection takes fully into account the serious 
deterioration of Russians' reproductive and general health. 
Also working against the hoped-for mitigation of the population 
decline is the harsh reality that the number of women in the 
prime childbearing ages of 20 to 29 is declining and will 
continue to fall sharply, while the rates of sexually 
transmitted diseases among men and women (which affect 
fertility) and gynecological illnesses are both rising. Between 
the year 2000 and 2037, the number of 20- to 29-year-old 
females (the age group in which two-thirds of births take place 
in Russia) will decline from 10,530,000 to 7,431,000. A short 
interval of increase, to a peak of some 11,840,000 from 2000 to 
2009, will be dramatically reversed during most of the rest of 
the first quarter of the century. This reflects the precipitous 
decline in births after 1987. These are persons already born. 
However, the likely outcome is a fall in the total fertility 
rate due to qualitative and quantitative reasons, as explained 
below.
---------------------------------------------------------------------------
    \7\ These and other official demographic projections are from 
Goskomstat RF, Predpolozhitel'naya chislennost naseleniya Rossiyskoy 
Federatsii do 2016 goda (Statisticheskiy byulleten), Moscow, 1999, 132 
pp.
---------------------------------------------------------------------------
    The ranks of eligible parents, especially fathers, are 
being thinned not just by deaths but by illnesses such as 
tuberculosis, HIV/AIDS, alcoholism, drug abuse, and other 
causes, including infertility. Even as disease and mortality 
take more and more young people out of the pool of potential 
parents, attitudes toward childbearing have changed for the 
worse. An estimated two-thirds of all pregnancies now end in 
abortions (excluding spontaneous abortions).
    Moreover, the recorded number of abortions excludes those 
performed in private clinics or illegal facilities, which if 
known would raise the ratio of artificially induced abortions 
to births even higher. Equally important is the frequent 
negative consequences of multiple abortions on the fertility of 
these women; up to 30 percent are reported to become ill or 
infertile.
    According to a study published in late June 2001 under the 
auspices of the Agency for Social Security of Russia, 30 
percent of young females do not wish to have children because 
of the economic hardships they confront. This source also cites 
the declining health of 33 percent of 17-year-old females which 
has led to a decrease in the ability to have children.\8\ 
Fifteen to 20 percent of all Russian families experience 
infertility, with 10 to 15 percent of females infertile, and 
some 5 to 10 percent of males. It is hard to see how the hoped-
for fertility gains will occur. Yet without a doubling or even 
tripling in the total fertility rate of Russian women, and a 
sharp decline in mortality, a steep decline in Russia's 
population seems unavoidable.
---------------------------------------------------------------------------
    \8\ The time period over which the decrease took place is not cited 
in the original source. S. Bazal'chuk, ``Opros. Pir vo vremya chumy,'' 
Moskovskaya Pravda, 29 June 2001, p. 2, from Eastview Press Web site.: 
http://udb.eastview.com. According to an ITAR-TASS News Agency report 
of March 10, 2001, ``every third married couple suffers from [one] form 
[or another] of sterility. Report by Anna Bazhenova. ``Only Every Fifth 
Newborn in Russia is Practically Healthy.'' The latter source is 
somewhat more negative than the other reports.
---------------------------------------------------------------------------

                               Migration

    Legal migration should fall far short of the numbers needed 
to ensure an overall increase in the population. Goskomstat now 
projects a decline in net immigration from 132,000 in 1999 to 
less than half that number in 2015 (at 60,600).\9\ Only massive 
immigration of Chinese could suffice to compensate for the 
trend, and this one would think would be unacceptable to the 
Russian authorities. Nonetheless, while it is likely not to 
occur, one of the leading migration specialists in Russia, 
Zhanna Zayonchkovskaya is cited in an article published in June 
2001, that she expects that ``the Chinese in Russia may become 
the second largest ethnic group after Russians and an 
inalienable component of the Russian labor force.'' \10\ If 
this bold assertion comes to fruition, it will change many 
social and economic parameters very significantly; but then 
Russia may not be Russia as we have known it until now.
---------------------------------------------------------------------------
    \9\ Predpolozhitel'naya chislennost naseleniya Rossiyskoy 
Federatsii do 2016 goda (Statisticheskiy byulleten), Moscow, 1999, 144 
pp.
    \10\ V. Yemelyanenko, ``Chinese Happiness'' Izvestiya, 23 June 
2001, online version. A fascinating new approach toward making this 
migration more viable is the announcement that a marketing network of 
made-in-China commodities will be established beginning in August 2001. 
The network will be set up in 22 Russian cities, with headquarters in 
Vladivostok. Asian Pulse, July 2, 2001 cited in Lexis-Nexis. And how 
many will accompany and/or be permanent staff members for this 
activity? How will the Russian national-patriots react to this putative 
``yellow peril'' about which they have always been paranoid?
---------------------------------------------------------------------------
    She continues:

        ``. . . the effectiveness of the labor market and the 
        country's social stability will depend in the future 
        directly on how well the authorities manage to organize 
        the coexistence with immigrant groups . . . [especially 
        if] 10 to 20 million Chinese will live in the Russian 
        Federation. Only a growth in immigration of this 
        magnitude will compensate sufficiently for the decline 
        in births and the rise in mortality.'' \11\
---------------------------------------------------------------------------
    \11\ Ibid. The German Government also is rethinking its attitude 
toward restrictions on immigration of workers due to impending 
demographic decline in their population.
---------------------------------------------------------------------------

                               Mortality

    Mortality rates are also assumed to rise in the official 
Goskomstat calculation, but much less markedly than I 
anticipate. The Goskomstat projection through 2015, shows a 
crude death rate of 14.3 deaths per 1000 population in 2000 
(exceeded in reality in both 1999 and 2000, with reported rates 
of 14.7 and 15.3 deaths per 1,000 population, respectively) and 
a projection of increases up to ``only'' 15.0 deaths per 1000 
population in 2015, barely above the reported rate in 1999, let 
alone the ``excess'' in 2000 as reported. Some further 
perspective on the Russian situation is provided by a 
comparison with the United States, which projects an average 
life expectancy at birth and survival rates for specific age 
groups that are far from the best in the world--especially 
among American 15- to 19-year-old males, who kill themselves 
with drugs, alcohol, and motorcycles. But in the United States, 
a boy who lives to age 16 has an 88 to 90 percent chance of 
living to age 60. His Russian counterpart has only a 58 to 60 
percent chance. And those chances are shrinking.

                                HIV/AIDS

    Tuberculosis, like HIV/AIDS, also is one of the maladies 
whose surging incidence is not reflected in current Goskomstat 
projections. The disease flourishes among people weakened by 
HIV/AIDS, alcoholism, and poverty. Findings by the research 
institute of the Russian Federal Security Service during the 
1990s projected enormous numbers of deaths from tuberculosis. 
According to the Russian Ministry of Health, the number of 
tuberculosis deaths increased by 12 percent in the 1998-1999 
period. The 1999 death toll from tuberculosis of 29,000 was 
about 15 times the number in the United States, or nearly 30 
times greater when measured as deaths per 100,000 population in 
both countries. The number of new cases increased from 50,640 
in 1990 to 124,044 in 1999. Correspondingly, the number of 
deaths increased slightly more proportionately from 11,571 to 
29,078 (or a case/fatality ratio of 22.8 deaths per 100 new 
cases in 1990 up to 23.4 in 1999).\12\
---------------------------------------------------------------------------
    \12\ Ministerstvo zdravookhraneniya Rossiyskoy Federatsii, 
Zdorov'ye naseleniya Rossii i deyatel'nost uchrezhdeniy 
zdravookhraneniya v 1999 godu, statisticheskiye materialy, Moscow, 
2000, p. 51. See also, http://www.minzdrav-rf.ru/cgi-bin/
show.pl?rubr=19&doc=551.
---------------------------------------------------------------------------
     The Russian Ministry of Health Web site reports that after 
a major shortfall in funding in 1998 (that is, only 58.3 
million rubles, equivalent to $2.1 million at a rate of 28 
rubles per dollar) of the 460.0 million rubles approved in the 
1998 Federal Budget actually was funded; in 1999, however, the 
full amount of 485.8 million rubles was fully allocated. In 
addition, a larger sum was provided for capital investment and 
reconstruction work of anti-tuberculosis facilities. Perhaps 
they feel that this pattern creates sufficient expectations of 
full funding internally to reject the proposed loan of the 
World Bank, for some $100 million for tuberculosis needs ($50 
million for AIDS).
    Many Russian authorities also underestimate the future 
impact of HIV/AIDS, spread chiefly by intravenous drug use and 
sexual contact. Dr. Vadim Pokrovskiy of the Federal Center for 
AIDS Prevention and Treatment, Russia's leading HIV/AIDS 
epidemiologist and the most aggressive messenger of the future 
AIDS-related difficulties facing the Russian Government and 
population, estimates there will be 5 to 10 million deaths in 
the years after 2015 (deaths that, again, I believe from the 
logic of the numbers and discussions in Moscow, are not 
reflected in the population projections). Most of the victims 
will be 20 to 29 years old, and most will be males--further 
diminishing the pool of potential fathers. According to 
information cited on the online Web site of the Canadian AIDS 
Research Project in 1999, it was reported in the Russian press 
that ``most Russian HIV/AIDS patients die within 3 to 5 years 
after infection.'' \13\ Several other key pieces of 
information, and/or projections add to the burden of this 
disease on the Russian population now and in the future. The 
Russian AIDS Center projects that within 5 years, there will be 
up to 5 million HIV positive individual patients. (How many 
will not be patients, and therefore not recorded in this number 
is unknown, but would undoubtedly add significantly to this 
number.)
---------------------------------------------------------------------------
    \13\ It is not clear whether these deaths occur among those whose 
illness has shifted from HIV to AIDS, or all persons starting from HIV. 
Moskovskiy komsomolets, 16 August 1999, p. 4, cited in http://
aidsrussia.org/English/news/99Oct28/99oct28.html.
---------------------------------------------------------------------------
    As a consequence, the first 4 months of 2001 found 27,500 
new cases of HIV\14\ and by the end of the 5th month, according 
to a staff member of the Ministry of Health, Dr. Irina 
Kochkarova, the number of new cases was 63,000 (apparently more 
than doubling from the end of the previous month).\15\ Thus, 
the prediction that
---------------------------------------------------------------------------
    \14\ Anastasiya Kuzina, ``Russia Will be Bankrupted Not by 
Bureaucrats but by AIDS. Each HIV-Infected Person Already Costs the 
Treasury $10,000 per Year,'' Moskovskiy komsomolets, 16 May 2001, p. 2. 
And if the Federal Budget for 2001 allocates 42.96 million rubles 
(which when divided by 28 rubles per dollar equals about $1.5 million 
for 300,000, 700,000 or 1 million HIV/AIDS patients, is sufficient for 
150 patients!
    \15\ Cited in Emily Charnock, ``Health Official Says HIV is 
Soaring; Cases Double in Five Months,'' The Washington Times, 17 June 
2001, p. A8.

        ``in 5 years' time, every 30th inhabitant of Russia 
        will be infected . . . Bearing in mind that HIV 
        primarily affects young people (90 percent of cases are 
        persons aged 15 to 29), every tenth person under the 
        age of 30 will be a carrier of the virus.'' \16\
---------------------------------------------------------------------------
    \16\ Kuzina, loc. cit.

    The Moskovskiy komsomolets report adds that if one looks at 
the increase in sexual transmission (heterosexual and 
homosexual) almost doubling from 6.0 percent of the total 
number of new cases of HIV in 2000, to 10.3 percent in the 
first quarter of 2001, is extremely worrisome. Dr. Kochkarova 
is cited as also asserting that the actual number of HIV-
positive people is five to seven times higher than the official 
figures. And, the article continues, if the sexual transmission 
rate reaches 30 to 40 percent of the new incidence ``and this 
will be a cinch for us,'' the virus will have gone far beyond 
just the infectious drug use (IDU) community.
    The most direct comparison between a reported and asserted 
number is revealed in an article about the etiology, co-factor, 
and prevalence of tuberculosis, injection drug use, and HIV/
AIDS in St. Petersburg. Problemy tuberkuleza provides 
remarkable details and information about these 
interconnections. To the point at hand, specifically, it 
contains a figure of 300,000 HIV-positive individuals who are 
drug abusers.\17\ Simultaneously, the latest officially 
registered number (prevalence) of cases of HIV/AIDS in St. 
Petersburg is 7,582 cases at the end of 2000. In addition, more 
than half of this total (4,712) was recorded during the first 4 
months of 2001.\18\ If the 300,000 figure is to be believed, 
and the trends continue, mortality will be even higher than 
projected by Goskomstat and the UN, unless and until a vaccine 
is found, distributed, and properly administered in time to 
mitigate this impending demographic disaster.
---------------------------------------------------------------------------
    \17\ K.I. Volkova, A.N. Kokosov, and N.A. Brazhenko, ``Tuberkulez v 
period epidemii vich/spida i narkomanii,'' Problemy tuberkuleza, no. 2, 
February 2001, p. 62.
    \18\ In contrast, a figure of 1,011 in all (prevalence) was 
reported for September 1, 2000. Cf. Anna Bazhenova, ``Russia to Have 
Over 1 Million HIV-Infected by Year End,'' ITAR-TASS News Agency, 3 
April 2001 and V.V. Pokrovskiy et al., ``Razvitiye epidemii VICh-
infektsii v Rossii,'' Epidemiologiya i infektsionnaya bolezn, no. 1, 
January-February 2001, p. 14, and ``Chislo VICh-infitsirovannykh 
rastet,'' SPV Vedomosti, 3 May 2001, p. 1. It would appear that the 
figure of 300,000 and these numbers are irreconcilable, even with any 
reasonable multiplier. However, a dissenting view on the numbers of 
HIV-positive persons is expressed by Dr. Nikolay Fedorov, head of the 
Department for Gene Testing of Blood and its Components, of the Central 
Scientific Research Institute of Transfusional Medicine and Medical 
Equipment, of the Russian Academy of Medical and Technical Sciences and 
of the Ministry of Health. He advocates the use of gene testing and not 
just testing for antibodies, which he indicates give many false 
positives. He blames, in part, poor quality reagents and careless 
laboratory personnel. Thus, it is not the testing per se, but the 
mechanics of the test process. See, Andrey Vaganov, ``VICh-infektsiya: 
prigovor ne okonchatel'nyy,'' Nezavisimaya gazeta, July 6, 2001, p. 2. 
The rate of false-positives in the United States perhaps is 3 percent, 
but most are verified or rejected by additional antibody testing and 
the Fedorov proposition apparently is exaggerated. Is this also a form 
of denial of the serious extent of the problem in the Russian 
Federation?
---------------------------------------------------------------------------
    Moscow reported a rate of only 2.5 new cases of HIV 
nationally per 100,000 population in 1998. However, if we apply 
the reported number of new cases of HIV in 2000 (56,471) to the 
total population, the rate increases to 38.8 per 100,000 
population (derived by dividing 56,471 by 1,455--the population 
in 100,000 units, mid-year 2000 estimate). The U.S. HIV 
incidence rate was 16.7 new cases per 100,000 population in 
1998. There are major regional differentials in the rates of 
infection. The Baltic port city of Kaliningrad and its 
surrounding oblast held the unhappy distinction of recording 
the highest official rate of HIV increase, at 76.9 new cases 
per 100,000 in that year. Moscow city and Moscow Oblast, as 
well as Irkutsk Oblast, and several others, however, are 
currently overtaking it.
    The burden of this disease will not fall only on the 
general population or the economy ensuing from treatment costs, 
but also on the armed forces of Russia. According to 
correspondent Anastasiya Kuzina, an internal use only document 
obtained by Moskovskiy Komsomolets, points to the growing 
incidence of HIV/AIDS within the military and rising concern 
among the leadership over this phenomenon.\19\ AIDS (read HIV, 
even though the original cites the later aspect of the illness) 
penetration into the military was classified as secret for 13 
years, until 2000. The report was signed by Dr. P. 
Mel'nichenko, Chief Public Health (Sanitarnaya) Physician of 
the Ministry of Defense, and entitled, ``Internal [Sluzhebnoye] 
Letter on HIV-Infection Morbidity in the World, in the Country 
and in the Armed Forces of the Russian Federation.'' The 
upsurge in Injection Drug Use in the general population has 
been reflected in the draftees into the military forces. Some 
of the infected military draftees reportedly have been 
sentenced under Article 228--the Drug Addiction Article. Still 
others may have joined to avoid their own medical care debt and 
to be cured by the military medical services. ``As in civilian 
life, the number of infected soldiers in our power structures 
[that is, not just the armed forces, per se, but also the KGB/
FSB, the internal security troops, etc.] began to double 
annually [except for 1998 and 2000], and half were registered 
as being ill in the last 2 years alone.'' \20\ The numbers of 
those officially diagnosed with HIV/AIDS in the military are: 
1991--4; 1992--2; 1993--2; 1994--7; 1995--2; 1996--29; 1997--
72; 1998--46; 1999--117; and 2000--110. The total is 391. 
Apparently, however, these numbers apply only to soldiers and 
sailors, not officers and warrant officers. The same source 
gives a total of ``about 550 soldiers and officers.'' Through 
1996, only 13 officers and warrant officers were afflicted with 
HIV, but the number implied here for this category is about 
150. In July 2001, Izvestiya was reporting that the Armed 
forces daily found up to 2 HIV-positive conscriptees, and in 
recent years over 800 persons were infected with the disease. 
Compounding the illness problem for the military are reports of 
illiterate conscripts coming even from the Moscow Oblast (46 in 
all) and the rejection of over 500 drug addicts in one region 
(Samara Oblast) for military service. The former figure implies 
a possible serious increase in illiteracy among 18-year-old 
males. In 1999, only 22 such illiterate persons were drafted 
from all of Russia, not from 1 of the 89 administrative-
territorial units. If the latter continues to expand and 
combine with the impending decline in the numbers of 18-year-
old males (beginning in 2005, 18 years subsequent to the major 
decline in births commencing in 1987), then the pressure on the 
military to reduce its demand for manpower is clear from this 
point of view, let alone from budgetary or national security 
concerns.\21\ Beginning in 2000, three-fourths of new cases 
were diagnosed in Moscow city, Moscow and Irkutsk Oblasts; 
until 1999, 80 percent were found in Kaliningrad Oblast. The 
spread beyond just one oblast must be very worrisome to the 
military.
---------------------------------------------------------------------------
    \19\ Described in ``Politika i ekonomika. VICh-polozhitel'naya 
armiya,'' Moskovskiy komsomolets, 1 March 2001, p. 2.
    \20\ Ibid. Also see Yelena Stroiteleya and Aleksandr Chuykov, 
``Strel'ba na porazheniye. Nasha armiya prodolzhayet voyevat protiv 
sebya, Izvestiya, July 10, 2001, p. 1.
    \21\ ``Russian army received 46 illiterate conscripts from the 
Moscow region [oblast],'' Ekho Moskvy Radio (in Russian), 1100 GMT, 4 
July 2001 (from FBIS CEP20010704000162) and ``Over 500 Drug Addicts 
exempted from military service in Samara Region [Oblast],'' from http:/
/www.militarynewsru/fcl--l/enews.asp?id=64646 (from FBIS, 
CEP20010705000076). Another example of the prevalence of the lack of 
formal education among young males is the report about the situation in 
Kurgan Oblast, Western Siberia, is reported on Russian Public TV (ORT), 
0500 gmt, 16 April 2001, as cited by BBC Monitoring, April 16, 2001, 
that ``Every sixth conscript has only an elementary education of four 
grades. Almost half of those recognized as physically fit for service 
left school after the 7th or 8th year of studies.''
---------------------------------------------------------------------------
    Sexually transmitted diseases have seen incredible rates of 
increase during the past decade. These diseases cripple and 
kill, damage reproductive health, and are associated with the 
spread of HIV/AIDS. The causes can be traced to the explosion 
of pornography and promiscuity; the growth of prostitution, 
notably among 10- to 14-year-old girls; and, especially, drug 
abuse involving shared needles and syringes. In 1997, the 
Ministry of Internal Affairs estimated that the market for 
illegal drugs was around $7 billion, 600 times greater than in 
1991 (assuming little inflation in prices during the period). 
Drug abuse and addiction is getting younger and more 
widespread. According to Dr. Tatyana Dmitriyeva, a former 
Russian Minister of Health, and head of the well-known Serbskiy 
Psychiatric Institute (with a history of political 
involvement), is quoted by Interfax about the devastating 
increase of addiction among young people. Whether she is 
paraphrased or quoted is not clear, but in the report of July 
8, 2001 from Interfax, she is cited as indicating that:

        ``the number of adult drug addicts has increased 8 
        times; over the past 10 years, that of teenage drug 
        addicts has multiplied 18 times. The growth of drug 
        addiction among children under [15] years of age is 
        even more shocking--by 24.3 times . . .''

    Exacerbating even these numbers is her revelation that 
``the percent of children [that is, those of 0 to 14 years of 
age who are drug abusers] has increased from 5 percent in the 
late 1980s to 26 percent in 2000.'' Even Moscow now does not 
have the highest rate of drug addiction, she notes, but Siberia 
at 313.2 addicts per 100,000 population, is distinctly higher 
than even the Far East (at 184.8 per 100,000 population), but 
the Far East is higher than in Moscow, with a figure of 154.3 
per 100,000 population. While one could hope that the reference 
to ``addiction'' is more in the line of ``abuse,'' and not yet 
quite so serious, but even the latter is a foreboding precursor 
for the future health of the population of Russia.
    The Russian Ministry of Health reported 450,000 new cases 
of syphilis in 1997, and Goskomstat published a figure of close 
to 405,000. Even if there is a 10 percent difference in the two 
numbers, these are the last reasonably accurate statistics we 
are likely to have, thanks to a 1998 law that imposes prison 
terms on syphilitics who contract the disease and are drug 
abusers. Presumably, the new law has reduced the number of 
persons willing to seek treatment. Therefore, the numbers of 
persons recorded as having the illness are below the 
``correct'' figures since that date. Just as one would predict, 
the number of registered new cases of syphilis declined in 1998 
and 1999.\22\ However, the explosion in new cases of HIV, and a 
concomitant increase in the estimated number of drug addicts, 
belie the latest figures on syphilis. The ``epidemiological 
synergy'' between HIV/AIDS and other sexually transmitted 
diseases (including gonorrhea, which is vastly under-reported 
in Russia) suggests not only that syphilis is more widespread 
than reported but that further increases in the incidence of 
HIV/AIDS can be expected.
---------------------------------------------------------------------------
    \22\ There were 342,657 new cases recorded in 1998 and 271,699 in 
1999. Zdorov'ye . . ., 2000, p. 55.
---------------------------------------------------------------------------
    The 1998 law that classified drug addicts as criminals 
ensured that few addicts--a group at high risk for HIV--will 
seek treatment. Dr. Oleg Zykov, president of the No to 
Alcoholism and Drug Addiction Foundation, in 1998, warned that 
as a consequence of this law:

        ``We will see an increased risk of complications and 
        overdoses; the death rate among drug addicts will rise; 
        incidence of HIV/AIDS will rise; [and] the illegal 
        market of drug-related services will begin to develop 
        quite intensively.'' \23\
---------------------------------------------------------------------------
    \23\ Cited in Yelena Salina, ``Vchera v Rossii nachali sazhat 
bol'nykh. Narkomafiya kayfuyet!,'' Komsomol'skaya Pravda, 16 April 
1998, p. 1. The Open Society Institute, funded by George Soros, issued 
a report prior to the UN General Assembly Conference on HIV/AIDS held 
in June 2001, stipulating that ``Authoritarian governments in states of 
the former Soviet Union which punish illegal drug users'' are enhancing 
the potential for a marked increase in AIDS. Agence France Presse, 
``Punishing drug users fueling risk of AIDS explosion in former 
U.S.S.R.: report,'' June 23, 2001. From the press coverage of the 
report, this clearly includes Russia. For the United States, see the 
Centers for Disease Control (CDC) report of May 18, 2001 issue of the 
Morbidity and Mortality Weekly Report (vol. 50, no. 19), p. 377.

    All predictions unfortunately are beginning to be reflected 
in the subsequent period. U.S. experience also clearly follows 
this pattern according to the Centers for Disease Control 
(CDC): ``Approximately one third of acquired immunodeficiency 
syndrome cases and one half of new hepatitis C cases are 
associated with injection drug use.''
    The contribution of IDU individuals to the soaring HIV 
rate, as well as those with venereal diseases (and non-IDU 
groups of the population) was documented by Pokrovskiy early in 
2001, covering the years 1994 up to September 1, 2000 (Table 
2).
    While the overall number of persons who were found to be 
HIV-positive among those who were examined--therefore possibly 
leaving out a significant number who were not examined--jumped 
from 161 in 1994 to 39,052 by September 2000. The internal 
distribution shown here encompasses a variety of transmission 
etiologies, with IDU the largest (at 16,646 cases), the 
incarcerated (5,088), those with venereal diseases (1,552), and 
other categories, including adults who are found positive when 
``clinically detected'' (which would seem to mean that the 
illness was asymptomatic and possibly at a late stage of 
development), and an ``other'' category not shown in the 
original source, but which is derived as the residual from the 
other groups and the total. It would appear to be a catch-all 
category for doctors who could not find the direct cause of the 
infection. Nonetheless, it is one-fifth to one-fourth of the 
total number of new cases per year.

                       TABLE 2.--NUMBER OF HIV POSITIVE IN RUSSIA, BY CATEGORY, 1994-2000
----------------------------------------------------------------------------------------------------------------
                      Category                         1994   1995    1996     1997     1998     1999   2000 \1\
----------------------------------------------------------------------------------------------------------------
Drug addicts........................................      0      0      442    1,286      929    6,171    16,646
Persons with venereal disease.......................     27     19       90      201      231      829     1,552
Blood donors........................................      3      6       23       59       69      189       378
Pregnant women......................................      8      8       18       92      122      296       480
Prisoners...........................................      3      5      218      893      800    3,010     5,088
Clinically detected adults..........................     61     59      385      932      799    5,195     5,366
Other...............................................     59     96      385      890    1,085    4,439     9,182
                                                     -----------------------------------------------------------
    Total...........................................    161    193    1,511    4,353    4,035   20,129    39,052
----------------------------------------------------------------------------------------------------------------
\1\ As of September 1, 2000.


    We are also informed of the number examined in each 
category, and the rate of infection per 100,000 of those 
examined. For drug addicts, the rate ranged from an unlikely 
zero in 1994 to 3,315.14 per 100,000 examined by September 
2000. And the latter rate (of 3,315) is more than 20 times 
higher than the rate for all categories examined (at 153.62), 
clearly demonstrating the impact of the IDU scourge, and 
inexorably related to the growth figures given by Dmitriyeva, 
cited above (Table 3).
    Perhaps linked to this risk of complications cited by the 
author is information about the number of pregnant women who 
are simultaneously found to be afflicted with syphilis. The 
number of those ill per 100,000 pregnant women in Moscow Oblast 
increased by 8 times in only a few years. That is, from 92 to 
710 per 100,000 in the 5 year period 1993 to 1997.\24\ The 
number of pregnant women tested ranged from 135,000 in 1993 to 
121,000 in 1997.
---------------------------------------------------------------------------
    \24\ In absolute terms, the number increased from 124 to 860 in the 
5 year period. K.K. Borisenko, L.I. Tichonova and A.M. Renton, 
``Syphilis and other sexually transmitted infections in the Russian 
Federation,'' International Journal of STD & AIDS, no. 10, 1999, p. 
667.
---------------------------------------------------------------------------
    The data on the impact of syphilis by age group demonstrate 
that youth is not a deterrent to the spread of the disease. A 
systematic set of data on notification rates, that is new 
incidence, by selected age group and the total population, by 
sex, in the years 1990 to 1997, demonstrates this clearly 
(Table 4). Females aged 0 to 14 were found to be syphilitic at 
a rate (including congenital syphilis) per 100,000 population 
in this age group at 0.1 in 1990, and at 14 per 100,000 in 
1997. This rate of increase must reflect not only better 
reporting, the increase in pregnant women with this illness, as 
well as child prostitution which bodes ill for reproductive 
health in the future.

                  TABLE 3.--HIV POSITIVE RATE PER 100,000 PERSONS EXAMINED IN RUSSIA, 1994-2000
----------------------------------------------------------------------------------------------------------------
                       Category                        1994  1995    1996     1997     1998     1999    2000 \1\
----------------------------------------------------------------------------------------------------------------
Drug addicts.........................................  0     0      415.19   733.82   413.14  1,723.98  3,315.14
Persons with venereal disease........................  3.05  1.97     6.97    13.59    15.43     47.64     77.82
Blood donors.........................................  0.07  0.15     0.54     1.5      1.83      4.93      8.94
Pregnant women.......................................  0.19  0.24     0.63     3.25     4.99     11.88     18.44
Prisoners............................................  0.58  1.01    43.62   137.35   113.16    361.31    520.49
Clinically detected adults...........................  1.19  1.33     8.53    19.72    16.54     87.61     83.16
Other................................................  0.83  1.7      5.5     13.45    16.36     64.77    111.54
                                                      ----------------------------------------------------------
    Total............................................  0.73  0.98     7.71    21.32    20.07     91.34    153.62
----------------------------------------------------------------------------------------------------------------
\1\ As of September 1, 2000.



   TABLE 4.--NOTIFICATION RATES PER 100,000 POPULATION OF NEW CASES OF
           SYPHILIS BY SEX AND AGE GROUP IN RUSSIA, 1990-1997
------------------------------------------------------------------------
           Category             1990  1991  1993   1994    1995    1997
------------------------------------------------------------------------
All ages:
    Male......................   5.9   7.9  36.3    92.7   188.8   286
    Female....................   4     6.7  31.6    80.3   166.5   266
Ages 0 to 14:
    Male......................   0.1   0.1   0.6     1.4     3       8.6
    Female....................   0.1   0.2   1.1     3.4     6.7    14
Ages 15 to 17:
    Male......................   2.7   4.6  15.2    65.3   129.7   317.1
    Female....................   8.8  14.1  89.4   217.4   436.5   564
------------------------------------------------------------------------

                       Other Health Status Issues

    The health status of the population is not only a function 
of the incidence and prevalence of tuberculosis, HIV/AIDS, and 
syphilis, as discussed above. There are issues of smoking, 
alcoholism, hepatitis B and C, micro-nutrient supply and 
avitaminosis, which are discussed briefly in the following 
materials. Subsequent to this section, materials related to 
environmental health hazards follows.
    More concern over smoking levels in eastern Europe and 
Russia has been expressed by the World Health Organization in 
the past year. Smoking is a habit among an estimated 70 percent 
of Russian males and one-third of females, and multinational 
tobacco companies aim to increase their sales in the country. 
The World Health Organization estimates that some 14 percent of 
all deaths in 1990 in the Soviet Union and eastern Europe were 
traceable to smoking-related illnesses; it expects that number 
to rise to 22 percent by 2020.
    Alcohol consumption reflects an epidemic of alcoholism. 
Russian vodka produced for the domestic market (usually in 
half-liter bottles) comes with a tear-off top rather than a 
replaceable cork or screw top presumably because it's assumed 
that the bottle, once opened, will not be returned to the 
refrigerator. An estimated 20 million Russians--roughly one-
seventh of the population--are referred to as being alcoholics. 
Russia's annual death toll from alcohol poisoning alone may 
have risen to 35,000 in 2000, as compared with 300 in the 
United States in the late 1990s.
     Hepatitis B has sharply increased in incidence, between 
1998 and 1999, increasing from 52,561 new cases to 64,140, in 
the 2 years.\25\ The then sole producer of vaccines for the 
disease told me in Moscow in September 2000, that only 1.3 
million doses are produced annually to meet a total demand of 
13 to 14 million doses; perhaps 4 million are now produced by a 
number of firms and imported, but still far short of demand. 
Perhaps even more alarming in the long run are increases in the 
incidence of hepatitis C, an illness that chiefly attacks the 
liver and requires a very costly, perhaps unaffordable 
treatment protocol, especially when combined with other needs 
for medical services and their attendant costs. The disease is 
often fatal. New incidence in Russia is given as 30,254 in 
2000, up by almost 2,000 cases in the year compared to 1999. 
The comparable hepatitis C figures for the United States are 
2,895 in 2000, down from 3,111 in 1999.\26\
---------------------------------------------------------------------------
    \25\ Zdorov'ye . . ., 2000, p. 49.
    \26\ Zdorov'ye naseleniya i sreda obitaniya, no. 1, January 2001, 
p. 34 and CDC, Morbidity and Mortality Weekly Report, vol. 49, Nos. 51 
and 52, January 5, 2001, p. 1169. The U.S. figure may be some ten times 
too low based on other CDC publications; the Russian figure probably 
also is much higher.
---------------------------------------------------------------------------
    Micro-nutrients are in short supply, especially iodine. No 
iodized salt has been produced in Russia since 1991, and little 
or none has been imported. However, an important contribution 
of supplies of iodized salt and production equipment has been 
made by Kiwanis International through a $900,000 fund earmarked 
for this purpose. The UNICEF office in Moscow, opened in 1997, 
includes solving the Iodine Deficit Deficiency disorder as one 
of its priorities. In young children, iodine deficiency causes 
mental retardation. A World Health Organization cartographic 
presentation provides a set of rates among all countries of the 
world who consume iodized salt shows that in Russia, only 30 
percent of them have iodized salt as part of their diet. Other 
information would seem to contradict such a high 
proportion.\27\ The United Nations Development Program (UNDP) 
regional offices report that ``only 15 percent of the total 
amount of common salt is being iodized'' throughout Central and 
Eastern Europe, the Commonwealth of Independent States, and the 
Baltic States. Thus, in Russia alone, it is very unlikely that 
the 30 percent figure is correct, and all the attendant 
consequences to such a shortfall is clearly another negative 
potential for young persons, in particular.
---------------------------------------------------------------------------
    \27\ See especially, two issues of the Kiwanis International 
magazine Web site, http://www.kiwanis.org/magazine/99may/99may--
russia.html; and http://www.kiwanisinternational. com/magazine/01june/
russia.html; and the Moscow Office of the United Nations Development 
Program (UNDP), http://www.undp.ru/eng/NewsletterSepPage7.htm.
---------------------------------------------------------------------------
    Avitaminosis is common. A longitudinal study by the 
Institute of Nutrition of the Russian Academy of Medical 
Sciences finds shortages of folic acid as well as vitamins A, B 
complex, D, and E among 30 percent of the population. This 
shortage of vitamins can cause an individual's system to be 
unable to resist pathogens, and may contribute to the high 
levels of some diseases. Malnutrition may well have contributed 
to the incredible increase in anemia, especially among pregnant 
women. For all adults, the rate of anemia per 100,000 
population increased from 222.3 in 1993 to 392.8 in 1998. 
Correspondingly, for children ages 0 to 14, inclusive, the 
anemia rate increased by 58 percent, from 926.4 to 1463.0 per 
100,000 children over the same period of time.\28\
---------------------------------------------------------------------------
    \28\ See the section on Nutrition and Health of the Population in 
Ministerstvo zdravookhraneniya Rossiyskoy Federatsii, Sanepidnadzor 
sluzhba, Gosudarstvenny doklad ``O sanitarno-epidemiologicheskoy 
obstanovke v Rossiyskoy Federatsii v 1998 godu,'' Moscow, 1999, pp. 69-
74, especially p. 70.
---------------------------------------------------------------------------
    Heart disease exacts a toll more than twice that in the 
United States and Western Europe. The death rate from heart 
disease per 100,000 population in Russia is 843.8 in the 11 
month period of January-November 2000, up from 810.2 in over 
the same period in 1999. In contrast, there were 267.7 deaths 
per 100,000 population in Belgium, 317.2 in the United Kingdom, 
and 352.3 in the United States. Cancer is becoming more common. 
New cases increased from 191.8 per 100,000 population in 1990 
to 200.7 in 1998, with a death rate of about 205.0 in 1999 and 
206.0 in the first 11 months of 1999 and 2000, respectively 
(the U.S. age adjusted rate for the year 1998 is 204.4). The 
incidence in Russia is likely to rise as a consequence of long-
term exposure to low doses of radiation from decades of nuclear 
testing, as well as to benzo(a)pyrene, dioxin, and other 
industrial carcinogens. As in so many other cases, official 
statistics understate the problem. There is significant under-
reporting of breast cancer, for example, especially among women 
of Muslim origin, who are reluctant to seek treatment from male 
doctors.

                          Some Positive Signs

    None of this is to say that there are not some positive 
aspects in the health provision area in Russia. Three-and-one-
half years after the adoption of a new ``Kontseptsiya of 
Development of Health Care and Medical Research'' in November 
1997, a Draft Resolution on the Progress of this Kontseptsiya 
of the Board of Directors of the Russian Ministry of Health, 
dated 20-21 March 2001, was adopted. The unpublished document 
reviewed the goals for the period 2001-2005 and for the period 
ending in 2010. It is quite frank regarding problems which 
still persist, but it also makes some very reasonable positive 
remarks about progress in the health care field. Better 
financing, more efficient use of these funds, and a reduction 
in the deficit are spelled out. In addition, While they do not 
provide precise numbers on the number of procedures or on their 
success rate, it is impressive that the numbers for the year 
2000 suggest that cardiac operations overall have doubled, 
bypass surgery has increased by 150 percent, hemodialysis by 
100 percent, kidney transplants by 50 percent, and bone marrow 
transplants by 900 percent. While these probably were small in 
number in the base period, it is quite an improvement in the 
availability of medical services. Many new Federal Programs 
such as anti-diabetes mellitus, anti-HIV/AIDS, anti-
tuberculosis and others are being implemented (though other 
information would indicate major shortfalls in their funding to 
date), and new programs scheduled for endorsement in 2001 
include high blood pressure, oncology, and sexually transmitted 
diseases. At least the issues are being confronted, but how 
long it will take to overcome the very significant size of the 
problems is still unclear. Words such as alarming, grave, 
serious threat, and similar descriptors are utilized in the 
review of the status of morbidity levels of various diseases 
and condition. Priority goals for the period ending in 2010 
include:

         ``Reduction of the rate of premature deaths from: 
        Cardiovascular diseases; Accidents, trauma and 
        suicides; [and] Malignant neoplasms; Combating diseases 
        of particular significance in the present demographic 
        circumstances of this century: Diseases threatening the 
        reproductive ability of mothers and neonatal diseases; 
        Diseases of the elderly. Combating diseases that pose a 
        threat to the health of the nation as a whole: 
        Tuberculosis; HIV/AIDS; drug addiction; alcoholism; and 
        sexually transmitted diseases. (p. 8)

    More specification of child health other than ``neonatal 
diseases'' would be helpful in describing these priorities. But 
that they are the priority goals serves to underscore the 
internal depiction of the problems they face.
    The listing of resolutions and decrees needed and 
responsible agencies to implement the Kontseptsiya are quite 
detailed. It can only be hoped that they will be successful in 
these endeavors given the depth of the problem and its 
implications for domestic and foreign policy.\29\
---------------------------------------------------------------------------
    \29\ From an unpublished pdf file found in http://www.google.com, 
entitled: The Ministry of Public Health of the Russian Federation. The 
Board (Collegium) (Draft) Resolution 20-21 March 2001, Progress in 
Implementing the ``Kontseptsiya of Development of Health Care and 
Medical Research,'' Objectives for the period 2001-2005 and for the 
period ending 2010, 27 pp.
---------------------------------------------------------------------------
     Childhood vaccination rates for tuberculosis, diphtheria, 
whooping cough, and other diseases have risen significantly 
since 1995. Vaccination for rubella (German measles), which 
causes birth defects when contracted by pregnant women in the 
first trimester, was added to Russia's prescribed immunization 
calendar, but only in 1999. However, rubella vaccine is not 
produced in Russia, and very little is imported; 597,000 cases 
of rubella were reported in 1999, and only 453,000 in 2000. In 
comparison almost no cases of rubella was found in the United 
States, due to immunization. The comparable figures for rubella 
at all ages and both sexes, in the United States, are 271 and 
152, respectively, in these 2 years.\30\ As noted earlier, 
hepatitis B vaccine is now produced by Russian and jointly 
owned firms with foreign manufacturers, nonetheless it still 
falls far short of needs. Moreover, contributing to the 
shortfall in medications and their supply, is the qualitative 
issue of laboratory standards. No laboratories in Russia meet 
good management practice and good laboratory practice even as 
late as 2000; they will be required to meet good management 
practice standards by 2005. A long time for this to be 
accomplished and expensive, but very necessary to ensure the 
quality of vaccines and medications produced in the country. 
Hospital to hospital contacts from throughout the United States 
and the former Soviet Union have been helpful in improving the 
situation, albeit clearly limited so far. Countries other than 
the United States also have major contacts and provided 
services for health needs.
---------------------------------------------------------------------------
    \30\ Same sources as for footnote 26.
---------------------------------------------------------------------------
    While there are a few encouraging signs, the larger trends 
support the vision of looming demographic catastrophe. And a 
number of other developments also offer dark portents for the 
country's future rates of fertility and mortality, and for the 
general health of its people, especially its children.

                  Selected Environmental Health Issues

    To all the foregoing challenges to the Russian future we 
must add a daunting array of environmental ills. Russia will 
have to cope with a legacy of industrial development undertaken 
virtually without heed of the consequences for human health and 
the environment, just as it will have to contend with the 
consequences of decades of testing and stockpiling of nuclear, 
chemical, and biological weapons.
    The crises that temporarily focus worldwide attention on 
these problems, such as the 1986 Chernobyl nuclear power plant 
accident, only begin to hint at their severity. The news media 
beamed shocking reports of the 1994 Usinsk oil spill around the 
world, but it was only one of 700 major accidents and spills 
(defined as those involving 25,000 barrels of oil or more) that 
occur every year in Russia, spreading phenols, polyaromatic 
hydrocarbons, and a variety of other toxic chemicals. As Victor 
Ivanovich Danilov-Danilyan, the former head of the State 
Committee on Environment, noted about the extent of all of 
these oil spills, that these losses are equivalent to about 25 
Exxon Valdez spills per month!
    Radioactivity remains a continuing concern. After the 1963 
Test Ban Treaty barred open-air atomic weapons testing, the 
nuclear powers continued to conduct underground tests. But 
there was an important difference in the Soviet Union. There, 
many of the nation's more than 100 nuclear explosions occurred 
in densely populated regions such as the Volga, as well as in 
the Urals and the less densely populated Yakutiya (Sakha) 
regions. After first denying that any of those explosions had 
been vented into the atmosphere, then Minister of Atomic 
Industry Viktor Mikhaylov later admitted when in Norway (not in 
Russia) that venting had occurred in 30 percent of the 
underground blasts.
    What the potential for human health hazards within the ten 
formerly secret nuclear cities devoted to the development and 
production of nuclear weapons in Russia remains largely a 
mystery. Around the city of Chelyabinsk, a thousand miles east 
of Moscow in the Urals, some 450,000 Russians face unknown 
risks from a series of spills and accidents that occurred from 
the late 1940s to the 1960s. And area rivers may have been 
tainted by seepage from nuclear waste directly injected deep 
underground at the Krasnoyarsk, Dmitrovgrad, and Tomsk nuclear-
related sites. Near the Tomsk-7 facility, the site of a serious 
nuclear accident in 1993, Russian and American 
environmentalists found evidence of phosphorous-32, a 
radionuclide with a half-life of only about 2 months. The 
discovery strongly suggests that radioactive wastewater used in 
cooling Tomsk-7's two remaining plutonium producing plants was 
illegally dumped. Thus, health hazards emanating from nuclear 
contamination is not only a matter of past practices.
    Chemical pollution is widespread. Even in Moscow, which is 
home to much heavy industry, there is evidence that pollution 
has caused genetic deformities in the young. In a study of the 
impact of chemical, petrochemical, and machine-building 
industries on human health, the Russian Ministry of Health 
found that newborns suffered congenital anomalies at a much 
higher rate (108 to 152 per 10,000 births) in industrial cities 
than in rural localities (39 to 54 per 10,000). Dangerous toxic 
emissions from the mining and metallurgical combine in Norilsk, 
still is reported (in Novaya Izvestiya, 28 April 2001, pp. 1, 
4) as emitting 8,450 kilograms (8.45 tons) of industry-produced 
poisons per capita per year; 98 percent of which is sulfur 
dioxide. Alarming cases of mercury pollution, which causes 
illness and birth defects, have been reported (though aggregate 
official data have never been published). Three years ago, 16 
tons of mercury was released upriver from the major northern 
city of Arkhangel'sk. A plant in Usol'ye-Sibirskoye of Irkutsk 
Oblast, when shutting down, spilled 25 tons of mercury. Due to 
mercury poisoning, mental deficiency and hypoxia was reported 
by Segodnya (on December 3, 1998, p. 7) among the illnesses 
suffered by 100 (sic) percent of newborns in Angara. Mercury 
has accumulated in the systems of area residents, and the 
dilapidated tanks leaked almost all the mercury into the 
ground. Moreover, in the 25 year period the plant had been in 
operation, some 550 tons ``at least'' had penetrated the ground 
near the facility, as well as in the Angara River. Perhaps ``in 
10 years'' it will be safe for the residents of the area. 
Simultaneously, mercury reportedly has affected the population 
of Sayansk city, as well as the Bratsk reservoir.\31\
---------------------------------------------------------------------------
    \31\ See the summary of the Novyye Izvestiya article of December 1, 
1998, p. 2 and of Segodnya of December 3, 1998 p. 7, in The Current 
Digest, vol. 50, no. 48, 1998, p. 17. Also FBIS translated the text of 
the ``Segodnya'' broadcast of November 30, 1998, on NTV, at 1900 gmt. 
The latter source called it the ``biggest environmental disaster of 
recent years.'' From FBIS, ``Siberian Plant Accused of Massive 
Environmental Damage,'' FTS 19981201001018, December 1, 1998.
---------------------------------------------------------------------------
    Another heavy metal, lead, is the underlying factor in a 
widespread pattern of nervous system and psychological 
impairments. Detailed data and information are now available 
from a joint Russian and American effort to determine the 
amount of lead contamination in the country and its human 
health impact, particularly on the young. The results show that 
the load rates far exceed the Russian (and U.S.) PDK (maximally 
allowed considerations). In the survey, it was found that 44 
percent of children in 120 Russian cities ``may have blood lead 
levels (BLL) that exceed the Centers for Disease Control 
standard of 9.9 micrograms per deciliter (mcg/dl) and a total 
of nearly 2.4 million children'' may be affected. But based on 
recent evaluations published in American medical literature 
indicating that a BLL above 5.0 mcg/dl is harmful, then some 
portion of the 2.6 million children with 0-9 mcg/dl detected--
perhaps 1 million, for a total of 3.4 million children are 
affected. If there are some 27 million children under age 15, 
then the 3.4 million total affected by neuropsychological and 
mental deficiency problems, would represent some 12 percent of 
all children. And this is from lead pollution alone.
    The incidence of mental retardation among children (0 to 14 
years of age) ensuing from such levels is noted to be as much 
as 75.7 percent in Krasnoural'sk, a town located in Sverdlovsk 
Oblast in the Middle Urals region, where lead car batteries 
were produced and copper smelting took place. There, the 
average content of lead in the blood of children is 13.1 
 0.5 mcg/dl. If one utilizes a broader definition, 
of complications of the nervous system and impaired 
psychological development, the share increases to 82.5 percent 
of all children 0 to 14 years of age, inclusive, in this city. 
Krasnoural'sk plants emit some 155 to 170 tons of lead per 
year; an unbelievable level, and devastating for the future of 
the city.\32\ Serious attention to this issue has led to a new 
method for producing car batteries, which will at least save 
some youngsters from such health hazards in the future.
---------------------------------------------------------------------------
    \32\ P. 124, in the full report, Doklad . . . cited below. A 
follow-up summary of the activity was published for USAID by MEASURE 
Communication, Lead in the Environment and Public Health in Russia; 
Five Years of American-Russian Collaboration. 1995-1999. (Place and 
date are not given, but likely is Washington, DC, in the year 2000. The 
original summary report in English, was published in Moscow in 1997, 
under the title: White Paper: Lead Contamination of the Environment in 
the Russian Federation and Its Effect on Human Health, Issued by the 
State Committee for Environmental Protection of the Russian Federation, 
48 pp. The Russian-language, full report, also issued by the State 
Committee, is: Doklad o svintsovom zagryaznenii okruzhayushchey sredy 
Rossiyskoy Federatsii i yego vliyaniii na zdorov'ye naseleniya. Moscow, 
1997, 233 pp. 200 copies.)
---------------------------------------------------------------------------
    The most striking information for current purposes of this 
paper is the information from a set of bar charts (without 
precise numbers) on the ``Percentage of children with elevated 
blood lead levels in selected Russian cities.'' From this 
chart, we can determine (roughly) that in Krasnoural'sk, the 
city referred to above, 78 percent of all children had high 
blood lead levels, split between 63 percent of all children (0 
to 14 years of age) who had elevated blood levels over 9.9 to 
14.9 micrograms per deciliter (mcg/dl), and 15 percent who had 
15.0 or more mcg/dl. Belovo was the next worse city with 51 
percent of all children affected, followed by Gus-Khrustalnyy 
with 36 percent, Saratov with 23 percent, Volgograd with 28 
percent, and so forth.\33\
---------------------------------------------------------------------------
    \33\ Lead in the Environment, op. cit., p. 13. Also see the 
unpublished paper by Valerie M. Thomas, Princeton University, and Anna 
O. Orlova, Johns Hopkins School of Hygiene and Public Health, entitled. 
``Soviet and Post-Soviet Environmental Management: Lessons from a case 
study of lead pollution.'' The paper was accepted for publication in 
AMBIO of June 22, 2000.
---------------------------------------------------------------------------
    Using the survey of 43 cities designated as Lead Project 
Sites, it was estimated using this same U.S. Environmental 
Protection Agency (EPA) biokinetic model, that 1.9 million 
children throughout urban Russia were likely to have behavior 
and learning problems because the lead content of their blood 
was between 10 and 19 mcg/dl. Some 400,000 additional children 
had 20 to 44 mcg/dl lead in the blood and needed a medical 
check-up and a subsequent test for lead in their blood, and 
90,000 children with 45 to 69 mcg/dl lead content were in 
immediate need of therapy within 48 hours.\34\ Hopefully 
treatment and other measures were promptly and properly 
undertaken. A number of appropriate steps were initiated, 
including adoption of a national program to decrease lead 
contamination. The 1999 National Environmental Action Plan and 
the 2000 National Environmental Health Action Plan, set a very 
high priority on lead reduction. Leaded gasoline production is 
expected to continue to decrease.\35\ However, the national 
plans may be aborted if the new environmental administration 
sets other priorities. The new environmental administration, 
the Ministry of Natural Resources, which absorbed the functions 
of the State Committee on Environment, now is headed by its 
third Minister in 1 year's time; whether there will be 
continuity in following up on this very serious problem is 
clearly not discernible at this juncture. The main function of 
the new ministry is to develop and exploit the nation's oil and 
gas reserves, and not to protect the environment and human 
health.
---------------------------------------------------------------------------
    \34\ Ibid., p. 12.
    \35\ Ibid., p. 16.
---------------------------------------------------------------------------
    Other heavy metals such as cadmium and arsenic are 
prevalent in the air and land throughout much of Russia. In the 
Arctic north, wind-blown heavy metal salts and other pollutants 
from the city of Norilsk's nonferrous metallurgical plants have 
left the land barren and treeless for 75 kilometers to the 
southeast. Lakes and rivers everywhere are badly polluted by 
heavy metals dumped by industry and allowed to run off 
farmland. Estimates by the Yeltsin-era Ministry of Ecology and 
more recent observers suggest that only 25 to 50 percent of 
Russia's fresh water is potable.

                   Foreign Assistance and Unmet Needs

    The world has not been blind to Russia's plight. By late 
1998, the United States and other donors had sent a total of 
more than $66 billion in aid, according to a U.S. Government 
estimate. The list of donors includes even South Korea, and 
recently officials of the European Union and the World Health 
Organization have recognized the need to act aggressively. But 
the aid has been inadequate and piecemeal, and/or its delivery 
has been hampered by corruption and inept administration. The 
frightening reality is that it may already be too late to help.
    In a pessimistic assessment, perhaps deliberately 
hyperbolic to draw attention to the various problems of the 
economy and society, Andrey Iliaronov, an economic adviser to 
President Putin, has pointed to 2003 as the year of reckoning, 
when the demographic crisis, the crumbling infrastructure, and 
the burden of massive foreign debt may combine to deal a 
crippling blow to Russia's remaining productive capacity--and 
thus, to its ability to help itself.
    Where will the money come from for all the myriad 
improvements needed in reproductive and child health, for 
tuberculosis prevention and treatment, for HIV/AIDS cocktails 
of protease inhibitors? (Especially now that the Putin 
government has rejected a proposed $150 million loan from the 
World Bank for these specific needs.) Who will supply the $200 
billion needed to clean up the water supply over the next 20 
years, or the $79 billion over 10 years for highway transport 
improvement as stipulated by Prime Minister Kasyanov or the $10 
to $12 billion to clean up chemical weapons storage sites, or 
the hundreds of billions of dollars to clean up nuclear waste? 
Yet at the same time, It is reported that Moscow spends $1 
billion per year conducting the war in Chechnya. The list of 
needs is depressingly long, and the Russian Government has not 
always taken the right steps to address them. And yet, despite 
how dismaying the task may seem, and how long the odds of 
success, we cannot simply ignore the ruin in Russia. The United 
States and other nations of the world have a profound interest 
in helping to avert an economic and demographic Chernobyl that 
would give a fearful new meaning to the word meltdown.








                   SOCIAL WELFARE: A SOCIAL CONTRACT


                         By Judyth L. Twigg \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   307
The Collapse of the Safety Net and Its Social Implications.......   308
Inequity and the Search for a Unifying Idea......................   314
The State Response to Social Crisis..............................   318
Sources of Societal Cohesion and Identity........................   321
Conclusion--Looking to the Future................................   324
                                Summary

    A large number of the Russian people have suffered 
significant losses from the dissolution of the social contract 
they enjoyed with the Soviet regime. The sudden withdrawal of a 
meager but comprehensive safety net covering health care, 
pensions, employment, housing, and other services has resulted 
in widespread poverty and disillusion. Health and demographic 
crises, increasing drug and alcohol abuse, and family breakdown 
are both causes and symptoms of unprecedented post-Soviet 
psychological alienation and withdrawal. Thus far, the 
government response to these social crises has been uneven. 
However, a handful of effective societal coping mechanisms, 
including strong interpersonal networks, non-governmental 
``civil society'' institutions, and the re-emergence of a 
significant middle class, provide some cause for optimism.
---------------------------------------------------------------------------
    \1\ Judyth Twigg, Ph.D. in Political Science from MIT, is currently 
Associate Professor of Political Science, Virginia Commonwealth 
University. Segments of earlier versions of this paper were originally 
prepared under the auspices of the Social Cohesion Study of the 
Carnegie Corporation of New York's Russia Initiative (available at 
www.carnegie.org), and for the Carnegie Endowment for International 
Peace, to be included in its forthcoming volume Russia: Ten Years 
After. The author thanks Andrew Kuchins of the Carnegie Endowment and 
Deana Arsenian and David Speedie of the Carnegie Corporation for their 
permission to reprint the work here. Thanks also to John Hardt for 
important comments on previous drafts.
---------------------------------------------------------------------------
    The human costs of the Soviet regime were unquestionably 
and unbearably high. Few would argue for a return to the 
political repression, pervasive economic and bureaucratic 
inefficiency, corruption, and general malaise that plagued late 
Soviet society. From the perspective of the Russian people, 
however, not everything about the Soviet Union was bad. In 
particular, an extensive and universal social safety net was an 
important positive element of Soviet rule. Free education and 
health care, a comprehensive and diverse system of pensions and 
social benefits, job security, and extensively subsidized 
housing, basic foodstuffs, public transportation, child care, 
and vacations all contributed to a meager but reliable floor of 
living standards for the vast majority of the Soviet people. 
Upward social and economic mobility may have been severely 
limited, but there was little reason to worry about slippage 
down the socio-economic ladder.\2\
---------------------------------------------------------------------------
    \2\ See Bertram Silverman and Murray Yanowitch, New Rich, New Poor, 
New Russia: Winners and Losers on the Russian Road to Capitalism 
(Armonk, NY: M.E. Sharpe, 1997), p. 22.
---------------------------------------------------------------------------
    Despite ubiquitous and sarcastic undercurrents about the 
flaws in the safety net and the inadequate labor incentives 
provided by the command economy--``we pretend to work, they 
pretend to pay us'' being the most popular expression of a 
common sentiment--the implied social contract of the Soviet era 
was a critical thread in the fabric of Soviet society. People 
accepted a low standard of living in exchange for economic and 
social security and equity. While economic inequalities did 
indeed exist, in the form of an extensive network of perks and 
privileges for the politically powerful and well-connected, 
they were carefully and mostly successfully hidden. To the 
extent, therefore, that Soviet consumers were aware of and 
craved unavailable luxury or convenience items--or even basic 
essentials of decent quality--there was a sense that the lack 
of consumer goods affected everyone equally. Everyone enjoyed 
the security of a rudimentary but all-encompassing social 
welfare network. On the flip side, living standards were not 
high, and the routine inconveniences borne of material 
shortages were a constant irritant, but these too were a 
universally shared fate.
    This common economic and social circumstance, together with 
a slow but gradual improvement in living standards during the 
late Soviet period, was a critical source of societal cohesion. 
A significant portion of the Soviet Union's national identity 
and political legitimacy derived from its provision of social 
benefits. As long as everyone viewed the state as the guarantor 
of some basic level of material comfort and survival, and to 
the degree that this guarantee extended universally to all 
segments of the population, the Soviet people could ``buy in'' 
to at least some portion of the regime's propaganda about the 
success of the socialist experiment.
    Over the last decade, the stress of market reform has 
ripped apart the Soviet safety net. The jolt of the sudden 
transition to capitalism has left the state unable to maintain 
the bulk of the social benefit package that generations took 
for granted, producing unprecedented poverty, material 
inequities, and socio-economic schisms. As a result, Russian 
society has become unanchored. One of its major sources of 
national identity and cohesiveness--the perception of socialist 
equity--has been fractured. The high expectations engendered by 
the early promises of reform have been devastated by a decade's 
worth of suffering and hardship. The Russian people's well-
documented yearning for order and stability derives at least in 
part from nostalgia for the days when the social contract was 
honored, the safety net was intact, and life for many was not 
consumed by a daily struggle for basic survival.

       The Collapse of the Safety Net and Its Social Implications

    The Russian Government's acceptance of fiscal 
responsibility in the early 1990s forced it to slash social 
spending. Budgets for schools, kindergartens, health 
facilities, sanatoria, day care, and a myriad of other formerly 
state-provided services plummeted. Wage arrears for workers in 
the state sector reached epidemic proportions. At the same 
time, workplace-based social benefits, substantial during the 
Soviet era, were also eroded by the sudden demand for 
enterprises either to become profitable or to go out of 
business. Inflation decimated savings, and wage and benefit 
increases could not keep up with even more rapidly rising 
prices. The state could no longer afford to subsidize a basic 
floor of material living standards for the entire population.
    As a result, a significant percentage of the Russian people 
have sunk into poverty. Anecdotal horror stories surrounding 
this phenomenon abound: the grandmother arrested in Ryazan in 
October 2000 for trying to sell her grandson for $90,000 so 
that his organs could be removed and sold in the West, or 
patients in Omsk with multi-drug-resistant tuberculosis (TB) 
marketing their disease-saturated phlegm to desperate customers 
anxious to infect themselves so that they can buy food with the 
money from a disability pension. But these sensationalist 
accounts should not mask the larger and more important fact 
that 30 to 40 percent of Russians now grind out a living below 
the poverty line, with those estimates varying depending on how 
poverty is defined. Most analysts agree, however, that the 
government's definition of a ``minimum subsistence'' income--
the amount of money required to purchase a basket of basic food 
and other consumer goods, and the figure on which pensions, 
child allowances, and other post-Soviet-era benefits are 
based--is woefully meager. In other words, these poverty 
levels, at monthly incomes of around $30 to $45, or the 
equivalent of less than $1 a day, represent real hardship. One 
analysis in early 2001 showed that the minimum monthly income 
in Novgorod Oblast could barely feed five cats. Bread 
production in Russia continues to increase each year, since it 
remains one of the few affordable staples as the overall 
purchasing capacity of the population dwindles. For the average 
Russian citizen, consumption levels have fallen by half since 
1992, and only one family in six is better off now than it was 
then.\3\
---------------------------------------------------------------------------
    \3\ Michael Slackman, ``Sold for His Organs,'' Newsday, November 5, 
2000; Valery Filonenko, ``A New Method of Obtaining Disability Benefits 
Threatens to Sweep Omsk: Infecting Yourself with Tuberculosis,'' Noviye 
Izvestiya, October 21, 1999, p. 5; ``Poverty Hits Across the Country,'' 
RFE/RL Newsline, Vol. 5, No. 35, Part I, February 20, 2001; ``Russians 
Buy More Bread as Poverty Bites,'' ITAR-TASS, October 5, 2000; Igor 
Semenenko, ``State Debates Poverty As Wealth Gap Grows,'' Moscow Times, 
October 18, 2000; Christopher Williams, ``Economic Reform and Political 
Change in Russia, 1991-1996,'' in Christopher Williams, Vladimir 
Chuprov, and Vladimir Staroverov, eds., Russian Society in Transition 
(Aldershot: Dartmouth Publishing Company, 1996), pp. 11-12.
---------------------------------------------------------------------------
    The root causes of poverty in today's Russia are 
unemployment and low-paying jobs. Although official 
unemployment figures hover around 2 percent, these statistics 
are notoriously difficult to interpret. On the one hand, they 
mask a significant level of underemployment among workers still 
officially categorized as enterprise employees but who actually 
perform little or no work and therefore receive few or no 
wages. These ``unpaid vacations'' may encompass as much as 
another 7 to 8 percent of the work force. On the other hand, 
the official statistics also miss what may be a significantly 
larger phenomenon, the substantial number of people working in 
the shadow economy, with wages paid off the books (largely for 
purposes of tax evasion). But these workers' unreported incomes 
most often involve unskilled labor, poor work conditions, and 
low pay. Both reported and unreported wage rates in Russian 
industrial enterprises and business offices remain frequently 
at levels comparable to developing countries, meaning that 
getting a job is no security against poverty.
    Poverty in today's Russia is also largely a female 
phenomenon. In the late 1990s, nearly 80 percent of Russia's 
unemployed people were women. The vast majority of single 
parents are women, and more than 80 percent of them have no job 
at all. The Russian labor code guarantees that a new mother can 
take a 3 year unpaid leave without losing her job, but 
employers almost never comply, and many employers hesitate to 
hire a woman with small children for fear that she will take 
frequent sick leave. Few single mothers receive child support, 
and the alimony law is rarely enforced. Bureaucratic red tape 
prevents many of the neediest single parents from claiming the 
scanty, untargeted child benefit offered by the state; only 30 
percent of the poorest families claim their monthly child 
stipend.\4\
---------------------------------------------------------------------------
    \4\ Sophie Lambroschini, ``Russia: Report Says Women Bear Brunt of 
Poverty,'' Radio Free Europe/Radio Liberty, September 27, 2000; Anna 
Badkhen and Anna Andreyeva, ``Lack of State Support Hits Single Parents 
Hard,'' Moscow Times, September 7, 2000.
---------------------------------------------------------------------------
    Although Russian culture still prides itself on cherishing 
its children as a precious national asset, the declining 
material and social position of children has been one of the 
most alarming consequences of the post-Soviet transition. The 
single most potent predictor of poverty during the transition 
period has been the birth of an additional child to a family. 
The poverty rate among families rises steadily with the number 
of children, to the point where nearly three-fourths of 
families with four or more children are poor. Thanks to these 
economic trends, well over 1 million children in Russia aged 14 
to 18 have been unable to finish high school in the last 
decade.
    Substandard living conditions are taking their toll on 
children's health, starting at the very beginning of life. 
According to the Russian Academy of Medical Sciences, because 
of an overall decline in the health of the population, poor 
prenatal care, and other factors, only 30 percent of Russian 
births can now be classified as ``normal.'' Leading Russian 
physicians now speak of the ``deceleration,'' or the mental and 
physical deterioration, of children and teenagers. More than 70 
percent of Russian young people aged 10 to 15 suffer from 
chronic diseases, the number of disabled persons in that age 
group is growing at an alarming rate, and the incidence of 
mental disorders among teenagers has increased fourfold in the 
last decade. These statistics are troubling in and of 
themselves, but when put into socio-demographic context--this 
is the post-Soviet generation that is supposed to transform 
Russia into an energized, market democracy--they are genuinely 
alarming.\5\
---------------------------------------------------------------------------
    \5\ ``Only 30 Percent of Russian Births Are `Normal,' '' RFE/RL 
Newsline, Vol. 4, No. 194, Part I, October 6, 2000; Children in the CIS 
Countries: Statistical Handbook (Moscow: Interstate Statistical 
Committee of the Commonwealth of Independent States, 2001), pp. 118-
119; ``Russia Sees Huge Rise in Incidence of Mental Illness,'' 
Interfax, April 5, 2001; ``70 Percent of Russian Youth Said 
Unhealthy,'' RFE/RL Newsline, Vol. 5, No. 61, Part I, March 28, 2001; 
``Russian Health Ministry Points to Deterioration of Russian Teenagers' 
Health,'' Interfax, March 27, 2001.
---------------------------------------------------------------------------
    The most extreme manifestation of these negative trends is 
the problem of abandoned and orphaned children. In the words of 
one orphanage director, ``I can tell how bad things are by the 
way families are starting to ask us to take their children. 
Families in Russia are falling apart.'' Networks of foster care 
and adoption services are still underdeveloped, and therefore 
almost 700,000 children must live in orphanages. Having been 
raised in an institutional environment, the long-term prospects 
for these children are not positive. According to recent 
Russian Government estimates, 40 percent of them will end up in 
prison, and another 30 percent will become alcoholics. Even 
more striking, the country is now home to 1 to 4 million 
homeless children, with that number largely dependent on the 
weather; more kids take to the streets in the summer months, 
and return home when the cold becomes unbearable. This seasonal 
variation hints at the peculiar nature of this ``social 
orphanhood''--more than 90 percent of these street children 
have one or more living parents who have simply lost the 
psychological or material wherewithal to raise their offspring 
(usually due to alcoholism or unemployment). Either they have 
voluntarily abandoned their sons or daughters, or the state has 
stripped them of parental rights.\6\
---------------------------------------------------------------------------
    \6\ UNICEF, ``After the Fall: The Human Impact of Ten Years of 
Transition,'' November 1999; ``Who Cares? A Special Report on Street 
Children,'' The World Bank, Spring 2000; Colin McMahon, ``Russia Slowly 
Faces Growing Problem: Social Breakdown Sentences Children to Life on 
Streets,'' Chicago Tribune, April 1, 2001; David E. Powell and Heidi A. 
Holzfaster, ``As Orphans Multiply and Languish, Russia `Decrees,' '' 
Boston Globe, December 10, 2000; ``Homes From Home: Russian Orphanages 
Boom as Children Founder,'' AFP, April 18, 2001; Masha Gessen, ``Not 
Good Enough, Even for Orphanages: No One Wants Babies of HIV-Positive 
Mothers,'' U.S. News and World Report, April 16, 2001; Viktoria 
Molodtsova, ``Is An Orphan's Lot Always An Unhappy One?'' Rossiiskaya 
Gazeta, March 2, 2000, pp. 1, 4; ``Neglected Children Plagued By 
Alcoholism,'' RFE/RL Newsline, Vol. 4, No. 224, Part I, November 17, 
2000.
---------------------------------------------------------------------------
    The plight of parentless children is but one manifestation 
of the breakdown of the Russian family. Elderly Russians are 
increasingly neglected, becoming known as the new bezprizorniki 
(unsupervised ones) because their adult children are too busy 
with their own lives to attend to the needs of their parents. 
On the whole, however, elders are generally better off than 
children and single parents, since the pension system is one of 
the few elements of the social safety net that has remained a 
political priority. Divorce, while remaining at about the same 
rate as in Soviet times, is increasingly costly for women and 
children. The number of weddings has declined over the last 
decade. More and more children are being born out of wedlock. 
An increasing number of intact families are opting not to have 
children at all, or to have just one child. In the last 10 
years, the number of children in Russia has dropped by over 4 
million, a manifestation of declining birth and fertility 
rates. While some of this drop stems from medical infertility, 
much is due to conscious choice. Low birth rates are a direct 
message from people who have lost faith in their society, and 
who have little confidence that their social and economic 
circumstance is likely to improve. A recent survey of new 
mothers in one Russian region showed that 14 percent had 
reacted with horrified, suicidal feelings upon learning that 
they were pregnant, wondering how they would possibly support a 
new, dependent life. Little wonder that there are two abortions 
for every child born in Russia.\7\
---------------------------------------------------------------------------
    \7\ ``Problems Mount for Old, Young, and Women,'' RFE/RL Newsline, 
Vol. 5, No. 54, Part I, March 19, 2001; ``Making Transition Work for 
Everyone: Poverty and Inequality in Europe and Central Asia,'' The 
World Bank, September 2000; Olge Nesterova, ``Russian Family Is 
Changing,'' Trud, May 17, 2001; Amelia Gentleman, ``Wanted: More 
Russian Babies To Rescue a Fast Dying Nation,'' The Observer (U.K.), 
December 31, 2000.
---------------------------------------------------------------------------
    Women's degraded economic positions have caused them to 
suffer in other ways as well. Hundreds of thousands of women 
have voluntarily turned to a life of prostitution, and tens of 
thousands more have been duped into sex slavery through an 
extensive European and Asian network of trafficking in women. 
At home, Russian women are now, even more than in Soviet times, 
routinely the victims of domestic violence. Between 12,000 and 
16,000 Russian women each year are killed by their spouses, and 
another 50,000 suffer severe injuries--10 times the comparable 
U.S. figures. Only six shelters for abused women exist in the 
entire country, all the result of private or local initiatives. 
Russian culture still sees victims as somehow ``deserving'' 
their fate, and a lack of legal protection follows those 
cultural assumptions.
    This view of women is unsurprising, given the blatant sex 
discrimination and sexualization of women that has accompanied 
the market reform process. The ideological doctrine of 
socialist gender equity has given way to a routine of overtly 
sexist remarks during parliamentary debates, job advertisements 
that specify positions for ``attractive'' females under age 30 
``bez komplexov'' (without complexes, or willing to perform 
sexual favors), and open street vendor sales of sexually 
explicit publications. One mid-1990s survey indicated that over 
half of Russian women had been the recipient of sexual advances 
by their job supervisors.\8\
---------------------------------------------------------------------------
    \8\ ``Pollsters Report Findings on Women's Issues,'' RFE/RL 
Newsline, Vol. 5, No. 48, Part I, March 9, 2001; Maria Kotovskaya, ``A 
Modest Little Castle in Switzerland and a Romantic Candlelit Dinner,'' 
Nezavisimaya Gazeta, December 25, 1998, p. 14; Valerie Sperling, ``The 
`New' Sexism: Images of Russian Women during the Transition,'' in Mark 
G. Field and Judyth L. Twigg, eds., Russia's Torn Safety Nets: Health 
and Social Welfare during the Transition (New York: St. Martin's, 
2000), pp. 173-189.
---------------------------------------------------------------------------
    Not surprisingly, breakdown at the societal and family 
level is producing individual-level pathologies as well. One in 
three Russians now have psychological problems, a 50 percent 
increase in the last decade, and the country's suicide rate is 
now among the highest in the world (and four times the U.S. 
rate). Work hours lost to psychological problems have been a 
significant factor in the country's loss of economic 
productivity. Over the last 10 years, disability certification 
for mental health reasons has grown more dramatically than for 
any other kind of illness. Meanwhile, Russia's mental health 
care infrastructure can accommodate only about 200,000 people, 
far below the capacity needed to cope with this growing 
problem, and even that network of facilities is rapidly 
decaying for lack of resources and investment.\9\
---------------------------------------------------------------------------
    \9\ ``One-Third of Russians Suffer `Psychological Disorders,' '' 
RFE/RL Newsline, Vol. 5, No. 24, Part I, February 5, 2001; Yury Bliyev, 
``No One's Safe from Poverty or Illness,'' Meditsinskaya Gazeta, 
October 22, 1999, p. 7; Nina Fokina, ``One Flew Over in a 
Straitjacket,'' Trud, October 29, 1999, p. 6; Colin McMahon, ``Russian 
System Isn't Coping At All With Surge in Mental Disorders,'' Chicago 
Tribune, February 1, 2001; ``One in Three Russians Has Psychological 
Problems,'' RFE/RL Newsline, Vol. 5, No. 69, Part I, April 9, 2001.
---------------------------------------------------------------------------
    Of course, the most well-known and visible manifestation of 
Russians' inability to cope with the stresses of the post-
Soviet transition is the vodka bottle. The average Russian man 
now drinks three half-liter bottles of vodka each week, and 
consumption levels appear to be steadily increasing. Alcohol is 
clearly a major contributor to the country's demographic 
crisis, accounting as it does for the growing rate of traffic 
and industrial accidents and cardiovascular disease in middle-
aged men. Alcoholic parents produce many, if not most, of the 
country's abandoned children. If the country had a functioning 
network of battered women's shelters, it would be filled with 
victims of domestic violence perpetrated by drunken boyfriends 
and husbands. Yet vodka remains cheaper than milk, supported by 
a state that relies on almost $500 million in annual revenues 
from alcohol duties. Despite efforts by the health ministry to 
call attention to this problem, the government continues 
programs like rewarding a few select oblasts over the May 2001 
holidays with additional vodka allocations as a prize for 
``good work'' carried out during the preceding 12 months. A 
draft law that would limit advertising for alcoholic beverages 
and promote public health campaigns about alcohol consumption 
has remained stalled for several years.
    Illegal drug use is also a growing problem, to the point 
where the health ministry refers to it as an ``epidemic.'' 
Between 3 and 5 million Russians are regular drug users. One-
third of the country's urban population has tried illegal 
substances at least once. The rate of drug addiction has 
increased more than sevenfold in the last decade, with an even 
greater explosion among children and teenagers and a pattern of 
usage where Russian young people abandon ``light drugs'' for 
heroin and other more dangerous narcotics far more quickly than 
is the norm in other countries. Russian specialists are also 
concerned about a recent drop in the age threshold for drug 
use, from 16 or 17 a few years ago to 12 and 13 today. 
Injectable drug use is the almost exclusive transmission vector 
for Russia's growing HIV/AIDS problem.\10\
---------------------------------------------------------------------------
    \10\ ``Alcoholism Is Becoming a National Security Problem,'' 
Sevodnya, May 26, 1999, p. 6; ``More Youths End Up Addicted,'' RFE/RL 
Newsline, Vol. 4, No. 249, Part I, December 29, 2000; ``Up To 5 Million 
Russians Are Drug Users--Health Ministry,'' Interfax, February 21, 
2001; ``Russian Drug Addicts Unofficially Put at 3 Million--
Parliamentary Official,'' Interfax, December 28, 2000.
---------------------------------------------------------------------------
    Illicit drugs are also a major factor in the country's 
growing problem with violent crime. Although crime rates fell 
slightly in the late 1990s, current levels still represent a 
significant increase over the Soviet period. Coupled with an 
unwieldy, often arbitrary judicial system, these crime levels 
have bestowed Russia with the world's largest prison 
population. One out of every four Russian adults has either 
been in one of the country's overcrowded, brutality-ridden 
prisons, or has had a family member there. The government's 
attempts to reform its penal system have generally involved 
mass amnesties, with the unfortunate result that tens of 
thousands of actively infected TB patients--Russia's jails are 
its main breeding grounds for a sweeping TB epidemic--have been 
released into the general population.\11\
---------------------------------------------------------------------------
    \11\ Fred Weir, ``Russia To Revise Crime, Penalty,'' Christian 
Science Monitor, January 9, 2001.
---------------------------------------------------------------------------
    These social pathologies are not limited to Russia's urban 
areas. Rural Russia has become increasingly isolated. Telephone 
and postal service throughout the country's vast land mass 
remains poor and unreliable, many regions still go without 
dependable electricity, and transportation to many areas is 
problematic. Soviet-era programs to build and maintain rural 
infrastructure, including houses and roads, gas and water 
supplies, and communication networks, have been largely 
abandoned. As a result, villagers--who comprise about one-
fourth of the country's population--must rely solely on radio 
and sometimes television as their primary contact with the rest 
of the country. This social isolation also extends to the 
economic realm. In Soviet times, the planned economy moved 
agricultural products to the cities, and manufactured goods 
back to the countryside. The lack of investment in rural 
infrastructure has now decimated Russian agriculture, to the 
point where most specialists estimate that it will take two 
generations to recover, and the country must routinely import 
food.
    According to several recent studies, Russian rural 
communities have responded to this circumstance by becoming 
autarchies largely outside the market economy. These 
communities are able to grow or make most of that they need for 
their people to survive, albeit at a relatively primitive 
level. Barter has resurfaced as the primary form of exchange of 
goods and services, and due to centuries-old village norms of 
equity and mutual support, nobody within the community goes 
without basic necessities. The good news is that nobody is 
starving to death, in a country where famine did indeed ravage 
the landscape several times in the twentieth century. Despite 
the existence of this community-based network of mutual 
support, however, Russia is currently undergoing a process of 
rural depopulation. Fewer employment opportunities and lowered 
living standards in the villages are pushing young villagers 
toward the perceived range of better conditions in the 
cities.\12\
---------------------------------------------------------------------------
    \12\ Margaret Paxson, ``The Cultural Dimension of Agricultural 
Reform: Social Organization and the Metaphysics of Exchange in Rural 
Russia,'' lecture at the Kennan Institute of the Woodrow Wilson 
International Center for Scholars, Washington, DC, January 29, 2001; 
Gennadi Zhuravlev, et al., ``The Socio-Demographic Situation,'' and 
Vladimir Staroverov, ``Antagonisms in Russian Society,'' in Williams, 
et al., Russian Society in Transition, 1996, pp. 66-67 and 122-124.
---------------------------------------------------------------------------

              Inequity and the Search for a Unifying Idea

    Perhaps most important in terms of societal cohesiveness, 
the stratification of society according to income level has 
increased dramatically during the post-Soviet period. The gap 
between rich and poor is steadily growing, as is the absolute 
number of both very rich and very poor. At the end of the year 
2000, salaries for the 10 percent of households with the 
highest income in Russia were 32 times those in the lowest 
income decile, and the richest households' total incomes were 
44 times higher. The new rich, or ``New Russians''--former 
Communist Party leaders, bureaucrats, and others who had the 
skills, connections, and good fortune to take advantage of the 
opportunities presented by the transition--rapidly became 
objects of considerable scorn in the early and mid 1990s. Their 
combination of garish displays of excessive wealth with lack of 
education and manners made them the butts of a whole new genre 
of jokes. (Two New Russians meet on the street. ``Hey, Vasya, 
where did you get your nice tie?'' ``At the Valentino store. 
Cost me $2,000.'' ``That's nothing, I know where you can get 
the same tie for $5,000!'') But their profligate spending, 
particularly in Moscow and other major cities, drove up the 
price of new housing, public entertainment, and other goods to 
the point that ordinary people suddenly found those things out 
of reach.
    The new poor, by contrast, are those who work for the 
government or other still-public industries, including a wide 
array of skilled workers and former intelligentsia. They have 
suffered through the humiliation of meager and often late wage 
payments, or in-kind compensation in the form of goods like 
bras, caskets, and manure, and the need to supplement the 
scientific or technical positions that continue to harness 
their intellectual capacities with second and sometimes third 
jobs as taxi drivers, cooks, or janitors. For some of these 
people, the fall from a Soviet-era position of prestige and 
privilege has been dramatic. Workers in the scientific, 
industrial, and military sectors, particularly those located in 
the ``closed cities,'' realized the best payoffs the Soviet 
social contract had to offer. (Indeed, their membership in the 
``First Circle'' carried with it a unique clause in the social 
contract: denial of interaction with the international 
scientific community and the tightest reins on their freedom of 
expression, in exchange for material benefits.) But those 
benefits, based primarily on priority allocation of scarce 
physical resources, have now disappeared. They have been 
replaced by a monetarized system in which current earnings and 
budget revenues available to these former elite cannot begin to 
match the perquisites that were formerly associated with place 
of work and politically mandated access. In this regard, the 
Soviet-era social pyramid has been inverted. Oligarchs and 
traders are now the primary claimants to government largesse, 
while highly educated specialists (who still, incidentally, 
suffer from limitations on their freedom of expression in the 
``closed cities'') have suddenly and unexpectedly become 
beggars.\13\
---------------------------------------------------------------------------
    \13\ ``25 Russian Regions Extricate Themselves from Poverty,'' 
Trud, December 23, 2000; ``Number of Impoverished in Russia Declines,'' 
RFE/RL Newsline, Vol. 5, No. 4, Part I, January 8, 2001.
---------------------------------------------------------------------------
    One late 2000 Russian Government economic development 
strategy report described the situation in these terms: socio-
culturally and economically, two unequal social layers have 
formed over the last decade. About one-fifth of the population 
has maintained or improved on its standard of living since the 
Soviet era, and a minority of those, about 5 to 7 percent of 
the population, have been able to adopt an essentially Western 
lifestyle, complete with modern spending and consumption 
habits. These people have been able to transcend Soviet 
assumptions and mindsets regarding the personal work ethic and 
the appropriate role of the state. To them, the free market 
rewards those with skills, tenacity, and ingenuity. Their post-
Soviet success has rendered the collapse of the old safety net 
irrelevant to them; they no longer need its protections.
    By contrast, the almost half of Russians who are subject to 
persistent poverty have become jealous and indignant over the 
new inequities. In their world, growing inequality has little 
to do with the natural results of free-market competition. 
Instead, success for the few has stemmed not from hard work, 
but from dishonesty and ``blat''--political and social 
connections. The gap between expectations and reality for these 
people has been psychologically as well as economically 
devastating. The disappointment and resentment among those who 
mistakenly thought they would benefit from the marketization of 
the economy has been profound, particularly when success seems 
often to stem from criminal behavior and financial speculation 
rather than the production of legitimate goods and services. 
Surveys have repeatedly shown that most Russians view the 
primary beneficiaries of the transition period as ``swindlers 
and manipulators,'' while few agree that ordinary, honest 
people have reasonable opportunities to increase their incomes 
and living standards. Hard work and a good education do not 
necessarily translate into a better life, and to the limited 
extent that they do, the latter is increasingly difficult to 
obtain. Declining public support for education and the rise of 
expensive private schools at all levels have seriously 
diminished one of the few remaining channels of social 
mobility.
    The dynamic of this new, very public division of society 
into the haves and have-nots has exacerbated centuries-old 
Russian anger at the separation and exploitation of the masses 
by their masters. The well-known mantra about what the Russian 
people currently crave--order and stability--encompasses not 
just social and economic stability, but also a fundamental 
sense of social justice. The gap between winners and losers in 
post-Soviet Russia still may not match the level of inequality 
in the United States, but the rate of explosion of inequality 
in Russia has been so rapid that people indoctrinated in the 
socialist mind-set have had little time to adjust. As a result, 
Russia has lost all sense of a common national identity. In the 
midst of socio-economic chaos, no common set of unifying 
principles has emerged to replace the ideal, flawed as it was, 
of Soviet socialism. Gorbachev's perestroika undermined much of 
Russian tradition, forcing society to question its history, its 
political culture, its achievements as a superpower, the 
essence of its national dignity. For over a decade since then, 
the Russian people have been struggling with questions that cut 
to the core of their identity. What values do we hold? What 
values do we want to transmit to our next generation? How can 
we regain a sense of pride and patriotism? For a few, the 
answer lay in Western-style individualism borne of the free 
market and of liberal political democracy. For the majority, 
however, that path has been tainted by the stain of crass 
commercialism and materialism and the gross inequities produced 
by shock therapy.
    Those people have struggled to find alternate social 
moorings. They feel isolated and abandoned. Most say that they 
can now count only on themselves in times of trouble; only a 
small minority claim they can rely even on family and friends. 
Only 30 percent are able to recall anything positive that has 
happened to them recently. Moscow's most popular radio station 
airs catchy tunes with lyrics that reflect the pessimism of 
post-Soviet life, songs about war death, death from hepatitis, 
and most strikingly, a number one single from early 2000 called 
``You Have AIDS (And That Means We Will Die).'' This national 
malaise indicates that Russia continues to suffer a wrenching 
psychological upheaval. The symptoms of its discontent extend 
far beyond what would be considered ``normal'' for a country 
undergoing the pangs of economic development, or even the 
sacrifices now routine for a post-socialist transition. Almost 
nobody has had confidence in the ability of public authorities 
to put the country back on the right track.\14\
---------------------------------------------------------------------------
    \14\ ``Nearly Four-Fifths of Russians Are Nostalgic About Soviet 
Union,'' strana.ru, March 15, 2001; ``Russians Have Trouble Recalling 
Good Times,'' RFE/RL Newsline, Vol. 5, No. 77, Part I, April 20, 2001; 
Gael Turine, ``Russia's Homeless,'' Time Europe, January 31, 2001; 
Alexander Khlop'ev, ``The Transformation of the Social Structure,'' in 
Williams, et al., Russian Society in Transition, 1996, pp. 93-106; 
Vladimir Shlapentokh, ``A Normal System? False and True Explanations 
for the Collapse of the U.S.S.R.,'' Times Literary Supplement (U.K.), 
December 15, 2000; Masha Gessen, ``Rockin' To Sad Songs,'' U.S. News 
and World Report,'' March 19, 2001.
---------------------------------------------------------------------------
    A dramatic cultural sea change has formed an integral part 
of this national identity crisis. Even factory workers and taxi 
drivers in the Soviet era could recite Pushkin, wax lyrical 
about the latest achievements of the Kirov ballet and the 
Chekhov theater, or discuss the finer philosophical nuances of 
Tolstoy and Dostoyevsky. Stagnant as life may have been under 
Brezhnev, it afforded people time and energy to think private 
thoughts and to place those ideas within a rich cultural 
context. The transition to the market swept away this luxury. 
Pushkin and Tolstoy have been replaced with the most base and 
commercial representations of Western popular culture, with 
billboards sporting half-naked women advertising Levi-Strauss 
``dzhinsy'' or Marlboro cigarettes. The television and film 
industries have become similarly dominated by American imports. 
Only 10 percent of the movies shown in Russian theaters in the 
mid-1990s were actually produced in Russia. And the domestic 
Russian media has responded by sinking to the lowest common 
denominator. Representatives of the Russian Orthodox Church 
have blamed Russian television and cinema for many of the ills 
currently plaguing Russian society, and one of Russia's leading 
film directors has accused Russian television of turning 
today's children into a ``generation of monsters.''
    In practical terms, the most common response to the last 
decade's social and economic upheaval has been apathy, spiced 
with a generous dose of hopelessness. Cynicism reigns. There 
are no longer ``honest'' or ``dishonest'' ways to make money--
just ``easy'' or ``hard.'' There have been practically no mass, 
public displays of discontent over the initial economic 
contraction in 1992, the financial crash in 1998, and the 
months' and years' worth of nonpayment of salaries. Instead, 
only a small minority of people express an interest in protest 
actions. Most Russians avoid reading about or discussing 
politics at all.\15\
---------------------------------------------------------------------------
    \15\ Vladimir Chuprov and Julia Zubok, ``Youth and Social Change,'' 
in Williams, et al., Russian Society in Transition, 1996, p. 132.
---------------------------------------------------------------------------
    Those few who do seek political expression of discontent 
are increasingly turning to extremist outlets. A small but 
expanding number of young people, even those with good jobs and 
higher educations, are joining radical Communist and Socialist 
groups to protest wage inequalities and economic dislocations. 
Even more disturbing are the growing ranks of neo-Nazi youth 
groups across Russia that have been violently targeting non-
Russians, particularly those from the Caucasus and Asia. Of the 
small number of Russian youth who express a strong interest in 
politics--no more than 5 or 6 percent of the total--over half 
claim to favor fascism. The two Chechen wars have provided more 
than ample fuel to this fire. Although it would be 
inappropriate to exaggerate the scope of these trends at the 
present time, it is a situation likely to be exacerbated if the 
Russian Government pursues its currently proposed policy of 
increased immigration as a solution to its demographic 
problems.\16\
---------------------------------------------------------------------------
    \16\ ``Russian Youth Seen Turning Left,'' RFE/RL Newsline, Vol. 5, 
No. 50, Part I, March 13, 2001; Valerii Solovei, ``Dragon's Teeth: A 
Look at Right-Wing Extremism Among Russian Youth,'' Vek, No. 17, April 
2001.
---------------------------------------------------------------------------
    Russian youth, although more individualistic, 
entrepreneurial, and adaptable than their parents, may be the 
most severely impacted by this crisis of values. Society has 
not offered them the ``vospitanie''--the process of deliberate 
instilling of society's positive values--that their parents 
enjoyed, primarily because society has been uncertain about 
what those values are. Their formative years have been ones of 
turbulence and upheaval. Unable to derive meaning from society 
as a whole, lacking crucial societal anchors, many of them seem 
to believe in nothing larger than themselves. While this may 
bode well for their ability to survive in a competitive market 
economy, it also has led a significant number of them into a 
life of crime; well over half of Russia's racketeers are under 
30 years old, and the crime rate for juveniles under 18 is 
higher than that for adults. The country desperately needs a 
mechanism to re-engage its young people and harness their 
considerable energies in a productive direction.\17\
---------------------------------------------------------------------------
    \17\ Igor Ilynsky, ``Law and Order,'' in Williams, et al., Russian 
Society in Transition, 1996, pp. 234-235.
---------------------------------------------------------------------------

                  The State Response to Social Crisis

    The Russian Government's response to the social crises of 
the 1990s has been, at best, uneven. The problems have stemmed 
both from shortages of revenue, and from ineffective allocation 
and distribution of the scarce resources on hand. The economic 
growth rates Russia has enjoyed over the last 2 years (albeit 
largely dependent on relatively high world oil prices) provide 
a window of opportunity for enhanced financing of reform 
efforts in the social sphere. But even during times of relative 
plenty, the budgetary choices are difficult. Debt servicing, 
the armed forces and military industry, and direct subsidies to 
individuals and regions continue to hold significant claims to 
any surplus budget revenues. And pouring more money into social 
benefits sectors still plagued by Soviet-era inefficiencies and 
perverse incentives does not constitute effective reform. 
Ironically, in many cases, austerity may go hand in hand with 
improved efficiency. Recent policy in the housing sector is 
illustrative here. Over the next several years, the Putin 
regime will phase out subsidies for housing and utilities, 
purportedly in an effort to free revenues for badly needed 
capital investment in the utilities infrastructure. Citizens 
who now average 5 percent of their monthly incomes on rent, 
heat, and water will be expected to pay up to 22 percent of 
their household budgets for these services. This reform 
presents both opportunity and danger. Smartly implemented, and 
with careful and appropriately targeted subsidies for the 
needy, it can revive a crumbling physical infrastructure and 
introduce market-based productivity to a huge sector of 
Russia's economy. Otherwise, however, it will evolve solely as 
another (monstrously significant) rip in the social safety net, 
with the basic material needs of a huge percentage of the 
population once again disregarded.\18\
---------------------------------------------------------------------------
    \18\ ``Russian Federation Housing and Utility Services: Policy 
Priorities for the Next Stage of Reforms,'' World Bank Report No. 
17483-RU, February 25, 1998.
---------------------------------------------------------------------------
    Government policies toward health are illustrative of these 
dynamics as they operate in the social sector as a whole. The 
government has addressed declining health status through a 
series of market-oriented reforms that have produced genuine 
progress in some areas, and unintended negative consequences in 
others. Chronically underfunded at around 3 to 4 percent of 
gross domestic product (GDP) in Soviet times, and cut to barely 
more than half that today, Russian hospitals and clinics exist 
on a shoestring. A system of nationwide compulsory medical 
insurance instituted in 1993 held out some promise for extra 
cash but, like the state budget, it suffers from chronic 
underpayment and late payment of taxes. Despite the earnest 
efforts of most physicians and nurses, dreadful quality of 
medical care is often the result. A shockingly high percentage 
of health facilities have no hot water or sewage systems, and 
most still use glass syringes and reusable needles, with 
sterilization procedures far below Western norms. Patients 
suffer long waits even for urgently needed care. A long list of 
medications is not only unaffordable, but unavailable. Perhaps 
most disturbing, a higher quality of services, in a system 
where comprehensive free medical care is constitutionally 
guaranteed, is now routinely provided only to the small number 
of people with the ability to pay for it. State-owned clinics 
openly (and illegally) demand money for such basic services as 
a spot at the head of the queue, accurate diagnoses, routine 
attention from ward nurses, anesthetics and other drugs, and 
the like. One recent study found that one-fourth of St. 
Petersburg residents were required to pay more than 20 percent 
of their monthly incomes for their most recent medical 
encounter, and another reports that a shocking 59 percent of 
all health care spending in the country consists of out-of-
pocket payments (compared to about 25 percent in the United 
States). Perhaps inevitably, health care has succumbed to 
market forces, but in a chaotic and uncontrolled manner that 
has left the most vulnerable parts of the population 
unprotected. Universal access to some level of free medical 
care, one of the hallmarks of the Soviet system, has been 
destroyed.\19\
---------------------------------------------------------------------------
    \19\ Yu. Shevchenko, ``Primary Measures for Development of the 
System of Health Care in the Russian Federation,'' Zdravookhraneniye 
Rossiyskoy Federatsii, No. 2, 2000, pp. 3-8; Igor Sheiman, ``Forming 
the System of Health Insurance in the Russian Federation,'' Social 
Science & Medicine, No. 39, 1994, pp. 1425-1432; Mark G. Field, David 
M. Kotz, and Gene Bukhman, ``Neoliberal Economic Policy, `State 
Desertion,' and the Russian Health Crisis,'' in Jim Yong Kim, et al., 
eds., Dying for Growth: Global Inequality and the Health of the Poor 
(Monroe, Maine: Common Courage Press, 2000), pp. 155-173; David E. 
Powell, ``The Dismal State of Health Care in Russia,'' Current History, 
October 1998, pp. 335-341; Judyth L. Twigg, ``Unfulfilled Hopes: The 
Struggle to Reform Russian Health Care and Its Financing,'' and Julie 
V. Brown and Nine L. Rusinova, ``Negotiating the Post-Soviet Medical 
Marketplace: Growing Gaps in the Safety Net,'' in Field and Twigg, 
Russia's Torn Safety Nets, 2000, pp. 43-64 and 65-82; V.E. Boykov, et 
al., ``Participation of the Population in the Financing of Health 
Care,'' Zdravookhraneniye, No. 2, 2000, pp. 32-46.
---------------------------------------------------------------------------
    The crux of Russia's health problems, of course, lies not 
only at the federal level. The 1993 Law on Self-Governance 
devolved primary responsibility for health and health care to 
the regions and municipalities. The situation with now-bankrupt 
enterprises, and the resulting taxation and budget crises, have 
left governors with unfunded mandates to provide an array of 
social services, including health. Corruption and incompetence 
in some areas have permitted this situation to fester, 
untreated, for over a decade. A handful of Russia's 
administrative regions, however, are providing more 
comprehensive and promising examples of systemic reform. 
Samara, for example, is universally heralded as a pathbreaker 
in this area. Its progress seems to derive from the confluence 
of a variety of important factors. First of all, regional 
political leaders have afforded health care top and consistent 
political priority. Diligent efforts by regional health 
insurance bodies and landmark legislation passed by the oblast 
Duma have resulted in practically full funding of health care 
budgets for the past 3 years. It is impossible to overstate the 
uniqueness of this situation. Literally every other one of 
Russia's 89 regions struggles with late or underpayment of 
health insurance taxes, leaving their coffers underfinanced and 
therefore their universal coverage promises impossible to 
fulfill. In contrast, Samara has voluntarily added benefits to 
the list of basic health services mandated by law.\20\
---------------------------------------------------------------------------
    \20\ Alexei M. Lavrov and Alexei G. Makushkin, ``Extrabudgetary 
Funds as a Channel for Territorial Redistribution of Public Finances,'' 
Chapter 7 of The Fiscal Structure of the Russian Federation: Financial 
Flows Between the Center and the Regions (Armonk, NY: M.E. Sharpe, 
2000), p. 133; Judyth L. Twigg, ``Russian Health Care Reform at the 
Regional Level: Status and Impact,'' forthcoming in Post-Soviet 
Geography and Economics, 2001.
---------------------------------------------------------------------------
    Samara's success also stems from its creative efforts to 
spend each health care ruble efficiently and effectively. 
Having abandoned the Soviet-style, central planning-oriented 
provider reimbursement mechanisms that remain the norm in most 
of the country, Samara now has in place an array of incentive 
structures to discourage wasteful spending at hospitals and 
clinics. The region is also developing a network of general 
practitioners, in an effort to overcome the Soviet habit of 
unnecessary and expensive physician overspecialization. The 
presence of family doctors affords patients greater freedom of 
choice and a higher quality of comprehensive services on a 
cost-effective outpatient basis.
    Samara also encourages state physicians to offer paid 
services within regular polyclinics and hospitals. Due to high 
start-up costs, there is still a relatively small number of 
physicians in private practice. But many state facilities now 
offer private, fee-based services alongside those covered by 
the state, and patients can choose to make these legal 
additional payments either for treatments not covered by basic 
national insurance, or for higher quality or more comfortable 
provision of state-mandated services. This mechanism has now, 
for the first time, provided physicians with an incentive to 
work harder and offer higher standards of care, despite the 
fact that their state salaries are still mandated according to 
rigid salary scales. They compete for the opportunity to 
provide these paid services, and they keep a portion of the 
proceeds earned from the business they attract. Visits to some 
of Samara's clinics that offer paid services and therefore 
enjoy this additional income, and those that do not, offer a 
striking comparison. The former contain at least some modern, 
Western equipment, and are undergoing significant capital 
repair, with evident new construction and remodeling. The 
latter continue to exhibit the shoddy construction and 
technical standards that were a hallmark of meager Soviet 
health care quality.
    The success of Samara's reforms is difficult to dismiss, 
with dramatic reductions in infant mortality rates in recent 
years (12.2 infant deaths per 1,000 live births in 1998, 
compared with a figure of 16.5 for Russia as a whole) and an 
undeniably greater return on each health care ruble. The 
lessons of its experience--the importance of stable leadership 
and policy continuity in the health and social sector, and the 
magnitude of what can be accomplished when high political 
priority is assigned to these issues--should be instructive for 
other regions throughout the Russian Federation.\21\
---------------------------------------------------------------------------
    \21\ Rudolf Galkin, ``They Can't Discredit Reform,'' Meditsinskaya 
Gazeta, January 5, 1996, p. 4; Galkin, ``Samara's Model of 
International Health Care,'' Meditsinskaya Gazeta, March 15, 2000, p. 
6; ``Health Care of a Region: Samara Oblast,'' Meditsinskaya Gazeta, 
June 17, 1998, pp. 5-10; Judyth L. Twigg, ``Samara Leads the Way with 
Innovative Medical Practices,'' Russian Regional Report, Vol. 5, No. 
32, September 7, 2000; author's interviews with health administrators 
and providers in Samara, March 2000.
---------------------------------------------------------------------------
    Russian reformers at the national level have conceptualized 
federal policies to regulate the health sector's transition to 
a market economy, taking into account the need for regulatory 
mechanisms that maintain access for the poor and discourage 
wasteful spending. These include reducing the Soviet-era focus 
on expensive inpatient care, instead performing routine tests, 
therapies, and even surgeries on an outpatient basis where 
appropriate; training a new generation of family practice 
physicians to overcome the Soviet habit of overspecialization; 
permitting patients to choose their own physicians, clinics, 
and hospitals, so that the benefits of competition can be 
realized; removing physicians from rigidly set government wage 
scales, so that they feel a monetary incentive to provide more 
and better treatment; adopting provider reimbursement 
mechanisms other than fee-for-service, or worse, Soviet-style 
fee-per-hospital-bed-occupied, which encourages inappropriately 
long lengths of stay and gross inattention to quality of care; 
and monitoring insurance company and provider behavior to limit 
adverse selection and eliminate or regulate the provision of 
paid services. In a handful of Russian regions, these and 
similar policies have been implemented to varying degrees, some 
with impressive results. Samara's example demonstrates that the 
key ingredients to success are attentiveness to the health 
sector and political will among leaders at the regional level, 
which should be applauded and encouraged where they exist. 
Certainly a significant increase in health budgets should be 
one of the first priorities of Russian social policy. However, 
given the obvious difficulties in achieving meaningful 
increases in health budgets, measures to improve fairness and 
efficiency are essential to ``cure'' Russian health care. But 
while the federal and some regional governments have, to 
varying degrees, conceptualized some appropriate and even 
innovative policies, the legacy of Soviet-era institutions and 
mind-sets has in most regions continued to put the brakes on 
reliable, consistent implementation of effective reform.\22\
---------------------------------------------------------------------------
    \22\ Christophe Raison, ``Regionalisation et crise sanitaire en 
Russie,'' Revue d'etudes comparatives Est-Ouest, Vol. 29, No. 3, 1998, 
pp. 207-239; ``Basic Directions in the State Regulation of the 
Development of Health Care in the Russian Federation for the Years 
2000-2010,'' Problemy Sotsial'noy Gigieny i Istoriya Meditsiny, No. 3, 
2000, pp. 3-14; I. Nazarova, ``Reform of Health Care: Pros and Cons,'' 
Zdravookhraneniye, No. 5, 2000, pp. 29-36; V. Shchepin, ``Structural 
Effectiveness in the System of Treatment-Preventive Care in the 
1990s,'' Problemy Sotsial'noy Gigieny i Istoriya Meditsiny, No. 3, 
2000, pp. 24-27; Yu. Shevchenko, ``Primary Measures for the Development 
of the System of Health Care in the Russian Federation,'' 
Zdravookhraneniye Rossiyskoy Federatsii, No. 2, 2000, pp. 3-8.
---------------------------------------------------------------------------

               Sources of Societal Cohesion and Identity

    Given the government's mixed success at addressing the 
country's ongoing social difficulties, how has Russian society 
survived the last decade's assault on its most basic structure 
and principles? Russian people and families have relied on a 
variety of coping mechanisms, some involving social structures 
held over from the Soviet past, others newly emergent from the 
chaos of market reform. Primary among the former are informal 
interpersonal networks. These ``kitchen table'' groups are 
close circles of family and friends that, during the Soviet 
era, not only served as trusted confidants but also as networks 
of mutual provision of scarce consumer goods. Now, in many 
cases, these informal circles continue to provide material and 
psychological support, serving as the primary or only remaining 
source of cohesion and stability for many people. A similar 
psychological and economic impact is being engendered by 
intergenerational transfers of wealth. It is well known that 
some young adults who have navigated the transition period 
relatively successfully have financially supported their less 
adaptable middle-aged and elderly parents throughout the last 
decade. Recent studies have further indicated that family 
survival in many other instances is being maintained almost 
entirely by older Russians ``giving until it hurts'' to their 
adult children and grandchildren, particularly in rural areas--
food from the dacha, money, whatever they have.\23\
---------------------------------------------------------------------------
    \23\ Cynthia Buckley, ``Family Matters: Intergenerational Wealth 
Transfers and Survival Networks,'' presentation at conference ``From 
Red to Gray: Aging in the Russian Federation,'' University of Texas, 
Austin, April 6, 2001.
---------------------------------------------------------------------------
    In addition, many Russians are returning to the symbols, if 
not fully to the substance, of the Russian Orthodox Church. 
Well over half of Russians now call themselves Orthodox, and 
millions of baptisms were performed in the aftermath of the 
Soviet collapse. The Church has deliberately tried to place 
itself at the center of a post-Soviet Russian national 
identity, referring repeatedly to a uniquely Orthodox ``Russian 
idea'' or ``Russian soul.'' But over the last decade, while 
successful in opening new parishes and monasteries, the Church 
has been less effective in bringing its essence to the center 
of people's lives. Basic knowledge of Orthodox doctrine and 
theology remains low. As a result, many Russians have turned to 
other faiths, a phenomenon to which the Orthodox Church has 
responded jealously. It has masterminded a law that restricts, 
and may ban, the activity of many of the thousands of non-
Orthodox religious groupings in Russia, excepting only those 
deemed ``traditional,'' such as Islam, Buddhism, and Judaism. 
Officially sanctioned discrimination against religious 
minorities, to the extent that it fosters a climate of 
divisiveness and intolerance, may undermine spirituality and 
religion as a sustainable source of family stability and 
societal cohesion.\24\
---------------------------------------------------------------------------
    \24\ Scott Peterson, ``A Russian Resurrection,'' Christian Science 
Monitor, December 21, 2000; Giles Whittell, ``Moscow Tightens Its Grip 
on Rival Faiths,'' The Times (U.K.), January 2, 2001; Paul Goble, 
``Russia: Analysis from Washington--A Religious Flowering,'' Radio Free 
Europe/Radio Liberty, April 19, 2001; U.S. Department of State, ``2000 
Annual Report on Religious Freedom: Russia,'' September 5, 2000; 
Elliott Abrams, ``In Russia, `Liquidating' Churches,'' Washington Post, 
November 14, 2000.
---------------------------------------------------------------------------
    Russia is also now home to a burgeoning network of over 
300,000 registered non-governmental organizations (NGOs), with 
many designed to provide families and individuals with social 
services and support. The obstacles these groups face are 
substantial, from ridiculous bureaucratic registration 
requirements to monitoring of their activities by the federal 
security services. Fund-raising also remains problematic for 
these groups, although some are now beginning to navigate the 
waters of public-private partnership, and others have been 
blessed by the largesse of well-known tycoons like Potanin and 
Berezovsky anxious to create positive public images for 
themselves through philanthropy. And many of them still suffer 
from public suspicion based on the fact that corrupt 
businessmen and politicians often set up illegitimate NGOs for 
purposes of money laundering. Nevertheless, many of Russia's 
most talented people are choosing careers in this ``third 
sector.'' To the extent that they grow and thrive, these 
networks of NGOs may prove instrumental in progress toward a 
climate of self-generated social welfare to replace the 
paternalistic model of state provision. Even more important, to 
the extent that they can link their efforts through regional 
and national associations, they can provide the foundation for 
a genuine civil society, creating a sense of ``common good'' 
and perhaps also the foundation of a stable, liberal 
democracy.\25\
---------------------------------------------------------------------------
    \25\ Sophie Lambroschini, ``Russia: NGOs Just Beginning To Take 
Root,'' Radio Free Europe/Radio Liberty, October 13, 2000; Joseph 
Boris, ``Russian NGOs Threatened, Praised by Officialdom,'' UPI, 
January 4, 2001; ``Good Works,'' The Economist (U.K.), March 24-30, 
2001; ``Putin Wants Dialogue with Civil Society, Welcomes Its Growth,'' 
RFE/RL Newsline, Vol. 5, No. 112, Part I, June 13, 2001; Marcia Weigle, 
Russia's Liberal Project: State-Society Relations in the Transition 
from Communism (University Park, PA: Penn State University Press, 
2000), pp. 333-379; 1999 Human Development Report for the Russian 
Federation, pp. 114-125; James Richter, ``Promoting Activism or 
Professionalism in Russia's Civil Society?'' and ``The Case for 
Assisting Russian NGOs,'' Policy Memos 51 and 137, Program on New 
Approaches to Russian Security (PONARS), November 1998 and April 2000; 
Jeffrey Checkel, ``Access, Influence, and Policy Change: The Multiple 
Roles of NGOs in Post-Soviet States,'' Policy Memo 80, PONARS, October 
1999.
---------------------------------------------------------------------------
    Government authorities have also recently attempted quite 
deliberately to re-establish a positive, distinctively Russian 
national identity. In a clear effort to build a new foundation 
for political legitimacy, President Putin is overtly 
cultivating a new patriotism, a new national pride--a sense 
that the country's past and present are nothing to be ashamed 
of, an attempt to step out of the shadow of a decade of socio-
economic turmoil and more recent disaster such as the sinking 
of the Kursk. The restoration of the old national anthem was 
the first step; the second was the restoration of basic 
military training and patriotism classes in the public schools. 
In March 2001, the government announced a full-blown, $6 
million ``patriotic education'' program designed to counter a 
wave of ``indifference, individualism, cynicism, unmotivated 
aggression, and disrespect for the state'' evident since the 
collapse of the Soviet Union. Over the next 5 years, the 
project will attempt to reshape the education system through 
new history and other textbooks, influence the mass media (with 
prizes offered to journalists, writers, and filmmakers whose 
work exemplifies the goals of the program), and create a 
network of ``military-patriotic youth clubs'' around the 
country. Whether these efforts are intended to foster 
positively directed Russian nationalism or a cult of 
personality around Putin himself is debatable, but in many ways 
they are clearly falling on fertile ground. Recent consumption 
patterns--``nasha'' products are now preferred over Western 
brands, and not just because of the price differentials with 
imported goods resulting from the August 1998 ruble 
devaluation--and numerous public opinion polls are now 
revealing a rejection of things Western. Consumer nationalism 
is leading advertisers to stress the ``Russian-ness'' of their 
products--even if those products are made by Western firms. 
U.S. confectioner Mars' newly launched candy bar, for example, 
is called ``Derzhava''--the Russian word for ``power,'' and an 
unofficial slogan of the strong Russian state.\26\
---------------------------------------------------------------------------
    \26\ Mark Franchetti, ``Russian Children to Train for War,'' The 
Sunday Times (U.K.), September 3, 2000; Susan B. Glasser, ``Letter from 
Russia: Patriotism, Selling Like Hot Cakes,'' Washington Post, May 9, 
2001; ``Russia's School for Patriots,'' AFP, March 15, 2001; Fred Weir, 
``Moscow Pitches Patriot Games,'' Christian Science Monitor, March 22, 
2001.
---------------------------------------------------------------------------
    One important constituency for a new, positive Russian 
nationalism is the emergent middle class. Significant evidence 
suggests that this new middle class has energetically arisen 
from the rubble of the 1998 financial crisis--middle class not 
only in income and wealth, but also in outlook and behavior. 
They vacation abroad. They frequent cinemas and theaters and 
the country's most recent craze, bowling alleys. On average, 
they hold a significantly more optimistic view of the future 
than the rest of the population. Many of them are young 
professionals who believe in the virtue--and in the 
possibilities--of hard work, and they are determined to build a 
Russia within which they and their children can succeed. They 
manage to save some money, and they purchase major durables 
like cars and houses. They typically invest whatever profit 
they make back into their ventures, creating jobs and the 
foundation for a stable economic base. Although it constitutes 
no more than 10 to 15 percent of the population, remains 
vulnerable to shifts in the economy, and is located primarily 
in Moscow and a handful of other major cities, this emergent 
social stratum, plugging the gap between rich and poor, could 
serve as a powerful foundation of the necessary context for 
stability and cohesiveness. They are a significant cause for 
optimism.\27\
---------------------------------------------------------------------------
    \27\ ``Russia's Middle Class Emerges from the Wreckage,'' AFP, 
November 6, 2000; Rob Parsons, ``The Rise of Russia's Middle Class,'' 
British Broadcasting Corporation, January 11, 2001; Paul Starobin and 
Olga Kravchenko, ``Russia's Middle Class,'' Business Week, October 16, 
2000; Anna Raff, ``Middle Class Is Back and Growing,'' Moscow Times, 
September 26, 2000; ``Looking for the Middle Class,'' Finansovaya 
Rossiya, No. 4, February 2001, p. 5; Tatyana Maleva, ``Middle Class: 
The Doors Are Closing,'' Vremya Novostei, August 8, 2000, p. 3.
---------------------------------------------------------------------------

                   Conclusion--Looking to the Future

    The Russian people have been subjected to seemingly 
unbearable humiliation and hardship over the last decade. It's 
hard not to ask why they've tolerated it. Why aren't masses of 
impoverished, disaffected, alienated Russians marching in the 
streets, demanding an improvement in their living conditions 
and in their social environment? Some Russian analysts 
cynically--but perhaps with a grain of truth--claim that the 
history of the Russian masses demonstrates a love of suffering, 
a craving for martyrdom. Others observe that many Russians have 
quite evidently chosen a more individualistic form of protest 
through withdrawal to the vodka bottle or the heroin needle, or 
more broadly, through withdrawal from active participation in 
society as a whole. Still others might cite a fear of disorder, 
of even more disruptive and destructive chaos if significant 
demands for change are made. And many observe that most 
Russians have been too preoccupied and exhausted by the daily 
struggle for survival to muster up the necessary energy to 
complain. Centuries-old Russian stoicism--an older Russian, 
looking back on her life, might observe that the last decade 
represents just one of many ups and downs for Soviet and 
Russian society--certainly goes a long way toward explaining 
the Russian people's acceptance of their fate.
    Perhaps the cultivation of symbols and slogans can serve as 
a rallying point around which people can restore the national 
identity they so desperately need. But resurgent patriotism, no 
matter how heartfelt, will not erase the grinding poverty and 
gross inequities that continue to plague the Russian socio-
economic landscape. The most important social questions for 
Russia today cannot be solved by surface propaganda. They can 
be addressed only by moving a significant portion of the truly 
depressed people and places throughout the Russian Federation 
stably into that new middle class. Regenerating the necessary 
degree of social mobility will require a restoration, albeit 
significantly amended and adapted to market circumstances, of 
the old social contract.
    Why, beyond the obvious humanitarian concerns, should these 
social issues in Russia assume importance for U.S. 
policymakers? Elsewhere in this volume, Russia's historical 
endowment with superior natural and human resources is noted. 
Appropriate concern is voiced over the deterioration of the 
country's physical infrastructure--its roads and bridges, 
communications networks, and utilities. But perhaps even more 
important for the long term, largely because its repair is a 
much more complex and long-term proposition, is the degradation 
of Russia's human capital. The evidence presented here suggests 
that the physical and psychological health of Russia's human 
resources have suffered tremendously during the transition 
period, as has the incentive structure governing human 
development. This decline, due in large part to the rupture of 
Soviet-era social safety nets, carries with it enormous 
economic and political implications. Democracy, economic 
reform, and stability in Russia are largely dependent on the 
emergence of a stable middle class engaged in the development 
of a robust civil society. A social landscape stratified into 
haves and have-nots, with the majority of the population 
disengaged from a government it no longer trusts to provide 
even a minimal safety net of social protections, may nudge the 
Russian voting public toward a preference for a return to the 
past. Only a healthy, energetic, positively motivated 
population can provide the necessary spark to reform the 
country's economy, revitalize its society, and rebuild its 
national security institutions. And a politically, 
economically, and militarily stable Russia is much more likely 
to emerge as a friend and partner to the United States than is 
a Russia filled with uncertainty, insecurity, and continued 
collapse and decay.
      

=======================================================================



         LONG-TERM PROSPECTS FOR RUSSIA'S ECONOMIC GOVERNANCE

=======================================================================







               LONG-RUN PROSPECTS FOR THE RUSSIAN ECONOMY


                         By James R. Millar \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   329
Introduction.....................................................   330
The Current Condition of the Russian Economy and of Economic 
  Reform.........................................................   332
    Economic measures............................................   332
    Politics, military reform and foreign policy.................   334
    Putin as leader..............................................   336
    Why is Putin popular?........................................   336
    Implications for the sustainability of economic reform and 
      growth in Russia in the near future........................   337
    Prospects for the long run...................................   338
    The future of Russia as a market economy: the transition in 
      historical perspective.....................................   339
    The probable structure of the Russian economy in the long run   341
References.......................................................   344
                                Summary

    Long-run forecasts are particularly hazardous, and that has 
to be especially the case when it comes to Russia. Enormous 
changes have taken place over the past one and a half decades. 
Gorbachev undermined the stability of the system in his attempt 
at reform. Yeltsin destroyed the old political and economic 
system in what can properly be called a revolution. His 
replacement, Putin, remains largely a mystery. How committed is 
he to continued market reform and to democratic processes? It 
is too early to tell with any confidence.
---------------------------------------------------------------------------
    \1\ James R. Millar is a Professor of Economics and International 
Affairs and the Director of the Institute for European, Russian and 
Eurasian Studies at the George Washington University, Washington, DC.
---------------------------------------------------------------------------
    One thing is clear, the economic transition, defined as 
radical change, is over. The population is exhausted and 
opposed to further radical change. The Putin government has 
benefited from the beneficial effects of the 1998 financial 
crisis upon Russian domestic industry and upon an unusually 
high and steady price of oil on world markets. In the short 
run, the economy appears relatively healthy. There are warning 
signs on the horizon, however, for the price effects of 
devaluation are wearing off, and the world market price of oil 
is unlikely to rise further or to remain at the current level. 
Consequently, steps need to be taken to provide alternative 
sources of economic growth. Putin's words thus far have been 
impressive. His actions have been more ambiguous.
    Chances are good that the economy will falter in the short 
run, or, at best, improve gradually. The best prospect for 
continued gradual reform in Russia is represented by the 
proximity of the European Union (EU). It is a major customer 
for Russian exports, and so are the Eastern European countries 
now in line for accession to the EU. The conditions for 
admission to the EU are essentially identical with those 
required for a successful economic transition to a workable 
market economy, and the charter spells out these requirements 
in chapter and verse.
    Long-run prospects of developing a complete market economy 
in Russia are quite good. An examination of world economic 
history reveals what appears to be an inexorable trend away 
from economies based on custom and command toward market 
relations. The current emphasis upon globalization represents a 
continuation of this trend. In historical perspective, the 
Soviet economic experiment with central planning represented a 
deviation from the trend line. Thus, Russian and the other 
transition states are returning to the trend line, to a more 
optimal relationship between markets and government 
intervention in the economy. Although prospects are good that 
this movement will continue in Russia, it does not follow that 
progress in economic welfare will be achieved readily. A market 
economy may be the best solution for the allocation of 
resources, but until individual countries and/or the 
international economy learn to steer clear of currency crises, 
trade conflicts and depressions, sustained economic growth will 
be difficult to attain. Russia will be fortunate to reach the 
status of Brazil or Mexico in the long run. Catching up with 
the G-7 countries, with the EU or even with the leading 
countries of Eastern Europe appears unlikely for the 
foreseeable future.

                              Introduction

          Burke ever held, and held rightly, that it can seldom 
        be right . . . to sacrifice a present benefit for a 
        doubtful advantage in the future. . . . It is not wise 
        to look too far ahead; our powers of prediction are 
        slight, our command over results infinitesimal. It is 
        therefore the happiness of our own contemporaries that 
        is our main concern; we should be very chary of 
        sacrificing large numbers of people for the sake of a 
        contingent end, however advantageous that may appear. . 
        . . We can never know enough to make the chance worth 
        taking. There is this further consideration that is 
        often in need of emphasis: it is not sufficient that 
        the state of affairs which we seek to promote should be 
        better than the state of affairs which preceded it; it 
        must be sufficiently better to make up for the evils of 
        the transition. (John Maynard Keynes, Treatise on 
        Probability, cited in Robert Sidelsky, John Maynard 
        Keynes. The Economist As Savior, 1920-37, p. 62.)

    Lord Keynes is here discussing Edmund Burke's philosophy of 
governance and reform. The statement was condensed in The 
General Theory, where Keynes stated simply that ``in the long 
run, we are all dead.'' The quote from Burke represents Keynes 
commitment to what has been the Anglo-American tradition of 
avoiding revolutionary change in favor of step-by-step, 
brokered reform of the economic system.
    In contrast, economic reform under Boris Yeltsin was 
radical and utopian. Shock therapy was expected to entail large 
costs for the population in the short run, but provide 
substantial benefits in the future. It turned out, however, 
that the cost was much greater and the period of sacrifice much 
longer than the radical reformers and Western advisors 
anticipated.\2\ They clearly did not ``know enough to make the 
chance worth taking,'' and the benefits of the reforms in 
Russia have yet to prove ``sufficiently better to make up for 
the evils of the transition.''
---------------------------------------------------------------------------
    \2\ Millar, James R. ``The Failure of Shock Therapy.'' Problems of 
Post Communism, Fall 1994.
---------------------------------------------------------------------------
    Russia from the time of Peter the Great through the Soviet 
period has a history of radical change imposed from the top on 
the population, change that has almost always entailed very 
large costs on the contemporary population in the name of 
future benefits. The Bolsheviks carried out a series of 
campaigns, such as mass collectivization, rapid 
industrialization, the Virgin Lands program, that were 
typically imposed from the top and implemented with little 
concern for the underlying population, whether opponents or 
not. Yeltsin followed this tradition like a good Bolshevik 
despite his renunciation of the Communist Party. Price 
liberalization in 1992 wiped out personal savings of the 
population at large. Hasty privatization of Soviet enterprises 
and natural resources transferred public wealth into a very 
small number of private hands to a degree unprecedented in 
history. Real income crashed for most Russian citizens. Poverty 
and unemployment caused untold misery for Russian pensioners, 
the working class and the farmers. Only a few have benefited in 
the short run. Some improvement is now taking place in the 
medium term, after 10 years, but much remains to be done to 
turn the Russian economy into a workable and stable market 
economy. And there is no assurance that the positive rate of 
growth of gross domestic product (GDP) that Russian has 
experienced for the past 2 years can be sustained.\3\
---------------------------------------------------------------------------
    \3\ Hedlund, Stefan. Russia's ``Market'' Economy: A Bad Case of 
Predatory Capitalism. London, UK: UCL Press Limited, 1999.
    Bush, Keith. ``The Russian Economy in June 2001,'' Russia and 
Eurasia Program, CSIS (June 2001), E-document.
---------------------------------------------------------------------------
    Vladimir Putin has thus far eschewed radical economic 
reform, preferring instead to work with the Duma to promote a 
series of measures designed to make the economy more responsive 
to markets and the global economy. He may be labeled a 
gradualist to date, and willing to compromise with the foes of 
a liberal market economy rather than confront them. What is the 
prospect that he will indeed be able to achieve gradually what 
his predecessor Boris Yeltsin failed to achieve by brute 
political force? What does the long run hold for the Russian 
economy? The concern of this paper is to try to specify what 
that long-run prospect is likely to be, with due deference to 
how ``slight'' our powers of prediction are and the uncertain 
command Russian leaders have over results.

  The Current Condition of the Russian Economy and of Economic Reform

    An examination of reform successes and failures among the 
25 independent countries that emerged from the Soviet Empire 
reveals that a strong, unambiguous commitment to economic 
reform has been an important, if not the most important, 
variable. The most successful states have been those that 
wanted desperately to get out from under Soviet power. They 
have sought to link their fortunes with Europe, especially to 
the European Union. Also critical, almost all had experienced a 
period of independent existence as states before coming under 
Soviet influence.\4\ As in almost all of the former republics 
of the U.S.S.R., the leadership in Russia has been ambivalent 
about introducing the reforms necessary to create a workable 
market economy and ambivalent also about its relationship to 
Europe.
---------------------------------------------------------------------------
    \4\ Millar, James R. ``The Post Cold-War Settlement and the End of 
the Transition: Implications for Slavic and East European Studies,'' 
NewsNet, The Newsletter of the AAASS (American Association for the 
Advancement of Slavic Studies), January 2001, v. 41, no. 1.
---------------------------------------------------------------------------
    Yeltsin's commitment to economic reform was never constant, 
and it diminished over the years of his erratic rule. His 
successor, Vladimir Putin, remains something of a mystery. Is 
Putin a cautious, but determined reformer seeking step-by-step 
reform in the spirit of Lord Keynes and Edmund Burke? A recent 
statement on Russia Day, a celebration of the tenth year since 
Russia was declared a republic, might qualify Putin for this 
title: ``Everything we endured over the past decade, all our 
experiences, successes and failures, shows one thing--any 
reform only makes sense when it serves the people.'' \5\
---------------------------------------------------------------------------
    \5\ Johnson's Russia List #5295; Reuters: Jon Boyle.
---------------------------------------------------------------------------
    Or is he primarily concerned with maximizing political 
power primarily in order to keep himself in power? Putin has 
certainly talked like a real reformer, but his actions have 
been more difficult to interpret. The high world market price 
of oil has provided a large windfall gain for Putin's 
government, as has the vigorous response of Russian industry to 
the benefits of the devaluation of the ruble that followed the 
1998 financial crisis. The question is: How effectively has 
Putin utilized this period of relative prosperity? What has he 
actually done to sustain economic growth after the windfall 
gains of 2000 and 2001 have been exhausted?

                           economic measures

    At the outset of his presidency, Putin indicated that he 
planned to reduce the political and economic power of the 
wealthy individuals known as ``oligarchs'' who benefited so 
greatly from privatization of Russian industry and natural 
resources. Thus far two of the most prominent and vocal 
oligarchs, Boris Berezovsky and Vladimir Gusinsky, have been 
thoroughly undermined. Gusinsky has apparently lost his media 
empire, and Berezovsky has gone from kingmaker (for both 
Yeltsin and Putin) to political outcast. However, Putin's 
motive appears to have had less to do with economic power than 
with the desire to quiet criticism from their media 
enterprises. Putin obviously does not appreciate criticism, and 
he has effectively crushed the independent media in Russia by 
undermining Berezovsky and Gusinsky. More recently,\6\ Putin 
engineered the removal of Rem Vyakhirev, who had been CEO of 
the giant natural gas monopoly Gazprom since 1992, and replaced 
him with Aleksei Miller, a long-time Putin loyalist. Vyakhirev 
was a variant type of oligarch, one appointed essentially by 
the government to manage a huge partly private, partly state 
enterprise. In replacing Vyakhirev, Putin has strengthened his 
hand in many respects because Gazprom is such an important cash 
cow for the budget. If Miller manages Gazprom more efficiently 
and does not use access to its great wealth mainly for his own 
personal enrichment, this change will represent a major 
economic advance. That is yet to be seen. The verdict on 
Putin's policy toward the oligarchs is, therefore, not yet in. 
The remaining oligarchs, with the exception of Anatoly Chubais, 
who has metamorphosed from radical reformer to oligarch and now 
runs the national electricity monopoly, are lying low 
politically, which may be the price they must pay to keep their 
ill-gotten wealth intact.
---------------------------------------------------------------------------
    \6\ New York Times, May 30, 2001.
---------------------------------------------------------------------------
    The Minister of Economic Development and Trade, German Gref 
has produced a 10 year plan for the Russian economy that was 
officially adopted by Prime Minister Mikhail Kasyanov in June 
2000,\7\ but it has yet to be truly engaged. Curiously, the 
plan has certain earmarks of Soviet-era long-term plans, and it 
may meet the same fate--to be announced with great fanfare and 
then forgotten. Meanwhile, Presidential economic advisor Andrei 
Illarionov has bitterly criticized Gref's plan as 
insufficiently reformist and unrealistic. Illarionov, who seems 
to be something of a loose cannon, continues to quarrel with 
Anatoly Chubais, CEO of RAO UES (Unified Energy Systems of 
Russia), concerning reform and management of the energy 
monopoly. He has also criticized the Prime Minister sharply for 
even suggesting earlier this year the possible postponement of 
payments of principal and interest to the Paris Club,\8\ and 
they have had other public quarrels too. Meanwhile, Putin has 
maintained silence regarding these conflicts among his economic 
advisors. Apart from a tax reform and, more recently, urban 
land tenure reform, progress on the many economic reforms that 
are needed has been modest at best. Everyone agrees, for 
example, on the need for better corporate governance, but no 
one seems to be doing anything other than talking about it. 
Similarly, restructuring and reform of commercial banking and 
the financial system generally have been oft mentioned but 
rarely acted upon convincingly.
---------------------------------------------------------------------------
    \7\ Russian Journal, June 29, 2000.
    \8\ Lipman, Masha. ``The Indecisive President.'' The Washington 
Post, February 6, 2001.
---------------------------------------------------------------------------
    Andrei Illarionov also forecast (wrongly it now seems) 
bleak economic performance for 2001 to the European Business 
Club in Moscow January 16: ``The party is over and the hangover 
is about to begin.'' He stated that the Prime Minister had had 
nothing to do with successful economic growth in 2000. It was 
``sparked by sky-high oil prices and the rapid depreciation of 
the euro to the U.S. dollar.'' \9\ In June, Illarionov, 
addressing members of the American trade chamber, amazed his 
audience by arguing that ``Russia has no need of investments or 
credits.''\10\ Meanwhile, Kasyanov has been urging investment 
in Russia during his foreign trips. The question is: Where was 
Putin? Are his economic advisors allowed to say anything they 
want; to quarrel publicly without official resolution of the 
issues?
---------------------------------------------------------------------------
    \9\ Semenenko, Igor. ``Illarionov Warns of Looming Gloom.'' Moscow 
Times, January 17, 2001.
    \10\ Izvestia, June 4, 2001.
---------------------------------------------------------------------------
    Privatization of rural land remains deadlocked. Putin has 
urged the regional governors to support ``coherent land 
legislation'' and a federal land code. German Gref, Mikhail 
Kasyanov and Andrei Illarionov all agree on the economic 
benefits private land tenure would bring about. Recent 
developments indicate that urban land, which comprises less 
than 10 percent of all land area in Russia, will be opened to 
private, and perhaps even foreign private, ownership. But the 
opponents of privatization of rural land in the Duma continue 
to oppose it on ideological and historical grounds.\11\
---------------------------------------------------------------------------
    \11\ Lambroschini, Sophie. ``The Government Uncertain Role to Land 
Privatization.'' Part 1, RFE/RL, February 9, 2001.
---------------------------------------------------------------------------
    Urban land has been controlled by mayors and regional 
governors for local ends and personal profit, and they may 
still find ways to frustrate or restrict private ownership. 
Agricultural land has always been treated as commons or as 
communal property, and even most peasants want it to stay that 
way. The result is that action on land tenure continues to be 
controversial and stagnate, which contributes to a poor 
environment for foreign direct investment.

              politics, military reform and foreign policy

    What is true of economic policy is true generally. Putin's 
policies have been anything but bold, coherent and decisive. 
Putin has had relatively good relations with the Duma, but he 
has yet to push reforms through it vigorously. He was 
successful in establishing federal control over the various 
provincial regions last year, at least pro forma. The regional 
governors were ousted from Parliament, but, in the end, they 
were allowed to appoint their replacements. Also, the maximum 
of two terms for the 89 regional leaders was revised in January 
2001, allowing 69 of them to run for a third term. As one 
observer put it, ``In other words, as long as the governors 
don't challenge Putin's authority, they can continue to rule as 
they have been [doing] . . . .''\12\ The jury is still out on 
how effective Putin's seven presidential super-governors will 
be in reigning in the regional governors. A recent Radio Free 
Europe/Radio Liberty (RFE/RL) Russian Federation Reform 
Roundtable discussion among American scholars suggests that the 
reform has been quite ineffective.\13\ The jury is still out on 
how effective Putin's seven presidential supergovernors will be 
in reigning in the regional bosses.
---------------------------------------------------------------------------
    \12\ Moscow Times, Editorial, January 29, 2001.
    \13\ Johnson's Russia List #5226, April 27, 2001.
---------------------------------------------------------------------------
    Putin has also succeeded in silencing media criticism of 
him and his government. Grigory Yavlinsky, head of the small 
liberal party, has described Putin's policies harshly as 
``National Bolshevism.'' What is happening to the country, he 
stated recently, is ``sham freedom of speech, sham independent 
judiciary, sham elections, sham multi-party system and a sham 
separation of powers.'' The Putin regime displays, according to 
Yavlinsky, ``Absence of any notion of the value of human life, 
any idea that there are inalienable rights and freedoms.''\14\
---------------------------------------------------------------------------
    \14\ Johnson's Russia List #5058, Moscow Times, January 30, 2001.
---------------------------------------------------------------------------
    Some progress has been made recently on military reform. 
The conflict between the chief of the general staff, Anatoly 
Kvashnin, and the minister of defense, Igor Sergeev, over what 
the relative priorities ought to be between strategic missiles 
and conventional weapons and troops may have been resolved in 
favor of Kvashnin recently, but it is too early to tell. But no 
resolution is apparent regarding the deep reforms of the 
military that budgetary constraints require. The military 
continues to deteriorate, along with the defense industry, 
which is deeply in debt. Russian military leaders have yet to 
confront the limitations they face after years of budgetary 
priority in the Soviet period. Today the budget for the 
military is, at best, one-fifth that for the U.S. military.\15\ 
Once again Putin has not spelled out a clear cut policy. The 
submarine Kursk episode shows that Putin is prepared to allow 
the military to lie to the public and the world about the 
probable cause of the sinking. This recalls Soviet times when 
high officials and military personnel sometimes maintained a 
lie despite the fact that only the least informed foreigner or 
domestic citizen believed them.
---------------------------------------------------------------------------
    \15\ Dr. Christopher Hill, British Ministry of Defense, London, 
Briefing, January 31, 2001.
---------------------------------------------------------------------------
    In foreign policy Putin has sought to restore economic and 
political relations with the Soviet Union's old allies: Iran, 
Iraq, Cuba, and North Korea. It has also strengthened relations 
with China. The Foreign Minister, Ivanov, has stated that the 
Near Abroad, that is, the former republics of the U.S.S.R., 
falls within Russia's sphere of influence. The implication is 
clear, Putin has been seeking to restore Russia's dominant 
position in the region and, to the extent possible, restore the 
Soviet empire through energy dependency, aggressive military 
exercises, showing of the flag, and minatory behavior in the 
Caspian region. With the exception of China, the countries 
Putin is reaching out to are either global outcasts or economic 
basket cases. It is an alliance of losers. The policy could be, 
therefore, a costly one internationally and economically. The 
attempt to attain hegemony over the so-called Near Abroad 
represents a serious drain on Russia's resources. So does the 
apparently interminable war in Chechnya. What the new conflict 
between the United States and Afghanistan portends for Russian 
foreign policy is still not clear, but it has all the makings 
of a quagmire that Russian might not be able to avoid.
    Interestingly, and related to ``empire envy,'' is the 
restoration of some Soviet symbols and the creation of new 
patriotic ones. The Soviet hymn has been resurrected and 
refurbished. Red banners have been restored for the military, 
perks have been created for the President that are competitive 
with those received by the American president. And Putin has 
traveled abroad to high visibility events where he can be 
photographed consorting with the world's powerful leaders. 
These activities, which have little to do with reform, have 
been met with approbation by the general public.
    Putin's positive response to the terrorist attack on the 
United States and to America's declaration of war on 
international terrorism appears to contradict his policies to 
date designed to restore former allies and republics of the 
U.S.S.R. to Russia's sphere of influence and support. Not only 
has he moved sharply back toward the Western camp, he has 
acceded to U.S. action in Afghanistan and, more surprisingly, 
to the placement of U.S. troops and other military assets in 
Uzbekistan and perhaps elsewhere in Central Asia. He will 
ultimately have to choose between creating a ``multi-polar'' 
counterweight to U.S. hegemony in the world and becoming a 
junior partner in the international alliance against terrorism. 
It is too early to tell how he will resolve this contradiction, 
but he cannot waffle for very long.

                            putin as leader

    On balance, Putin appears to be rather indecisive. If one 
reads only his speeches, Putin provides accurate diagnoses and 
reasonable prescriptions as remedies, but the follow through 
has been weak.\16\ Putin avoids direct conflict with his 
subordinates. When trouble arises, he tends to back down, or to 
claim he knew nothing about the issue, or that he has no 
authority in the case in question, or remains silent. Time-
Europe correspondent Paul Quinn-Judge writes:
---------------------------------------------------------------------------
    \16\ Putin's January 1, 2000 speech, ``Russia at the Turn of the 
New Millennium.'' Web page of Russian Federation, http://
pravitelstvo.gov.ru.

          ``The pessimistic variant is that, when major 
        problems arise, Putin will opt for the easy way out--
        blaming enemies, stifling criticisms and muddling 
        through.''\17\
---------------------------------------------------------------------------
    \17\ ``The Politics of Mind Over Matter,'' Time-Europe, January 22, 
2000.

---------------------------------------------------------------------------
    According to Alexandr Tsipko:

          ``Like many of his predecessors, solving moral and 
        political problems comes more easily to Putin than 
        solving social and economic problems.''
          ``Gorbachev's glasnost rehabilitated truth, ethics 
        and common human values. Putin has rehabilitated 
        Russian patriotism, national dignity, statist integrity 
        and the consolidation of Russian statehood.''
          ``The task of maintaining . . . the national 
        consensus . . . will be in constant conflict with the 
        task of modernizing Russia and implementing market 
        reforms.''\18\
---------------------------------------------------------------------------
    \18\ Jamestown Foundation Prism, A Monthly on Post-Soviet Studies, 
January 2001, Vol. VII, Issue 1, Part 2
---------------------------------------------------------------------------

                         why is putin popular?

    Survey research specialist Yuri Levada states that: ``He 
has given Russia leadership.'' Paul Quinn-Judge writes:

          ``Putin's first year has turned out to be a 
        remarkable example of mind over matter in public 
        opinion. There have been few major accomplishments, 
        several disasters and some ominous developments in the 
        field of human rights and press freedom.''\19\
---------------------------------------------------------------------------
    \19\ Time-Europe, January 22, 2000.

    The simple answer may be a variant ``Linda Tripp'' 
phenomenon. Judging by his behavior, Putin does not really have 
to consult the polls because he is ``just like them.'' He 
clearly regrets the breakup of the U.S.S.R. and Russia's loss 
of military power and respect in the world community. He is 
suspicious of markets and prefers state control of heavy 
industry, the military-industrial complex, communications and 
the media, banking and transportation. He is in favor of a 
paternalistic and strong state. The public agrees on every 
count.

 implications for the sustainability of economic reform and growth in 
                       russia in the near future

    The outlook for economic reform and continued economic 
growth over the next year or so is positive, but only 
marginally so. Gorbachev sought to reform the Soviet socialist 
economy, to make it more humane and more responsive to the 
popular will by introducing certain elements of a market 
economy. The reform failed. Yeltsin led a revolution that 
destroyed the coordinates of the Soviet economy and attempted 
to replace it with market institutions. The revolution achieved 
partial success. The planned economy was destroyed totally, but 
the disastrous economic consequences of the revolution for the 
population at large and the capture of it by the nomenklatura 
caused it to grind to a halt. Putin is now leading a partial 
restoration of Russia, a pause in the radical changes that have 
been taking place since perestroika and glasnost were 
introduced in 1988-1989. In this sense the economic transition 
is over, but, of course, a good deal remains to be done to 
complete market institutions.
    Putin is restoring hope for the future, the sense that 
Russia will again assume her proper place as a major power in 
the world, that domestic order will be restored, corruption 
will be curtailed and that the economy will rebound. He has 
also created the hope that these ends may be accomplished 
without further violent disruptions to society. In the short 
run these aspirations are doomed to disappointment. Economic 
growth is more likely to stagnate than to be maintained, for 
too much depends at present upon the uncertain price of oil and 
of other natural resource exports, such as gas and metals, and 
upon the diminishing boost to domestic production from the 1998 
devaluation. Foreign direct investment is unlikely to increase 
significantly until reforms in corporate governance, commercial 
banking and competition policy are enacted. The distraction 
caused by empire aspirations will continue to drain the 
treasury and inhibit economic reform. Also, despite brave 
statements to the contrary, Putin has yet to tackle the problem 
of public or private corruption.
    Thus far, Putin has been more focused upon the accumulation 
of power than upon its exercise. This is a sign of insecurity 
by a leader who, above all, wants to remain in power. 
Completion of the reforms necessary to turn the Russian economy 
into a functioning, workable globally competitive economic 
system will require the expenditure of power and the risk, as 
Gorbachev discovered, of removal from power. Putin's caution 
may, therefore, slow the reform process and highlight instead 
the pageantry and ritual of the process of restoration. This is 
not to say that the Soviet economy or the Communist Party will 
be restored. They are dead and gone and cannot be resurrected. 
What Putin is trying to restore is the national pride and will 
of the Russian people. This is a necessary but insufficient 
condition for the completion of market reform and successful 
entry into the competitive global economy. At present, however, 
the most likely outcome is gradual change, with economic 
stagnation a close second. A much bleaker picture was presented 
in a recent Russian Government Report, which forecast the 
conjuncture of three major negative trends in the year 2003. 
The economic infrastructure will crumble. The demographic 
crisis will peak. And external debt service will become 
overwhelming.\20\ Like the ``wonderful one-hoss shay,'' the 
Russian economy might go ``to pieces all at once . . .''.\21\
---------------------------------------------------------------------------
    \20\ Weist, Fred. Christian Science Review, February 15, 2001.
    \21\ Holmes, Oliver Wendell. ``The Wonderful One-Hoss Shay.'' 
http://www.library.utoronto.ca/uetl/rp/poems/holmes9.html.
---------------------------------------------------------------------------

                       prospects for the long run

    In October 1980 a conference was held at Airlie House in 
Virginia which ``had as its theme the long-term prospective 
growth of the Soviet economy.'' The conference was organized by 
Professors Abram Bergson and Herbert Levine, two very senior 
specialists on the Soviet economy. The list of contributors and 
participants reads like an honor role of Soviet specialists. 
Their charge was to appraise economic prospects to the year 
2000.
     Participants considered several scenarios, but, in the 
end, the consensus was that the Soviet economy would continue 
to ``muddle'' on without radical changes for the next two 
decades. In summing up his reaction to the presentations, 
Seweryn Bialer, in ``Politics and Priorities,'' concluded:

          In sum, we can anticipate no fundamental changes in 
        the Soviet Union during the 1980s despite intense and 
        divisive discussions concerning economic reforms, a 
        number of organizational policy initiatives, 
        experimentation with the economic structure, and 
        significant political conflict.\22\
---------------------------------------------------------------------------
    \22\ The Soviet Economy Toward the Year 2000, p. 419.

    Needless to say, the forecasts produced in 1981 were 
history by 1988 much less 2000. The picture painted for the 
year 2000 was totally off, whether predictions of GDP, 
population, agricultural production, development, planning and 
management or politics. Like everyone else, the top specialists 
on the Soviet economy were blindsided by Gorbachev and Yeltsin.
     Soviet specialists' experience in this attempt to project 
current trends 20 years into the future must give pause to any 
attempt to do the same today with Putin's Russia. The analysis 
and forecast that follow differ in two respects from those 
produced at Airlie House. First, The Soviet Union had 
experienced a decade or more of stagnation under Leonid 
Brezhnev. Russia, by contrast, has undergone radical change and 
much political and economic instability over the past decade. 
Further radical economic change is highly unlikely because the 
population is exhausted and opposed to new economic 
experiments. Putin appears to oppose radical change too. The 
transition is over for Russia. Second, the Bergson-Levine 
volume was not based on any explicit theory of economic and 
social change. Pure extrapolation is always dangerous.

the future of russia as a market economy: the transition in historical 
                              perspective

    Peering into the future cannot be based merely on an 
extrapolation of current trends. An examination of Russia's 
place in the historical process of economic development may 
provide some insights into what we can expect the Russian 
economic developments to be over the next several decades.
    A debate engaged Western economists during the 1950s and 
1960s over the possible convergence of socialist systems, such 
as the Soviet Union, and capitalist systems, such as the United 
States. The debate over convergence appears in a quite 
different perspective today in the light of the universal 
collapse of the Soviet command economy and the contrasting 
vitality of capitalist systems. Two positions in the debate 
were considered extreme and highly unlikely outcomes by most 
participants in the debate. Marxists anticipated the overthrow 
of capitalism and worldwide convergence on a Communist economic 
system. The expansion of Soviet power in East Europe, Mao's 
success in China, and the attraction of Marxism for many 
underdeveloped countries provided a foundation for the 
viewpoint. For the Marxists, market institutions represented 
merely a transitory stage in human history, one that would be 
followed by equity in economic allocations and, consequently, 
an end to economic conflicts caused by scarcity.\23\
---------------------------------------------------------------------------
    \23\ Marx, Karl. Capital: A Critique of Political Economy, New 
York, NY: The Modern Library, 1906.
---------------------------------------------------------------------------
    The other extreme view was expressed most fully by 
Friedrich A. von Hayek. He expected the abandonment of central 
planning in the socialist economies because of the inherently 
superior efficiency of market economies in solving the crucial 
``economic problem,'' that is, the rational allocation of 
resources among competing alternative uses. The argument held 
that central planning cannot substitute for markets because 
there are simply too many supply and demand equations for any 
central agency to solve satisfactorily. Decentralized decision 
making by private individuals represented the only successful 
way to do so historically.\24\
---------------------------------------------------------------------------
    \24\ Hayek, Friedrich A. The Road to Serfdom. Chicago, IL: The 
University of Chicago Press, 1957.
    ------, ed. Collectivist Economic Planning. London, England: Butler 
& Tanner Ltd., 1935.
---------------------------------------------------------------------------
    Neither argument for unilateral convergence gained much 
traction in the debate of the 1950s and 1960s. Mutual 
convergence was instead the prevailing view. Capitalism and 
socialism were conceived as occupying opposite ends of a 
spectrum, with the U.S. and Soviet economies near either 
extreme. Proponents of mutual convergence viewed socialist and 
capitalist economies as moderating their distinctive 
institutions and becoming more alike. Welfare capitalism was 
developing in the West, and, at the same time, socialist 
economies were experimenting with the introduction of market 
elements.
    The most sophisticated version of mutual convergence was 
put forward by the Nobel Prize winning economist Jan Tinbergen. 
His main contribution was the ``theory of the optimal regime.'' 
Tinbergen recognized the inevitability of a trade off between 
economic efficiency and economic equity in any actual human 
society. There exists, he assumed, an optimal regime that 
rational men and women would ultimately recognize and work 
toward, one that balanced the benefits of efficiency against 
those of equity. If so, extreme regimes, such as the United 
States and the Soviet Union, would prove unstable, and each 
would approach the mean. Thus, he predicted convergence under 
which the Soviet Union would gradually introduce markets, 
reduce government intervention in the economy and allow a 
greater role for private property. Similarly, the United States 
would develop increasingly as a welfare state, strengthen 
government regulation of markets and increase public ownership 
of productive property. Capitalist and socialist systems would, 
therefore, converge over time on the optimal economic 
regime.\25\
---------------------------------------------------------------------------
    \25\ Tinbergen, Jan. ``Do Communist and Free Economies Show a 
Convergence Pattern?'' Soviet Studies. 1961, vol. 12, n. 4, pp. 335-
341.
    ------. ``The Theory of the Optimum Regime,'' in Klaasen, L.H., 
L.M. Koyck and H.J. Witteveen, eds. Selected Papers. Amsterdam, 
Holland: North-Holland Publishing Company, 1959, pp. 264-305.
---------------------------------------------------------------------------
    In retrospect, Tinbergen's theory, and others like it based 
on rational choice and political pragmatism, appears seriously 
flawed. The implicit assumption that the U.S. and U.S.S.R. 
economies were equidistant from the optimal regime may be seen 
today to have been wrongheaded. Von Hayek's analysis has fared 
much better as a prediction. When the planned economies were 
opened to the global economy they wilted like tropical plants 
deprived of a hothouse. The egregious extent to which these 
economics had become distorted as a result of central planning 
based on quantitative orders and arbitrary pricing of final 
goods and services confirmed Hayek's point. Soviet-type 
socialism was clearly highly inefficient in the allocation of 
resources and in fostering innovation. The problem was 
efficiency, not equity. Command economies may be highly 
effective in mobilizing resources for a specific purpose, such 
as a war or to develop the atomic bomb, but they have failed to 
compete successfully with capitalist economies in the long run. 
For longer periods, the absence of flexible prices, 
entrepreneurship and local decision making was costly in 
efficiency and growth.
    It is not necessary, however, to abandon Tinbergen's notion 
of an optimal regime, a regime that balances equity and 
efficiency. The Soviet economy was, it seems, the historical 
outlier, and it is now presumably being modified in the 
direction of the optimal regime. Support for this view is 
provided by another Nobel Prize winner, J.R. Hicks, in his 
Theory of Economic History (1969). Hicks is interested in the 
rise of the market as an historical phenomenon, and he views 
the non-market economy, which includes the command economy, as 
an older form of economic organization. He traces the evolution 
of markets from the earliest periods of recorded history. 
Markets originated for the conduct of external trade, but 
gradually penetrated the domestic economy. First, there was the 
growth of internal trade in goods. Second, was the extension of 
the market to include labor services. Subsequently, land and 
capital became subject to the market. Domestically, the market 
has continued to broaden its coverage, displacing, for example, 
what had been considered family obligations to children and 
parents with paid services. The system of custom and command 
has gradually retreated as we have moved toward a cradle to the 
grave market economy. The temporal sequence by which markets 
have penetrated personal as well as business relationships is 
telling, for a similar sequence may be seen in the transition 
economies of today.
    Morris Copeland, quite independently, developed a 
complementary theory of economic history, one that stresses the 
critical role of money and credit in market economies as 
sources of economic discretion, and, by implication, 
rationality. Money implies the existence of prices, wages and 
interest rates and thus the possibility of multilateral trade. 
The spread of pecuniary institutions co-developed with markets 
and facilitated efficient trade.\26\
---------------------------------------------------------------------------
    \26\ Copeland, Morris. Essays in Socioeconomic Evolution. New York, 
NY: Vintage Press, 1981.
---------------------------------------------------------------------------
    Seen in this light, the Soviet-type socialist economy was 
an historical regression, a deliberate, conscious attempt to 
reverse fundamental historical processes. Soviet economic 
institutions were created for the explicit Marxist intention to 
minimize and eventually eliminate markets, money, credit, 
prices and wages. It is not surprising that the Soviet economy 
performed well in WWII as a way to mobilize and concentrate 
resources on a limited number of goals. However, the attempt to 
maintain the command economy indefinitely implied the need for 
a permanent emergency, and the cold war afforded a rationale. 
The Hicksian-Copeland understanding of the spread of the market 
economy implies, therefore, that Russia is today back on the 
track of normal evolution of markets and market instruments 
after a long and costly deviation. Russia, and the other former 
republics of the U.S.S.R., traveled the longest and farthest 
along this historical deviation. As the theory suggests, it has 
been the most difficult for Russia and the other former 
republics of the U.S.S.R. to redevelop those markets that were 
relatively underdeveloped at the time of the 1917 Revolution, 
such as the markets for urban and rural land, or that were 
extirpated thoroughly by the Bolsheviks, such as investment, 
financial and existing productive asset markets. It has also 
proven difficult for them to establish true commercial banking 
systems, effective and equitable corporate governance 
institutions and workable competitive markets. Attempts to 
catch up with capitalist institutions in the more advanced 
countries have been opposed by Marxist ideologues, Soviet 
traditionalists, and a deep-seated and widespread popular 
belief in the uniqueness of Russia's mission in the world. 
Economic interests vested in the monopolistic and oligopolistic 
structure of enterprise ownership that Russian-style 
privatization created have also been obstacles to further 
reform.

     the probable structure of the russian economy in the long run

    At the outset of radical economic reform under Yeltsin in 
Russia there were a number of economists and policy makers in 
the West who dreamed of creating the perfect capitalist system 
in Russia. The collapse of communism and central planning was 
viewed as a ``clean slate.'' Jude Wanniski, for example, wrote 
in 1992:

          It is possible to imagine a future of Russian 
        capitalism that asserts itself early in 21st century as 
        the envy of the world. . . .
          The Russian people are now engaged in nothing less 
        than designing the basic architecture of a brand new 
        country. Why not consider all possibilities? Why not 
        design the Russian system of capitalism to be the best? 
        \27\
---------------------------------------------------------------------------
    \27\ Quoted in Millar, James R. ``The Economies of the CIS: 
Reformation, Revolution, or Restoration?'' in The Former Soviet Union 
in Transition, Volume 1, Study Papers submitted to the Joint Economic 
Committee Congress of the United States. 103d Congress, U.S. Government 
Printing Office, Washington, DC: 1993, p. 36.

    By the ``best'' Wanniski clearly meant an economy in which 
state ownership and intervention in the economy would be even 
less than in the most advanced capitalist countries, such as 
the United States. As a more ``pure'' capitalist system, the 
transformed Russian economy would outperform the rest. Jan 
Wanniski's idea that Russia might leapfrog the west in 
perfecting capitalism has proven an idle dream. Old economic 
institutions and behaviors do not ordinarily disappear without 
a trace, and especially where the they have continuing support 
from the population at large, including the leadership.
     The Gosplan has disappeared, but surveys both before and 
after the collapse of the Soviet economy reveal that very 
substantial majorities still expect the government to provide, 
for example, price stability, job security, subsidized housing, 
free medical care, and free public education through college. 
Similarly, the majority has repeatedly indicated a preference 
for public ownership of railroads, airlines, heavy industry, 
communications, banks and other large-scale enterprises such as 
the defense industries.\28\ In addition, many enterprises and 
public institutions still operate like company towns and have 
yet to rationalize employment. The Russian economist Nikolay 
Shmelev aptly pointed out that it had taken ``three 
generations'' to build the ``insane asylum'' that was the 
Soviet economy and that it would take at least three more to 
escape from it. To escape will require changes in both the 
thinking and the behavior of citizens and leaders alike.\29\
---------------------------------------------------------------------------
    \28\ Millar, James R. ``Empire Envy, Stop-Go Economic Policies, and 
Political Constraints in Economic Reform in Russia.'' Problems of Post-
Communism. 1998, vol. 45, no. 3.
    ------. ``Prospects for Economic Reform. Is (Was) Gorbachev Really 
Necessary?'' in Lee, J.J. and Walter Korter, eds. Europe in Transition: 
Political, Economic and Security Prospects for the 1990s. Austin, TX: 
Lyndon B. Johnson School of Public Affairs, 1991.
    \29\ Millar, James R. ``The Economies of the CIS: Reformation, 
Revolution, or Restoration?'' in The Former Soviet Union in Transition, 
Volume 1, Study Papers submitted to the Joint Economic Committee 
Congress of the United States. 103d Congress, U.S. Government Printing 
Office, Washington, DC: 1993, pp. 34-54.
---------------------------------------------------------------------------
     In the 1920s Vladimir Lenin persuaded the Bolsheviks to 
give up the attempt to go directly from capitalism to 
socialism. The Great War and the revolutions and civil war that 
ensued had left the economy in ruins, and Lenin realized that 
the Bolsheviks were too few and too inexperienced to build a 
new economy from scratch. Consequently, the Bolsheviks 
introduced the New Economic Policy (NEP), which permitted 
small-scale private enterprise both in rural and urban areas, 
but reserved what Lenin called the ``commanding heights'' to 
state ownership and control. The commanding heights included 
heavy industry, electric power generation, transportation, 
communications and banking. It was anticipated that eventually 
the superiority of the socialist state sector would allow it to 
crowd out the private sector. The New Economic Policy was 
relatively successful, and, partly for this reason, it was 
destroyed by Joseph Stalin's introduction of rapid 
industrialization and forced mass collectivization in the 
1930s.
    What has been developing in Russia over the last decade is 
not Wanniski's pure capitalism, but a modified version of the 
NEP. Let's call it the neo-NEP. Small business is private, but 
the ``commanding heights'' are mostly shared by the state and 
the oligarchs. Privatization in Russia often did not break 
cleanly with state ownership. The state, as in the case of 
Gazprom for example, maintained either a controlling or a 
significant minority position as shareholder. Thus, the state 
also has appointed members of the boards of these enterprises 
and, occasionally, even the director himself. This kind of 
sharing between the state and private capital is not uncommon 
in Europe, and it is likely to remain a feature in Russia for 
the indefinite future.
     Although Russia is not now a candidate for accession to 
the European Union, the institutional structure of the EU can 
be expected to shape Russian economic and legal institutions in 
substantial degree in the future. In fact, the EU is much more 
likely to influence economic development and reform in Russia 
than are the International Monetary Fund (IMF) and World Bank, 
both of which are associated with major policy failures in the 
transition economies. The EU is an important trading partner 
and likely to become increasingly important over time, if only 
because Russia is such an important source of energy supplies 
to Europe. Russia also trades with East Central and East 
Europe, and many of the countries are either on the path to 
accession or hope to be in the near future. The EU has spelled 
out in chapter and verse just what a country needs to do to 
harmonize its institutions with those of Europe. Russia is 
certain to be influenced both directly and indirectly to 
harmonize with Europe. This is the most optimistic outlook for 
the future of capitalism in Russia.\30\
---------------------------------------------------------------------------
    \30\ Implications for Slavic and East European Studies,'' NewsNet, 
The Newsletter of the AAASS (American Association for the Advancement 
of Slavic Studies), January 2001, v. 41, no. 1.
---------------------------------------------------------------------------
     As many observers have noted, the criteria for accession 
to the EU are essential the same as the requirements for a 
successful transition to a workable market economy from the 
Soviet-type model. Accession indicators that are used to 
determine eligibility for membership include measures of the 
extent of large-scale and small-scale privatization, of success 
in restructuring enterprises to harden budget constraints, 
rationalize production and improve corporate governance. They 
also seek to measure the degree to which markets are 
competitive, prices have been liberalized and import and export 
restrictions have been eliminated. In addition, banking and 
financial institutions are evaluated against international 
standards of regulation and performance. Basically, the 
accession process involves modeling the transition economy upon 
the most successful members of the EU.
     Countries are scored on each of the eight principal 
indicators on a scale ranging from ``1'' for little progress, 
to ``4+'' for achieving standards and performance typical for 
advanced industrial economies. According to my own rough 
estimate, Russia's scores today range from a ``2+,'' for 
example, on large-scale privatization and corporate governance, 
to a ``3+'' on price liberalization and foreign trade and 
foreign exchange system policies, for an overall score of ``3'' 
or ``3-.'' These scores would not be sufficient to earn Russia 
membership, but they are indicative of the progress that has 
been made in market reform since 1991. The neo-NEP model 
described above as most nearly characteristic of the Russian 
economy today need not hamper further progress so long as 
enterprises controlled by the state singly or jointly with 
private interests meet governance and other requirements. The 
long-run outlook is, therefore, positive if the Putin 
government continues to press consistently for gradual reform 
and avoids foreign policy adventurism and domestic distortions 
caused by corruption and an ambiguous commitment to join the 
world economy as a full member.
    Russia is moving haltingly, therefore, toward the ``optimal 
regime'' Jan Tinbergen envisioned. It will never get there, of 
course, but the historical processes of marketization and 
pecuniarization are back at work in Russia, after 70 years or 
so of regression. Russia's economy is not going to be closed to 
the global economy. International trade is too profitable and 
memory of the failure of autarky and central planning is too 
fresh for that.
    It is highly likely, therefore, that Russia will become a 
full-fledged market economy in the European style. It does not 
necessarily follow that the market economy that develops will 
be any more successful than many other late developing market 
economies, such as Brazil, Mexico or Argentina. Stop-go 
economic policies are the most likely policies in these 
countries because reform will always run into public 
resistance. The adverse economic consequences of stopping 
reform eventually generate another round, which, in turn, again 
generates public resistance. Escaping from this circular 
process is Russia's challenge in the long run, as it is for so 
many countries aspiring to develop. Putin may not to be up to 
the job, it is too early to tell, but a successor may do so if 
Russia continues to focus on Europe as a trade partner. On the 
other hand, empire envy may prevail, thereby limiting Russia's 
options in the long run as well as today.

                               References

Aslund, Anders. How Russia Became a Market Economy. Washington, 
        DC: The Brookings Institution, 1995.
Bergson, Abram and Levine, Herbert S. eds. The Soviet Economy 
        Toward the Year 2000. London, England: George Allen & 
        Unwin, 1983.
Bush, Keith. ``The Russian Economy in June 2001,'' Russia and 
        Eurasia Program, CSIS (June 2001), E-document.
Copeland, Morris. ``Communities of Economic Interest and the 
        Price System,'' in Chandler Morse, ed. Fact and Theory 
        in Economics. Ithaca, NY: Cornell University Press, 
        1958.
------. Essays in Socioeconomic Evolution. New York, NY: 
        Vintage Press, 1981.
Dobson, Richard. Is Russia Turning the Corner? Changing Russian 
        Public Opinion, 1991-1996. Washington, DC: Russian, 
        Ukraine, and Commonwealth Branch Office of Research and 
        Media Reaction, U.S. Information Agency, 1996.
Ellman, Michael. ``Against Convergence.'' Cambridge Journal of 
        Economics. 1980, vol. 4, pp. 199-210.
Hayek, Friedrich A. The Road to Serfdom. Chicago, IL: The 
        University of Chicago Press, 1957.
------. ``The Use of Knowledge in Society.'' Economic Review. 
        1945, vol. 35, no. 4. pp. 519-530.
------, ed. Collectivist Economic Planning. London, England: 
        Butler & Tanner Ltd., 1935.
Hedlund, Stefan. Russia's ``Market'' Economy: A Bad Case of 
        Predatory Capitalism. London, England: UCL Press 
        Limited, 1999.
Hicks, John. A Theory of Economic History. London, England: 
        Oxford University Press, 1969.
Hill, Christopher. British Ministry of Defense, London, 
        Briefing, January 31, 2001.
Holmes, Oliver Wendell. ``The Wonderful One-Hoss Shay.'' http:/
        /www.library.utoronto.ca/uetl/rp/poems/holmes9.html.
http://pravitelstvo.gov.ru.
Izvestia, June 4, 2001.
Johnson's Russia List #5058, Moscow Times, January 30, 2001.
Johnson's Russia List #5226, April 27, 2001.
Johnson's Russia List #5295; Reuters: Jon Boyle.
Lambroschini, Sophie, ``The Government Uncertain Role to Land 
        Privatization.'' Part 1, RFE/RL, February 9, 2001.
Lipman, Masha, ``The Indecisive President.'' The Washington 
        Post, February 6, 2001.
Marx, Carl. Capital: A Critique of Political Economy, New York, 
        NY: The Modern Library, 1906.
Millar, James R. ``The Post Cold-War Settlement and the End of 
        the Transition: Implications for Slavic and East 
        European Studies.'' NewsNet, January 2001, v. 41, no. 
        1.
------. Susan J. Lintz, ed. The Soviet Economic Experiment. 
        Chicago, IL: University of Illinois Press, 1990.
------ and Elizabeth Clayton. ``Quality of life: Subjective 
        Measures of Relative Satisfaction,'' in Millar, James 
        R., ed. Politics, Work and Daily Life in the USSR. New 
        York, NY: Cambridge University Press, 1987, pp. 31-60.
------. ``Empire Envy, Stop-Go Economic Policies, and Political 
        Constraints in Economic Reform in Russia.'' Problems of 
        Post-Communism. 1998, vol. 45, no. 3.
------. ``The Failure of Shock Therapy.'' Problems of Post 
        Communism, Fall 1994.
------. ``The Economies of the CIS: Reformation, Revolution, or 
        Restoration?'' in The Former Soviet Union in 
        Transition, Volume 1, Study Papers submitted to the 
        Joint Economic Committee Congress of the United States. 
        103d Congress, U.S. Government Printing Office, 
        Washington, DC: 1993, pp. 34-54.
------. ``Prospects for Economic Reform. Is (Was) Gorbachev 
        Really Necessary?'' in Lee, J.J. and Walter Korter, 
        eds. Europe in Transition: Political, Economic and 
        Security Prospects for the 1990s. Austin, TX: Lyndon B. 
        Johnson School of Public Affairs, 1991.
------. ``The Importance of Initial Conditions in Economic 
        Transitions: An Evaluation of Economic Reform Progress 
        in Russia.'' Journal of Socio-Economics. 1997, vol. 26, 
        no. 4, pp. 359-381.
Moscow Times, Editorial, January 29, 2001.
Mundell, Robert A. ``The Great Contractions in Transition 
        Economies,'' in Blejer, Mario I. and Marko Skreb, eds. 
        Macroeconomic Stabilization in Transition Economies. 
        Cambridge, England: Cambridge University Press, 1997, 
        pp. 73-99.
New York Times, May 30, 2001.
Pigou, A.C. Socialism Versus Capitalism. London, England: 
        Macmillan, 1968.
Quinn-Judge, Paul. ``The Politics of Mind Over Matter,'' Time-
        Europe, January 22, 2000.
Russian Journal, June 29, 2000.
Semenenko, Igor. ``Illarionov Warns of Looming Gloom.'' Moscow 
        Times, January 17, 2001.
Sidelsky, Robert. John Maynard Keynes. The Economist As Savior, 
        1920-37. Viking Penguin, 1994.
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Tinbergen, Jan. ``Do Communist and Free Economies Show a 
        Convergence Pattern?'' Soviet Studies. 1961, vol. 12, 
        n. 4, pp. 335-341.
------. ``The Theory of the Optimum Regime,'' in Klaasen, L.H., 
        L.M. Koyck and H.J. Witteveen, eds. Selected Papers. 
        Amsterdam, Holland: North-Holland Publishing Company, 
        1959, pp. 264-305.
Tsipko, Alexandr. Jamestown Foundation Prism, A Monthly on 
        Post-Soviet Studies, January 2001, Vol. VII, Issue 1, 
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        Washington, DC: USIA, 1998.
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        20, no. 6, pp. 84-90.








                RUSSIA'S EVOLUTION AS A PREDATORY STATE


                       By Peter J. Stavrakis \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   347
The Predatory State: Model and Characteristics...................   349
    Official corruption, cronyism, and clan politics.............   349
    Ambiguous boundaries between key societal sectors and 
      institutions...............................................   351
    Difficulty in consolidating the rule of law..................   352
    Efficient informal communication networks....................   353
    Societal withdrawal and economic marginalization.............   354
    Recentralization and atrophy of regional authority...........   355
Explaining Russia's Affinity for the Predatory State.............   356
    Old wine in new bottles: the ``recomposition'' of traditional 
      Russian power..............................................   357
    Appearance matters: ``presentability'' and the image of 
      democracy..................................................   359
    The legacy of imperial success...............................   361
Conclusions and Implications for the West........................   363
                                Summary

    The decade since the collapse of the Soviet Union has seen 
the lively debate regarding the future of Russia move from 
early exuberant optimism, through growing concern, to deep 
pessimism. Official pessimism.\2\ Official Western policy has 
avoided either extreme, but there is little doubt that 
America's vision for Russia early on reflected considerable 
optimism for the transition to free market democracy. 
Regrettably, Russia proved to be more complex than prevailing 
theories of democratization and development could have 
anticipated. The end of the Yeltsin era left scholars and 
policymakers hopeful for Russia's future, yet deeply concerned 
that their hopes might not be fulfilled.
---------------------------------------------------------------------------
    \1\ Dr. Peter J. Stavrakis is in the Political Science Department 
of the University of Vermont. His doctorate was from the University of 
Wisconsin.
    \2\ Jeffrey Tayler presents the pessimistic view that the past 
decade has been the beginning of Russia's long--and seemingly 
permanent--descent from Great Power to international nonentity, 
``Russia Is Finished,'' The Atlantic Monthly, May 2001.
---------------------------------------------------------------------------
    President Vladimir Putin has now been in office for more 
than eighteen months, yet there has still been no persuasive 
account of the direction in which the new president is leading 
Russia. This is partly because many in the West have no 
persuasive, coherent model for understanding Russia other than 
as an emerging liberal democratic society. The purpose of this 
essay is to present an alternative framework for understanding 
Russia and, in so doing, provide policymakers with a model that 
more reliably informs them of Russia's future development. The 
central premise of the model is straightforward: post-Soviet 
Russia is not destined to be a liberal, free market democracy. 
Instead, a form of elite rule is being consolidated that, while 
principally corrupt, nevertheless retains considerable economic 
regenerative capacity. Understanding this emerging political 
system--the predatory state--makes it possible to recognize the 
motive forces driving Russia toward considerable social 
stability, a primarily productive economy, and a potentially 
influential role in global affairs.
    This is not to deny the considerable achievements in 
Russian reform during its first post-Communist decade: 
tolerably free democratic elections, the emergence of a free 
press, mass privatization, and considerable decentralization of 
governance, to name a few. The worrisome thing, however, is 
that President Vladimir Putin has aggressively pursued a 
prominent rollback of key reform achievements, and provided 
clear signals that Russia will move in directions different 
from those of liberal democracy: (1) prospects for economic 
recovery have improved, yet capital flight remains high and the 
revival of production is reliant on the vagaries of the oil 
export market; (2) privatization consumed Russian reform, but 
the state and a handful of economic oligarchs retain control 
over core enterprises and private ownership of agricultural 
land remains taboo; (3) state power is being recentralized and 
evidence accumulates daily that societal institutions such as a 
free press are being suppressed by renascent security organs; 
(4) earlier images of democratic governance have been replaced 
by an informal network of clan and crony rivalry, suffused with 
a kind of violent politics and corruption that harkens back to 
the first days of Soviet power; and, (5) previous hopes for the 
emergence of a limited state have been eclipsed by the 
renaissance of the strong state.
    The Putin era differs from the freewheeling chaotic 
struggles of the Yeltsin era--a period more akin to the 
populist despotisms seen elsewhere in the developing world. 
Under Putin, talk of state weakness has ceased, and clan 
politics continues, albeit in a more regulated fashion than 
previously. There is in the record of the past 2 years a sense 
that the basic elements of liberal democracy are being forcibly 
molded to suit Russian tastes and filled with a more familiar 
traditional content. Putin's policies reflect less a 
qualitative break with the past than a re-ordering of the ranks 
of privileged oligarchs and the institutionalization of the 
norms of political conduct--it is a bureaucratized variant of 
the disorderly blend of post-Communist populism that 
characterized the Yeltsin years. The rough edges of elite 
conflict have been smoothed off, the state has returned to its 
privileged position in society and economy, foreign investors 
now mull over not whether, but when and how, to re-enter the 
Russian market; and being from St. Petersburg or the Federal 
Security Service (FSB) has gained a level of respectability and 
influence that grates against the sensibilities of the 
Muscovite elite. This is no democracy, to be sure, but it is 
unmistakably the case that some form of order is taking shape 
out of the ruins of the past decade. Russia, in Shakespeare's 
words, may be madness, but there is method to it.
    The remaining sections are devoted first to an explanation 
of the nature of the predatory state and illustrations of its 
core characteristics present in contemporary Russia. A section 
devoted to explaining why Russian elites prefer the predatory 
state to the alternative of liberal democracy follows this. On 
the face of it, it is difficult to comprehend why a system 
interpenetrated by pervasive criminalization and corruption; 
weak legal and administrative institutions; and extensive state 
intervention (or ownership) would be preferred to the stability 
and productivity that liberal democracy promises. The final 
section presents some of the implications of the predatory 
state model for Russia's future, and its relations with the 
West.

             The Predatory State: Model and Characteristics

    Russia's recent past and more distant future are best 
explained by the model of the predatory state derived from the 
experience of post-imperial and post-colonial polities. The 
developmental path of these societies moves from state crisis 
to an equilibrium in which authoritarian elites exploit 
informal networks and corrupt practices to enhance their power 
and wealth at the expense of society. This produces a pattern 
in which an externally strong state undergoes a period of 
(often substantial) growth and influence. The economic and 
social marginalization attendant to predatory practices, 
however, generates growing vulnerabilities that in time may 
return the state to instability and crisis.\3\ Predatory elites 
sustain themselves through the arbitrary, coercive absorption 
of successful autonomous spheres of economic and social 
life.\4\ Free markets and civil society are hostage to 
political elites who are free to intervene whenever and 
wherever this appears financially profitable or politically 
useful.
---------------------------------------------------------------------------
    \3\ A similar case of predatory state behavior was earlier observed 
in Africa: ``hybrid regimes [in which] an outward democratic form is 
energized by an inner authoritarian capacity, especially in the realm 
of economic policy.'' Thandika Mkandawire, ``Crisis Management and the 
Making of `Choiceless' Democracies,'' in Joseph, Richard ed. State, 
Conflict and Democracy in Africa (Boulder, Co.: Lynne Rienner, 1999).
    \4\ More detailed examples of these processes can be found in Peter 
Stavrakis, Shadow Politics: The Russian State in the 21st Century 
(Carlisle, Pa.: U.S. Army War College, Strategic Studies Institute, 
December 1998).
---------------------------------------------------------------------------
    A brief review of some of the main features of the 
predatory state reveals its success in capturing key aspects of 
contemporary Russian experience.

            official corruption, cronyism, and clan politics

    Perhaps the most glaring defect of post-Soviet Russia is 
the pervasiveness of official corruption, which extends up to 
the highest level of the political elite and is so widespread 
it is often assumed to constitute an aspect of ``normal'' life. 
Transparency International has consistently ranked Russia as 
one of the most corrupt countries in the world, placing it 
firmly in the neighborhood of post-colonial societies where 
predatory practices abound.\5\ Enormous transfers of wealth 
occur within the framework of transitional societies, so some 
corruption linked to the reform process is unavoidable. What 
distinguishes Russia from most other states, however, is the 
scale of corrupt practices and the actors involved: Russia's 
ambitious privatization program was among the largest transfers 
of property in history, whether measured by the number of 
enterprises affected, or the potential wealth that changed 
hands. Still more importantly, corruption was not restricted to 
a narrow segment of economic actors, but was instead embraced 
by government officials--even ``reformers''--and quickly became 
accepted practice.
---------------------------------------------------------------------------
    \5\ In 1999 Transparency International ranked Russia as 76th--a 
mere 9 places away from the rock bottom score of 85th. This suggested a 
level of corruption similar to that found in Nigeria, Indonesia, and 
Ukraine.
---------------------------------------------------------------------------
    The second stage of the Russian privatization process is 
perhaps the best example of the interwoven nature of corruption 
and cronyism in the setting of predatory practices. Following 
the voucher stage of privatization (which brought its own form 
of graft with it), Anatoly Chubais, former Chairman of the 
Russia State Property Committee and Chief of Staff to Yeltsin, 
and Vladimir Potanin, former head of Uneximbank, concocted the 
``loans for shares'' privatization. A select group of seven 
``court'' banks were provided controlling shares in the crown 
jewels of the Russian economy in exchange for loans the Russian 
Government needed to cover its budget deficit. This arrangement 
ostensibly permitted the government immediate access to 
finances while preparing the ground for the sell off of key 
industries that would generate still more revenue. The scheme 
was blatantly corrupt, however, as the favored banks all had 
intimate links to the reform government, and they subsequently 
purchased Russia's richest assets at far below the market 
value.\6\
---------------------------------------------------------------------------
    \6\ Author interview with Iuri Iurievich Boldyrev, Deputy Chairman, 
Accounting Chamber of the Russian Federation, January 15, 1997. 
Boldyrev also covers this episode in ``V strane sozdany ideal'nye 
usloviia dlia korruptsii,'' Novaia ezhednevnaia gazeta, October 28, 
1996, p. 1.
---------------------------------------------------------------------------
    The loans for shares scheme also demonstrated the 
willingness of Russian reformers to use economic reforms to 
preserve their hold on political power. The need to use the 
privatization process to create a critical political 
counterweight to clans opposed to Yeltsin has been acknowledged 
recently by Russians involved in the struggle for reform.\7\ 
The scheme had its origins as far back as 1994 and amounted to 
a ``crude trade of property for political support'' \8\ that 
played a pivotal role in bringing into existence the financial 
oligarchy. Russian oligarchs such as Boris Berezovsky, Vladimir 
Gusinsky, Mikhail Khodorkovsky, Peter Aven, and others returned 
the favor by providing crucial financial and media support for 
Yeltsin's re-election in 1996.\9\
---------------------------------------------------------------------------
    \7\ Vladimir Mau, ``Rossiiskie ekonomicheskie reformy glazami 
zapadnykh kritikov,'' Voprosy ekonomiki (1999) no. 11. Mau is an 
economist sympathetic to the privatization policies of Chubais and 
Potanin.
    \8\ Chrystia Freeland, Sale of the Century: Russia's Wild Ride from 
Communism to Capitalism (New York: Crown Business, 2000), p. 169.
    \9\ Boris Berezovsky affirmed this in unequivocal terms in an 
interview for the Financial Times, December 1, 1996.
---------------------------------------------------------------------------
    The reliance on cronies and clans at the expense of formal 
government capacity meant that Russian elites had to actively 
undermine the efforts of agencies responsible for combating 
corruption. Hence, Russia was witness to numerous bizarre 
instances of alleged reformers attacking or debasing the very 
institutions and individuals they ostensibly sought to imbue 
with effective authority. When, for example, Yuri Skuratov 
began to take seriously his position as Procurator and 
initiated investigations of Kremlin officials--including 
Yeltsin's family--he was soon the target of kompromat: the 
release by Skuratov's opponents of compromising documents, 
whose negative political impact outweighs their often 
questionable legal status. The tactic succeeded, as Skuratov 
soon found himself embroiled in a scandal that resulted in his 
removal from office. Even out of office, Skuratov defends the 
validity of his investigation, and has recently released the 
names of top-ranking officials whose illegal dealings in 
Russian treasury bonds (GKOs) he maintains helped trigger the 
1998 financial crisis: both of Yeltsin's daughters, Chubais, 
Viktor Serov, former foreign minister Andrei Kozyrev, and five 
deputy finance ministers.\10\
---------------------------------------------------------------------------
    \10\ ``Former Prosecutor Fingers Top Politicians for Money 
Laundering,'' Russia Today citing Agence France Presse, August 22, 
2001, http://www.europeaninternet.com/russia. Skuratov also alleges 
that Russian officials sold their insider information to the West, and 
claims that members of the ``so called Harvard Project [used] U.S. 
taxpayers' money to buy GKO bonds.''
---------------------------------------------------------------------------
    A similar fate befell the effort to form a professional 
civil service, which had not existed in Russia since the 
October Revolution. In an effort to assume direct control over 
the process, Chubais used foreign assistance funds to construct 
Russia's massive privatization program. Russian Privatization 
Centers (RPCs) were created to implement the program, yet the 
RPCs needed to recruit personnel. A ready pool of labor was 
found among government personnel loyal to Chubais, who were 
secretly paid for their consulting services. Chubais could 
count on finding many recruits because his government was 
responsible for the low wages paid civil servants. 
Privatization thus triumphed in Russia only by compromising the 
possibility of a genuine civil service.\11\ Putin has recently 
ordered the formation of a commission, headed by Prime Minister 
Mikhail Kasyanov, and charged it with developing a plan for 
reforming the civil service by the end of 2001.\12\ It is, 
however, the third such effort to address civil service reform 
since the collapse of the Soviet Union.
---------------------------------------------------------------------------
    \11\ More information on civil service reform is in Stavrakis, 
Shadow Politics. Boldyrev's interview with the author (note 5 above) 
also confirmed this.
    \12\``Putin  Forms  Commission  to  Reform  State  Service,''  
Russia  Today,  August  22, 2001, http://www.europeaninternet.com/
russia.
---------------------------------------------------------------------------

   ambiguous boundaries between key societal sectors and institutions

     In contrast to modern democracies, which place 
extraordinary importance on a clear delimitation of the legal 
and political boundaries among institutions, predatory states 
eschew formal efforts to sustain such meaningful divisions. 
This sacrifices considerable clarity and efficiency, but the 
trade off for post-imperial elites comes in their ability to 
remain key players in virtually all spheres of society. An 
entrepreneurial class independent of state activity has clearly 
emerged in Russia over the past decade, but it is overshadowed 
and increasingly constrained by far more powerful 
``entrepreneurs'' who owe their existence to the state's 
decision to vest them with property and protection. In doing 
so, predatory states retain the ability to select the specific 
composition of the ``entrepreneurial'' class and thereby retain 
direct influence over the development of the market. This 
process has been documented in post-Soviet Russia,\13\ but it 
is most vividly illustrated by the government's formal policy 
of having top government officials sit on governing boards of 
the country's major economic enterprises, such as Unified 
Energy Systems (UES, the state electricity monopoly) and 
Gazprom. Putin's recent ouster of Gazprom chief Rem Vyakhirev 
and replacement with Aleksei Miller was an excellent 
opportunity for serious structural reform, yet the Russian 
Government has maintained that even after reforms, Gazprom will 
retain its monopoly over gas exports.\14\ Similarly, the reform 
of UES recently approved by the government calls for the break 
up and privatization of power generation but creates a state-
owned monopoly to operate the entire national grid.\15\ This 
also appears to reflect a victory of the informal clan network 
over formal institutions. It is the brainchild of Economic 
Development Minister German Gref and largely ignored the 
recommendations of the State Council in favor of a plan that 
allows Anatoly Chubais to retain control over energy reform--
and custody of the state-owned power grid.\16\
---------------------------------------------------------------------------
    \13\ Details on cronyism and the creation of the economic class in 
Russia can be found in: Olga Kryshtanovskaia and Stephen White, ``From 
Power to Property: The Nomenklatura in Postcommunist Russia,'' in 
Graeme Gill, ed. Elites and Leadership In Russian Politics (London: 
Macmillan, 1998); and, Olga Kryshtanovskaia, ``Smert' oligarkhii: 
oligarkhiia soderzhala gosudarstvo v litse ego kliuchevykh 
chinovnikov,'' Argumenty i fakty, no. 46, November 11, 1998, p. 5. Jean 
Francois Bayart captures the essence of this in the African setting: 
``The state is the prime (though not the only) channel of accumulation 
. . . Even the successful businessmen in the informal sector are highly 
dependent on the state because they need constantly to circumvent 
regulations and obtain official permits. It is, therefore, otiose to 
seek to establish a conceptual difference between the private and 
public sectors.'' Bayart, ``Civil Society in Africa,'' in Will Reno, 
Corruption and State Politics in Sierra Leone (Cambridge: Cambridge 
University Press, 1995), p. 16.
    \14\ Statement of Deputy Prime Minister Viktor Khristenko on August 
6, 2001; RFE/RL Security Watch , August 13, 2001; http://www.rferl.org/
securitywatch/index.html
    \15\ ``Electricity  Monopoly  Reform  Plan  Adopted,''  Russia  
Watch  no.  6  (June  2001),  p.  2; http://www.ksg.harvard.edu/bcsia/
sdi.
    \16\ Marina Volkova, Vladislav Kuzmichyov, ``Ssora Grefa i 
Illarionova stavit vlast v situatsiiu buridanova osla,'' Nezavisimaia 
gazeta, June 20, 2001. Gref and Chubais are both from the ``St. 
Petersburg clan'' that has dominated much of post-Soviet politics.
---------------------------------------------------------------------------

              difficulty in consolidating the rule of law

    Given the centrality of illegal practices to sustaining 
elites in power, predatory states reflect a profound weakness 
in consolidating effective judicial and police institutions, 
despite a formal commitment by elites to combat crime and 
corruption. In this respect, Putin's goal of restoring ``law 
and order'' carries with it a hypocritical ring present in 
developing economies: coherent formal institutions of coercion 
and control will emerge, yet they will intentionally refrain 
from enforcing meaningful distinctions between public and 
private, legal and illegal, formal and informal.\17\ Western 
exhortation and advice to fight crime is therefore unlikely to 
alter Russian elites' preference for using coercive 
institutions to advantage one set of clans at the expense of 
others in the struggle for control over resources.
---------------------------------------------------------------------------
    \17\ Vadim Volkov, ``Politekonomiia nasiliia, ekonomicheskii rost i 
konsolidatsiia gosudarstvo,'' Voprosy ekonomiki (1999) no. 10.
---------------------------------------------------------------------------
    Indeed, despite having pledged to restore legality in 
public life, Putin has in actuality done little more than 
revive the coercive power of the state by resuscitating 
security organs.\18\ The principal thrust of more efficacious 
enforcement bureaucracies, however, has not been on eliminating 
the shadow (underground) economy and corruption in society at 
large. Instead, Putin has marshaled his forces toward the goals 
of molding clan behavior to his satisfaction and restraining 
the sphere of civil rights. This explains the simultaneous 
crackdown against the likes of Berezovsky and Gusinsky, while 
ignoring credible claims that Prime Minister Mikhail Kasyanov 
(known popularly as ``2 percent Misha'') owes most of his 
considerable wealth to kickbacks.\19\ Here Russian behavior is 
consistent with the predatory state: strong bureaucratic 
structures exploiting vague and shifting boundaries between 
illegal and legal activity. This feature of the state allows 
the Russian president to exploit illegal means when useful, yet 
still rely on formal institutions to implement such policies. 
Reformers in the Central Bank of the Russian Federation 
(Central Bank of Russia or CBR) exhibited similar skill in 
exploiting ambiguities in international financial regulations 
to reap additional profits.\20\
---------------------------------------------------------------------------
    \18\ Coulloudon maintains that Russia's numerous anti-corruption 
campaigns have had a moralistic aim, with no real effort to attack 
structural problems underlying corruption; ``Corruption and Governance 
in Russia.''
    \19\ When the author referred to Kasyanov as ``7 percent Misha'' in 
conversation with a senior official at Iukos Oil Company, the official 
shook his head and immediately added the correction: ``It was 2 percent 
Misha, a fact he could confirm from his own experience''; June 26, 
2000.
    \20\ The CBR in 1999 conceded that it channeled some of its 
reserves (some sources claim as much as $50 billion) into FIMACO, an 
obscure off-shore corporation in Jersey, principally to prevent its 
recapture from Western creditors. Sergei Aleksashenko, former Deputy 
Chairman of the CBR, admitted that the sequestering of bank funds was 
done to protect them from Western creditors. FIMACO was a French 
corporation chartered in Jersey. It was 78 percent owned by the Russian 
Government. The reform team had deftly exploited western financial 
practice to securely channel money to themselves--out of reach of 
creditors. More information on the FIMACO affair can be found in 
Kommersant and well as in IMF documents.
---------------------------------------------------------------------------

               efficient informal communication networks

    In contrast to expectations, predatory states possess a 
highly efficient informal communications network, but it is one 
restricted to a charmed circle. Those individuals blessed with 
favorable access to the informal communication network can, 
whenever circumstances require it, circumvent formal 
bureaucratic structures to achieve their goals.\21\ The speed 
at which communication can be passed within Russia is often 
staggeringly short--and becomes shorter still whenever the 
issues revolve around an opportunity to acquire money.\22\ 
These networks were developed under Yeltsin and remain intact 
under Putin; indeed, there is every reason to maintain them, 
for they are remarkably efficient at relaying information in a 
short period of time. The common perception of Russia as 
incapable of accomplishing anything is misguided: formal 
Russian state structures can often accomplish little, yet the 
capacity of elite networks to fill in the gap remains 
impressive.\23\
---------------------------------------------------------------------------
    \21\ Interesting in this regard was the fate of the internal phone 
network that in Soviet times was accessible only to high-ranking party 
members. It never disappeared, but was instead appropriated by the new 
elite who later replaced it with a system more in tune with current 
fashion in technology--the predatory elite has gone high tech and 
cellular.
    \22\ This is especially true whenever foreign assistance funds are 
concerned. This is in marked contrast to the slow and deliberate pace 
of Western aid agencies. The author was involved in several such cases, 
where Russian organizations were able to filter information from 
Washington, DC, through Moscow to the regions and back again all in 
less than 24 hours.
    \23\ The author was present in August 1999 when one governor--
clearly ``in the loop,''--used his cell phone from his regional office 
to juggle successive calls to and from Anatoly Chubais and Viktor 
Chernomyrdin. He later explained that Yeltsin was angered by the 
declaration of a ``left'' electoral bloc by Yuri Luzhkov and Evgenii 
Primakov in advance of the December 1999 Duma elections, and had 
ordered Chubais to undertake the formation of a ``right'' bloc. Chubais 
asked the governor in question to serve as mediator between Chubais and 
Chernomyrdin to lay the groundwork for subsequent negotiations. An 
agreement proved elusive, but the speed and means by which it was 
arranged was impressive.
---------------------------------------------------------------------------
    The combination of efficient informal communications, weak 
and malleable legal institutions, and institutional ambiguity 
helps explain how predatory states are successful in extracting 
profit. Several examples reveal how an interventionist state 
can move into any promising sphere of economic activity, 
molding legal institutions to suit its needs. The arbitrary 
nature with which tax laws were interpreted and enforced, for 
example, so frustrated General Electric that it elected to 
close its Moscow subsidiary.\24\ Similarly, Australia's Star 
Mining learned that its purchase of part of Lenzoloto, a small 
gold mining business, was invalidated because it purportedly 
violated privatization rules. The problem was that ``the laws 
are so vague, the bulk of the Russian stock market could easily 
be deemed to have breached these rules.'' \25\ Trans-World 
Metals, a London-based metals company that has acquired a 
substantial portion of the Russian aluminum industry, was also 
caught in the maelstrom of elite conflict. Trans-World's sin 
was to acquire its investments under the patronage of former 
Kremlin security chief Alexander Korzhakov and former First 
Deputy Prime Minister Oleg Soskovets. Once Yeltsin fired both 
of these men and the aluminum industry came under suspicion of 
supporting Aleksandr Lebed, Trans World became an easy target 
for state agencies controlled by Chubais and Viktor 
Chernomyrdin. Not surprisingly, local Russian officials soon 
nullified its stake in at least one major smelter.\26\
---------------------------------------------------------------------------
    \24\ Financial Times, 20 March 1997.
    \25\ Financial Times, 10 April 1997.
    \26\ The Independent, March 15, 1997. Another instance of 
expropriation of western interests occurred when the Russian Government 
terminated the work of NM Rothschild in developing a $1 billion 
telecommunications share offer. The government turned it over to MOST 
Bank and Alfa Bank, both of which were members of the charmed ``group 
of seven,'' The Financial Times, November 26, 1996, p. 1.
---------------------------------------------------------------------------
    Domestic actors are also fair game for the predatory state. 
Moscow Mayor Yuri Luzhkov succeeded in 1998 in using a modest 
municipal payroll tax on Moscow residents to generate a road 
fund of approximately $645 million. Yet the federal 
parliament--evidently with executive support--entered the 
picture and passed a law requiring that at least half this 
amount be spent on the national road system. This effectively 
stripped the mayor of control over part of the municipal 
budget.\27\
---------------------------------------------------------------------------
    \27\ Moskovskii komsomolets, 23 May 1997.
---------------------------------------------------------------------------

            societal withdrawal and economic marginalization

    Russia's predatory proclivities have had a significant 
negative impact on society. Despite having invested 
considerable energy in developing an institutional framework 
for articulating public sentiment, Russian civil society has 
slid toward greater apathy in civic life. Demonstrations 
marking the tenth anniversary of the failed Soviet coup (August 
19 to 21) were noteworthy only because the police outnumbered 
those who felt it important enough to show up on Red Square--a 
pale echo of the remarkable and courageous resistance to 
communism a decade ago. Public sentiment appears resigned to 
viewing its relations to state power solely in tributary terms: 
the state takes what it demands, and individuals seek to 
achieve their objectives primarily by circumventing its 
authority. Predictably, the most significant political parties 
today are the Communists and those created at the instigation 
of the presidential administration
    Political withdrawal is paralleled by economic withdrawal. 
Since productive activity is viewed by state elites as 
something that can be either expropriated or arbitrarily taxed, 
producers retreat from the legal economy to preserve autonomy. 
This explains the persistence and growth of the extra-legal, 
``informal'' economy in post-Soviet Russia. Consolidating a 
stable tax regime in this environment becomes a challenge, for 
if a tax regime is viewed by producers merely as a means of 
being identified for future expropriation, they have strong 
incentives to move production underground where chances of 
detection are smaller.
    Finally, the marked disparity between Moscow's affluence on 
the one hand, and severe economic deprivation in the rest of 
Russia, is leading to the creation of a two-tiered economy in 
which the vast majority of the population is economically 
marginalized and sees little to no chance for improving their 
lives.\28\
---------------------------------------------------------------------------
    \28\ This was the image of Russia--strikingly similar to many 
African societies--described by an official in Putin's administration; 
conversation with Vladimir V. Shemiakin, Advisor to the Administration 
of the President of the Russian Federation, June 30, 2000.
---------------------------------------------------------------------------
    It is precisely here that predatory politics sow the seeds 
for potential future instability, for no society can sustain 
itself indefinitely on the basis of an economy based 
principally on the material well being of its capital city. 
Failure to provide the Russian public a meaningful stake in 
economic life will lead to an insufficient revenue base that 
undermines government policy. Similarly, Russian elites should 
by now appreciate the fact that a resigned or alienated 
population in the context of sagging economic expectations is a 
combination likely to produce a serious challenge to their 
legitimacy.

           recentralization and atrophy of regional authority

    Whereas Boris Yeltsin initially urged Russia's regions to 
take as much sovereignty as they could, the style and substance 
of President Putin's regional policy has moved in the opposite 
direction. The earlier momentum of efforts to decentralize 
governance in Russia has slowed significantly, as the 
presidential administration's policy initiatives have adopted a 
more pragmatic style, leavened with a distinct preference for a 
recentralization of political authority. The disorderly parody 
of federalism that emerged under Yeltsin certainly made some 
degree of recentralization a rational means of restoring order. 
But such recentralization was also consistent with the logic of 
predatory states, as it maximizes access to potential sources 
of economic wealth and deprives regional politicians of the 
safety of a constitutional framework. While it is true, as some 
commentators have noted, that Putin has yet to clearly 
articulate his ultimate objective in regional policy, recent 
events support a disturbing trend toward the growth of central 
authority. In place of the personalistic style of Yeltsin 
(which Putin is said to disdain), the Russian president has 
organized the country's regions into seven administrative 
districts. The heads of these sit, along with federal 
authorities, on the recently created State Council, whose 
jurisdiction remains ambiguously defined. The impact on 
regional influence is clearer to discern, however: the state 
Duma, or lower house of parliament is increasingly 
marginalized, and powerful regional governors have gravitated 
to lobbying the State Council.
    More importantly, while still a prime minister, Putin 
announced his view that the various bilateral treaties 
concluded during the Yeltsin era that formed the basis for 
regional power ought to be scrapped. Accordingly, President 
Putin delegated to Tatarstan President Mintimer Shaimiev (who 
is a member of the State Council) the responsibility of 
elaborating a clear division of powers between the federal and 
regional governments. But Shaimiev's working group concluded 
that the central government ought to fully legalize these 
regional treaties and use them as the basis for a broader 
regional policy. This displeased the President so he disbanded 
Shaimiev's group, ignored their proposals, and appointed 
Dimitrii Kozak, (member of the more loyal presidential 
administration) to a new working group on regional issues. This 
time, however, Kozak has made plain that his goal is to 
formally re-establish the primacy of Moscow (the so-called 
``power vertical'') in regional affairs.\29\ In Putin's Russia, 
the Kremlin appears likely to demand--and receive--the right to 
greater intrusiveness in regional and municipal life than was 
envisaged in the more optimistic predictions of the previous 
decade.
---------------------------------------------------------------------------
    \29\ Vladimir Lysenko, ``Otryzhka demokratiei,'' Novaia gazeta July 
19, 2001.
---------------------------------------------------------------------------

          Explaining Russia's Affinity for the Predatory State

    If the preceding analysis proves more useful in making 
sense of developments under President Putin, then it 
strengthens considerably the conclusion that Russia has 
deviated from progress toward free market democracy. It is 
moving toward a predatory state model that consolidates an 
authoritarian elite whose principal objective is in managing 
social contradictions to its benefit. This raises a central 
question: Why have Russian elites rejected the promise of 
liberal democracy in favor of a political system that embraces 
pre-existing inefficiencies and retains the tension between an 
overly powerful central elite and marginalized society that 
will surely prove the source of future discord?
    Clearly, a major factor at work is the fundamentally 
different way in which Russian elites view the potential 
payoffs of any reform. Western strategies of reform focused on 
how short-term obstacles and dislocations could be managed to 
achieve longer-term economic transformation. But in Russia, 
Imperial and Communist legacies created a predisposition to 
predatory practices, with the result that precious few Kremlin 
elites ever had the political security to focus on long-term 
goals. They instead preferred to concentrate their energies on 
achieving short-term gains by using familiar institutions and 
political styles.\30\ Simply put, the benefits of pursuing 
immediate gains through traditional means were preferred to the 
potential rewards of a risky and uncertain future.
---------------------------------------------------------------------------
    \30\ Even Yeltsin era elites initially committed to reform felt 
reforms could only be achieved quickly. Hence, Chubais and Boris 
Nemtsov viewed their tenure in office as short and accordingly endorsed 
a ``shock therapy'' approach. Nemtsov, in particular, was fond of 
characterizing himself as a ``kamikaze'' reformer.
---------------------------------------------------------------------------
    The impulse toward predatory practice can thus be broken 
down into two component parts: a preference for retaining 
traditional political styles and values, and the consequent 
need to situate them in an institutional setting acceptable to 
the outside world. In Russia, an additional factor proved 
decisive: the ineradicable memory of success in achieving the 
status of Great Power as an empire whose practices rested 
heavily on the political precursors of predatory rule. A brief 
examination of each of these factors helps explain how Russian 
elites could find the rewards of predation greater than those 
of a liberal democracy.

 old wine in new bottles: the ``recomposition'' of traditional Russian 
                                 power

    The recomposition of power,\31\ refers to the process 
whereby traditional forms of state power are placed into a 
modern institutional infrastructure. This results in modern 
state agencies operating in distinctly traditional ways. 
Eurasian and African states have proven remarkably adept at 
this: as new political institutions replace earlier ones, they 
are filled with a traditional cultural content. This preserves 
the ability of elites to function as in the past 
(recomposition); while allowing institutions of power to 
acquire the external appearance of respectability.
---------------------------------------------------------------------------
    \31\ The term was first employed by Achille Mbembe, 
``Democratization and Social Movements in Africa,'' Africa Demos 1 
(1990) no. 1; Richard Joseph, ``The Reconfiguration of Power in Late 
Twentieth-Century Africa,'' in Richard Joseph, ed. State, Conflict and 
Democracy in Africa (Boulder, Co.: Lynne Rienner, 1999).
---------------------------------------------------------------------------
    The reason Russian elites would prefer this outcome is 
clear: their new responsibility to build a modern state and 
economy necessarily entails ceding large spheres of their 
authority and subjecting their own actions to the rule of law. 
But who among them could willingly consent to this limitation 
of their own power? The preferred alternative is to hold on to 
the institutional resources of the autocratic center. Reformers 
thus become seduced by the very entity they seek to eliminate, 
which explains why many veteran reformers of the 1990s find it 
impossible to leave the political arena.
    The traditional weakness of society also militates against 
a breakthrough to modern governance and in favor of a 
resurrection of traditional authority. Imperial Russia 
exemplified the tragic consequences of perfecting autocratic 
power in advance of a free economy and national consciousness. 
The state simply overwhelmed and dominated nascent civil 
society, depriving it of the opportunity to develop its own 
independent identity. Post-Soviet experience repeated this 
pattern, as a small group of state elites assumed 
responsibility for creating the new property owning classes and 
decreeing the formation of political parties and social 
organizations.
    The combination of strong state and weak society helps 
explain why no political elites--reformers or otherwise-- 
abandoned the familiar context of Russian clan rivalry in favor 
of establishing a limited decentralized government and 
genuinely free economy. Predatory behavior is linked to the 
political elite's inability to see beyond its short-term gains 
to the more distant rewards of reform, hence their preference 
for political intrigue, a weak legal regime, and a market with 
only contingent freedom. State and society drift away from 
commitment to genuine reform, as a narrow clique of rulers 
contents itself with augmenting the number of select clans 
eligible to struggle for central power. Indeed, some scholars 
have argued convincingly that the Russian reforms in January 
1992 were converted into a political struggle among ruling 
elites as early as April of that same year, as then prime 
minister Yegor Gaidar opted for compromise with the ``red-
brown'' opposition made up of Communists on the one hand, and 
industrialists and entrepreneurs on the other hand.\32\
---------------------------------------------------------------------------
    \32\ The most thorough treatment of this period can be found in 
Peter Reddaway and Dimitri Glinski, The Tragedy of Russia's Reforms: 
Market Bolshevism Against Democracy Washington, DC: United States 
Institute of Peace, 2001), chap. 6 passim.
---------------------------------------------------------------------------
    The Soviet regime's toleration of illegal and criminal 
practices in its later years also provided an important route 
for the infiltration of predatory behavior. The Kremlin must 
remain first among equals, whether dealing with financial 
oligarchs, regional leaders or organized criminal structures 
(mafias). Hence, instead of challenging the legitimacy of these 
actors or seeking their elimination in favor of a more 
equitable order, the predatory state aspires to be the largest 
economic oligarch, the most potent of all mafias, and the most 
dynamic of all the regions.\33\ Its possession of the reins of 
formal state power provides it with a decisive advantage; for 
the Kremlin alone among competitors can claim the right to 
interact with the outside world. Moscow thus parlays its 
privilege into that of a legal entity willing to undertake 
illegal actions.
---------------------------------------------------------------------------
    \33\ Vadim Radaev examines this phenomenon of the state as the 
largest and most influential mafia in society; ``O roli nasiliia v 
rossiiskikh delovykh otnosheniiakh,'' Voprosy ekonomiki (1998) no. 10.
---------------------------------------------------------------------------
    The rule of law in this setting is a direct challenge to 
autocratic power; for it implies an institutional framework 
that would inhibit the power of the elite to intervene 
arbitrarily in society and the economy.\34\ And while rents 
\35\ typically generate the bulk of elite revenues at society's 
expense,\36\ predatory states can--where profitable--evince 
profound interest in economic development. It is not 
development they disdain; rather, it is the need for working 
within a legal framework. This allows them to exploit any 
lucrative economic activity that emerges in the informal or 
criminal sector of society. Their paramount concern is to 
exploit this, rather than to find a legal context within which 
entrepreneurial dynamism can flourish. Ultimately, what 
sustains predatory rule is not some abstract fear of progress, 
but the toleration by ruling elites of a political style that 
is sufficiently familiar and rewarding in the short-term to 
arrest the impetus for genuine reform. Russian elites are not 
afraid of the free market; they simply find it far more 
profitable to tailor the market to their interests, rather than 
risk allowing it to determine the winners and losers in 
society.
---------------------------------------------------------------------------
    \34\ This comports with the view of Yuri Yurievich Boldyrev who, as 
Vice Chairman of the Russian Government's Accounting Chamber, had 
extensive experience in battling corruption and efforts to enforce the 
rule of law, ``Corruption in Russia as an Element of a System of Total 
Lawlessness,'' paper delivered at the Princeton University-Central 
European University Joint Conference on Corruption, Budapest, Hungary, 
November 5, 1999 (http//:www.coc.ceu.hu).
    \35\ Rents are those opportunities for economic gain created by the 
state's restriction of the free market. In Russia, government licenses, 
restrictions on free trade, state intervention in enterprise decision 
making, and rationing of foreign exchange, were ``rent havens'' 
exploited by well-connected businessmen and bureaucrats. Russia's 
second stage of privatization, by restricting eligible recipients of 
state property, also fits this category.
    \36\ On this point, see: Joel Hellman, ``Winners Take All: The 
Politics of Partial Reform in Postcommunist Transitions,'' World 
Politics 50 (1998) no. 2, pp. 203-234. This phenomenon has far broader 
applicability: Roger Tangri, for example, (1999) has observed in that 
Uganda, Kenya, Ghana and elsewhere in Sub-Saharan Africa, privatization 
programs came to focus more on the dispensation of lucrative rents to 
privileged and well-connected elites than to the original goal of 
getting the state out of the private sector; Tangri, Roger. The 
Politics of Patronage in Africa: Parastatals, Privatization, and 
Private Enterprise (Trenton, NJ: Africa World Press, 1999).
---------------------------------------------------------------------------

   appearance matters: ``presentability'' and the image of democracy

    States in the contemporary international system cannot 
afford either the luxury of isolation or the burden of 
exclusion, so it is important to understand how a predatory 
state survives in a globalized world. Economic globalization 
presses states to demonstrate a commitment to maintaining 
domestic institutions ensuring some predictable measure of 
transparency, legality, and democratization. Without this, the 
foreign investment flows essential to participation in the 
global economy simply cannot be guaranteed. Yet, none of the 
predatory state's internal characteristics reflect even modest 
adherence to these preconditions.\37\ This contradiction 
between the international and domestic norms is managed through 
the practice of presentability, in which the formal 
institutions of market democracy are paralleled by the informal 
embrace of practices, norms, and institutions that are animated 
by pre-existing political culture. This is necessitated because 
predatory states must mediate between promising opportunities 
in an international economy they cannot control, and a domestic 
socio-economic environment they have structured to their 
advantage.\38\ Russia's elites skillfully embrace the rhetoric 
of democracy and the free market while yielding little in the 
way of public accountability or effective economic reforms.
---------------------------------------------------------------------------
    \37\ It is true that many states do not possess these attributes in 
full. Some of these are undoubtedly admitted for the ``formal'' reasons 
discussed below. Another factor is that Western industrialized nations 
and multilateral institutions are not fully confident that potential 
Russian misbehavior, unlike that of most other states, can be managed 
with existing institutional remedies. China also falls into this 
exceptional category.
    \38\ Recent discussions of ``virtuality'' in democratic practice 
echo similar sentiments. See: Richard Joseph, ``Democratization in 
Africa after 1989: Comparative and Theoretical Perspectives,'' 
Comparative Politics 29 (1997) no. 3, pp. 367-368; Fareed Zakaria's 
``illiberalism,'' discusses the similar same phenomenon, though he does 
not view culture as the determining factor, ``The Rise of Illiberal 
Democracy,'' Foreign Affairs 76 (November/December 1997) no. 6 passim.
---------------------------------------------------------------------------
    Western policy has played an important--if unsuspecting--
supporting role in the evolution of presentability, as key 
Eurasian, African and Asian states deemed by Western 
institutions as too important to fail are evaluated solely on 
the basis of formal, rather than substantive, criteria. 
Democratic reform acquires a brittle skin-deep quality, though 
sufficiently opaque to permit the process of political 
recomposition to proceed. The end results are modern formal 
institutions filled by a more familiar traditional political 
substance.
    The elites' preference for presentable, as opposed to 
substantive, democratic reform receives a powerful impetus from 
the recomposition of traditional power. Since predation is 
largely a function of elite political culture and is 
indifferent to the architecture of formal institutions, Russia 
can absorb much of the formal infrastructure of free market 
democracy even as the substance and style of its politics fills 
these institutions with more traditional values. The new Russia 
conforms neither to the West's desired image of it, nor is it a 
simple return to the past--Czars, boyars, commissars and 
democrats have blended the dark arts of autocracy with the 
``dismal science'' of economics and a pretense of populism, 
molding reform to preserve their interests.
    Key political and economic developments over the past 
decade vindicate the image of Russia as a presentable society: 
Democratic presidential elections were largely determined by a 
narrow elite with access to state resources. In Yeltsin's case, 
his initial support by a cluster of ``reformers'' was augmented 
to include financial oligarchs. Putin, by contrast, was 
virtually anointed by Yeltsin as the latter's successor, with 
strong endorsement from the Kremlin ``family,'' Chubais, and 
Putin's allies from St. Petersburg. Political parties are 
formed by presidential diktat and sustained in large part by 
funds drawn from state coffers. And Putin's appointment to high 
office of his former colleagues from within the former KGB has 
aided the re-entry of the secret police organs back into the 
fold of Kremlin politics. Finally, the rhetoric regarding 
separation of state from economy is belied by a policy in which 
the government retains crucial share holdings in huge economic 
enterprises and government ministers sit on governing boards of 
enterprises.
    The recent behavior of former privatization chief Alfred 
Kokh provides a vivid example of the transition from reformer 
devoted to Russia's transformation, into loyal combatant in the 
predatory state. In his current incarnation as head of media 
relations for Gazprom, Kokh spearheaded the successful effort 
to crush NTV, Russia's only independent television network. In 
barely 3 years' time, Kokh shifted from a reformer advocating 
for free market democracy to a high-ranking member of the 
nebulously-defined Russian ``private sector,'' doing the Putin 
administration's bidding by crushing an independent voice of 
opposition to government policy.\39\
---------------------------------------------------------------------------
    \39\ See, for example, Kokh's ``Gusinsky has Made `Freedom' a Bad 
Word,'' Russia Watch, no. 6 (June 2001), pp. 19-20; http://
www.ksg.harvard.edu/bcsia/sdi.
---------------------------------------------------------------------------
    Presentability is in certain respects the key aspect of the 
predatory model, for it explains why Western policy toward 
Russia tolerated the persistence of traditional Muscovite 
politics. Once Western states had resolved that only Yeltsin 
could implement reform, it became imperative to permit him to 
secure his domestic political position. Yeltsin, however, had 
learned his political survival tactics in the old school; 
hence, if the he were to survive as president, he had to resort 
to the familiar world of clan politics and not democratic 
processes. The West felt obliged to accept this reality, and 
did so on the condition that the leading clan reflect the 
interests of free market democratic reform. Yeltsin responded 
by developing what might be a textbook recipe for a 
``presentable'' transition: (1) seizing the rhetorical high 
ground and imposing upon all Russian elites (excepting the 
Communists) the vocabulary of reform; (2) producing sufficient 
substantive changes to permit the West to declare transition a 
success; (3) exploiting Communist ineptitude to cast them as 
the perfect villain. This allowed Yeltsin to declare outright 
war on the ``red-brown'' opposition while simultaneously 
replacing many of his shock therapists with old-style economic 
managers and restoring state subsidies to enterprises.\40\ This 
is the unsettling reality of predatory Russia, which resembles 
closely the ``choiceless'' democracies in Africa: \41\ the 
domain of electoral rights are broadened with great fanfare, 
even as the range of meaningful policy options presented to the 
public narrows to the vanishing point. The popular election of 
a Russian president is indeed an event unprecedented in 
history; but this achievement must be balanced by recognition 
that in 1996 and 2000, the Russian public has had the 
opportunity only to legitimize the candidate pre-selected by 
the elite. That is why presidential elections in Russia have to 
date been won only by former Communist Party bosses and 
operatives of the secret police.
---------------------------------------------------------------------------
    \40\ Tim McDaniel, The Agony of the Russian Idea (Princeton: 
Princeton University Press, 1996), p. 153.
    \41\ Mkandawire, ``Crisis Management and the Making of `Choiceless' 
Democracies.'' Other variants of democracies lacking a democratic 
essence: Igor Klyamkin and Lilia Shevtsova compare Yeltsin's regime to 
an ``elective monarchy,'' Nevavisimaia gazeta, June 24, 1998; still 
others, such as Terry Karl, have noted the phenomenon of 
``electoralism,'' where the election procedures function, but a 
meaningful choice is absent.
---------------------------------------------------------------------------

                     the legacy of imperial success

    The third fundamental dimension of Russia's evolving 
predatory regime distinguishes it from all other similar 
systems: Russia is a country with demonstrated success in 
achieving Great Power status in the 18th, 19th, and 20th 
centuries, and a society familiar with the challenges of 
extracting extraordinary results from dysfunctional 
institutions. It is precisely for this reason that the thrust 
of this analysis is not about inherent Russian weakness but 
about the challenges of managing the consequences of Russia's 
restoration, and preparing for the next contraction that 
signifies yet another turn in the wheel of Russian history. The 
focal point is Russia's adaptive response to its historical 
crises, which has allowed it to develop a polity distinct from 
Western models, and to achieve a substantial measure of 
international power and prestige.
    Whether as Czarist or Soviet regime, Russia acquired 
extensive experience in the global competition for power. The 
belief is widespread in Russia that power is a key element in 
maintaining a state's--especially a Great Power's--independence 
in the international system. The alternatives to this, Russians 
fear, are to be penetrated by other states or become the 
objects of territorial aggrandizement.\42\ Russia has vivid 
memories of both and its ruling elites will find it intolerable 
to again be at the mercy of other powers--a view that is 
increasingly articulated by oligarchs, bureaucrats, Putin 
himself, and even democratic reformers. The dictates of the 
International Monetary Fund grate against Russian sensibilities 
and Russia has the potential to be far less accepting of the 
constraints imposed by international assistance than many other 
societies. NATO's military intervention in the Balkans further 
reinforces the desire of Russian elites to position themselves 
out of the grasp of Western institutions they see as either 
depriving them of sovereignty or limiting their freedom of 
maneuver. The festering Russian offensive in Chechnya was made 
presentable to the West by Putin's exploitation of the 
vocabulary of Western politics--as well as its fear of Islamic 
fundamentalism--arguing that Russian actions follow the NATO 
precedent and seek the objective of destroying alleged Chechen/
Islamic terrorists.
---------------------------------------------------------------------------
    \42\ Western scholars have also concluded that these are the most 
likely outcomes for much of the developing world. See, for example, 
Robert H. Jackson, Quasi-states: Sovereignty, International Relations, 
and the Third World (Cambridge: Cambridge University Press, 1990). The 
more contentious issue, however, is whether such an outcome will prove 
beneficial or detrimental to socio-economic development.
---------------------------------------------------------------------------
    The globalization of capital and investment flows is 
another factor complicating the predicament of predatory 
states, and with which Russia must contend. Increasingly, 
economic processes challenge sovereignty without resort to 
territorial expansion, and the price to pay for entry into a 
globalized world is greater transparency and predictability in 
the legal and economic environment. Many other states grappled 
with this reality for decades while Russia remained insulated 
behind the walls of communism. Russian elites therefore had to 
contend with a second shock in addition to the loss of empire: 
economic progress threatened a loss of control over domestic 
life. This sense of vulnerability and the new requirements and 
resources for competition in the state system may prove 
precisely the factors capable of persuading Russian elites to 
become more than rentier capitalists. Global rivalry may 
eventually compel Russia's rulers to focus on raising 
productivity in order to restore the institutions (i.e., the 
military) that can return Russia to the concert of Great 
Powers. But this still cannot ensure the transformation of 
Russia into a law-governed state. Indeed, the elites' evidenced 
skill in using the illicit side of the global economy suggests 
this may be their preferred means for exploiting opportunities 
there.
    Another factor with a distinctive impact on Russia concerns 
still unresolved questions of national identity. Russia was the 
center of a multinational empire that denied the existence of 
constituent nations. Recent imperial memory lingers in the 
Russian consciousness, interacting with memories of power lost. 
To the extent that the Soviet mythic legacy continues to 
dominate Russian popular thinking, elites will find fertile 
soil in the public mood for building a Russian state that 
restores a substantial measure of the influence it wielded in 
previous eras. Even if not expansionist in content, such a 
conception retains the close link between identity and state 
power. National self-definition, with prodding from political 
elites, could reinforce popular resentment arising from the 
loss of sovereignty and serve as an important element to revive 
national power.
    Russia also possesses a human and natural resource base 
that defies comparison with the any other predatory system. 
Even with its environment and population threatened, the 
enormous investment in education and training in the natural 
sciences by the Soviet regime has left a skilled workforce that 
can be harnessed quickly. Unlike post-colonial societies that 
tend to bristle with economists and political scientists, 
Russia can marshal millions of trained engineers, physicists, 
chemists and other professions essential to catalyzing a post-
Soviet economic transition. Russia's present malaise, moreover, 
should not ignore the reality of a substantial nuclear 
stockpile and residual military power. Even a modest 
improvement in Russia's economic fortune could allow these 
military resources to have a profound impact on international 
security.
    Finally, there is the unavoidable reality that Russia 
simply possesses too much potential for mischief to be left to 
the whim of entropic forces. Hence, the dialogue between the 
Putin government, international financial institutions, and 
Western governments will remain important. But the concessions 
already made to Russia's predatory pathway mean that it will 
seek only the necessary mix of symbols, gestures and minimal 
substantive commitments to persuade the West that it is in 
transition to a reassuring destination. If the past decade is 
any guide, Russia will certainly attempt to achieve what it 
desires while making the West feel good about what it is.

               Conclusions and Implications for the West

    Viewing Russia as a predatory state carries important 
implications for expectations of its domestic development, as 
well as for multilateral and bilateral efforts to engage Russia 
in international affairs. Russian-American relations will be 
far more complex than the recent or even Communist past.\43\ 
The United States has in the past dealt with dysfunctional 
developmental regimes as well as Great Powers, but the 
coincidence of the two in one state is rare, if not unique. The 
following points are therefore intended to project into the 
future some of the main lines of development of a predatory 
Russia, with some of its implications for international 
politics.
---------------------------------------------------------------------------
    \43\ Some of these points are amplified in an Occasional Paper 
prepared by the author for The Atlantic Council of the United States: 
``After the Fall: U.S.-Russian Relations in the Next Stage of Post-
Soviet History,'' December 1998.
---------------------------------------------------------------------------
    (1) Russia is not destined for development as a free market 
democracy, nor is it likely to remain an irresponsible power.--
The predatory model suggests that Russian elites will succeed 
in integrating a state-economic elite that responsibly 
exercises power in pursuit of its own interests, often at the 
expense of society. Such a system will undergo considerable 
development and restoration of power, but the burdens 
associated with sustaining it militate against permanent 
stability.
    (2) The consolidation of the predatory Russian state does 
not exclude the development of capitalism.--On the contrary, 
some form of capitalism is inevitable. It will, however, be 
heavily textured by an interventionist state and the constraint 
of civil liberties.
    (3) Successful foreign investment in Russia will require 
the ability to establish and maintain constructive relations 
with influential clans.--Russian elites will be keen to 
encourage investment, but the low value placed upon a coherent 
and enforceable legal framework for commercial activity implies 
that personal and political factors will be the critical 
determinants of which foreigners gain access to lucrative 
Russian markets. Moreover, Russian elite motivations will 
spring from a desire to enrich themselves and their allied 
clans, rather than for budgetary revenues. Hence, so long as 
Putin remains president, those Russians linked to him and his 
entourage will receive favorable treatment, while those outside 
this group become targets for expropriation and political 
pressure. In all likelihood, the Putin government will maintain 
the practice of the Yeltsin era by offsetting prohibitive or 
inhospitable formal conditions for investment with informal 
guarantees that circumvent all obstacles. Foreign investors may 
well succeed in Russia, but they will have to operate in 
fluctuating political conditions, and place greater reliance on 
personal rather than institutional guarantees.
    (4) The true test of Russia's potential over the long-term 
rests on the character of the leader or leaders who succeed 
Putin.--This is most likely to occur sometime after 2010. The 
historic pattern of Russia's development has been a cycle that 
moved through a ``time of troubles,'' then to state 
consolidation, and finally, power projection. If the past is 
any guide, the next stage in Russia's cyclical development 
requires a leader with more dynamism than Putin has exhibited. 
Russia thus awaits its leader--or vozhd--who blends his 
personal authority with the resources of state (which include 
an economy with deep organic links to the government elite) to 
undertake the great task of mobilization that has always been 
necessary to produce a quantum change in Russian societal 
development.
    (5) Given his role as a stabilizer rather than a mobilizer, 
Putin's policies--foreign and domestic--will likely be 
temporizing, focused on providing the time and space needed for 
restoration and positioning of Russia for greater future 
influence in foreign affairs.--Putin and Russia will seek to 
avoid costly engagements abroad in preference for consolidating 
a network of relations that expand its influence. It presents 
little immediate direct threat to the United States or the 
West.
    (6) The potential for Russia's return to a consequential 
global role rests heavily on the qualities of its next 
leader(s).--If the predatory model holds, Putin's successors 
will be vetted by the political elite and legitimized through 
popular elections. They will not, as was once hoped, be 
individuals who worked their way up from the lower ranks of 
democratic society to the upper echelons of power.
    (7) A decentralized federalism is not in Russia's future.--
While it is doubtful that Russia can return to the level of 
centralization of Soviet rule, there is little chance that the 
center will consent to surrendering large spheres of its 
authority to regional competitors. This is one of the most 
complex aspects of Russia's future, for it requires the 
articulation of a novel form of government--neither federal nor 
wholly central--for which there is no precedent.
    (8) Corruption, cronyism, and a vast informal economy will 
be integral building blocks of future predatory Russian 
society.--The opportunity for the West to radically transform 
the dynamics of the informal economy has passed. Privatization 
resulted in the transformation of political elites into 
economic elites who now claim their place at the table of 
Kremlin power. Their reliance on extralegal measures to attain 
that status and the future benefits they can expect to derive 
from corrupt practices militate against serious reform. But 
predatory practice has demonstrated that, given the proper 
political conditions, substantial efficient and productive 
activity remains possible.
    (9) The economic and social costs associated with Russia's 
development as a predatory state will still leave it vulnerable 
to periods of instability.--The predatory project is attractive 
because of the short term gains it provides elites; but the 
long-run economic and social costs are undeniably high: 
excessively high barriers to entry to the elite, enormous 
expenditure of resources to maintain crony networks, 
maintenance of extensive oversight over the economy, and 
marginalization of society. These factors echo many of the same 
problems present at the end of Soviet power: tightening 
resource constraints, a diminishing pool of skilled elites, low 
workplace morale and productivity, and an unwillingness to cede 
political control for the sake of economic gains. The failure 
of predatory elites to address basic social problems and 
consolidate the foundations of a free market economy may lead 
to an accumulation of problems that overwhelm self-interested 
elites. Historically, Russia has relied on strong leadership to 
avoid such crises. But the collapse of Romanov autocracy and 
the implosion of the Soviet Union are clear reminders that 
Russia's institutional structures tend to be too rigid and 
inflexible to survive crises on their own. In essence, Russian 
elites are more adept at surviving socio-economic crises than 
avoiding them. The challenge of dealing with Russia in the 
future will therefore be more complex than the already daunting 
task of dealing with a socio-political order that rejects the 
basic essence of liberal democracy; it will also require 
engaging a society that, despite recapturing significant global 
influence, retains internal tensions that may undermine 
stability.
      

=======================================================================




              RUSSIA'S ECONOMIC FUTURE AND U.S. INTERESTS

=======================================================================







             U.S. BILATERAL ASSISTANCE TO RUSSIA, 1992-2001


                          By Curt Tarnoff \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   369
A Decade of Assistance...........................................   370
    Security programs............................................   370
        Weapons destruction and dismantlement....................   371
        Control and protection of nuclear material...............   371
        Demilitarization.........................................   371
    Humanitarian programs........................................   371
    Stability programs...........................................   371
        Economic reform..........................................   372
        Democratic reform........................................   372
        Social and environmental reform..........................   373
Criticism and Achievements.......................................   373
    Criticism....................................................   374
        Too little, too late.....................................   374
        Too much, too early......................................   375
        Too American.............................................   375
        To the wrong Russians....................................   376
        The wrong strategy.......................................   376
    Achievements.................................................   377
        Security program achievements............................   377
        Humanitarian program achievements........................   377
        Stability program achievements...........................   377
The Russia Program Today.........................................   380
Prospects for the Future.........................................   383
                                Summary

    For nearly 10 years, the United States has supported 
programs of bilateral and multilateral assistance to Russia. 
Although policymakers always anticipated that multilateral 
assistance through the World Bank and International Monetary 
Fund (IMF) would compose the bulk of global efforts to assist 
Russia, throughout this period the United States has maintained 
a program of bilateral assistance that more directly and 
immediately reflects U.S. interests and priorities. While 
smaller than the multilateral effort, as a grant, not loan, 
program, bilateral assistance can be employed in a wider range 
of situations than multilateral aid.\2\
---------------------------------------------------------------------------
    \1\ Curt Tarnoff is a Specialist in Foreign Affairs in the Foreign 
Affairs, Defense and Trade Division of the Congressional Research 
Service.
    \2\ For a discussion of multilateral aid, see the paper ``Russia 
and the International Financial Institutions: From Crisis to a Normal 
Country'' by Jonathan E. Sanford.
---------------------------------------------------------------------------
    The U.S. bilateral program has had three overarching and 
related aims--security, stability, and humanitarian. The United 
States has sought to achieve security, both U.S. and Russian, 
by promoting nuclear and chemical weapons non-proliferation 
activities. It has sought stability--Russian and world 
stability--by supporting a range of programs to create a 
democratic and economically prosperous Russia that would, as a 
result, be a cooperative member of the international community. 
Its humanitarian programs, like those elsewhere in the world, 
transcend specific U.S. strategic and other interests in 
Russia--they are a reflection of traditional American values.
    As might be evident from the current state of Russia's 
economy, society, politics, and military, the numerous and 
diverse projects that were developed in order to achieve these 
aims have had a mixed record. Over time, as a consequence of 
failures, successes, lessons learned, financial constraints, 
and program restrictions and conditions, the aid program today 
is substantially different in size and scope than it was early 
on. How it will change over the next decade is unclear. But in 
determining where the program is to go in the future, it may be 
helpful to know where the program has been.

                         A Decade of Assistance

    Through September 2000, about $8.8 billion in grant 
assistance has been budgeted for programs in Russia.\3\ Roughly 
37 percent of these funds have been targeted at security 
objectives, 32 percent at humanitarian goals, and 31 percent, 
at stability objectives (see Figure 1).\4\
---------------------------------------------------------------------------
    \3\ Another $908 million was expected to be allocated for Russia 
programs in 2001.
    \4\ The United States also provided loan and other guarantees to 
support roughly $6 billion in the face value of U.S. goods and 
investments to meet trade objectives. As these mostly benefited U.S. 
exporters and investors, they are not discussed here.

---------------------------------------------------------------------------
      FIGURE 1._OBJECTIVES OF U.S. ASSISTANCE TO RUSSIA: 1992-2000

[GRAPHIC] [TIFF OMITTED] T6171.042


                           security programs

    Of the roughly $3.3 billion intended for security purposes, 
most has come from the Department of Defense appropriations, 
largely authorized under the so-called Nunn-Lugar Cooperative 
Threat Reduction (CTR) Program first approved by Congress in 
November 1991. Related programs are also funded and implemented 
by the Department of Energy and Department of State. The bulk 
of security programs are intended to lessen the potential 
threat to the United States posed by Russian nuclear weapons, 
material, and expertise vulnerable to sale, theft, or hire by 
terrorists or rogue nations. There are several key components 
of these efforts.
Weapons destruction and dismantlement
    The CTR program has helped Russia meet START I Treaty 
limits by facilitating the elimination of delivery vehicles for 
nuclear weapons, including SS-18 missile silos and heavy 
bombers, and supporting destruction of its chemical weapons 
stockpile.
Control and protection of nuclear material
    The United States has provided design and construction 
assistance for a storage facility for fissile material from 
dismantled nuclear warheads, along with the containers for the 
transport of warheads and storage of materials. It has sought 
to enhance the security of warheads and materials during 
transport, storage, and at research facilities by such measures 
as providing super-containers, inventory control systems, 
sensors, and personnel reliability methodologies. Customs 
officials have received training and radiation detectors have 
been provided in order to thwart illegal export of fissile 
materials.
Demilitarization
    U.S. assistance has supported the conversion of Soviet 
defense industries into commercial, non-military, enterprises. 
Several programs aim to employ Soviet weapons scientists in 
peaceful civilian research.

                         humanitarian programs

    Since 1992, the U.S. Government has provided Russia with 
$2.8 billion in humanitarian assistance. Almost all of it has 
been food aid, delivered under the P.L. 480 Food for Peace, 
Section 416(b), and the Food for Progress programs carried out 
by the Department of Agriculture. In some cases, food was given 
to private voluntary organizations for distribution to the 
needy. In other cases, commodities were sold and their proceeds 
were used to support development objectives--such as the 
cooperative credit system, child vaccination programs, and the 
Russian Pension Fund. The U.S. Government has also provided 
transport costs for medical and other aid donated by the 
private sector, and has contributed to international 
organizations working in Chechnya.

                           stability programs

    Programs aimed at creating a stable and peaceful Russia by 
facilitating its transition from authoritarian communism to a 
free market democracy receive particular attention from 
Congress and the public. During the past 10 years, $2.7 
billion, mostly funded under the foreign operations 
appropriations and authorized under the FREEDOM Support Act has 
gone to such efforts. Projects designed to meet these 
objectives have been numerous and diverse. The breadth of 
purpose and sectors they cover, many of which overlap, make it 
difficult to categorize them. They might be put into three 
broad baskets.\5\
---------------------------------------------------------------------------
    \5\ A fourth, miscellaneous, catch-all group, composes 5 percent of 
stability efforts. These mostly include funds for the Peace Corps and 
USAID training programs--cross-cutting activities that benefited all 
three stability objectives.
---------------------------------------------------------------------------
Economic reform
    More than half (54 percent--about $1.5 billion) appear to 
have as their primary objective the economic restructuring of 
Russia and development of a strong private sector economy (see 
Figure 2). Among the projects that sought to meet this need 
were efforts to encourage reform of tax, banking, fiscal, 
energy, housing, and privatization policies. U.S. funds have 
been made available for equity investments in small and medium 
business, and loans to small and micro-business. Technical 
advice has been provided to farmers and businesses, as well as 
opportunities to gain experience in U.S. firms. Various efforts 
have been made to encourage U.S. trade and investment in 
Russia.

       FIGURE 2._U.S. ASSISTANCE FOR RUSSIAN STABILITY: 1992-2000

[GRAPHIC] [TIFF OMITTED] T6171.041


Democratic reform
    By the narrowest definition, only 8 percent of stability 
efforts in Russia were directly geared toward the development 
of democratic institutions and practices. These would include 
projects providing advice to staff of political parties and 
political election commissions, encouraging the growth of civil 
society through offering advice and funding to non-governmental 
advocacy organizations, promoting the rule of law through 
provision of judicial training programs and expertise on a 
civil code, and crime and anti-corruption programs. Democracy 
programs, more broadly defined, also have included a wide range 
of U.S. exchange programs and small grants to non-governmental 
organizations (NGOs), many of which facilitated economic reform 
objectives, but whose effect, through exposure to U.S. 
institutions or development of indigenous civil society, has 
been helpful to democratic development. Just under one-fourth 
of stability programs fit into this broader definition.
Social and environmental reform
    Social and environmental reform activities account for 
about 17 percent of stability efforts. Programs to improve the 
social welfare and environmental conditions of the Russian 
public, while meeting humanitarian concerns, were largely 
intended to bolster the key U.S. objectives of economic and 
democratic reform. Experts have argued that the Russian public 
would be more likely to support these objectives if they 
experienced fewer negative consequences as a result of reform 
efforts. Unenforced environmental standards by the Communist 
regime and the end of a cradle-to-grave social system has 
fostered a dramatic health and environmental crisis in Russia. 
Health programs supported by U.S. assistance have sought to 
reform health care delivery and financing systems, and they 
have targeted specific diseases such as HIV/AIDS and 
tuberculosis. U.S. hospitals have provided equipment and 
expertise to partner hospitals in Russia. Family planning 
assistance has been provided as an alternative to the common 
practice of abortion. Russian orphanages have been assisted.
    Environmental programs have provided small grants to 
innovative indigenous projects and replication of ``best 
practices,'' and have supported use of the Internet and e-mail 
to strengthen communication between environmental groups spread 
throughout Russia. They have supported forest management reform 
and reforestation, and pilot demonstration anti-pollution and 
energy efficiency projects. To avoid a Chernobyl-like scenario, 
the Department of Energy and the Nuclear Regulatory commission 
have provided training and equipment to improve the safety of 
Soviet-designed power plants.

                       Criticism and Achievements

    When the FREEDOM Support Act was introduced in 1992, 
government officials tried to sell the program as a relatively 
short-term effort, lasting until fiscal year 1998. However, 
even then, many realized that the transition to democracy and 
free markets might take a generation or more, depending on the 
sincerity and rapidity with which political leaders adopted the 
basic framework and laws of a new polity and economy. At the 
present time, Russia remains an unfinished work with analysts 
ranging from doubtful to hopeful in their views of its future 
course.\6\ Views of the U.S. assistance program follow the same 
trajectory. Both optimistic and pessimistic perspectives have 
helped shape the current program and can provide lessons for 
its future.
---------------------------------------------------------------------------
    \6\ The former category might include Stephen F. Cohen, Failed 
Crusade: America and the Tragedy of Post-Communist Russia, W.W. Norton, 
NY, 2000. More hopeful views are expressed by Anders Aslund, 
``Underselling Russia's Economy,'' New York Times, January 18, 2000, 
and Michael McFaul, ``Getting Russia Right,'' Foreign Policy, Winter 
1999-2000.
---------------------------------------------------------------------------
    In any case, the role of the aid program in Russia's 
progression to what it is today and to what some expect it to 
become is hard to define. Even in countries such as South Korea 
or Costa Rica where the aid programs were proportionately large 
and their political and economic development highly successful, 
making a connection between the U.S. programs there and 
specific consequences is obscured by the numerous variables 
that come into play. The results of some programs are more 
easily measured than others, such as numbers of children 
vaccinated, which logically means lesser incidence of disease, 
or elimination of missile launchers, which directly leads to 
the conclusion that U.S. security is enhanced. The immediate 
returns on most programs are often straightforward such as 
numbers of micro-loans provided or people trained in business 
management. How the trainees or loan recipients ultimately 
contributed to the broader objective of creating a market 
economy, however, is less transparent. If the objective is 
concrete, the program budget ``sufficient,'' activities 
narrowly focused on the goal, and the recipient environment 
cooperative, as was more often the case with security and 
humanitarian programs in Russia, the results may be more 
transparent. Stability programs had few of these features and 
only the short-term results appear ``measurable.'' Further, 
U.S. stability assistance was never expected to be the primary 
determinant of a successful Russian transition. Its impact 
could only be at the margins. Such considerations should be 
kept in mind when judging the impact of U.S. assistance 
programs in Russia.

                               criticism

    From the time it was launched, critiques of the aid program 
have emerged with regularity. Some attacks, many hyperbolic, 
had ulterior motives--those linking the aid program to Vice 
President Gore as the 2000 election approached or the snipes at 
aid implementors made by some unsuccessful applicants for 
funds. But criticism came also from knowledgeable individuals 
who sought a more effective outcome. The range of criticism can 
be summarized as follows: \7\
---------------------------------------------------------------------------
    \7\ In addition to these substantive, policy-related, critiques, 
observers have raised concerns regarding the administration of 
projects, such as the inadequacy of management, ineffectiveness of 
implementation, and possible malfeasance of individuals employed in 
projects. Some have opposed aid to Russia entirely, arguing that funds 
would be better spent on programs in the United States. Among more 
recent critiques are: ``Food Aid to Russia: The Fallacies of U.S. 
Policy,'' Mark Kramer, Harvard University, October 1999; An Agenda for 
Renewal: U.S.-Russian Relations, Carnegie Endowment for International 
Peace, December 2000; Collision and Collusion: The Strange Case of 
Western Aid to Eastern Europe 1989-1998, Janine R. Wedel, New York, 
1998; International Efforts to Aid Russia's Transition Have Had Mixed 
Results, GAO, November 2000; Russia's Road to Corruption: How the 
Clinton Administration Exported Government Instead of Free Enterprise 
and Failed the Russian People, Speaker's Advisory Group on Russia, 
House of Representatives, September 2000.
---------------------------------------------------------------------------
Too little, too late
    Efforts to assist the democratic and economic transition in 
Russia have often been criticized as offering too little 
funding, too late. Early on, the George H. Bush Administration 
was criticized for reacting too cautiously to the dramatic 
changes taking place in the Soviet Union in 1991. CTR security 
initiatives came entirely from Congress. Although some small 
stability-related programs were proposed by the Administration, 
it was not until the April 1992 announcement of the FREEDOM 
Support Act, following critical comments from national figures 
such as former President Nixon, that a concentrated effort was 
made to offer U.S. aid and organize support from international 
donors. To those expecting a new Marshall Plan in response to 
what appeared then to be a short window of opportunity for 
adoption of revolutionary but painful reforms, the U.S. 
contribution was considered paltry and half-hearted, and the 
bulk of offered international assistance, loans from the IMF 
and World Bank, were not appealing to a country reluctant to 
add to its debt.
    A year later, the Clinton Administration proposed a 
significant increase in U.S. assistance--roughly $1.5 billion. 
Following this one-time infusion of aid, annual levels 
appropriated for Russia quickly declined, settling below $200 
million. Throughout the decade, critics continued to remark on 
the disparity between the supposed importance of Russia to U.S. 
interests and the level of funding for efforts to effect change 
there. Although Russia received a greater proportion of 
available funding for the region, neighboring nations, such as 
Armenia and Georgia, with significantly smaller populations 
consistently ranked higher than Russia on a per capita basis.
Too much, too early
    Some would argue that a major reason for failed projects 
and wasted resources in the early years was the impetus to 
spend before there was a serious prospect of success in certain 
sectors. Economic reform legislation was developed with U.S. 
assistance while a Communist dominated parliament promised to 
thwart each measure. Assistance was offered to develop farming 
before land was privatized. And foreign investment was 
encouraged before rule of law safeguards were in place to 
protect investors.
Too American
    However much the United States claimed to provide to 
Russia, the fact is that much of the focus was self-serving, 
and many of the funds never left American hands.\8\ Moreover, 
many critics complained that Americans with specific knowledge 
of Russia were underutilized in the formulation and 
implementation of assistance programs. Stability programs 
designed and run by non-expert Americans were accused of 
displaying little cultural sensitivity and providing advice 
that was inappropriate. Few Russian staff members were hired to 
compensate for American ignorance of local matters. This 
critique was mostly aimed at the large for-profit contractors 
which focused on government policy reform work and dominated 
the aid program in the early years. Critics also argued that 
inadequate funds were provided to the relatively smaller NGOs 
which worked with the Russian grassroots and were more 
responsive to local realities and needs. As a result, U.S. 
assistance created a degree of public resentment, critics would 
argue, instead of the anticipated good will.
---------------------------------------------------------------------------
    \8\ A GAO report criticized the DOE Initiatives for Proliferation 
Prevention program for providing only one third of its funds to Russian 
institutes for employment of scientists. But most security assistance, 
in the form of U.S. equipment such as containers, and humanitarian 
aid--U.S. commodities--were items requested by the Russian Government. 
On the other hand, stability aid was mostly U.S. technical advisers and 
equipment, key exceptions being monetary grants to grassroots 
organizations, equity investments in private sector firms, and grants 
provided for on-lending to small and micro-business. The Russian 
Government had little to do with how stability funds were spent.
---------------------------------------------------------------------------
To the wrong Russians
    Both the George H. Bush and Clinton Administrations argued 
that aid should follow reform. However, some argued that, 
partly due to the lack of Russia expertise or a misguided 
effort to support the Yeltsin government, aid was provided to 
individuals or groups that were not reformist. In particular, 
critics pointed to U.S. support for Anatoly Chubais' program of 
privatization, which they argue exacerbated income divisions 
and helped foster the so-called oligarchs. Policymakers, 
according to critics, blindly provided support to individuals 
like Yeltsin, despite his inconsistent support for economic 
reform and democracy, rather than to democratic 
``institutions.'' When a substantial amount of food aid was 
provided in 1993, many suggested that proceeds were channeled 
through corrupt officials who may have used them 
illegitimately. Others argued that congressional directives 
funneling funds to specific regions insured ineffective 
programs by assisting non-reformers.
The wrong strategy
    Some critics disagreed with the mix of programs that were 
funded by the United States. They argued, for example, that 
stability programs emphasized economic reform efforts while 
leaving democracy programs underfunded. Stronger democratic 
institutions, they suggested, would have led to more economic 
reform. Other critics argued that too much assistance was 
provided to programs in Moscow and not enough to the regions. 
Others contended that too much went to the reform of Russian 
Government policies and not enough to grassroots activities and 
the private sector.
    Some CTR critics argued that funding the destruction of 
chemical weapons was less important than elimination of nuclear 
weapons; others that more funds should have gone to insuring 
the security of materials used to produce weapons. Some 
questioned the wisdom of defense conversion programs, arguing 
they subsidized the Russian defense industry and had no effect 
on current production capacity. Others suggested that funding 
weapons dismantlement while Russia continued to modernize its 
systems simply subsidized modernization. Critics of food aid 
argued that sale of the commodities lowered local food prices 
and harmed Russian farmers, especially the new independent 
farmers some aid programs were trying to encourage.
    There are many possible responses to the numerous and 
disparate criticism made during the past 10 years: It could be 
said that, no matter the amount of funds available, little 
could be done without a strong commitment on the part of the 
Russian Government to support the few Russian reformers who 
emerged in positions of power. While, there may have been 
American experts on Russia who knew more than Kremlinology, few 
of these had experience in running assistance programs, and no 
one had expertise on the transformation from communism to 
democratic capitalism. Everyone had a formula for how funds 
could best be spent. Each donor had different priorities and 
did not channel funds into a coherent program for maximum 
leverage. Congressional directives caused dispersal of limited 
U.S. funds on too numerous objectives.

                              achievements

    In taking aim at individual aspects of the aid program--the 
privatization effort, corrupt food aid, insufficient support 
for democratization, etc.--critics often promoted the 
impression that the whole aid program was in dispute. While 
there was much in the critiques that rang true, there were also 
many things that could be said to be right with the program, 
positive accomplishments, some of which have been noted by the 
critics themselves.
Security program achievements
    A January 2001 report by the Russia Task Force co-chaired 
by former Senate Majority Leader Howard Baker and former White 
House counsel Lloyd Cutler found that ``current 
nonproliferation programs in the Department of Energy, the 
Department of Defense, and related agencies have achieved 
impressive results thus far . . .''.\9\ Among these are 
elimination of 336 SLBM launchers, 369 ICBM silos, 83 strategic 
bombers, 422 ICBMs, and 19 SSBNs. Secure storage of fissile 
materials has been enhanced by delivery of 32,000 containers 
and by assistance in construction of a storage center. The 
stockpile of nuclear weapons is more secure due to upgrades in 
inventory and security systems. Interdiction capabilities have 
been enhanced by providing border crossings with radiation 
detection equipment and guards with training. The employment of 
thousands of scientists may have helped prevent a brain drain 
of sensitive expertise in weapons of mass destruction and to 
some extent has re-directed it toward peaceful, commercial 
enterprises.
---------------------------------------------------------------------------
    \9\ A Report Card on the Department of Energy's Nonproliferation 
Programs with Russia, January 10, 2000, Russia Task Force, Secretary of 
Energy Advisory Board, page 1.
---------------------------------------------------------------------------
Humanitarian program achievements
    The aid program has provided large quantities of food 
assistance to Russia, 1 million metric tons in fiscal year 2000 
alone. It has also provided transport costs to deliver more 
than $628 million in privately donated food, medical and other 
supplies, and contributed to international organization work in 
the North Caucasus region. While some of the food deliveries 
may not have been necessary, tens of thousands of displaced 
persons, children, pensioners, and other needy individuals 
received food and pensioners received financial aid from the 
proceeds of food sales they may otherwise not have received.
Stability program achievements
    While no one will argue that Russia has become a full 
fledged western democracy and free market economy, it has 
changed radically since the end of the Communist era (and 
continues to evolve in directions we can only surmise). Tens of 
thousands of private businesses now exist, political parties 
and grassroots advocacy organizations proliferate, travel 
abroad is unrestricted, an open exchange of information, 
including the Internet and a free press exist. Stability 
programs did not create this situation, but they nurtured it, 
and, to some facets of the new order, the contribution was 
arguably significant. Stability programs sought to affect many 
discrete aspects of Russian life, but perhaps their greatest 
cumulative impact in the long-term may have been the 
introduction, dissemination, and practice of new ideas.
    Exposure to new ideas.--A large number of assistance 
projects sought to change Russia by exposing its government and 
citizens to new ideas.

   Policy reform.--U.S. technical experts have provided 
        advice to national and local governments on legal and 
        administrative reforms in a wide range of sectors. 
        While many reforms have yet to be implemented, these 
        efforts have introduced officials to procedures and law 
        in other countries and may influence future reform 
        developments. A program to assist fiscal reform, for 
        example, provided the Ministries of Finance and 
        Taxation, the Budget Committee of the State Duma, the 
        regional administrations of six Oblasts, and the 
        municipal administrations of Novgorod and Tver with 
        analytical models for forecasting the effects of tax 
        policy. The program also trained a team of Russian 
        specialists in these skills.\10\ Housing reform project 
        staff reportedly contributed views on 160 national laws 
        and decrees and directly drafted 37 legislative 
        acts.\11\
---------------------------------------------------------------------------
    \10\ Work carried out for USAID by Georgia State University. Final 
Report Evaluation of the Impact of Technical Assistance on Russia's 
Fiscal Reform and the Identification of Possible Future Work, Carana 
Corporation, March 21, 2000, p. 49. Advice on tax administration and 
enforcement was also provided by Department of Treasury-appointed 
advisers in the Ministry of Finance.
    \11\ Work carried out for USAID by Urban Institute. Evaluation 
Report: The Russian Housing Sector Reform Project Phases I and II, 
Carana Corporation, November 1999, p. 4.
---------------------------------------------------------------------------
   Mortgage finance.--Housing reform specialists 
        introduced the practice of residential mortgage lending 
        to Russia by drafting a legislative framework for this 
        activity, writing the industry's ``how-to'' handbook, 
        and offering technical assistance to banks. By 1998, 47 
        banks were making mortgage loans.\12\
---------------------------------------------------------------------------
    \12\ Evaluation Report: The Russian Housing Sector, p. 28-33.
---------------------------------------------------------------------------
   International accounting standards.--U.S. experts 
        promoted the use of international accounting standards 
        to Russian business in order to make it easier to 
        attract investors and qualify for loans and to promote 
        transparency. In 1999 alone, 3,670 were trained.\13\
---------------------------------------------------------------------------
    \13\ Results Review and Resource Request: USAID/Russia, April 2000, 
p. 14.
---------------------------------------------------------------------------
   Direct exposure to the United States.--Since 1992, 
        more than 47,500 Russians were brought to the United 
        States for both targeted education and training and 
        broader familiarization with U.S. culture and 
        institutions. For example, the SABIT program provided 
        experience working in a U.S. business (131 in 2000), 
        the Cochran program experience in agriculture-related 
        concerns (50 in 2000), and the productivity enhancement 
        program management-training internships (425 in 2000). 
        The Russian leadership program brought promising 
        leaders for short visits, including home-stays, at the 
        grassroots level (1,605 in 2000).\14\
---------------------------------------------------------------------------
    \14\ Implemented by the Department of Commerce, Department of 
Agriculture, and Library of Congress, respectively. The vast majority 
of exchange programs (serving more than 32,000 Russians since 1992) are 
conducted by the Department of State's Bureau for Education and 
Cultural Affairs; USAID has brought over 9,000 Russians to the United 
States for project-related training.
---------------------------------------------------------------------------
   Person-to-person exposure.--Several programs brought 
        American volunteers to Russia, emphasizing personal 
        contact with Americans as much as provision of ``know-
        how'' at a grassroots level. During their 2 year term 
        of service, Peace Corps volunteers (100 in 2000) taught 
        English and business skills. The Farmer-to-Farmer (150 
        in 2000), Financial Service Volunteer Corps, 
        International Executive Service Corps, and others 
        provided the technical skills of practicing and retired 
        farmers and businessmen to their counterparts in Russia 
        on a one-to-one, short-term basis.
   Advice and training for business.--Emerging 
        businesses and their employees received both general 
        and specialized training in business skills as well as 
        targeted, individualized advice. Many of the volunteer 
        programs noted above were aimed at providing experts to 
        individual business clients to help solve specific 
        problems, such as how to improve production or 
        marketing. Nearly 1 million Russian school children 
        were introduced to concepts of capitalist economics 
        through Junior Achievement programs.

    Creating vehicles for dissemination of ideas.--Many aid 
projects sought to increase the capabilities of organizations 
that traditionally act as agents of change and disseminators of 
new ideas.

   Internet networking.--In the first years of the 
        assistance program, aid was provided to the Initiative 
        for Social Action and Renewal in Eurasia (ISAR), an 
        organization which facilitated the sharing of ideas and 
        strengthened the solidarity of environmental NGOs in 
        part by establishing an e-mail network system linking 
        them. Support for Internet access and training at more 
        than 50 sites throughout Russia has been provided to 
        alumni of U.S.-sponsored exchanges in order to build 
        contacts among them and reinforce positive experiences 
        gained while in the United States.\15\
---------------------------------------------------------------------------
    \15\ The Internet Access and Training Program is carried out by 
Project Harmony for the Department of State.
---------------------------------------------------------------------------
   Think tanks.--To continue the policy reform work 
        provided by U.S. experts, USAID supported the creation 
        and strengthening of indigenous Russian think tanks 
        whose expertise--often former Russian associates of 
        U.S. technical experts--could be drawn upon by national 
        and regional governments. For example, the Institute 
        for Economies in Transition, run by Yegor Gaidar, 
        received grants for tax, budget, land code, and other 
        policy studies and providing advice to the government. 
        The Moscow School of Political Studies trained young 
        leaders in democratic principles.
   Developing civic organizations.--The United States 
        has aided the development of institutions, such as 
        NGOs, political parties, and trade unions, that 
        advocate new ideas and are essential to a healthy civic 
        society. U.S. assistance helped 5,000 NGOs in 1999 
        through 48 Russian NGO resource centers.\16\
---------------------------------------------------------------------------
    \16\ Work carried out for USAID by International Research and 
Exchange Board (IREX), ISAR, and others. USAID Results Review, p. 28.
---------------------------------------------------------------------------
   Independent media.--U.S. aid has provided training 
        and technical assistance to television and print media. 
        During the 1998 economic crisis, grants were provided 
        to help independent television stations survive despite 
        a drop in advertising revenue.\17\
---------------------------------------------------------------------------
    \17\ Work carried out for USAID by Internews and others.
---------------------------------------------------------------------------
   Developing business support organizations.--
        Assistance programs provided support to 33 business 
        service centers to provide consulting and other 
        services to small and medium business, and fostered 
        development of business educational training through 
        support to 59 business schools.\18\
---------------------------------------------------------------------------
    \18\ Service centers work implemented for USAID by Citizens 
Democracy Corps, Agricultural Cooperative Development International and 
Volunteers in Overseas Cooperative Assistance (ACDI/VOCA), and others; 
Morozov schools by the Russian Academy for Management and Market.

    Putting ideas into practice.--Through grants, lending 
programs and other means, U.S. assistance has helped individual 
businesses and civic organizations apply the new 
entrepreneurial and democratic concepts often learned through 
---------------------------------------------------------------------------
training and technical assistance.

   Loans and guarantees.--The United States provided 
        funds to Russian institutions for on-lending to micro-, 
        small-, and medium-sized businesses. USAID programs 
        alone disbursed more than 7,100 micro-loans between 
        1995 and 1999. U.S. guarantees on bank loans promoted 
        introduction of consumer finance activities in Russia. 
        A U.S. assistance program provided guarantees on loans 
        to enable Russian banks to make their first residential 
        mortgage and auto loans.\19\
---------------------------------------------------------------------------
    \19\ Work carried out by the U.S.-Russia Investment Fund. The U.S.-
Russia Investment Fund also made more than $30 million in equity 
investments in more than 30 promising Russian small and medium 
businesses. The results, however, are not demonstrably positive at this 
time.
---------------------------------------------------------------------------
   Grants.--Several programs provided competitive 
        grants to NGOs to enable them to conduct programs 
        contributing to reform at the grassroots level. Since 
        1993, a U.S. funded foundation has provided more than 
        2,000 grants worth over $50 million to NGOs, local 
        governments, independent media, and private businesses 
        seeking demonstrable positive results in the fields of 
        enterprise development, public administration, and 
        civil society. Another program awarded funds (87 grants 
        in 1999, most in the $30,000 range) to replicate 
        successful environmental practices.\20\
---------------------------------------------------------------------------
    \20\ Work implemented for USAID by the Eurasia Foundation and the 
Institute for Sustainable Communities, respectively.
---------------------------------------------------------------------------

                        The Russia Program Today

    The U.S. assistance program of today is substantially 
different from that of its initial several years. Lessons 
learned as a result of failure and achievement, of criticisms 
and congressional review during the first years set in motion 
an evolving re-evaluation of programs and redistribution of 
resources. In many cases, programs were revised internally even 
before outside criticisms were made.
    By fiscal year 2000, the most recent year for which data is 
available, the program's broad profile had shifted dramatically 
(see Figure 3). First, program priorities appeared to have 
changed. Whereas a 10 year profile showed a near balance 
between spending on security, stability and humanitarian 
concerns, by fiscal year 2000, there was an overwhelming 
emphasis on the security objective, while the stability effort 
declined significantly. This relationship is real as well as 
proportionate. Security funding increased in absolute terms 
over the period and even began to be drawn from the chief pool 
of resources available for stability funding, the NIS account 
appropriations. Meanwhile, stability funding, as suggested by 
NIS account levels, was cut (see Table 1). Cuts came partly due 
to the perception that the program was slow in meeting its 
economic and political reform objectives. They also reflect 
broad cuts in foreign aid following the accession of a budget-
trimming Republican Congress (that have been reversed since 
1999). Moreover, cuts were made specifically for Russia 
programs in response to concerns regarding Russian Government 
behavior abroad and at home.

           FIGURE 3._OBJECTIVES OF U.S. ASSISTANCE TO RUSSIA

                           [Fiscal year 2000]

[GRAPHIC] [TIFF OMITTED] T6171.040



          TABLE 1.--U.S. ASSISTANCE TO RUSSIA FROM NIS ACCOUNT
                          [Dollars in millions]
------------------------------------------------------------------------
                                                             Allocation
               Fiscal year                 Administration      after
                                               request     appropriation
------------------------------------------------------------------------
1992-1993................................          (\1\)         $350.0
1994.....................................          (\1\)        1,300.0
1995.....................................         $379.4          344.2
1996.....................................          260.0          137.0
1997.....................................          173.0           94.8
1998.....................................          241.5          133.2
1999.....................................          225.4          161.2
2000.....................................          295.0          186.6
2001.....................................          161.9          167.8
2002.....................................          167.0             --
------------------------------------------------------------------------
\1\ Prior to fiscal year 1995, the administration did not break down its
  NIS account request by country.

    Bearing the brunt of budget cuts and criticisms, the 
composition of the stability program changed far more sharply 
during the decade than did the humanitarian or security 
programs.\21\ Perhaps the most striking feature has been a 
shift in emphasis from economic reform to democratic reform. 
For the whole period, economic reform received 54 percent of 
stability funds; but in fiscal year 2000, it received only 31 
percent (see figure 4). Democratic reform efforts, on the other 
hand, were supported with 24 percent of overall funds, but in 
fiscal year 2000 received 47 percent. To be sure, the emphasis 
seems to be on exchanges rather than institution-building, but 
even the narrowly defined democracy programs now represent 13 
percent of stability efforts versus 8 percent during the whole 
period. The greater priority now given broad democracy 
activities reflects the lack of progress in economic reform 
until recently, past criticism that not enough attention was 
being paid to democracy-building and person-to-person contacts, 
and cuts in assistance to the central government of Russia 
which was the recipient of much economic reform aid. The cuts 
were the result of congressionally imposed conditions that 
subjected half of aid to the central government in fiscal year 
1998 and later years to the requirement of a presidential 
determination that Russia had terminated sales or transfer of 
nuclear reactor technology to Iran.
---------------------------------------------------------------------------
    \21\ Within the security program, percentages devoted to weapons 
dismantlement, material control, and demilitarization changed little 
during the period.

---------------------------------------------------------------------------
         FIGURE 4._U.S. ASSISTANCE FOR RUSSIAN STABILITY, 2000

[GRAPHIC] [TIFF OMITTED] T6171.039


    By 2000, the make-up of the stability program had changed 
in a number of other important ways. Extrapolating from the 
experience of USAID, which accounted for roughly half of 
stability program activity, very little assistance was still 
being directed toward helping the central government of Russia. 
Although the central government was the key target of the large 
number of policy reform efforts undertaken in the 1993-1995 
period--in fiscal year 1996, the first year for which data is 
available, accounting for 17 percent of USAID's program--by 
2000, central government-related projects accounted for only 7 
percent. The proportion is likely smaller today. Support for 
private sector activities rose correspondingly, from 68 percent 
of the fiscal year 1996 program to more than 82 percent in 
fiscal year 1999.
    There is also some evidence that, compared with its early 
years, the assistance program now has more activities in the 
regions than in Moscow and Petersburg (80 percent in the 
regions in fiscal year 2000), more funds directed toward NGOs 
(75 percent in fiscal year 2000), and more Russian nationals 
involved as both implementors and staff. Many of these changes 
were featured in the Clinton Administration's Partnership for 
Freedom initiative, which was introduced in 1997 largely in 
response to the criticisms noted above and in an effort to 
recover congressional support. A Regional Investment Initiative 
was introduced at the same time, concentrating aid on three 
(now four) regional sites in a bid to attract foreign 
investment and increase program effectiveness. The two 
initiatives promised to alter the presiding aid strategy toward 
Russia, and, in this, appear to have succeeded.

                        Prospects for the Future

    Ten years after the assistance program was launched, the 
time may be ripe for an assessment (and, in the case of 
stability assistance, a reassessment) of the strategies 
designed to make each aid objective achievable. A review of the 
broader issue of what should be the objectives of the U.S. aid 
program in Russia may also be in order.
    While the stability program may now have met the main 
criticisms of the early to mid-1990s--and scrutiny of 
individual projects under this program must continue in order 
to enhance its effectiveness--it is not clear whether the 
program adequately meets present or future needs. This question 
is put into sharper focus in 2001, as the Russian Government at 
last appears serious in its support for economic reform 
legislation. Some argue that constraints on U.S. support for 
economic policy reform--restrictions on aid to the central 
government and limited availability of funds--may mean a lost 
opportunity for a critical U.S. contribution on this issue. In 
view of recent threats to freedom of expression in Russia, the 
U.S. program's growing attention to democratic reform would 
appear to merit continued, if not strengthened, U.S. support, 
but constraints on funding levels and program flexibility may 
limit U.S. efforts here as well.
    Questions have also been raised regarding the availability 
of funding for security programs. The Bush Administration 
submitted an fiscal year 2002 request for Energy Department 
non-proliferation activities--control and protection of nuclear 
materials and demilitarization programs that fund alternative 
employment for scientists--that represented a 12 percent 
decrease from fiscal year 2001 allocations.\22\ With some 
observers arguing for significant increases in non-
proliferation assistance to Russia--the Baker-Cutler report 
called for spending $30 billion over the next 8 to 10 years, 
and the September 11 attacks generated heightened nuclear 
proliferation concerns--Congress restored some, but not all, of 
the funding, leaving an 8 percent cut. Efforts by one member to 
redirect $130 million to non-proliferation programs did not 
meet with success, but indicated that there is likely to be 
further discussion in the coming year on how security programs 
have met and will continue to meet critical U.S. interests.
---------------------------------------------------------------------------
    \22\ An Administration review of non-proliferation programs in 2001 
proposed no significant change to Department of Defense CTR programs.
---------------------------------------------------------------------------
    In fact, there is dispute over whether relative proportions 
of funding going to stability, security, and humanitarian 
objectives appropriately represent current and future U.S. 
interests. Until now, policymakers have dealt with stability 
and security objectives mostly through different funding 
spigots and rarely considered the U.S. effort in Russia as a 
whole piece. But some analysts would argue that there can be no 
sure security for the United States regarding Russia's weapons 
of mass destruction unless that country is a more democratic 
and economically stable society. All three objectives, 
according to this view, are intimately intertwined.
    The United States continues to hold a very strong interest 
in Russia and the outcome of events there. Whatever the 
accomplishments of the past 10 years, U.S. assistance may 
continue to play a role in those events. Whether that role 
should be expanded--and, if so, how--is likely to challenge 
policymakers in the future.







   ARMS EXPORTS AND RUSSIA'S DEFENSE INDUSTRIES: ISSUES FOR THE U.S. 
                                CONGRESS



                         By Kevin P. O'Prey \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   385
The State of Russian Arms Exports................................   387
    Making money.................................................   389
    Russia's markets.............................................   390
        The China market.........................................   391
        Cooperation with India...................................   392
        The Iran relationship....................................   393
Understanding Russia's Success...................................   394
    The Russian appeal...........................................   394
    Constraints on further Russian success.......................   395
The Rationale for Russian Exports................................   397
    Excess capacity..............................................   398
    State policy.................................................   401
    Graft........................................................   404
Impact on the Russian Defense Sector.............................   404
Issues for Congress..............................................   408
    The virtual certainty of continued aggressive promotion of 
      arms exports by Russia.....................................   408
    The limited effects that export success will have on Russian 
      defense industrial advancement.............................   409
    The negative impact that these exports will have in terms of 
      greater proliferation of high technology weapons systems to 
      potential U.S. competitors.................................   409
                                Summary

    In recent years, Russia has experienced a significant 
improvement in its arms export performance. During the year 
2000, Russia signed deals making it the world's second leading 
supplier of armaments. Moreover, in contrast to Soviet 
experience, the Russian Government and defense enterprises 
actually are making money off of these commercial deals.
---------------------------------------------------------------------------
    \1\ Dr. Kevin P. O'Prey is Executive Vice President of DFI 
International's Government Practice, a Washington, DC-based research 
and analysis firm. The analysis presented here is based on work he has 
conducted at DFI International, at the Brookings Institution, and for 
his doctoral dissertation for the Massachusetts Institute of 
Technology. The author would like to thank Ms. Agnes Lee, Mr. Erik 
Teleen, and Mr. Graig Saloom for their research assistance and Dr. 
Eugene Rumer for providing comments on a previous draft.
---------------------------------------------------------------------------
    The implications for U.S. national security and the 
Congress are several. First, regardless of the state of U.S.-
Russia relations, the United States will have little leverage 
to overcome Moscow's very significant incentives to export as 
many weapons as possible to whoever will pay for them. Second, 
export success will do little to improve the current poor state 
of Russia's military and defense industries. While export 
revenues have certainly improved the financial health of some 
Russian defense enterprises, overall they are not likely to 
help Russia to develop and produce new, technologically 
competitive weapon systems. Third and perhaps most important 
for the United States, Russia's aggressive approach to arms 
exporting will almost certainly contribute to the proliferation 
of high technology weapon systems to countries that are 
potential U.S. competitors--China and Iran being the most 
significant cases in point.
    What is the current state of Russian conventional arms 
sales abroad and what are Russia's near-term prospects? What 
does the answer mean for Russia's defense industrial sector, 
for the proliferation of high technology weapons, and, by 
extension, for U.S. national security? In recent years, 
Russia's state organs and defense enterprises have improved 
Russia's performance as an arms exporter. This paper examines 
Russia's recent success, the factors that explain it, as well 
as their broader implications for Russia and the West.
    While Russia's arms sales successes have had a positive 
impact on the financial health its defense sector, their 
effects have been decidedly limited in scope. Only about seven 
to ten of Russia's approximately 1,600 defense enterprises 
appear to have benefited significantly from arms sales. 
Moreover, even for these fortunate few, arms export achievement 
has not translated into success in overcoming the many 
structural challenges to the development of profitable firms in 
the Russian defense sector. At most, arms export success 
appears to have helped a few design bureaus undertake modest 
research and development (R&D) initiatives and a few production 
facilities to maintain a manufacture that, by historical Soviet 
standards, is modest. Translating this R&D and low 
manufacturing rate into the production of new, technologically 
competitive weapon systems, however, seems exceedingly 
difficult.
    Overall, the infrastructure of the Russian defense sector 
appears to be remarkably immutable. Despite a decade of 
economic privation and repeated attempts to reform or downsize 
the defense industries, few, if any, defense enterprises have 
formally gone bankrupt. Rather than shut their doors, many 
plants continue to operate at minimal production levels. While 
managerial changes have occurred in many plants, organizational 
restructuring has been very limited.
    Against this backdrop, there is a broad consensus among 
Russian decisionmakers--in government and industry--on the need 
to export arms. From the government's perspective, the value of 
arms export ranges from diverting the attention abroad of 
potential subsidy-seeking enterprises; sustaining key 
components of a defense industrial base it can no longer 
afford; reducing the per unit costs of defense production; as 
well as obtaining hard currency revenues for state and, in some 
cases, personal coffers. For industry, exports represent the 
potential to restart or maintain modest production levels; to 
pay worker salaries; to invest in some new projects; and to 
profit on a personal level.
    The implications for the U.S. Congress are several. First, 
the motivations for continued aggressive Russian efforts in the 
global arms export arena are profound and, probably, enduring. 
The United States possesses few instruments to discourage 
Russian efforts in this arena. Moreover, post-9/11 improvements 
in U.S.-Russian security relations are not likely to change 
Moscow's export behavior. Second, Russia's increased arms 
export success seems unlikely to have much of an impact on 
Russia's defense industrial capabilities. While export revenues 
improve the financial position of some enterprises, export 
success appears fundamentally only to delay inevitable 
restructuring. Third, Russia's export efforts will increase the 
proliferation of advanced conventional systems to countries 
that might pose a threat to U.S. forces--China and Iran being 
the most important examples.

                   The State of Russian Arms Exports

    Like the Russian economy more broadly, the Russian defense 
industries have turned a corner in the last 2 years. After 
hitting bottom in terms of economic performance, some Russian 
defense enterprises appear to be showing signs of modest levels 
of activities. While a spike in procurement orders due to the 
war in Chechnya provided an initial boost, the real basis for 
this improved state of affairs has been arms export success. 
During calendar year 2000, Russia succeeded in signing arms 
sales agreements worth approximately $7.7 billion. As Figure 1 
demonstrates, this represents an improvement over 1999 results 
by nearly 90 percent and a remarkable 270 percent increase over 
the 1998 figure. According to unofficial estimates, Russia's 
performance for calendar year 2001 would be comparable.\2\ 
After a decade of efforts by the government and defense 
industries, Russian export promotion is finally paying off.
---------------------------------------------------------------------------
    \2\ Richard F. Grimmett, Conventional Arms Transfers to Developing 
Nations, 1993-2000, (Washington, DC: Congressional Research Service, 
August 16, 2001), Figure 1, p. CRS-21.
    By November 2001, Rosoboroneksport was predicting export revenues 
on the order of $4 billion for 2001. If historical trends hold, that 
would put the overall revenue Figure for Russian arms exports at 
approximately $5 billion. See ``In Brief: Arms Sales Near $4 Bln,'' 
Moscow Times, November 16, 2001, p. 6.
---------------------------------------------------------------------------
    Part of Russia's export success can be attributed to a 
global increase in the level of the arms trade. After bottoming 
out at $24.3 billion in 1997, the level of worldwide arms 
transfer agreements increased steadily to $36.9 billion in 
2000.\3\
---------------------------------------------------------------------------
    \3\ These figures are in constant calendar year 2000 dollars. The 
data are from Richard F. Grimmett, Conventional Arms Transfers to 
Developing Nations, 1993-2000, Table 8A, CRS-72.
---------------------------------------------------------------------------
    Yet Russia's 2000 success also reflects a trend of 
increasing market share relative to its non-U.S. competitors in 
the global arms trade. Although the United States continues to 
hold the dominant position in the market--50 percent of year 
2000 arms transfer agreements--Russia has laid claim to a 
strong second place with nearly 21 percent of the 2000 value 
(See Figure 2). Figure 2 also demonstrates that, with the 
exception of 1998, when it signed agreements worth only $2.6 
billion, Russia has occupied either second or third place among 
global arms exporters since 1995.
    The lion's share of Russia's recent success can be 
attributed to Asia. As Figure 3 depicts, during the 1997-2000 
period, the Asian market accounted for over three-fourths of 
Russia's export agreements with the developing world. The 
lucrative Middle East market, meanwhile, accounted for a 16 
percent share of Russia's agreements. Africa accounted for just 
over 6 percent.

  FIGURE 1._RUSSIAN ARMS TRANSFER AGREEMENTS WITH THE WORLD, 1993-2000
[GRAPHIC] [TIFF OMITTED] T6171.029


  Source: Richard F. Grimmett, Conventional Arms Transfers to 
Developing Nations, 1993-2000, 2001.


 FIGURE 2._ARMS TRANSFER AGREEMENTS WITH THE WORLD, BY SUPPLIER, 1996-
                                  2000

[GRAPHIC] [TIFF OMITTED] T6171.030


  Source: Richard F. Grimmett, Conventional Arms Transfers to 
Developing Nations, 1993-2000, 2001.

    Even within the Asian market, Russia's success is highly 
concentrated to two customers: China and India. Recent Chinese 
acquisitions include over 20 Su-30MKK and 8 Su-27UBK fighter 
aircraft; a Kilo-class submarine; 13 Tor M1 surface to air 
missiles; and 2 Sovremenny class destroyers. Some reports 
project China as potentially accounting for between 30 and 50 
percent of Russia's arms exports over the next decade. In terms 
of India, over the 2000-2001 period, New Delhi signed deals for 
the purchase or licensed co-production of over 130 Su-30MKI 
fighter aircraft; 310 T-90 tanks; and a Kilo submarine.\4\
---------------------------------------------------------------------------
    \4\ Interfax interview with Konstantin Makienko, ``Military-
Technical Cooperation between Russia and China, 17 July 2001, reprinted 
on www.cast.ru/english/database1.html?article=102.

---------------------------------------------------------------------------
     FIGURE 3._RUSSIAN REGIONAL ARMS TRANSFER AGREEMENTS, 1997-2000

[GRAPHIC] [TIFF OMITTED] T6171.031


  Source: Richard F. Grimmett, Conventional Arms Transfers to 
Developing Nations, 1993-2000, 2001.

                              making money

    Perhaps more important than the overall value of 
agreements, in contrast to the Soviet era and the experience of 
the early 1990s, Russia appears to be earning hard currency 
from its recent arms sale successes. During the 1980s, arms 
export ``success'' on the order of $20 billion a year was 
tempered by the fact that the U.S.S.R. typically received hard 
currency payment for only one-third of its arms exports.\5\ The 
situation did not improve markedly in the early 1990s, as 
Rosvooruzheniye, the Russian arms export agency, reportedly 
negotiated deals that often involved payments in kind, debt 
swaps, or ``soft'' currency, such as Indian rupees. For 
example, in a deal that sent MiG-29s to Malaysia, Moscow agreed 
to accept one-fourth of the payment in the form of palm oil. In 
another case, the director of the Krasnoye Sormovo shipyard 
complained that half of China's payment for two diesel 
submarines was made up of jogging shoes and women's sandals, 
all of which reportedly disintegrated within a month of 
delivery.\6\
---------------------------------------------------------------------------
    \5\ See Kevin P. O'Prey, The Arms Export Challenge: Cooperative 
Approaches to Export Management and Conversion, (Washington, DC: 
Brookings Institution, 1995), p. 75 and Pavel Fel'gengauer, ``Rezkoye 
sokrashcheniye eksporta otechestvennogo: oruzhiya vpervyye obyavleny 
ofitsial'nyye tsifry voyenno tekhnicheskogo sotrudnichestva za 1991 
god,'' (Sharp Reduction in Exports of Our Weapons: The First Releases 
of Official Figures of Military-Technical Cooperation for 1991), 
Nezavisimaya Gazeta, September 29, 1992, pp. 1-2.
    \6\ See Sergey Mashtakov, ``MiG i v Malayzii. Kto eshche kupit 
nashi istrebiteli?'' (MiG also in Malaysia. Who Else Will Buy Our 
Fighters?'' Rossiyskaya Gazeta, September 7, 1994, p. 3; Pavel 
Fel'gengauer, ``Torgovlya oruzhiyem ne tak vygodnaya Rossiy, kak 
utverzhdayet Rosvooruzheniye,'' [The Arms Trade Is Not As Beneficial to 
Russia as Rosvooruzheniye Asserts] Segodnya, March 10, 1995, p. 2; and 
Unidentified Correspondent, ``Shibayev, Deputy Chairman of the 
Committee for Foreign Economic Relations: If Everyone Were Allowed to 
Sell Arms, the Unjustified Competition Would Lead to a Fall in 
Prices,'' Komsomolskaya Pravda, February 25, 1992, p. 1, translated in 
Foreign Broadcast Information Service (FBIS) SOV 92-039, pp. 31-32.
---------------------------------------------------------------------------
    As Figure 4 demonstrates, the situation turned for the 
better in 1997 and has been improving ever since. According to 
Rosoboroneksport, its predecessor as the official Russian arms 
export agency took in hard currency for approximately 90 
percent of its sales in 1999 and 2000.\7\
---------------------------------------------------------------------------
    \7\ There are no data available for hard currency returns of 
enterprises operating independently of Rosvooruzheniye/
Rosoboroneksport.

  FIGURE 4._ROSVOORUZHENIYE'S ARMS EXPORTS AND CURRENCY RETURNS, 1995-
---------------------------------------------------------------------------
                                  2000

[GRAPHIC] [TIFF OMITTED] T6171.033


  Source: Novichkov, Nikolai. ``Russia Exports $3.6B of Arms in 
2000, Sees Strong Growth.'' Jane's Defence Weekly, 2001.

                            russia's markets

    Although some of Russia's client relationships appear only 
to be curiosities of the international arms market--e.g., 
purchases by North Atlantic Treaty Organization (NATO) member 
Greece and by the United Arab Emirates, which can afford to 
maintain relationships with multiple suppliers--the broader 
picture is more worrisome. From the U.S. perspective, most 
importantly, the principal markets for Russian conventional 
arms sales are some of those countries that have been the most 
vocal opponents of America's leadership role around the globe. 
Although commercial sales do not suggest an anti-U.S. alliance, 
in some cases, they could pose threats either through 
technology transfer or the direct enhancement of military 
capabilities that might be used against the United States or 
our allies. The remainder of this section addresses Russia's 
most noteworthy partners.
The China market
    Beijing clearly ranks as Russia's most important client for 
armaments. Although Russia and the People's Republic of China 
have had an on-again, off-again relationship in terms of 
military-technical cooperation throughout China's Communist 
period, ties between the two strengthened considerably during 
the 1990s. During this period, Russia's defense complex has 
come to look on the China market as essential for its survival. 
In a series of 1999 interviews with a range of officials from 
the Russian Government and defense industries, virtually all 
respondents strongly defended arms sales to China as critical 
sources of revenue for Russian enterprises and design 
establishments. As one interviewee put it, Russian defense 
industrialists may find cooperation with China to be 
``degrading'' as they would prefer to work with Western high-
tech partners. However, financially speaking, they find that 
they have few options.\8\
---------------------------------------------------------------------------
    \8\ Kevin O'Prey, ``Analytical Report of Trip Findings,'' 
Unpublished Report for DFI International, December 21, 1999, p. B-3.
---------------------------------------------------------------------------
    Apparently, only the Russian General Staff had expressed 
any objections to military technical cooperation with China. 
Reportedly, some General Staff officials argue that in 10 to 15 
years, the Chinese military threat could return based on a 
foundation of transferred Russian technology. Yet these 
arguments do not carry the day as Kremlin decisionmaking is 
more focused on near-term financial and domestic political 
considerations.\9\
---------------------------------------------------------------------------
    \9\ Kevin O'Prey, DFI Trip Report, p. B-3.
---------------------------------------------------------------------------
    The full extent of Russian-Chinese cooperation is difficult 
to determine through open sources. According to one observer, 
one of the conditions that Beijing demands for its cooperation 
with Russia is absolute secrecy regarding its agreements. 
Reportedly, the Chinese Government explicitly threatens to 
terminate any deals that are leaked to the public. The Russian 
Government and enterprise managers evidently view the 
relationship as important or valuable enough to comply with 
these conditions. As a consequence, despite a general tendency 
to advertise arms sales success and to discuss defense industry 
issues in public, virtually no commentators--official or 
unofficial--will touch this subject in any but the most general 
terms, either publicly or privately.\10\
---------------------------------------------------------------------------
    \10\ Kevin O'Prey, DFI Trip Report, p. B-2.
---------------------------------------------------------------------------
    The only restraint on the China relationship currently 
appears to be the product of Moscow's concern about Chinese 
reverse engineering of Russian technologies. Historically, 
China has sought to use arms imports as a means of technology--
rather than hardware--acquisition. In an often-cited example, 
Chinese industry evidently reverse engineered MiG-21s purchased 
from the Soviet Union as the basis for its J7 fighter aircraft 
development. As a consequence, the Russian Government evidently 
bars transfer of its highest technology items to Beijing. In 
fact, according to one source, Russia permits India greater 
access to high technology than it does to China, a fact that 
has proved to be a continuing sore spot for Beijing.\11\
---------------------------------------------------------------------------
    \11\ For example, according to one observer, cooperation over the 
Su-27 program has been constrained by Russian refusal to share advanced 
hot zone technology for the Lyulka engine. See Kevin O'Prey, DFI Trip 
Report, p. B-4.
---------------------------------------------------------------------------
    Last, although technology acquisition is still a priority 
for Beijing, recent agreements suggest that the trend for the 
Chinese Government currently is in the direction of purchase of 
foreign systems, rather than the development of indigenous 
capabilities. This development might be due to Beijing's 
perceived need to build up its military forces rapidly to match 
its foreign policy priorities, or its recognition that its 
experience with reverse engineering has not been particularly 
effective, or some combination of the two factors. Since the 
mid-1990s, Chinese deals with Russia have included:

   The purchase of more than 72 Sukhoy 27 fighter 
        aircraft;
   The purchase of 4 Kilo class attack submarines;
   Co-production of 200 Su-27 aircraft;
   2 Sovremenny-class destroyers and their associated 
        missile systems;
   The purchase of 40 to 60 Su-30MKK fighter aircraft; 
        and
   An agreement to purchase at least 4 upgraded A-50E 
        Mainstay airborne early warning aircraft.\12\
---------------------------------------------------------------------------
    \12\ Richard F. Grimmett, Conventional Arms Transfers to Developing 
Nations, 1993-2000, p. CRS-8.

    Of particular concern to U.S. national security, many of 
these capabilities reportedly are being acquired to improve 
Chinese forces for a Taiwan Straits scenario.\13\
---------------------------------------------------------------------------
    \13\ See e.g., Interfax interview with Konstantin Makienko, 
``Military-Technical Cooperation between Russia and China,'' 17 July 
2001, reprinted on www.cast.ru/english/database1. html?article=102.
---------------------------------------------------------------------------
Cooperation with India
    Long a client of the Soviet Union, New Delhi has continued 
a robust relationship with the Russian defense industries. In 
late 2000, Russia concluded a licensed production agreement 
with India valued in excess of $3 billion for 140 Su-30MKI 
combat aircraft. It also concluded an agreement for the sale to 
India of 310 T-90C main battle tanks for about $700 million, 
and an agreement to retrofit and deliver the Admiral Gorshkov 
aircraft carrier for over $650 million.\14\
---------------------------------------------------------------------------
    \14\ Richard F. Grimmett, Conventional Arms Transfers to Developing 
Nations, 1993-2000, (Washington, DC: Congressional Research Service, 
August 16, 2001), p. 8.
---------------------------------------------------------------------------
    In contrast to recent developments with China, New Delhi 
appears to view its relationship with Russia as a source not 
just for armaments, but also for technology to support India's 
growing defense sector. For example, India has a long history 
of co-production agreements with Soviet and then Russian 
defense industries. The trend continues as New Delhi's recent 
purchase of 124 T-90 tanks was exceeded in quantity by the 186 
additional T-90s for which India purchased production 
licenses.\15\
---------------------------------------------------------------------------
    \15\ See Lyuba Pronina, ``Fired Up About Arms,'' The Moscow Times, 
September 24, 2001.
---------------------------------------------------------------------------
    Despite the recent improvements in U.S.-India ties, New 
Delhi's military-technical cooperation with Moscow appears to 
be both robust and likely to persist. For one, as noted below, 
with a force compromised primarily of Soviet and Russian 
weaponry, it would be extremely expensive for New Delhi to 
further diversify into NATO-standard equipment.\16\ Second, 
Russian weapons are affordable, and Moscow has demonstrated a 
willingness to supply India with its most advanced technology.
---------------------------------------------------------------------------
    \16\ On the Indian arsenal, see The Military Balance, 1999-2000, 
(London: The International Institute for Strategic Studies), pp. 161-
163 and Rahul Bedi, ``India's T-90 Tank Deal with Russia Runs Into 
Difficulty,'' The Asian Age, December 1, 2000, pp. 1-2.
---------------------------------------------------------------------------
The Iran relationship
    In the past year, Moscow has renewed its cooperation with 
Tehran in the conventional military arena. Immediately after 
the fall of the Soviet Union, Iran was a major purchaser of 
Russian weapons. Among the Russian items acquired by Iran were 
MiG-29 fighter aircraft, Su-24 fighter-bombers, T-72 
submarines, and Kilo-class attack submarines.\17\ Under 
pressure from the United States, Russia largely suspended 
conventional cooperation with Iran throughout the 1990s.\18\ 
However, as a result of the decline in U.S.-Russia relations, 
increased economic pressure at home, or both, in 2000 Moscow 
notified the United States that it would resume its arms 
cooperation with Tehran. True to its word, Russia signed 
agreements in December 2000 to provide Tehran with air defense 
systems (the S-300 and Tor-M1) and Kamov-50 helicopters.\19\ 
According to one Russian source, Tehran acquired the advanced 
air defense systems to defend the Bushehr reactor complex.\20\
---------------------------------------------------------------------------
    \17\ Richard F. Grimmett, Conventional Arms Transfers to Developing 
Nations, 1993-2000, p. CRS-8.
    \18\ Illicit transfer of ballistic missile technology and broader 
nuclear cooperation were notable exceptions to the rule.
    \19\ David A. Fulghum, ``Iran Specifies New Weapons Mix,'' Aviation 
Week and Space Technology, March 26, 2001, p. 32.
    \20\ David A Fulghum, ``Iran Specifies New Weapons Mix,'' p. 32.
---------------------------------------------------------------------------
    Subsequently, during a March 2001 visit to Moscow, Iranian 
President Mohammad Khatami presented a more robust wish list to 
Russian officials. Among the items Khatami sought were:

   Tanks;
   Patrol boats;
   The Shkval and other torpedoes;
   Upgrades to its MiG and Sukhoy fighters;
   Yakhont anti-ship missiles.\21\
---------------------------------------------------------------------------
    \21\ Chris Stephen, ``U.S. Anger as Putin Seals Arms Deal with 
`Rogue' Iran,'' The Scotsman, March 13, 2001, p. 13.

    In a much heralded October 2001 visit, Iranian Defense 
Minister Ali Shamkhami signed a military-technical cooperation 
agreement worth up to $300 million annually. Although the 
agreement constitutes only a framework, press reports described 
Shamkhami as negotiating to purchase Inconder long range 
supersonic missiles, Yakhont anti-ship missiles, surface-to-air 
missiles, and stealthy patrol boats.\22\ Earlier in the summer, 
Iran had signed contracts with Rosoboroneksport for 30 Mi-8 
cargo helicopters.\23\
---------------------------------------------------------------------------
    \22\ See Nikolai Novichkov and Vladimir Shvaryov, Vremya MN, 
October 3, 2001; and Agence France Presse, October 4, 2001, via Lexis 
Nexis.
    \23\ The total value of that deal was reportedly $150 million. See 
Vedomosti, November 1, 2001, reprinted in The Russian Business Monitor, 
November 2, 2001.
---------------------------------------------------------------------------
    Tehran's wishes aside, there are a number of reasons to 
expect some limits on m Moscow's future dealings with the 
Iranians. Most significantly, Tehran's wishes certainly exceed 
its current means. Regardless of the common cause that Moscow 
and Tehran have found in fighting Islamic extremists in Central 
Asia, Iran is a financially strapped state. Moreover, Russia 
has commercial interests mitigating against a strong 
relationship with Tehran. In particular, Moscow recognizes the 
transfer of advanced capabilities to Iran will potentially 
alienate the Gulf states, who, both individually and 
collectively, represent substantially more market potential 
than Iran.\24\
---------------------------------------------------------------------------
    \24\ Marina Koroleva, interview with Ruslan Pukhov, Director of the 
Centre of Analysis of Strategies and Technologies (CAST), and 
Konstantin Makienko, Deputy Director of CAST, during Ekho Moskvy Radio 
program, 1408 GMT, January 17, 2001, translated in FBIS, January 17, 
2001, Document ID: CEP 20010117000369.
---------------------------------------------------------------------------

                     Understanding Russia's Success

    Russia's recent success can be attributed to a broad range 
of factors, ranging from the appeal of Russian weapons on the 
global market, to the need for defense plants to find any 
resource of revenues in the absence of state orders, to the 
government's desire either to divert the attention of needy 
defense enterprises or to find international funding for its 
priority initiatives. Also, for some officials in industry and 
government, arms exports are personally enriching. Despite 
recent growth in the economy, it is impossible to overstate the 
value of hard currency in Russia.

                           the russian appeal

    On the demand side of the equation, Russian armaments are 
very attractive commodities in some markets. One of the most 
important factors behind this appeal is the affordability of 
Russian weapons. Because Russia's defense enterprises are still 
the beneficiaries of a range of implicit subsidies, Russian 
weapons typically are the product of negative net value or 
value subtraction in production: the inputs to the typical 
weapon system are worth more on the world market than the final 
product itself.\25\ These subsidies are generally not the 
product of a defense promoting strategy on the part of the 
Russian Government. Rather, they are a by-product of what 
economists Clifford Gaddy and Barry Ickes termed the ``virtual 
economy.'' \26\ In short, because Russian enterprises do not 
pay market prices, key factors of production such as energy are 
exchanged at prices well below international market rates. 
Furthermore, because barter persists among enterprises, much of 
the real value of economic transactions goes unrecorded. As a 
consequence, soft-budget constraints persist and Russian 
manufacturers can offer prices for weapons that are 
considerably cheaper than the input costs.
---------------------------------------------------------------------------
    \25\ Vitaliy Shlykov, ``The Potemkin Complex: A Government Program 
Cannot Solve the VPK's Problems,'' Itogi, April 10, 2001, translated in 
FBIS, April 9, 2001, Document ID: CEP 200110409000302.
    \26\ Clifford Gaddy and Barry Ickes, ``Russia's Virtual Economy,'' 
Foreign Affairs, vol. 77, no. 5.
---------------------------------------------------------------------------
    Second, despite the financial and technological struggles 
of the Russian defense sector in recent years, some Russian 
systems are actually quite competitive technologically on the 
global market. For example, Russia has been willing to sell the 
state of the art Yakhont, an anti-ship missile that uses 
scramjet technology.\27\ In addition, Russia also produces 
reliable space launch systems such as the Proton rocket at a 
time when there is global shortage in space launch.\28\ 
Russia's competitiveness in this area is underscored by the 
fact that U.S. defense giants such as Lockheed Martin have 
entered into joint ventures. Furthermore, although their 
electronics components are poor, Russia continues to produce 
outstanding air defense missile systems, such as the S-300.\29\
---------------------------------------------------------------------------
    \27\ John A. Battilega, David R. Beachley, Daniel C. Beck, Robert 
L. Driver, and Bruce Jackson, Transformation in Global Defense Markets 
and Industries: Implications for the Future, National Intelligence 
Council Report, Russia chapter, p. 9 (Found on http://www.cia.gov/nic/
pubs/index.htm).
    \28\ Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, Bonn International Center for Conversion, Brief 17, p. 47
    \29\ Mark Galeotti, ``Russia's Arms Bazaar,'' Jane's Intelligence 
Review, April 1, 2001.
---------------------------------------------------------------------------
    Third, Russian defense enterprises and state organs have 
demonstrated little discretion in terms of end users. 
Governments that find themselves internationally ostracized can 
often find a willing seller in Moscow. Generally speaking, 
unless a government is under United Nations (UN) sanction, 
Russia will sell to it. For example, as noted above, Russia 
proceeds with a robust arms sale relationship with China 
despite Russian General Staff concerns that Beijing is a likely 
future military competitor.\30\
---------------------------------------------------------------------------
    \30\ Kevin O'Prey, DFI Trip Report.
---------------------------------------------------------------------------
    Finally, the Russians have simply gotten better at sales. 
Western participants in recent international arms expositions 
observe that Russian presentations have become significantly 
more professional. From the attire of the industry 
representatives to the quality of their glossy brochures, there 
is a marked improvement in the salesmanship of Russian 
exporters. Part of the explanation can be traced to learning. 
Another part can be attributed to the recently achieved 
organizational stability of Russian arms export organizations, 
which have been reorganized numerous times over the past 
decade.

                 constraints on further russian success

    Yet there are a number of reasons to expect that Russia 
will only modestly improve upon its arms export success in the 
coming years. Any growth will likely come from Moscow's 
existing client base, rather than winning markets in head to 
head competition with Western suppliers.
    First, interoperability concerns on the part of buyers will 
likely continue to hamper Russian arms export efforts. In fact, 
the continued success of the United States, United Kingdom, and 
France noted in Figure 2, underlines the global trend toward 
NATO-standard armaments. Possessing an armaments inventory that 
is all of one standard vastly reduces the complexity of 
operations and reduces maintenance costs. Few countries can 
afford and are willing to maintain an arms inventory that 
possesses both NATO and Russian standard equipment.\31\ Even 
Russia's former Warsaw Pact allies are shifting to NATO 
standard equipment in order to position themselves better for 
ultimately joining the NATO alliance.
---------------------------------------------------------------------------
    \31\ The United Arab Emirates, which is both wealthy and is seeking 
independence from a single arms supplier, is a notable exception.
---------------------------------------------------------------------------
    Second, beyond the areas of rockets, airframes, and air 
defense systems, Russian weapon systems are generally held in 
low regard for their technological levels and overall 
reliability. In particular, Russia, for all intents and 
purposes, missed the electronics revolution that occurred 
during the 1980s and 1990s in other industrialized countries. 
Given the importance of electronics to the effectiveness of 
most modern weapons systems, Russian arms exporters are 
necessarily at a disadvantage. For example, although the Su-27 
fighter reputedly has the highest performance air frame in the 
world, it's poor electronics capabilities--in terms of avionics 
and armaments systems--make it relatively uncompetitive when 
compared to analogous systems in the West.\32\
---------------------------------------------------------------------------
    \32\ For example, in early 1992, Deputy Minister of Defense, Andrey 
Kokoshin, lamented that the Russian electronics sector--a linchpin for 
any modern economy--lagged terribly behind world standards. In his 
view, this lag had a dangerous multiplier effect, hampering Russia's 
ability to compete in the world economy and, for that matter, to defend 
itself. See Andrey Naryshkin, ``Andrey Kokoshin ob industrial'noy 
politike,'' [Andrey Kokoshin on Industrial Policy], Krasnaya Zvezda, 
August 25, 1992, p. 3.
    For a western analysis, see Harley Balzer, ``Dismantling Russia's 
Technotopia: Six Ministries in Search of an Industrial Policy,'' in 
Judith B. Sedaitis, Commercializing High Technology: East and West, 
Center for International Security and Arms Control, Stanford 
University, January 1996, p. 48.
    See also Aleksandr Anatolyevich Ivanov, first deputy chief of 
communications of Russian Federation Armed Forces, and Lev Ivanovich 
Titov, general director of Telecommunications Systems Development Fund, 
Vooruzheniye, Politika, Konversiya, no. 1 (4), 1994, (signed to press 
August 4, 1994), pp. 45-50, translated in JPRS-UMA 94-056, pp. 29-32.
---------------------------------------------------------------------------
    Decades of Soviet economic inefficiency and backwardness 
also took a toll on the capital stock of Russian defense 
enterprises. Despite niches of high technology distributed 
throughout the defense industries, by 1990 overall the sector 
was characterized by technological obsolescence. For instance, 
in the late 1980s the chief designer of the Temp aviation 
design bureau complained that over a third of his equipment had 
been produced before 1940.\33\ Nor did the situation improve in 
the weak economy of the 1990s. The decline in investment 
surpassed the fall in overall industrial output such that by 
1999, the volume of capital investment stood at only 10 percent 
of its 1990 level.\34\
---------------------------------------------------------------------------
    \33\ I. Mosin and A. Pokrovsky, ``Conversion without Illusion,'' 
Pravda, June 7, 1990, p. 4, translated in FBIS-SOV 90-116, pp. 75-80.
    On production obsolescence generally, see Directorate of 
Intelligence, Central Intelligence Agency, The Soviet Weapons Industry: 
An Overview, DI 86-10016, September 1986, pp. 29-30.
    \34\ Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, p. 18.
---------------------------------------------------------------------------
    The regional concentration of Russia's export markets is 
also a limitation. As noted above, Russia's success relies 
heavily on markets in the developing world. Over the 1997-2000 
period, among arms exporting countries only China (92.5 percent 
of agreements) was more dependent than Russia (90.9 percent) on 
developing world arms markets. The United States, United 
Kingdom, Germany, and Italy, by contrast, relied on developing 
markets for less than 60 percent of their agreements.\35\ 
Despite the recent expansion of this market, the developing 
world by definition lacks substantial financial resources to 
invest in arms. The weakness of the global economy is likely to 
serve as a further brake on this market in the near term.
---------------------------------------------------------------------------
    \35\ See Richard F. Grimmett, Conventional Arms Transfers to 
Developing Nations, 1993-2000, Figure 1, p. CRS-21.
---------------------------------------------------------------------------
    Furthermore, within the developing world market, Russia 
does not have a strong position in the one consistent bright 
spot: the petro-dollar infused Near East market. The Near East 
accounted for 47 percent of the developing world market over 
the 1997-2000 period. As is the case around the globe, the 
United States dominates this market with a 61 percent market 
share over the same period. Russia, meanwhile, possessed only a 
7 percent share.\36\
---------------------------------------------------------------------------
    \36\ See Richard F. Grimmett, Conventional Arms Transfers to 
Developing Nations, 1993-2000, Table 1E, p. CRS-44.
---------------------------------------------------------------------------
    Despite improvements in export salesmanship over the past 
decade, Russian arms exporters still can not match the West in 
their after sale support. Because they were politically driven, 
after sale support--in the form of technical training, spare 
parts, and servicing--were not major features of Soviet arms 
export deals. Thus, when Russian arms exporters were thrust out 
onto a competitive global commercial market, few or none 
possessed organizations with this capability, or, for that 
matter, experience. Moreover, despite discussion of this 
liability throughout the 1990s, Russian exporters appear to 
have done little to improve these capabilities.\37\
---------------------------------------------------------------------------
    \37\ In October 2001, President Putin reportedly chastised his 
Cabinet after hearing complaints from South Korean President Kim Dae 
Jung. In particular, President Kim complained of the poor quality of 
hardware purchased from Russian in the mid-1990s, lack of maintenance, 
and chronic delays with deliveries of parts. Malaysia reportedly had 
similar complaints regarding the MiG-29s it had purchased.
    See Ivan Safronov, ``Russia May Liberalize Arms Exports,'' 
Kommersant, October 25, 2001, p. 2.
---------------------------------------------------------------------------
    Finally, the collapse of the Soviet bloc has allowed new 
competitors to crowd into previously loyal Russian markets. 
Beyond the Westward tilt of Russia's former allies in eastern 
Europe, this phenomenon includes the market for upgrades of 
Soviet weapons systems. Israel, in particular, has aggressively 
moved into the upgrade market for MiG-21 aircraft.\38\
---------------------------------------------------------------------------
    \38\ See e.g., Mohammed Ahmedullah, ``Russians Say Copycat Firms 
Robbing Millions in Spares Sales,'' Defense Week, vol. 22, no. 41., 
October 15, 2001.
---------------------------------------------------------------------------

                   The Rationale for Russian Exports

    The United States and international community appear to 
have very little leverage in discouraging Russian efforts to 
export armaments as widely and in as great numbers as possible. 
In short, Russia's Government and industry possess extremely 
compelling incentives to expand their arms sales as much as the 
market will bear. Although some of Russia's incentives are 
universal to all arms producing countries, others are 
particular to Russia's unique circumstances
    The first set of reasons for seeking arms exports are 
shared by virtually all arms producing countries worldwide. By 
increasing the overall number of a production run, exports 
reduce the per unit cost of any subsequent purchases of that 
item, making weapons production more profitable. Even if the a 
government elects not to procure more of a particular model, 
exports provide the producing firm with more resources to 
invest in new development projects. Moreover, if a government 
seeks to maintain a defense industrial base on the cheap, 
foreign purchases can keep production lines open--``smoothing 
out'' production peaks and valleys--in anticipation of future 
procurement orders.\39\
---------------------------------------------------------------------------
    \39\ Kevin P. O'Prey, The Arms Export Challenge: Cooperative 
Approaches to Export Management and Conversion, (Washington, DC: 
Brookings Institution, 1995), pp. 10-11.
---------------------------------------------------------------------------
    Beyond these universal incentives, Russia's industry and 
government confront pressures generated by the persistence of 
excess capacity in the defense industries, the drop in state 
procurement orders, and the continued political-economic 
importance of defense enterprises to their local communities. 
While the rationale behind Soviet arms exports was 
geopolitical--to buy influence among Moscow's client states--
during the Russian period the rationale has become 
predominantly commercial, oriented toward domestic politics. 
The remainder of this section deals with each of these factors 
in turn.

                            excess capacity

    From the perspective of Russian industry, the most 
compelling reason for greater levels of arms exports is the 
persistence of a very large defense industrial base with very 
little domestic demand. When the Soviet Union collapsed in 
1991, it bequeathed to Russia a defense industrial base with a 
size and diversity worthy of a superpower. In all, Russia 
inherited approximately 1,700 state owned defense enterprises 
and industrial establishments organized into nine functional 
ministries (e.g., Ministry of Aviation Industry). Beyond the 
official defense complex, defense procurement orders reached 
far and wide in the Soviet-Russian economy. According to 
Clifford Gaddy, more than one third of all industrial 
enterprises had some role in arms manufacture.\40\
---------------------------------------------------------------------------
    \40\ Clifford Gaddy, The Price of the Past: Russia's Struggles with 
the Legacy of a Militarized Economy, (Washington, DC: Brookings 
Institution Press, 1996), pp. 24-26
---------------------------------------------------------------------------
    Perhaps as problematic as the sheer number of Russian 
defense establishments at a time when the cold war demand was 
slacking off was the vast size of these enterprises. By U.S. 
standards, these enterprises were enormous. Within the Soviet 
defense industries there were approximately 100 enterprises 
with over 10,000 employees.\41\ For example, a single facility 
such as the Moscow ``Znamya Truda'' [Banner of Labor] Machine 
Building Plant--a builder of MiG aircraft--employed 30,000 
personnel in 1990.\42\ In contrast, it appears that there are 
no more than a handful of U.S. industrial establishments with 
more than 10,000 employees.\43\
---------------------------------------------------------------------------
    \41\ Clifford Gaddy, The Price of the Past: Russia's Struggles with 
the Legacy of a Militarized Economy, (Washington, DC: Brookings 
Institution Press, 1996), p. 25.
    \42\ U.S. Department of Commerce, Russian Defense Business 
Directory--1993, (Washington, DC: U.S. GPO, 1993, pp. 38, 36.
    \43\ Although a number of firms possess in excess of ten thousand 
employees, few possess such a concentration at a single establishment. 
See Paul Joskow, et al., ``Competition Policy in Russia During and 
After Privatization, p. 312.
---------------------------------------------------------------------------
    Part of the reason for the enormous scale of Russian 
defense enterprises was related to the logic of Soviet 
economics. The exigencies of the command economic system 
encouraged a degree of concentration and autarky in defense 
industry organization that is rarely encountered in the U.S. 
economy. Constant conditions of scarcity in the supply system 
created pressure for self-sufficiency in material inputs as 
enterprise managers sought to minimize the degree to which they 
depended on outside help.\44\ The Izhevsk Mechanical Plant is a 
case in point. A producer of small missiles, the enterprise 
possessed shops for the manufacture of all the electronics 
components for its missiles, as well as virtually all of the 
tools necessary to produce the electronics.\45\
---------------------------------------------------------------------------
    \44\ See Ed Hewett, Reforming the Soviet Economy: Equality versus 
Efficiency, (Washington, DC: The Brookings Institution), p. 173.
    \45\ See Nikolay Belin, ``Izhevskiy oruzheyniki,'' (The Izhevsk 
Gunsmiths), Krasnaya Zvezda, September 9, 1992, pp. 1, 4.
---------------------------------------------------------------------------
    At both the micro- and the macro-levels, the trend was 
toward mass scale at the expense of efficiency. Consequently, 
Russia inherited a defense sector that was--and continues to 
be--grossly inefficient by Western standards. When comparing 
the personnel size of the Russian and European aerospace and 
missile production sectors, Russia performs extremely 
inefficiently. According to Vitaliy Shlykov, a Russian defense 
industry observer, Europe's combined aerospace and rocket 
industries generate approximately $2.2 billion in revenues with 
98,000 personnel. However, it takes the comparable Russian 
industry 800,000 personnel to generate $2 billion in 
revenue.\46\
---------------------------------------------------------------------------
    \46\ Vitaliy Shlykov, ``The Potemkin Complex: A Government Program 
Cannot Solve the VPK's Problems.''
---------------------------------------------------------------------------
    During the cold war, the Soviet Government was willing to 
absorb the opportunity cost of such a large, inefficient 
defense sector because it was producing vast quantities of 
weapons to support its superpower competition. However, when 
the cold war ended with the collapse of the Soviet regime, the 
defense industries saw the domestic demand for their wares drop 
off dramatically. One of the first measures of Yegor Gaydar as 
acting Prime Minister in 1992 was to reduce state orders for 
arms procurement by 68 percent.\47\ State expenditures on 
tactical aircraft, missiles, as well as anti-aircraft and air-
launched missiles were cut by 80 percent. Tanks and field gun 
expenditures were cut by a dramatic 97 percent.\48\
---------------------------------------------------------------------------
    \47\ See Julian Cooper, ``The Soviet defence industry heritage and 
economic restructuring in Russia,'' p. 36; and Yegor Gaydar, ``The Race 
with the Crisis,'' Novoye Vremya, no. 48, 1991, p. 13, as cited in 
Anders Aslund, How Russia Became a Market Economy, (Washington, DC: The 
Brookings Institution), p. 66.
    \48\ Oleg Vladykin, ``Novaya Armiya so starym oruzhyem. Nuzhna li 
Rossiy takaya perspektiva?'' [A new Army with Old Weapons. Is This the 
Kind of Prospect Russia Needs?] Krasnaya Zvezda, August 19, 1992, pp. 
1-2.
---------------------------------------------------------------------------
    Taking the historical view, the cuts in weapon procurement 
were remarkable. For example, 3,500 tanks were built in 1988. 
But the state ordered only 20 tanks in 1992.\49\
---------------------------------------------------------------------------
    \49\ See Peter Almquist, ``Soviet/Russian Procurement Database;'' 
Marina Chernuka and Vyacheslav Terekhov, interview with First Deputy 
Minister of Defense Andrey Kokoshin, ``Nation and Society'' feature, 
Interfax, 0545 GMT, July 24, 1992, translated in FBIS-SOV, 92-143, July 
24, 1992; and Aleksey Shulunov, ``K chemu vedyet byudzhetnaya 
strategiya pravitel'stva.''
---------------------------------------------------------------------------
    Nor did the cuts in Russian defense orders stop there. 
Figure 5 depicts the relative decline in state arms procurement 
spending from 1984 to 2000. Overall military output in the 
defense complex in 1999 accounted for only one-third of the 
1991 level.\50\ This year only 10 percent of Russian defense 
enterprises have any state orders for defense output. Moreover, 
there will be no deliveries this year to the Russian Government 
of combat aircraft, helicopters, tanks, or other armored 
vehicles.\51\
---------------------------------------------------------------------------
    \50\ Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, p. 4.
    \51\ Vitaliy Shlykov, ``The Potemkin Complex: A Government Program 
Cannot Solve the VPK's Problems.''
---------------------------------------------------------------------------
    Although Russian procurement levels have increased over the 
past 2 years, the net effect has not been significant.\52\ As 
Figure 5 demonstrates, even with this increase, state arms 
procurement funding in 2000 was still only 76 percent of the 
1994 level. Given the low levels of the procurement budget, the 
practical impact of these investments is small. For example, in 
1999, the procurement budget funded only ten Topol-M missiles, 
ten satellites, and one Tu-160 strategic bomber.\53\ In 2000, 
the aviation industry leading Sukhoy design bureau received 
state orders only for an aircraft upgrade development project, 
which ended up amounting to only 10 percent of the bureau's 
business for the year.\54\
---------------------------------------------------------------------------
    \52\ In 1999, then Prime Minister Putin established defense 
production for domestic consumption as a priority over conversion and 
arms exports. Furthermore, Deputy Prime Minister Klebanov pulled 
several converted enterprises back from civilian to military 
production. The effect of these measures was to generate 80 percent 
growth in the procurement budget in 2000. Kseniya Gonchar, Russia's 
Defence Industry at the Turn of the Century, p. 17.
    \53\ Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, p. 40.
    \54\ Interview with Mikhail Pogosyan, General Director of Sukhoy 
Aircraft Military Industrial Complex, ``Only a Definite Strategy Can 
Attract Money,'' Eksport Vooruzheniy, May-June 2001, p. 18.

FIGURE 5._PERCENTAGE INDEX OF 1994 RUSSIAN ARMS PROCUREMENT BUDGET PLAN

         [In constant 1996 prices, where the 1994 value = 100]

[GRAPHIC] [TIFF OMITTED] T6171.034


  Source: Kseniya Gonchar, Russia's Defense Industry at the 
Turn of the Century, 2000.

    The net effect of these cuts in defense orders without 
comparable contraction in industry, of course, was substantial 
excess capacity. In late 1999, Russian defense sector still had 
the capacity to produce 3,500 tanks and 4,500 pieces of movable 
artillery per year. Approximately 40,000 people are also 
currently employed in duplicating R&D within the strategic 
missile program, when the Ministry of Defense estimates that 
8,000 to 10,000 would suffice.\55\ The aviation industry is 
capable of manufacturing about 350 fixed-wing aircraft and 300 
helicopters per year. The actual output in 1998, however, 
reached only 100 pieces.\56\ In an indication that this problem 
of excess capacity was broadly understood, Ministry of Defense 
industrial plan in the early 1990s stipulated that only 220 of 
the 1,700 defense enterprises would be essential for Russian 
security.\57\
---------------------------------------------------------------------------
    \55\ See Anatoliy Sitnov, Chief of Armaments, Ministry of Defense, 
interview in Eksport Vooruzheniy, November/December 1999, pp. 20-22, as 
cited in Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, p. 17.
    \56\ Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, p. 33.
    \57\ See A.A. Kokoshin, First Deputy Minister of Defense, 
``Protivorechiya formirovaniya I puti razvitiya voenno-tekhnicheskoy 
politiki Rossiy,'' (Contradictions of Formation and Ways of Developing 
the Military-Technical Policy of Russia), Voyennaya Mysl, #2, 1993; and 
Lt. Colonel Valentin Rudenko, ``My sposobny proizvodit unikal'noye 
oruzhiye i etu sposobnost nel'zya uteryat,'' (We Are Capable of 
Producing Unique Weapons and This Capability Must Not Be Lost), 
Krasnaya Zvezda, March 11, 1993, p. 2.
---------------------------------------------------------------------------
    In this environment, arms exports have proven to be the 
most important source of income for the defense industries. As 
Figure 6 demonstrates, military production for the domestic 
market accounted for only 17 percent of defense industry output 
in 1999. Production for arms exports, by contrast, accounted 
for 37 percent of the defense sector's production. Table 1 
provides more tangible evidence of the disparity in output 
terms, by specific weapons type.

        FIGURE 6._SHARE OF RUSSIAN DEFENSE COMPLEX OUTPUT, 1999

[GRAPHIC] [TIFF OMITTED] T6171.035


  Source: Kseniya Gonchar, Russia's Defense Industry at the 
Turn of the Century, 2000.


    TABLE 1.--ESTIMATE OF NUMBERS OF WEAPON SYSTEMS MANUFACTURED FOR
               DOMESTIC AND INTERNATIONAL SALES, 1992-1999
------------------------------------------------------------------------
                                                    Domestic     Export
                  Weapon system                   procurement    sales
------------------------------------------------------------------------
Ships...........................................           2          11
Tanks...........................................          31         435
Submarines......................................           2          10
Aircraft........................................           7         278
Helicopters.....................................           8          98
Air defense systems.............................           1          22
Armored vehicles................................          17        217
------------------------------------------------------------------------
Source: Kseniya Gonchar, Russia's Defense Industry at the Turn of the
  Century, 2000.


                              state policy

    Excess capacity persists in the Russian defense industries 
in large part because the Federation Government has avoided 
imposing fundamental reform on the sector throughout the 1990s. 
As Kseniya Gonchar argues, Russia's ideal pattern of defense 
planning--drafting of the military doctrine, long-term planning 
of supply and procurement, and finally contracting--has been 
replaced by an adjustment to minimal funding, lobbying, and the 
implicit prioritizing of the nuclear forces.\58\
---------------------------------------------------------------------------
    \58\ Boris Kuzik, Oboronno-promyshlennyy Kompleks Rossii: Proryv v. 
XXI Vek [The Russian Defense Industrial Complex: Breakthrough to the 
21st Century] (Moscow: Russkiy Biograficheskiy Institut, 1999), cited 
in Kseniya Gonchar, Russia's Defence Industry at the Turn of the 
Century, p. 15.
---------------------------------------------------------------------------
    Both reform-oriented and more conservative administrations 
have viewed the defense industry problem as something to be put 
on the back burner. Although neither the managers nor the labor 
forces of Russian defense enterprises were powerful political 
groups, no Russian Government has had the appetite to take them 
on directly.
    The primary reason that successive Russian Governments have 
been reluctant to take on real defense industry reform has been 
the social ramifications of the militarization of the Russian 
economy. Estimates of the number of personnel who worked in the 
Soviet defense establishment--the lion's share of which was 
located in Russia--at the height of the cold war range from 9 
to 14 million.\59\ By comparison, in 1990 U.S. defense industry 
work provided employment to only 1.5 to 1.9 million 
workers.\60\
---------------------------------------------------------------------------
    \59\ Julian Cooper offers the estimate of 9 million while Andrey 
Kokoshin estimates the number of Soviet defense industry jobs as 
ranging between 12 and 14 million. Julian Cooper, ``The Soviet Defence 
Industry Heritage and Economic Restructuring in Russia,'' in Lars B. 
Wallin, ed. The Post-Soviet Military-Industrial Complex, FOA 
Symposium--October 20, 1993, (Stockholm: The Swedish Nations Defence 
Research Establishment, 1994), p. 30; and Andrey Kokoshin, ``Defense 
Industry Conversion in the Russian Federation,'' Russian Security After 
the Cold War: Seven Views from Moscow, in Teresa Pelton Johnson and 
Steven E. Miller, eds, (Brasseys, U.S., 1994), p. 48.
    \60\ Adjusting to the Drawdown, Report of the Defense Conversion 
Commission, pp. 17-18.
---------------------------------------------------------------------------
    Perhaps as many as 70 Soviet cities were developed around a 
single defense enterprise.\61\ In the extreme case, the 
republic of Udmurtiya depended upon defense work for 57 percent 
of its industrial workforce. Six other oblasts--the Soviet/
Russian equivalent of a state in the United States--depended 
upon defense work for over 40 percent of their industrial labor 
forces.\62\ In contrast, in 1991 defense work accounted for 
only 8.3 percent of non-farm, private sector employment in the 
most defense industry-dependent state in the United States, 
Connecticut.\63\
---------------------------------------------------------------------------
    \61\ Stepan Sulakshin, ``Dva kvartala na golodnom paykye;'' [Two 
Quarters Starvation Rations], Krasnaya Zvezda, May 28, 1994, p. 3.
    \62\ See Julian Cooper, The Soviet Defence Industry: Conversion and 
Economic Reform, (NY: Council on Foreign Relations Press, 1991) and 
Clifford Gaddy, unpublished trip notes, Summer 1992.
    \63\ Logistics Management Institute, Impacts of Defense Spending 
Cuts on Industry Sectors, Occupations Groups, and Localities, Table 3-
2.
---------------------------------------------------------------------------
    Beyond their role in providing employment, Soviet defense 
enterprises played a major role in providing social services to 
their regions. In the majority of cases, a Soviet defense 
worker and his/her family depended on the defense plant to 
supply their housing, hospitals, kindergartens, and, even, 
vacation facilities.\64\ Even after the onset of Russian 
reforms, in some enterprises the social infrastructure employed 
over 20 percent of the plant's staff.\65\ One defense industry 
official later reported that in 1994, 9 to 25 percent of funds 
in the defense complex were devoted to maintaining social 
infrastructure.\66\
---------------------------------------------------------------------------
    \64\ See, e.g., Yelena Druzhinina, ``The Defense Industry is 
Revealing Its Cards,'' Delovoy Mir, November 2, 1991, p. 8 in JPRS-UMA 
91-031, pp. 62-64.
    \65\ Kseniya Gonchar, ``Employment Aspects of Defense Conversion in 
Russia,'' mimeo, May 1994, footnote 13.
    \66\ Aleksey Shulunov, ``K chemu vedyet byudzhetnaya strategiya 
pravitel'stva.''
---------------------------------------------------------------------------
    Therefore, the net effect of this militarization of the 
Russian economy is the creation of a direct link between the 
financial health of a Russian defense enterprise and the socio-
economic welfare of the surrounding community. For example, 
because the Komsomolsk-na-Amure Aviation Production Association 
(KnAAPO)--the producer of Su-27 aircraft exported to China--
accounts for 78 percent of the industrial output of the 
Khabarovsk Krai, KnAAPO's welfare is the region's welfare.\67\
---------------------------------------------------------------------------
    \67\ Alexander Golts, ``A Dead-End. The Defense Industry is Not 
Deeply Distributed in Depth: Military Production in Russia is Living on 
Foreign Orders for the Time Being but That Can't Continue for Long,'' 
Itogi, October 24, 2000, translated in FBIS October 31, 2000, Document 
ID: CEP 20001031000156.
---------------------------------------------------------------------------
    In political terms, the Russian Government has been left 
with few options. Moscow has had neither the resources nor the 
inclination to increase defense procurement significantly. When 
Deputy Prime Minister Ilya Klebanov announced the 2010 defense 
program, he promised that the government would increase the 
value of defense industry contracts from the current level of 
approximately 2.6 percent of GDP to 3.5 percent of GDP in 2006. 
But in a blow to any hopes for the development of new systems 
and the opening of new series production efforts, the first 7 
to 8 years of this 10 year plan emphasize the upgrading and 
modernization of existing defense systems.\68\
---------------------------------------------------------------------------
    \68\ ``Russia: State Planning to Boost Defense Sector Contracts,'' 
Interfax, 1351 GMT, March 30, 2001, reprinted in FBIS March 30, 2001, 
Document ID: CEP20010330000296.
---------------------------------------------------------------------------
    Nor has Moscow been willing to undertake the politically 
painful process of streamlining the defense sector by 
permitting, encouraging, or even directing failing enterprises 
to close. In the same initiative, Klebanov promised to address 
excess capacity by reducing the size of the defense industry 
from its current level of enterprises from 1,700 to 1,000. The 
initiative would also address organizational and efficiency 
issues by overseeing the reorganization of leading defense 
enterprises into 30 to 40 holding companies.\69\ For example, 
by 2006 the reform would concentrate the aircraft sector by 
creating two holding companies: one merging MiG, Tupolev, and 
Kamov and the other integrating Sukhoy, Ilyushin, and Mil.\70\
---------------------------------------------------------------------------
    \69\ Dmitry Safonov, ``Military Industry Reform Approved,'' 
Izvesitya, July 28, 2001.
    \70\ ``RF Government Has Approved Federal Targeted Program for 
Reform and Development of the Defense Industrial Complex for 2001-
2006,'' Agenstvo AK&M, July 27, 2001, translated in FBIS, Document ID 
CEP2001 10727000193.
---------------------------------------------------------------------------
    However, defense industry officials and outside observers 
could not be criticized for their pessimism that the reform 
would come to pass because it resembled in significant detail 
previous, much-heralded government reform proposals. In 
particular, Klebanov's plan looked a lot like Kokoshin's plan 
of 8 years earlier as well as a series of draft initiatives in 
between. Although all of these plans got it right in terms of 
objectives, none were ever seriously implemented.
    Consequently, rather than carry out real reform or cave in 
to industry demands for financial support, both the Yeltsin and 
Putin Administrations sought the less painful ``third way'' of 
encouraging industry self help through arms exports. As early 
as January 1992, President Yeltsin was urging defense 
enterprises to find arms exports customers.\71\ In a move that 
probably cost it little financially, the Yeltsin government 
relaxed restrictions on the types of armaments that could be 
exported and vastly increased the share of revenues that 
enterprises received from their exports.\72\ The government 
also took an active role in promoting defense industry 
exports.\73\
---------------------------------------------------------------------------
    \71\ Nikolay Burbyga, ``Boris Yeltsin: Russia Has No Special Secret 
Policy Regarding Nuclear Issues,'' Izvestiya, Feb. 24, 1992, pp. 1, 3 
in FBIS-SOV 92-036, pp. 35-39.
    \72\ See Nadezhka Potapova, ITAR-TASS, June 8, 1992 in FBIS-SOV 92-
111, p. 63; and Vremya, Moscow Television, July 21, 1990, in FBIS-SOV 
90-143, p. 76.
    \73\ For example, even the westward leaning Foreign Minister 
Kozyrev described arms export promotion as one of the main reasons for 
his May 1992 trip to the Persian Gulf region. See Aleksandr Golts, 
``Andrey Kozyrev Spends Six Days in Six Countries Seeking New Partners 
for Russia,'' Krasnaya Zvezda, May 6, 1992, p. 3.
    On at least one occasion the cash-strapped Federation Government 
actually provided credits to a foreign government in order for it to 
purchase Russian weapons-related technologies. In March 1992, the 
Russian Federation Government agreed to provide credits to India for 
the purchase of Russian weapons. Although the Federation is required to 
spend some of its revenue in India, the money will also go toward the 
purchase of goods that will go directly to Russian defense enterprises. 
See Correspondent Nikolay Paklin, Radio Rossii, 1100 GMT, March 26, 
1992 in FBIS-SOV 92-060, p. 22.
---------------------------------------------------------------------------

                                 graft

    Beyond all the other factors providing incentives for 
Russian arms exports, perhaps the most compelling one 
throughout the past decade has been personal profit--or 
outright graft--by state officials and industry managers. 
Because (1) the state of the Russian economy has generally been 
poor, and (2) Russia has little that it could export for hard 
currency, arms exports have joined the energy industries as the 
objects of fairly intense political competition at the top of 
the Russian political system. The frequent turnover of the 
Russian Government's arms export agencies as well as the 
periodic reorganization of these agencies themselves were 
evidence of constant competition among elite groups around 
Presidents Yeltsin and Putin. For example, in order to help 
finance Yeltsin's successful campaign for re-election in 1996, 
members of the ``Family''--the political faction of Yeltsin 
boosters that included his daughter, Tatyana Dyachenko--put 
their own people in charge of Rosvooruzheniye in order to get 
access to the hard currency revenues from arms exports.
    The benefits for the ``Family'' and anyone else who has 
access to arms export deals are not limited to skimming off the 
top of any transaction. Merely controlling hard currency bank 
accounts and benefiting from the interest provides a range of 
benefits that are not available to capitalists exploiting 
wholly domestic Russian sectors.
    Although defense enterprise managers have argued that they, 
not the state organs, should control the export revenues that 
they generate, there is no evidence that they are more 
magnanimous than state officials. On the contrary, they appear 
to be equally oriented toward using their control over these 
hard currency accounts for their personal enrichment.
    Thus, beyond any well-reasoned policy or political impulse 
supporting Russian arms export efforts, there is a more 
fundamental reason--elites stand to make more money.

                  Impact on the Russian Defense Sector

    Despite the positive overall picture for Russian arms 
export performance in recent years, the effects on the state of 
Russian defense industries has been limited in scope. For the 
small number of enterprises that have found foreign demand for 
their manufactures, export revenues have provided economic 
resuscitation. Yet given the very significant economic and 
organizational challenges confronting these enterprises, to use 
a medical analogy, they have moved from being on life support 
to intensive care. Arms exports have improved their 
performance, but none of these enterprises appears to resemble 
a financially solvent firm. Nor do the prospects seem much 
enhanced for technological or procurement breakthroughs as the 
widespread economic malaise in the defense industries will be a 
barrier to significant R&D and production.
    The effects of Russia's arms export success have been 
fairly concentrated in a handful of enterprises. Figure 7 
details the Russian sources of arms agreements during the year 
2000. As the Figure depicts, most the 2000 arms export revenues 
were funneled through state coffers. Rosvooruzheniye, 
Rosoboroneksport, and Promeksport--three state agencies at the 
time charged with promoting exports--accounted for three-
fourths of the year 2000 Russian arms trade. Within this 
category, 70 percent of exports were aircraft and related 
services. The largest of these projects were supplies and 
licensed production of Sukhoy combat aircraft.\74\
---------------------------------------------------------------------------
    \74\ Interview with Aleksandr Mikheev, Director of the Air Force 
Department of Rosoboroneksport, ``Our Obligations are Being Fulfilled 
in Time,'' Eksport Vooruzheniy, July-August 2001, p. 6.

---------------------------------------------------------------------------
      FIGURE 7._ENTERPRISE ORIGINS OF RUSSIAN ARMS TRANSFERS, 2000

[GRAPHIC] [TIFF OMITTED] T6171.036


  Source: Makienko, Konstantin. Preliminary Estimates of 
Russian Performance in Military-Technical Cooperation with 
Foreign States in 2000, 2001.

    In contrast, only three individual enterprises shared the 
remaining one-fourth of export revenues. Of these, the Antey 
Concern--the producer of the Tor-M1 surface to air missile 
system--was the big winner among individual enterprises, taking 
in roughly $500 million. The Tula Instrumentmaking Design 
Bureau--the designer and producer of tracked air defense 
systems such as the Pantsir--took in roughly $100 million. The 
corporate successor to the famed Mikoyan design bureau and 
production facilities, RSK MiG, also took in the remainder--
approximately $100 million.
    These enterprises also are concentrated in just two 
sectors: aircraft and air defense systems. The MiG-29, Su-27, 
and Su-30 aircraft variants account for two-thirds of Russian 
exports. Air defense systems--principally the competing 
versions of the S-300--account for most of the remainder of 
Russian exports in 2000.\75\ The picture became a little more 
complex in 2001 with the large sale of tanks to India. 
Moreover, this picture does not capture the export success of 
Russia's nuclear and space industries, which are no longer 
counted within the defense complex.\76\
---------------------------------------------------------------------------
    \75\ Dr. Mark Galeotti, ``Russia's Arms Bazaar,'' Jane's 
Intelligence Review, April 1, 2001.
    \76\ On the success of these sectors, see Kseniya Gonchar, Russia's 
Defence Industry at the Turn of the Century, p. 4.
---------------------------------------------------------------------------
    The principal effect of arms export success has been to 
create a class of relatively successful Russian defense 
enterprises. Throughout the 1990s, arms export revenues were 
the dominant factor in explaining the relative success or 
failure of Russian defense enterprise performance. In a survey 
of 72 defense enterprises over the 1990-1995 period, I found 
that only 15 percent were performing in a way that could be 
considered to be relatively successful--e.g., they appeared to 
be more or less covering their operating expenses with some mix 
of revenues and state subsidies.\77\ The feature that separated 
this group from the 21 percent that were failing outright and 
the remainder that were ``muddling'' at best was the fact that 
they had foreign markets for their arms products.\78\
---------------------------------------------------------------------------
    \77\ Kevin P. O'Prey, Russian Defense Enterprise Adaptation--1984-
1995: Coping with Political-Economic Reform and Transformation, MIT 
Doctoral Thesis, January 1998.
    This figure tracks with current estimates of economist Kseniya 
Gonchar, who argues that only one-fifth of the entities within the 
defense industry show signs of stability and long-term viability. See 
Kseniya Gonchar, Russia's Defence Industry at the Turn of the Century, 
p. 4.
    \78\ Twenty-one percent of surveyed defense enterprises--the 
``basket cases''--were experiencing periodic shut-downs due to a 
variety of financial maladies, including an inability to pay energy 
bills, wages, and so forth. These shut downs typically involved the 
enterprise management locking the gates and sending the workforce on 
unpaid leave for weeks at a time.
    The majority (67 percent) of surveyed enterprises could be 
performing in a way that could only be characterized as ``muddling.'' 
Although they by and large kept their doors open, they clearly lacked 
products whose revenues could sustain them as currently constituted. 
See Kevin P. O'Prey, Russian Defense Enterprise Adaptation--1984-1995: 
Coping with Political-Economic Reform and Transformation, MIT Doctoral 
Thesis, January 1998.
---------------------------------------------------------------------------
    Perhaps the best sign of the relative prosperity of arms 
exporting enterprises is the fact that they have been hiring 
workers. The S-300 producing Antey Concern in Moscow is looking 
to hire another 10,000 employees to add to its existing 40,000 
personnel. A 1998 report described the Tula Instrumentmaking 
Design Bureau--the developer and producer of the Pantsir air 
defense system--as hiring 400 new engineers to support its 
export-led business. Uralvagonzavod, the beneficiary of the 
2000 agreement to supply 310 T-90 tanks to India, was similarly 
reported to be hiring personnel to support renewed production 
after an extended down period.
    Exports have also helped some enterprises undertake the 
development of new systems. Most notably, the Tula 
Instrumentmaking Design Bureau's deal to sell the Pantsir air 
defense system to the UAE apparently includes explicit UAE 
financing of the system's final development.\79\
---------------------------------------------------------------------------
    \79\ Col. Stanislav Lunev, ``Russia's Arms Sales Destabilizing Gulf 
Nations,'' Newsmax, March 28, 2001, reproduced on http://
www.newsmax.com.
---------------------------------------------------------------------------
    Yet the Pantsir case appears to be more the exception than 
the rule. Without a robust, multi-year government defense R&D 
budget, the development of fundamentally new systems appears to 
be exceedingly difficult. In the aviation sector, despite the 
change of nomenclature, the Su-30 aircraft being sold to China 
and India are upgrades of the Su-27. Despite frequent press 
references to the imminent development of a fifth generation 
Russian fighter to succeed either the MiG-29 or the Su-27, no 
financing appears to be in the offing. According to Mikhail 
Pogosyan, the General Director of the Sukhoy design bureau, the 
biggest obstacle is the lack of state financing: ``Everyone 
understands that it is impossible to carry out all the R&D 
related to the new generation with [current levels of] budget 
funding alone.'' Thus, the Sukhoy design bureau invests some of 
the revenues from exports, and hopes to convince foreign 
clients to invest in the development of new systems, or to 
encourage foreign joint development.\80\
---------------------------------------------------------------------------
    \80\ Interview with Mikhail Pogosyan, ``Only a Definite Strategy 
Can Attract Money,'' p. 19.
---------------------------------------------------------------------------
    The Sukhoy complex of enterprises also provides an 
illustration of how export success cannot overcome the 
obstacles created by the organizational vestiges of the Soviet 
system. The Soviet-era Sukhoy complex included four 
geographically dispersed, organizationally distinct entities. 
In addition to the Moscow design bureau, there were three 
production facilities for Su-27 variants: the Komsomolsk-na-
Amure Aviation Production Association (KnAAPO), the Irkutsk 
Aviation Production Association (IAPO), and the Novosibirsk 
Aviation Production Association (NAPO). Since the collapse of 
the Soviet-era aviation ministry, the managers of these 
enterprises have resisted repeated efforts to create a unified 
firm. In particular, as the producers of the exported aircraft, 
each of the production associations has sought to keep the 
resulting revenues for themselves.
    Today, the divided approach appears to have mixed results. 
While the design bureau and KnAAPO are doing relatively well, 
the Novosibirsk and Irkutsk plants hare having difficulty 
fulfilling their orders.\81\
---------------------------------------------------------------------------
    \81\ Interview with Mikhail Pogosyan, ``Only a Definite Strategy 
Can Attract Money,'' p. 18.
---------------------------------------------------------------------------
    Perhaps partly in response, like the Yeltsin Administration 
before it, the Putin government is seeking to create a unified 
firm of all of Sukhoy's components. However the prospects for 
this effort are dubious due to the differing forms of ownership 
across the different Sukhoy enterprises.\82\
---------------------------------------------------------------------------
    \82\ See comments by Ruslan Pukhov in Guy Chazan, ``Russia to 
Reduce Weapons Producers in a Bid to Streamline the Defense Sector,'' 
Wall Street Journal, July 31, 2001.
    On Yeltsin era efforts, see Dmitry Safonov, ``Military Industry 
Reform Approved,'' Izvesitya, July 28, 2001.
---------------------------------------------------------------------------
    Finally, while arms export success appears to provide a 
palliative, it cannot overcome the fundamentally weak state of 
the Russian defense economy. Across the board, it is clear that 
arms export revenues--when they reach the individual 
enterprise--can help enterprise directors to pay their bills 
and, perhaps, to fund some new initiatives. However, none of 
these enterprises appears to be profitable, as they could not 
cover their costs without substantial explicit and implicit 
subsidies. Nor can they help these plants overcome the 
challenges of operating in the transitional Russian economy. In 
a telling example, Uralvagonzavod is reportedly finding it 
difficult to produce T-90s for its India export orders because 
its former sub-contractors have either failed or have moved to 
other pursuits.\83\
---------------------------------------------------------------------------
    \83\ ``Russia: Uralvagonzavod Not Prepared to Produce Tanks for 
Indian Contract,'' Vremya Novostey, March 14, 2001, p. 1, translated in 
FBIS, March 15, 2001, Document ID: CEP 20010315000367.
---------------------------------------------------------------------------

                          Issues for Congress

    There are three compelling issues for the U.S. Congress 
that emerge from this analysis.

   The virtual certainty of continued aggressive 
        promotion of arms exports by Russia.
   The limited effects that export success will have on 
        Russian defense industrial advancement.
   The negative impact that these exports will have in 
        terms of greater proliferation of high technology 
        weapons systems to potential U.S. competitors.

    In short, despite the improving climate of U.S.-Russian 
relations, the United States possesses few levers against 
Russia's efforts to sell high technology weapons systems to 
anyone who will pay for them. Sanctions or attempts to create 
diplomatic linkages are highly unlikely to overcome the very 
significant incentives for Moscow to continue to promote 
exports. While it is difficult to envision arms export success 
helping the Russian defense sector rebuild itself anew into a 
competitor with the United States and the West, the 
proliferation impact could pose challenges to U.S. forces. The 
remainder of this section addresses each of these issues in 
turn.

the virtual certainty of continued aggressive promotion of arms exports 
                               by russia

    As described above, it is a virtual certainty that Russia 
will continue to aggressively promote arms exports for the 
foreseeable future. There are virtually no stakeholders in the 
Russian political system who have an interest in constraining 
Russian arms exports. For the government, arms exports help to 
maintain priority defense industrial capabilities on the cheap 
while reducing industrial demands for bail outs for the state. 
Given the likely enormous amount of financial resources and 
time that it would take to reform the defense industrial base--
thereby reducing the political pressure to export--it is 
difficult to imagine any government choosing any other course. 
Moreover, as arms continue to be one of the only hard currency 
generating items that Russia can export, there will always be 
prominent figures in the government who stand to profit 
personally from export promotion.
    For Russian defense industries, export revenues represent 
the difference between success and failure. Russian defense 
industrialists recognize that aside from intercontinental 
ballistic missile (ICBM) manufacture, there are virtually no 
prospects for meaningful state R&D or production orders over 
the next 5 years at a minimum. If these industrialists do not 
find foreign markets for their weapons, they are faced with 
very bleak prospects.
    Unfortunately, the United States has very little in the way 
of moral suasion on this issue. As the dominant player in the 
military export market over the past decade (see Figure 2), 
Washington cannot credibly appeal for Russian restraint in 
terms of general export promotion efforts.

 the limited effects that export success will have on russian defense 
                         industrial advancement

    Russia's arms export success is not likely to be a vehicle 
for the reinvigoration of the Russian defense industrial 
complex. Russia's defense industries today are very sick. They 
have not overcome the organizational vestiges of the Soviet 
period and few, if any, enterprises have developed into viable 
firms. By U.S. standards, none of these organizations is 
profitable.
    Given this environment coupled with the lack of government 
resources, the prospects for the development and production of 
a wholly new weapon system appear to be very bleak. While the 
Russian system can turn out modifications of existing systems 
such as the Su-27 fighter, fundamentally new programs require 
the large-scale, multi-year funding that appears beyond the 
reach of the Russian Government and enterprises for the 
foreseeable future. Simply stated, at a time when Russian 
enterprises are trying to stay afloat, it is extremely unlikely 
that they can take on a robust development program that would 
be taxing to even advanced defense industries like that of the 
United Kingdom, France, or Germany.
    From the U.S. perspective, therefore, the worst-case 
scenario is that Russia could return to manufacturing large 
quantities of older generation weapons. In the unlikely event 
of renewed military competition with the United States and the 
resulting political prioritization of domestic Russian 
investment, and given the persistence of a large defense 
industrial infrastructure, Russia could once again turn out 
large numbers of ICBMs, artillery, tanks, and aircraft. 
However, continued limitations in electronics and other aspects 
of modern military systems would likely hobble this military in 
actions against any Western force.

 the negative impact that these exports will have in terms of greater 
  proliferation of high technology weapons systems to potential u.s. 
                              competitors

    The more significant problem for the United States and the 
West is the proliferation of advanced Russian weapons systems 
to potential regional competitors. There is little doubt that 
the rationale for China's and Iran's acquisition of Russian 
weapons and technologies is at least partly based on improving 
their capabilities vis-a-vis the United States. If Iran were to 
acquire Yakhont anti-ship missiles, for example, it would put 
Tehran in a position from which to threaten U.S. naval forces 
and international shipping in the Persian Gulf. Modern air 
defense systems, furthermore, might help Iran defend its 
nuclear facilities from preemptive strikes. Similarly, Chinese 
acquisitions of high performance aircraft and other weapons are 
likely based on a desire to improve Beijing's capabilities in 
regional competition with the United States.
    In this area the United States does possess some options. 
Moscow still appears to respect international legal 
restrictions. Moscow abides by UN sanctions on its former arms 
client in Iraq. It also officially respects the terms of the 
Missile Technology Control Regime (MTCR). Although there are 
serious questions about illicit cooperation between Russian 
missile manufacturers and Iran, among others, it appears that 
Moscow is responsive to international pressure whenever these 
relationships are exposed. Continued efforts to strengthen 
existing international legal regimes governing arms trade--and, 
perhaps, developing new ones--appears to be a good return on 
U.S. diplomatic investment.
    Targeted sanctions, however, do not appear to offer much 
promise. Although U.S. sanctions against particular individuals 
or enterprises puts the international spotlight on problems, 
they cannot overcome the fact that the United States does not 
possess economic levers over Russian industry. Most 
importantly, Russian enterprises do not care if they are 
subject to U.S. sanctions because they do not generally do any 
business with U.S. firms anyway. Moreover, in extreme cases, it 
is hard to foresee how a cut-off of all Western business with a 
Russian enterprise would hurt more than one sizeable contract 
with a country like Iran. The only exception to the rule 
appears to depend upon tactical diplomatic efforts. In the case 
of Iran sales, for example, the United States can encourage the 
Gulf states to break off current cooperation and/or rule out 
future Russian purchases. The opportunities for similar efforts 
with respect to China, however, appear to be limited by the 
fact that few Asian countries represent market opportunities 
for Moscow.
    In sum, therefore, the rationale for Russian arms exports 
has become largely based on commercial interests and domestic 
politics. Gone are the days when geopolitics drove Soviet arms 
transfers. As a consequence, the United States is likely to 
have an exceedingly difficult time finding anyone in Moscow or 
Russian defense industries willing to listen to appeals for 
restraint unless it is in their economic interest. For the 
foreseeable future, the Russian Government and defense 
industries will be focused on the near-term opportunities 
offered by arms exports. Thus, as the Bush Administration and 
the Congress evaluate the evolving U.S.-Russian relationship, 
both must recognize that the arms trade is almost certainly 
going to be a continuing source of disagreement.


       U.S.-RUSSIAN TRADE AND INVESTMENT: POLICY AND PERFORMANCE



         By Inga Litvinsky, Matt London, and Tanya Shuster \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   411
Policy Goals and Vehicles........................................   412
Bilateral Trade..................................................   414
    Russia, U.S. major trading partner in Central Eastern Europe, 
      not in the global economy..................................   414
    Trade imbalance increased, 1995-2000.........................   414
    U.S. exports to Russia varied but leading exports were stable   415
    Some U.S. imports from Russia increased consistently.........   416
Bilateral Investment.............................................   417
    Foreign direct investors into Russia.........................   417
        U.S. investors in Russia.................................   418
        Regions attracting foreign investment....................   418
Business Environment Issues in Russia............................   419
    Good governance..............................................   419
    Commercial taxation with international accounting standards 
      (IAS)......................................................   420
    Commercial energy development................................   420
    Russia's accession to the World Trade Organization (WTO).....   421
    U.S.-Russian treaty on mutual protection of investments......   421
Outstanding Trade Issues with the United States..................   421
    Russia's non-market economy status...........................   421
    Trade implications of the Trade Reform Act of 1974 Jackson-
      Vanik Amendment............................................   422
    1999 Steel agreements........................................   422
Prospects for Trade and Investment...............................   422
                                Summary

     The U.S. Administration would like to see business become 
a bedrock for overall U.S.-Russian relations. At the same time, 
President Putin and the Russian Government are banking on 
foreign investment and integration in the global economy led by 
the United States to expand and sustain Russia's gross domestic 
product (GDP) growth. Thus, U.S. and Russian interests and 
policies appear to be in alignment to commence a new bilateral 
commercial era.
---------------------------------------------------------------------------
    \1\ Inga Litvinsky is the Senior Russia Desk Officer and Matt 
London is the Russia and Caucasus Desk Officer for the U.S. Department 
of Commerce, International Trade Administration. Tanya Shuster is 
Deputy Director and Senior Russian Specialist with the Business 
Information Service for the Newly Independent States (BISNIS), U.S. 
Department of Commerce. BISNIS provides market research, business 
leads, and expert guidance and assistance to U.S. companies with 
interests in the 12 Newly Independent States (NIS) countries 
(www.bisnis.doc.gov). Chang Suh, an intern with the Department of 
Commerce, also contributed to this article.
---------------------------------------------------------------------------
    In order, however, to turn these intentions into increased 
commercial opportunities so that bilateral trade and investment 
can finally take off, concrete steps will be required by both 
sides. Finishing Putin's reform agenda with financial, rule of 
law, and other institutional reforms are essential conditions 
precedent to developing a new Russian business climate capable 
of attracting significant new investment. Specific improvements 
in corporate governance, tax policy and commercial energy 
developments are likewise required. Implementation of bilateral 
treaties fostering commercial relations and Russian accession 
to the World Trade Organization (WTO) would also be catalysts 
for increased trade and investment. If Russia moves closer to 
integration into the international economic institutions and 
the global market, the United States would need to reexamine 
its domestic trade laws in order to address Russia's concerns 
regarding trade restrictions, access to the U.S. market and 
expansion of appropriate trade and investment promotion 
measures.
     U.S.-Russian trade and investment increased over the 
decade of the 1990s from a very low base. Russia's financial 
crisis in 1998 accelerated the trade imbalance and interrupted 
the overall upward trends, leading to a setback from which 
bilateral trade and investment performance have not yet fully 
recovered. Even at the past low level of trade turnover, some 
American sectors and enterprises fared rather well, e.g., 
machinery and poultry. While foreign direct investment (FDI) to 
Russia was minuscule, the United States led the advanced 
western nations as a supplier of FDI. Russia has been far and 
away the leading U.S. commercial partner in the region formerly 
controlled by the Soviet Union. If trade and investment were to 
substantially increase, sectors and enterprises already in the 
Russian market would expect to be primary beneficiaries of the 
expanding commerce. However, new participants such as small- 
and medium-sized businesses may also be able to flourish in a 
new business-friendly environment.
    The current U.S. Administration is emphasizing the leading 
role of the private sector in driving the bilateral commercial 
relationship and has warmly welcomed the formation of the 
Russian-American Business Dialogue.

                     Policy Goals and Vehicles \2\
---------------------------------------------------------------------------

    \2\ For a good overview of the Administration's commercial policy 
toward Russia, see October 5, 2001 remarks by Secretary of Commerce' 
Donald Evans to the U.S.-Russia Business Council at www.doc.gov.
---------------------------------------------------------------------------
    As the United States seeks to advance its relations with 
Russia in all spheres, including development of a new security 
framework, the Bush Administration is giving priority to the 
bilateral commercial relationship. The Administration would 
like to see private business relations become a bedrock for 
overall U.S.-Russian relations. For their part the Russians, 
under President Putin and the economic reform team led by 
Economic Development and Trade Minister Gref, are banking on 
increased foreign investment and integration into the global 
economy. This development would sustain and expand the 
country's GDP growth and favorable balance of payments, which 
have been primarily fueled by high oil prices and depreciation 
of the ruble in recent years. Thus, in principle, U.S. and 
Russian interests and policies are in alignment to commence a 
new bilateral commercial era.
    While the first Bush Administration and Clinton 
Administration conducted business with Russia through a 
bilateral Commission made up of eight Committees, the new Bush 
Administration has de-emphasized formal intergovernmental 
structures and stressed the role of the private sector in 
relations with Russia. They have disbanded the previous 
Administration's principle vehicle for economic discussions 
with Russia, the Joint Commission on Economic and Technological 
Cooperation (or ``Gore-Chernomyrdin Commission''), and have 
opted for a more informal and decentralized approach to 
commercial enhancement.
    At the first meetings between Presidents Bush and Putin at 
the Ljubljana, Slovenia and Genoa Summits (in May and July 
2001), commercial issues were high on the agenda. In Genoa, 
Italy, the two Presidents announced formation of a private 
sector-led Russian-American Business Dialogue to promote new 
business opportunities and make policy recommendations to the 
two governments. The creation of the private sector led 
Business Dialogue is a recognition that our bilateral 
commercial relations are at the beginning of a new era, one 
that will be driven by the two countries' private sectors 
rather than by the governments.
    Following up on the economic discussions between the 
Presidents, Commerce Secretary Donald Evans and Treasury 
Secretary Paul O'Neill went to Russia in July 2001 to begin to 
chart a new business-driven policy with the stated purpose of 
expanding bilateral trade and investment. Subsequently, at the 
request of President Bush, Commerce Secretary Evans led a 
successful business development mission of senior U.S. 
executives from a variety of sectors, including Committees on 
Energy, Aviation, and Information Technology, to Russia in 
October 2001. Several companies, including those new to the 
Russian market, signed investment protocols during that visit.
    In order to turn these positive intentions into increased 
commercial opportunities, trade liberalization and business 
environment issues will need to be addressed by both sides. It 
is generally acknowledged by trade and investment specialists 
in both countries that critical improvements are needed in 
Russia's business climate, including corporate governance and 
rule of law for business, commercial taxation, and improvements 
in the banking system. While Russia is still perceived as a 
risky place to do business by domestic and foreign businesses 
alike, there have been positive changes in the past year, 
including in commercial tax reform and simplification of 
business licensing requirements.
    Russia's accession to the WTO would be a major catalyst for 
increased trade and investment as it would reinforce Russia's 
economic reform program and would ensure that Russia abides by 
international trade rules. As Russia moves closer to WTO 
membership, the United States will need to re-examine its 
domestic trade laws. If both sides are to reap the full 
benefits of Russia's accession to the WTO, reconsideration of 
the Jackson-Vanik Amendment to the Trade Reform Act of 1974 may 
be necessary so that permanent normal trade relations (PNTR) 
status may be accorded to Russia. The United States may also 
need to address Russia's concerns regarding access of Russian 
products, such as steel, to the U.S. market.

                          Bilateral Trade \3\
---------------------------------------------------------------------------

    \3\ The analysis of trade and investment performance has been 
prepared by Tanya Shuster, Deputy Director of BISNIS. Additional 
information on U.S. trade and investment with Russia and other CIS 
countries, including data on exports from individual U.S. states to the 
NIS, is available via BISNIS Online, www.bisnis.doc.gov. For a more 
comprehensive summary of trade between the United States and Russia in 
2000, see BISNIS U.S.-Russia Trade Profile, available via the Russia 
page of BISNIS Online www.bisnis.doc.gov/russia.html. Data in this 
article is from authoritative official sources.
---------------------------------------------------------------------------

 russia, u.s. major trading partner in central eastern europe, not in 
                           the global economy

    A more detailed examination of the U.S. and Russia trade 
activities provides some, perhaps unexpected, perspectives. 
Russia has emerged among all countries from Eastern Europe and 
the Newly Independent States (NIS) as the United States' 
leading trading partner in the region, but nonetheless accounts 
for less than 1 percent of total U.S. foreign trade. In 2000 
this pattern largely held true, with Russia capturing 80 
percent of U.S. trade with the NIS. In this trade, Russia 
provided nearly 40 percent of platinum, 14 percent of aluminum 
and 3 percent of iron and steel imported into the United 
States.\4\
---------------------------------------------------------------------------
    \4\ U.S. platinum (palladium) imports from Russia nearly doubled 
between 1998 and 2000, to more than $1.6 billion.
---------------------------------------------------------------------------

                  trade imbalance increased, 1995-2000

    According to Russia's Ministry of Economic Development and 
Trade, the United States accounted in 2000 for less than 5 
percent of total Russian foreign trade but ranked third as a 
market for Russian exports, after Germany and Ukraine. However, 
if oil and gas are excluded from consideration (the United 
States imports a disproportionately low level of oil and gas 
from Russia compared to other leading trade partners), the 
United States ranks second among all countries as a recipient 
of Russian exports. In short, while Russia plays a minor 
nominal role in U.S. imports and exports on a worldwide scale, 
it remains very important as a trade partner in the region 
(former Soviet-bloc countries). The United States ranked lower 
(in eleventh place) as an exporter to Russia. The U.S. market 
is especially important to Russia as a recipient of certain 
products.
    U.S.-Russian trade differ from worldwide trade trends 
because of significant growth in Russia's trade surplus with 
the United States.\5\ (See Table 1 and Figure 1). Russia had 
solid growth in its exports to the United States each year 
since 1996,\6\ while there was a the sharp decline in U.S. 
exports to Russia in 1999 following the financial crisis. The 
deficit in U.S.-Russian trade was far more pronounced than 
Russia's overall worldwide trade performance, although less 
severe than that experienced by Japan.\7\ While Russian total 
trade worldwide in 2000 was roughly the same level as in 1995, 
U.S.-Russian total trade reached all-time highs in 2000. The 
total dollar value of U.S.-Russian trade grew more than 50 
percent between 1995 and 2000 largely attributable to the 93 
percent growth in the value of U.S. imports from Russia during 
the period (the value of U.S. exports in 2000 was only 82 
percent of the level in 1995).
---------------------------------------------------------------------------
    \5\ Russia's trade surplus with the United States grew 350 percent 
between 1995 and 1998, while Russia's trade surplus worldwide grew 240 
percent.
    \6\ Initial U.S. Department of Commerce data for January-June 2001 
indicates a small decline (4 percent) so far for the year in U.S. 
imports from Russia, which is attributable at least in part to 
declining prices for fuel and other commodities imported from Russia.
    \7\ Japan's exports to Russia dropped 57 percent in 1999 over 1998. 
The value of U.S. imports declined 48.5 percent. The European Union 
(EU) experienced a 45 percent decrease.

                                     TABLE 1.--U.S.-RUSSIA TRADE, 1995-2000
                                            [In billions of dollars]
----------------------------------------------------------------------------------------------------------------
                                                        1995      1996      1997      1998      1999      2000
----------------------------------------------------------------------------------------------------------------
U.S. exports........................................    $2.826    $3.340    $3.289    $3.585    $1.845    $2.318
U.S. imports........................................     4.035     3.561     4.290     5.734     5.805     7.796
                                                     -----------------------------------------------------------
    Total trade turnover............................     6.681     6.901     7.579     9.319     7.650    10.114
                                                     ===========================================================
Trade balance.......................................    -1.209    -0.221    -1.001    -2.149    -3.960    -5.478
----------------------------------------------------------------------------------------------------------------
Source: BISNIS.



                FIGURE 1._U.S.-RUSSIAN TRADE, 1993-2000

                        [In billions of dollars]

[GRAPHIC] [TIFF OMITTED] T6171.032


                U.S. exports    {time}  U.S. imports

  Source: BISNIS.

     u.s. exports to russia varied but leading exports were stable

    Initial U.S. data for the first 6 months of 2001 indicate 
that the modest recovery continues, although if performance in 
the second half of the year is consistent with the first, the 
United States will attain year-end export levels only on par 
with the mid-1990s. Growth in U.S. exports to Russia of 25 
percent in 2000 over 1999 showed some recovery from the effects 
of ruble depreciation and other factors. The U.S. exports to 
Russia were only $633 million for January-June 1999. For the 
same period of 2000, U.S. exports were valued at $1.23 billion. 
The value of U.S. exports to Russia for January-June 2001 was 
nearly $1.4 billion. U.S. export levels in 2000 and 2001 
remained far below levels achieved each year between 1993 and 
1998.
    Some Russian demand for U.S. imports has emerged in waves. 
First, in the early 1990s came demand for U.S. food products, 
followed by strong demand for U.S. consumer products. 1995 saw 
a surge in demand for construction materials, hotel and 
restaurant equipment, and furniture. Following the 1998 ruble 
devaluation and financial crisis, Russian consumers cut back 
heavily on many imported consumer and manufactured goods, with 
Russian companies benefiting from a cheap ruble and stepping up 
production, and quality, to meet increased domestic demand.
    Still the Russian demand for core U.S. exports was more 
stable. The overall portfolio of leading U.S. exports to Russia 
\8\ has remained fairly consistent since the late 1990s, 
although the relative importance of some categories of goods 
has shifted. The leading U.S. exports to Russia in 2000, in 
order of dollar sales were: poultry,\9\ aircraft, oil/gas 
machinery and parts, uranium, corn and wheat, computers and 
components, beef and pork, telecommunications equipment, 
electrical machinery, and other machinery. Meat products (which 
shifted from a balance of pork, beef and chicken in the mid-
1990s to predominantly chicken in 2000), and machinery have 
remained in the top tier of U.S. exports throughout this 
period. Prior to 1998, U.S. prepared foods, including sausages, 
were among the strong export categories for the United States--
these categories have been all but absent from U.S. exports 
since 1998. The granting by the Russian Government of tariff 
waivers on U.S. aircraft generated a record-breaking dollar 
value of aircraft exports in 1998; this achievement was not 
repeated in 1999 or 2000. U.S. food aid and grain packages 
resulted in high volumes of wheat exports in 1999 in 
particular, although this dropped in 2000.
---------------------------------------------------------------------------
    \8\ Determined according to the dollar value of the exports on the 
basis of the first two-digits of HS classification. Using two digits is 
a fairly broad way of categorizing products. In contrast, a complete HS 
classification for a specific product can be up to ten digits long.
    \9\ Specifically, frozen chicken quarters, which came to be known 
as ``Bush legs'' in Russia and the CIS for their forceful appearance on 
the market during the Presidential Administration of George H.W. Bush.
---------------------------------------------------------------------------

          some u.s. imports from russia increased consistently

    Russian exports to the United States continue to consist 
primarily of raw materials. Platinum (palladium), aluminum, 
uranium, oil, seafood (crab and fish fillets), iron/steel, 
clothing, and nickel were the most important Russian exports to 
the United States in 2000 by dollar value. Although iron/steel 
played a larger role in the U.S. import profile from Russia 
prior to 1999, as did fertilizers, the general group of items 
in this ``basket'' of leading imports has remained fairly 
consistent. Clothing was the only finished good export that 
showed strongly on Russia's export profile to the United States 
in 1998 and 2000.\10\
---------------------------------------------------------------------------
    \10\ In 1999 clothing did not make the ``top ten'' list, but vodka 
did.
---------------------------------------------------------------------------

                       Bilateral Investment \11\
---------------------------------------------------------------------------

    \11\ Additional information about U.S. investment into Russia is 
available in the BISNIS Commercial Overview for Russia, available at 
www.bisnis.doc.gov/russia.html.
---------------------------------------------------------------------------
    Foreign investors have been attracted to Russia because of 
its large domestic market, vast supply of natural resources, 
and skilled and well-educated labor force. However, the risks 
in the Russian market have kept many investors at bay. Russia's 
long-term sovereign rating by the international rating agency, 
Standard & Poor's (S&P), is currently B- with a stable outlook, 
a rating also given to Turkey and India. While FDI in Russia 
far outpaced FDI for CIS countries, foreign investment levels 
into Russia in 2000 fell far behind the levels S&P reported for 
China ($46 billion) and Eastern European countries such as the 
Czech Republic ($5 billion). Meanwhile, many potential domestic 
investors have sent their money abroad as ``flight capital.''
    Russia reported record-high levels of FDI for 2000, 
although Russian estimates for total foreign investment \12\ 
indicate that the country attracted higher levels of total 
investment in 1997 and 1998. Cumulative FDI into Russia as of 
January 2001 was $16.13 billion.\13\
---------------------------------------------------------------------------
    \12\ Official Russian data on total investment reflects direct + 
portfolio + other investment, the latter of which includes trade 
credits and foreign loans. Estimates of FDI in Russia can vary widely 
by source.
    \13\ Note: Cumulative FDI does not equal the sum of annual FDI due 
to divestment.

        TABLE 2.--ANNUAL FOREIGN INVESTMENT IN RUSSIA, 1993-2000
                 [All countries, in billions of dollars]
------------------------------------------------------------------------
                                                  Foreign
                                                   direct     Portfolio
                     Year                        investment   investment
                                                   (FDI)
------------------------------------------------------------------------
2000..........................................        $4.43       $0.145
1999..........................................         4.26        0.031
1998..........................................         3.36        0.191
1997..........................................         3.90          3.3
1996..........................................         2.05          3.2
1995..........................................         1.50          1.5
1994..........................................         1.30          2.5
1993..........................................         1.36        0.300
------------------------------------------------------------------------
Source: BISNIS.


                  foreign direct investors into russia

    The United States has been and continues to be the leading 
foreign direct investor into Russia, accounting for nearly 35 
percent of all cumulative FDI.\14\ Table 3 indicates the 
leading foreign direct investors into Russia according to 
cumulative investments as of January 2001.
---------------------------------------------------------------------------
    \14\ Germany, which has provided more trade credits and ``other 
investments'' has had the highest total investment levels into Russia, 
but the United States leads all countries as a foreign direct investor 
into Russia.
---------------------------------------------------------------------------
U.S. investors in Russia
    Many major U.S. companies have approached Russia with an 
eye toward developing a long-term commercial strategy. As 
indicated above, U.S. companies are active across many sectors. 
While the level of U.S. activity in Russia slowed following the 
financial crisis in August 1998, the majority of U.S. direct 
investors remained in the country, reportedly to protect 
sizable investments and further their long-term prospects.

            TABLE 3.--TOP FOREIGN DIRECT INVESTORS IN RUSSIA
          [By cumulative investment levels as of January 2001]
------------------------------------------------------------------------
                                                     Leading investment
            Country                Cumulative FDI      sectors in 2000
------------------------------------------------------------------------
United States..................  $5.49 billion....  Transportation,
                                                     fuel,
                                                     communications,
                                                     engineering
Cyprus.........................  3.24 billion.....  Food,
                                                     transportation,
                                                     fuel, construction
Germany........................  1.26 billion.....  Advertising/
                                                     auditing, food,
                                                     forestry
Netherlands....................  1.18 billion.....  Transportation, food
Great Britain..................  982 million......  Construction
Sweden.........................  610 million......  Communications
France.........................  256 million......  Chemical/
                                                     petrochemical
Japan..........................  215 million......  Fuel
Italy..........................  160 million......  NA
------------------------------------------------------------------------
NA--Not available.
Source: BISNIS.


    The American Chamber of Commerce in Moscow counts some 500 
U.S. company members as foreign-directed investors in Russia. 
Some of the more well-known U.S. companies who have already 
made significant investments developing production capability 
in Russia are: Caterpillar (a dealer network in Russia/NIS and 
in a factory for road building machinery in Leningrad Oblast), 
Coca Cola (bottling and beverage production plants across 
Russia), ExxonMobil (oil/gas development), Ford (a factory to 
produce the Ford Focus in Leningrad Oblast), General Motors 
(multiple production projects), Gillette (shaving accessories 
factory in St. Petersburg), ICN Pharmaceuticals (pharmaceutical 
production in multiple Russian locations), International Paper 
(pulp and paper mill in Leningrad Oblast), Kraft (instant 
coffee plant in Northwest Russia), Lucent (telephone line 
production), Mars (confectionery and pet food production), 
McDonald's (at least 60 restaurant outlets in Russia), Procter 
& Gamble (production of detergents and cleaning agents), Xerox 
(copiers), and Wrigley (chewing gum production). In addition to 
these well-known companies, numerous small- and medium-sized 
firms are active in Russia.
Regions attracting foreign investment
    According to Goskomstat statistics, Moscow city attracted 
the most foreign direct investment in 2000, worth more than 
$1.47 billion, or roughly 33 percent of incoming FDI. This is 
consistent with the city's overall performance in the years 
since 1991. Other top regions for FDI were: Krasnodar Territory 
(almost $1 billion), Sakhalin ($246 million),\15\ Leningrad 
Oblast (just over $205 million), and Moscow Oblast (just under 
$205 million). Novosibirsk, Tyumen, and St. Petersburg city all 
received between $145 and $151 million. The Yamal-Nenets 
Autonomous District in northern Russia received approximately 
$100 million in FDI. Volgograd, Sverdlovsk, Samara, Tatarstan, 
and Orenburg each received roughly $50 to $77 million in FDI.
---------------------------------------------------------------------------
    \15\ In the summer months, when work on Sakhalin Island's multi-
billion-dollar offshore oil and gas development projects is in full 
swing, Sakhalin reports the third-highest U.S. expatriate population in 
Russia, after Moscow and St. Petersburg.
---------------------------------------------------------------------------
    While U.S. firms have invested heavily in the cities of 
Moscow and St. Petersburg and in the Leningrad Oblast, American 
companies have also moved beyond these population centers into 
Russia's regions. Sakhalin Island, with its multi-billion-
dollar offshore oil and gas projects, reportedly has the third-
largest U.S. expatriate community in Russia during the summer 
months. U.S. firms are also heavily invested into Western 
Siberia (mostly for oil and gas), Russia's Volga regions, and 
elsewhere.

                 Business Environment Issues in Russia

    American firms note a number of issues critical to the 
development of Russia's business environment, including 
improved corporate governance, a fair commercial tax system, 
and an investor-friendly regime for the energy sector. Russian 
accession to the WTO.

                          good governance \16\
---------------------------------------------------------------------------

    \16\ To assist U.S. companies and to build Russia's capacity and 
institutions of rule of law, the Department of Commerce has developed 
several specific programs, including a Handbook on Commercial Dispute 
Resolution in Russia, as well as Basic Guidelines for Codes of Business 
Conduct which was accompanied by training in the United States. There 
are plans to develop a Manual on Enforcement of Arbitration Awards and 
Court Judgement and a Corporate Governance Guidebook for Enterprises in 
Russia as well. Furthermore, the U.S. Government is providing technical 
assistance to help Russian Government agencies to stem the high rates 
of intellectual property rights (IPR)-related crime.
---------------------------------------------------------------------------
    Good governance is a concept which covers good business 
ethics, corporate governance, protection of IPR, and effective 
commercial dispute resolution. All of these are institutions of 
rule of law for business that are attributes of most successful 
economies. An evolution in commercial conditions and business 
thinking is motivating some Russian managers to improve 
business practices and corporate governance for the purpose of 
obtaining business partners, capital, and loans. However, it is 
generally recognized that much more needs to be done by the 
Russian Government and business community.
    Russia has made progress in harmonizing its IPR laws with 
international norms, but enforcement of laws and regulations 
remains poor and the country has not been able to stem the high 
rate of IPR-related infringements. Protection of well-known 
trademarks is weak, and the high rate of counterfeiting of 
consumer goods has become a major issue for U.S. companies 
operating in Russia. Another major problem is enforcement of 
commercial arbitration awards and court decisions. Indeed, 
notwithstanding awards and decisions in their favor, several 
U.S. companies have been mired in long standing battles to have 
their judgments enforced.

   commercial taxation with international accounting standards (IAS)

     Russia's onerous tax laws and their inconsistent 
application was the number one complaint of both Russian and 
U.S. companies in the 1990s. Since 1993, the U.S. Department of 
Commerce has co-chaired a Bilateral Tax Working Group with the 
Russian Ministries of Finance and Taxation, which allows the 
U.S. tax experts to make recommendations on improving the 
commercial tax regime. Many of these recommendations have been 
incorporated in the new Russian Tax Code. Overall tax laws have 
been significantly improved under the Putin Administration, 
with Duma passage of Part II of the Tax Code in summer 2000 and 
subsequent actions to reduce the commercial tax burden in 
summer 2001. Specifically, the personal income tax rate was 
reduced to a flat rate of 13 percent; social taxes on 
corporations have been unified; business expense deductibility 
has been recognized; and the profits tax has been cut from 35 
percent to 24 percent. While reducing the tax burden on 
entrepreneurs, these actions have resulted in increased tax 
collections. The key issue will increasingly become Russia's 
commitment to fair tax administration. American companies still 
cite arbitrary and confiscatory actions by tax authorities, 
alleging that foreign companies are targeted as ``cash cows.''
    In order to develop fair and predictable commercial 
taxation Russia needs to adopt IAS. IAS is important to 
Russia's effort to attract investment through fair taxation. In 
evaluating opportunities, international investors typically 
insist on reviewing IAS prepared financial documents so that 
they ``know what they are looking at.'' By contrast, Russian 
accounting standards have been based largely on identifying, in 
some cases, concealing tax obligations. Many of Russia's large, 
``blue-chip'' companies have already gone to IAS. This is a 
positive development which should be encouraged and broadened 
to all companies.

                     commercial energy development

    Despite Russia's vast oil and gas reserves and need for 
world class exploration experience and technology, U.S. and 
other foreign companies have been unable to commit to large-
scale investments. Due to the long-term nature of major oil and 
gas projects, energy companies need to be guaranteed a stable 
tax and tariff framework, and assured repatriation of profits 
over the life of the project. In many resource-rich countries, 
the preferred vehicle for multi-year energy projects is a 
production sharing regime, in which the host government and the 
foreign company split the production and revenue of a specific 
hydro-carbon deposit on an agreed-upon basis. Russia passed a 
production sharing agreement (PSA) law in 1996, but 
implementing regulations have been stalled for most of the 
projects. At this time, the primary impediment is opposition to 
PSA by Russia's own energy firms and in the parliament.

        russia's accession to the world trade organization (wto)

    The Russian Government, under President Putin, has made WTO 
membership a priority, stating that Russia would like to join 
the organization next year in time to participate in a new 
global trade round. The U.S. Government supports Russia's 
accession to the WTO on commercially acceptable terms and is 
providing technical assistance to help Russia meet membership 
obligations. In the current interconnected global economy, 
Russia understands that it cannot achieve sustained economic 
growth without an open trade and investment framework. Adoption 
of the WTO's provisions will complement and reinforce Russia's 
broader economic reform program and promote transparency and 
the rule of law in trade and investment. To join the WTO, 
Russia must implement and enforce the organization's agreements 
in such critical areas as IPR, standards and certification, 
customs valuation, and industrial subsidies. The adoption of 
these WTO rules will promote trade and investment 
liberalization and harmonize Russian laws and regulations with 
international norms, thereby helping to facilitate access of 
U.S. goods and services to the Russian market.
    The pace of progress toward eventual membership will be 
determined by Russia's actions to adopt WTO rules and to make 
commercially meaningful market access commitments in goods, 
services and agriculture to other WTO Members. In this regard, 
the Russian Government will need to make hard decisions about 
the pace of trade liberalization and the extent to which they 
will commit to opening up the economy in areas that are 
priorities for their major trade partners, including 
agriculture, civil aircraft, information technology, financial 
services.

        u.s.-russian treaty on mutual protection of investments

    Russia's ratification of the Bilateral Investment Treaty 
(BIT) which was negotiated with the United States in 1992 would 
send a positive signal to U.S. investors. The BIT, if 
implemented, would guarantee non-discriminatory treatment for 
U.S. investments and operations in Russia, hard currency 
repatriation rights, expropriation compensation, and the right 
to third party international arbitration in the event of a 
dispute between a U.S. company and the Russian Government. 
While the BIT was ratified by the U.S. Senate in 1992, it still 
awaits ratification by the Russian Duma.

            Outstanding Trade Issues with the United States

    Although Russia continues to enjoy a significant trade 
surplus with the United States ($5.5 billion in 2000), the 
Russian Government has consistently raised several trade issues 
with the U.S. Government, including a desire to be treated as a 
Market Economy under U.S. trade law, a request to be freed from 
the constraints of the 1974 Jackson-Vanik Amendment, and 
increased access for Russian products, including steel, to the 
U.S. market.

                   russia's non-market economy status

    The Russians believe that their non-market economy status 
makes them more vulnerable to various anti-dumping petitions 
under U.S. trade law. However, if Russia is deemed a market 
economy under U.S. trade law, they will no longer be able to 
negotiate quota based anti-dumping suspension agreements with 
the U.S. Government and will be subject to possible 
countervailing duty actions.

   trade implications of the trade reform act of 1974 jackson-vanik 
                               amendment

    The Russian Government sees continued application of the 
1974 Jackson-Vanik Amendment as trade-disruptive and a relic of 
the cold war. In practice, Jackson-Vanik does not restrict 
trade as Russia currently enjoys conditional Normal Trade 
Relations status with the United States and for some time has 
been found to be in full compliance with the emigration 
requirements of the legislation. Termination of the application 
of Jackson-Vanik clause of U.S. law and granting Russia PNTR 
status will require Congressional action. Congress will likely 
review PNTR for Russia as Russia moves closer to joining the 
WTO, as has been the case for other acceding countries, such as 
Kyrgyzstan and Georgia.

                         1999 steel agreements

    Russian steel exports to the United States are currently 
subject to three agreements: Agreement Concerning Trade in 
Certain Steel Products from the Russian Federation 
(Comprehensive Agreement); Suspension of Antidumping Duty 
Investigation: Certain Cut-to-Length Carbon Steel Plate from 
the Russian Federation; Agreement Suspending the Antidumping 
Investigation on Certain Hot Rolled Flat-Rolled Carbon Quality 
Steel Products from the Russian Federation. The Russian 
Government has indicated that they seek renegotiation of the 
1999 Agreements to increase the access of Russian steel to the 
U.S. market.

                   Prospects for Trade and Investment

    The history of U.S.-Russian commercial engagement has been 
one of small trade and investment with periodic hopes raised 
for increases that were consistently dashed by trade and 
investment restrictions. Now, for the first time in the long 
history of U.S.-Russian commercial relations, including the 
Soviet period, there is an expectation of a substantial and 
enduring commercial relationship between the two countries. If 
this were to occur, it would represent an historic turning 
point in the bilateral commercial relationship and represent a 
major factor in the overall relationship. The prospective 
development is based on official policy and national interest 
declarations from both the U.S. and Russian leadership, 
projected improvement in the business environment in Russia, 
and a new mechanism for promoting commerce based on private 
sector initiatives in each country.
    However, stated policy and expression of national interest 
would have to be translated into concrete changes in the 
business environment and market access in both countries. 
Improved business environment in Russia requires substantial 
implementation of Putin's institutional reform and introduction 
of market-friendly systems that reduce risk in investment and 
foster competition in trade. U.S. business enterprises look for 
improved corporate governance, a commercial tax system, 
commercial energy development, adherence to bilateral 
commercial treaties and agreements and substantial progress 
toward accession to the WTO. Russian business interests look to 
their American counterparts for reduced trade barriers, such as 
removal of restrictions on most-favored-nation trade, improved 
access to the U.S. market, promotion of commercial development 
of energy production, and development of assistance through a 
favorable official credit policy.
    The tradition of Russian and Soviet trade and investment 
has been high on hopes for substantial increases in commerce 
and low on favorable, enduring results. Severe setbacks, such 
as the default on Russian debt and securities in the 1998 
financial crisis have been characteristic of the past 
commercial relations. Prudence by policymakers requires 
evidence of concrete changes in the bilateral business 
environments and performance. Even with U.S. sponsorship and 
Russian priority for joining the WTO, U.S. policymakers may be 
cautious in assuming that by steps toward accession Russia will 
effectively join the global capital and commercial market and 
develop a new bilateral commercial relationship with the United 
States.
    Notwithstanding these cautions, there are a number of 
reasons to be optimistic about the prospects for the U.S.-
Russian commercial relationship over the next several years. 
First, both the Bush and Putin Administrations have 
demonstrated their commitment to taking business cooperation to 
the next level. Indeed, as a result of recent high-level 
meetings, the two governments are already pursuing practical 
solutions to achieve measurable results. A checklist of issues 
and corresponding time line is being developed, including 
advancing work on Russia's WTO accession, consulting on the 
market economy status for Russia, and exploring new Export-
Import Bank financing programs.
    Second, while in the past West European countries have been 
the major trading partners and promoters of commerce with 
Russia, the new Russian-American business dialogue is designed 
to provide an initiative for development of a major, perhaps 
leading, American commercial relationship with Russia. The 
Russian business community clearly recognizes the advantages of 
developing commercial ties with the United States, which is the 
dominant source of international capital, the world's largest 
market, and a global technology leader. For the U.S. business 
community, Russia, despite the frustrations, remains a market 
of considerable potential, especially beneficial at a time of 
domestic economic downturn in the United States. The new 
Russian-American business dialogue may engender greater 
familiarity and trust between the respective business 
communities opening the way for new joint commercial projects, 
particularly among the small- and medium-sized businesses.
    Third, Russia's economy is growing and offering new market 
opportunities. Russia's economic reform program is only now 
beginning to gain traction, and it is not unreasonable to posit 
that conditions will improve if reforms are expanded and 
implemented.
    On the other hand, expected advancement of U.S.-Russian 
trade and investment may not be forthcoming if past patterns of 
uncertainties and instability of bilateral commercial relations 
return. The path to increased trade and investment is full of 
hurdles. Most notably, Russia's business climate and culture 
still does not yet inspire broad U.S. investor confidence. 
Changing this perception may not be a short term proposition. 
Russia may yet give in to impulses toward economic nationalism 
and protectionism. Trade disagreements, for example, over 
Russian exports of steel to the United States could cloud the 
commercial relationship. Other advanced industrial countries, 
particularly the Europeans, may more aggressively compete for 
the Russian market. Russia's economy remains vulnerable to 
external shocks, such as a significant drop in oil prices and/
or a major global recession, that may impede bilateral 
commercial development.
    Nevertheless, at this time, both governments expect 
progress. At a strategic level, a more robust commercial 
relationship is in the interests of both countries, business 
communities and governments alike. U.S. companies stand to gain 
substantial profit if significant new commercial opportunities 
are realized. For the Governments of Russia and the United 
States, increased bilateral business holds the promise of 
stabilizing the overall bilateral relationship.










RUSSIA AND THE INTERNATIONAL FINANCIAL INSTITUTIONS: FROM SPECIAL CASE 
                          TO A NORMAL COUNTRY



                       By Jonathan E. Sanford \1\

                              ----------                              


                                contents
                                                                   Page

Summary..........................................................   426
Overview.........................................................   427
A Decade of Special Consideration................................   428
    Prelude and overture.........................................   428
        Special association......................................   428
        What is to be done.......................................   428
        The 1992 shadow program..................................   429
    Russia joins the IFIs........................................   431
    IFI operations in Russia.....................................   431
        The IMF..................................................   431
        The World Bank...........................................   432
        The European Bank for Reconstruction and Development 
          (EBRD).................................................   434
    Composition of the IFI assistance programs...................   435
        The IMF..................................................   436
        The EBRD.................................................   437
        The IFC..................................................   438
Five Stages in the Transition from Special Case to Normal Country   439
    Disburse regardless: 1992-1994...............................   440
        Synopsis.................................................   440
        IMF Programs: 1992-1994..................................   441
        World Bank programs: 1992-1994...........................   444
    Disburse with compliance: 1995...............................   445
        Synopsis.................................................   445
        IMF operations: 1995.....................................   445
        World Bank operations in Russia: 1995....................   447
    Disburse despite resistance: 1996-mid 1998...................   447
        Synopsis.................................................   447
        IMF programs: 1996-1998..................................   448
        World Bank programs: 1996-1998...........................   450
    Commit in the face of crisis: 1998...........................   453
        Synopsis.................................................   453
        IMF programs: 1998.......................................   453
        World Bank programs: 1998................................   455
    Reconsideration: 1999-2001...................................   457
        Synopsis.................................................   457
        IMF programs: 1999-2001..................................   457
        World Bank programs: 1999-2001...........................   458
Treating Russia as a Normal Country..............................   459
Concluding Comments..............................................   462
      
---------------------------------------------------------------------------
    \1\ Jonathan E. Sanford is a Specialist in International Political 
Economy in the Foreign Affairs, Trade and Defense Division of the 
Congressional Research Service.
---------------------------------------------------------------------------

                                Summary

    The international financial institutions (IFIs)--the 
International Monetary Fund (IMF), World Bank, and European 
Bank for Reconstruction and Development (EBRD)--provided 
substantial levels of assistance and policy advice to Russia 
during the past 10 years. Between 1992 and 2001, the IMF and 
the multilateral development banks (MDBs) approved programs of 
financial assistance for Russia which totaled altogether about 
$59 billion. Of this, $32.5 billion was disbursed, $24.6 
billion was canceled, and the rest is awaiting disbursement as 
projects are implemented. All of the money lent by the IMF took 
the form of balance-of-payments support tied, to varying 
degrees, to plans for macro-economic and structural reform. For 
the World Bank, over half the money it agreed to lend and 
nearly two-thirds the amount it disbursed went for similar 
purposes. Many of the World Bank's project loans have been slow 
getting underway due to difficulties finding an effective 
policy environment for their implementation. Many of the issues 
which are the focus of these loans--enterprise reform, reform 
in the financial system, corporate governance and the legal 
framework, etc.--are matters on which there remains 
considerable disagreement between reformers and their 
opponents. Most of the assistance from the EBRD and from the 
International Finance Corporation (IFC)--the World Bank's 
private sector aid facility--has gone to strengthen private 
firms and promote growth of the private sector. The EBRD and 
IFC have had less difficulty implementing their projects 
because these are not directed at core policy issues but rather 
at private sector growth.
    Until 1999, with the strong support of the United States 
and other major member countries, the IFIs treated Russia as a 
special case. The standards and guidelines for assistance to 
Russia were more relaxed and flexible than those applied to 
other countries at a similar stage of development Only one non-
member country--the Soviet Union--ever had ``special 
association'' status with the IMF and World Bank and had a 
major program of technical assistance committed for its behalf. 
No other country besides Russia had a shadow program with the 
IMF in place before it became a member. No other group of 
countries--Russia and the other struggling former Communist 
countries--had a special loan account created for them in the 
IMF offering loans with such little conditionality. No other 
country, considering its relative size--a gross domestic 
product (GDP) barely larger than Turkey, smaller than Argentina 
and half the size of Mexico and Brazil--received such a 
disproportionately large amount of money and bulked so large 
upon the agenda of the IFIs. No other country received large 
and increasing loan commitments from the IMF and World Bank at 
the same time that it was failing conspicuously to meet the 
full performance requirements of its earlier loans.
    The IFIs sought through their programs to strengthen the 
hand of the Russian reformers and to promote macro-economic and 
structural reform in Russia. During the early years, the 
establishment of macro-economic stability was the primary goal 
and structural reform--change in the basic way the economy is 
organized and its underlying operational principles--was an 
important but secondary concern. During the latter part of the 
1990s, however, the IFIs put increased emphasis on structural 
reform. In 1999, the IMF and World Bank canceled most of their 
big loan programs for Russia and they shifted their basic 
approach. It appears that dissatisfaction with the slow 
progress Russia was making with many key types of structural 
reform was as great, if not a greater, consideration in 1999 
than was Russia's uncertain macro-economic situation.
    Today, the IFIs and their major member countries 
increasingly view Russia as a ``normal'' country, that is to 
say, a country that does not need special standards and special 
dispensations. As with most middle-income developing countries, 
Russia has major problems and it needs substantial reforms in 
the structure and operating principles for its economy. No 
large programs of balance-of-payments assistance are planned, 
however, and most MDB projects are likely to focus on specific 
projects aimed at improving social conditions, promoting 
institutional reform, or encouraging policy change in specific 
well defined situations. Russia's current macro-economic 
situation is such that it does not need new IFI stabilization 
or structural adjustment loans (SALs). Given its performance 
with structural reform in prior loans--the substantial overhang 
of as-yet unsatisfied commitments--Russia is unlikely to 
qualify for such loans even if it needed them. The size of the 
EBRD and IFC's assistance programs in Russia will likely 
depend, in future years, on the level of interest shown by 
foreign investors and the private sector. The size and focus of 
the IMF and World Bank's future assistance programs in Russia 
will likely depend, by contrast, on the types of reforms the 
Putin government puts into effect.

                                Overview

    There are four principal parts to this paper. The first 
provides an overview of the IFI's operations in Russia. The 
composition of their programs are discussed in some detail. The 
second part discusses the course of events during the 1990s, 
the way the IFIs sought to balance their enforcement of 
conditionality with their desire to provide levels of 
assistance to Russia sufficient to keep the hope and effort 
toward reform underway. The five stages of the process are 
labeled here as follows: disburse regardless, 1992-1994; 
disburse with compliance, 1995; disburse despite resistance, 
1996-1997; commit in the face of crisis, 1998; and 
reconsideration, 1999-2001.
    The third section relates the IFI's views on their 
experience with Russia. As it indicates, the concept that 
Russia is a ``normal'' country does not imply that it is a 
country without major problems. Rather, it is a country whose 
situation is no longer unique and whose problems resemble those 
seen in many other developing countries. The fourth section 
provides some concluding remarks.
    This paper makes extensive use of public documents 
available from the IFIs. It also uses some information obtained 
through interviews.

                   A Decade of Special Consideration

                          prelude and overture

Special association
    Since 1987, under Chairman Gorbachev, the Soviet Government 
had been pursuing--against considerable internal resistance--a 
program aimed at restructuring (perestroika) the Soviet 
economy. In 1990, the Soviet Union was in the midst of a deep 
financial and economic crisis and Gorbachev reached out to the 
West for advice and assistance in dealing with the situation. 
At their summit meeting in Houston, in June 1990, the leaders 
of the G-7 countries commissioned the World Bank, Organization 
for Economic Cooperation and Development (OECD), EBRD, and IMF 
to do a study of the Soviet economy. Issued in early 1991, the 
four agency study recommended a comprehensive program of 
reform. This included the early and comprehensive decontrol of 
prices, restructuring of the financial system, clarification of 
property rights, and commercialization and privatization of 
industry. It also included trade and investment liberalization, 
labor market liberalization, and the creation of an affordable 
social safety net. The West would provide technical and project 
assistance and food aid to help facilitate Soviet economic 
reform.
    On October 5, 1991, the IMF and Soviet Union signed an 
accord giving the U.S.S.R. ``special association'' status with 
the IMF. A similar agreement with the World Bank was signed on 
November 5. Because it was not a member, the Soviet Union could 
not borrow from the two agencies. However, the IMF and World 
Bank agreed to provide technical assistance and advice to help 
the Soviets stabilize their economy, improve their system for 
gathering statistics, reform the banking system, and strengthen 
their social safety net. On August 27, the Bank's executive 
board created a $30 million special trust fund (using some of 
the Bank's net income) to support technical cooperation 
programs in the U.S.S.R. during the next 2 years. Most of the 
funds were reportedly committed late in the year and not spent 
until later. Russia and three other republics eventually signed 
the agreement. Until October, according to IMF sources, the 
Soviet Government insisted that the IFIs deal with and through 
the Soviet Government.\2\ Later, as the handwriting on the wall 
became increasingly clear, the IFIs began direct talks as well 
with Russia and the other republics.
---------------------------------------------------------------------------
    \2\ Interview with John Odling-Smee, Director of the IMF department 
responsible for the former Soviet Union, June 14, 2001. On October 14, 
the IMF Interim Committee said that assistance would be available ``to 
assist the [U.S.S.R.] authorities in moving forward with urgently 
needed economic stabilization and structural reforms.'' IMF Annual 
Report, 1992. Interim Committee Press Communique, October 14, 1991, p. 
126.
---------------------------------------------------------------------------
What is to be done
    On October 28, 1991, President Boris Yeltsin delivered a 
speech to the Russian Congress of Peoples' Deputies and the 
Russian people outlining his plans for radical economic reform 
and the transition from state socialism toward capitalism and a 
market economy. ``I appeal to you at one of the most critical 
moments in Russian history,'' he said. ``Right now it will be 
decided what kind of country Russia will be in the coming years 
and decades.'' At the time, Russia was not yet an independent 
country but the Soviet state was rapidly withering away.
    The central focus of Yeltsin's new economic program was 
stabilization and economic freedom. Strictly speaking, it was 
not to be a ``big bang'' or ``shock therapy'' approach, since 
by intention (and by actual events) its provisions were phased 
in over a period of time. The macro-economic portion of the 
plan was an orthodox stabilization program emphasizing price 
liberalization and strict budgetary policy. Major cuts would be 
made in the budget deficit, state administration, and subsidies 
for enterprises. A fixed exchange rate would be established for 
the ruble, Yeltsin said, and it would be made convertible. 
Restrictions on foreign trade and investment would also be 
lifted. Privatization of small- and medium-sized enterprises 
would be a priority and he hoped that one-half could be 
privatized within 3 months.
    Yeltsin's speech showed the direction in which he wanted 
the economy to move. On many key issues, though, it was vague. 
He said the country's tax system should be put in order, but 
there was no mention of the plummeting rate of tax collections. 
He said there should be more competition and a break-up of 
monopolies, but there was no discussion of corporate governance 
or fundamental change in the structure of state industry. The 
banking system should be reformed, but there was no mention of 
privatization or new systems of regulation. Monetary and credit 
policy should be strictly controlled, but there was no 
indication whether he believed the ruble zone should be 
continued or dissolved or how the Central Bank of the Russian 
Federation (Central Bank of Russia or CBR) would be brought 
under government control. Yeltsin admitted that the process of 
change would be painful and that ``today in the severest crisis 
we cannot carry out reform painlessly.'' Living standards would 
decline and it ``will be worse for everybody for about half a 
year.'' Afterward, though, he said, prices would fall and the 
markets would be full of goods. By fall 1992, he said, ``as I 
promised before the elections, the economy will stabilize and 
people's lives will gradually improve.''
The 1992 shadow program
    Yeltsin called, in his October speech, for the outside 
world to come to Russia's aid. ``We turn officially to the IMF, 
the World Bank, the European Bank for Reconstruction and 
Development and invite them to elaborate detailed plans in 
cooperation and participation in economic reforms. He appealed 
for developed countries and international organizations to 
provide technical assistance and policy recommendations. 
``Russia carries out its reforms in its own interests,'' he 
indicated, ``and not under external pressure. Help from the 
world community can facilitate our movement along this road 
considerably and accelerate the reforms.'' Yeltsin promised the 
West whatever information or collaboration it would desire.
    The same day that Yeltsin spoke, the deputy finance 
ministers of the G-7 countries and representatives of eight 
Soviet republics, including Russia, signed a memorandum of 
understanding (MOU) allowing a moratorium on principal payments 
for Soviet debt owed to the G-7. Under the terms of the MOU, 
the moratorium could not extend beyond March 31, 1992 unless 
the IMF approved a shadow program for Russia.
    It is very rare, if not unprecedented, for the IMF to 
negotiate a shadow program with a country that is not a member 
of the organization. Shadow programs are not unusual. Countries 
may negotiate such arrangements with the IMF when they do not 
need (or could not qualify) for loans but they wanted to 
demonstrate (through IMF endorsement) the basic soundness of 
their economic policies. The shadow program allowed the Russian 
Government to announce a package of economic policies which had 
the IMF's active endorsement. Among other things, this was 
supposed to create some basis for international confidence in 
Russian policy. It was also intended to assure the country's 
creditors that any resources saved through debt relief would 
not be dissipated through bad economic policies. The shadow 
program was not a condition for Russian membership in the IMF. 
However, most people assumed it was a condition for future IMF 
assistance. The G-7 also made it clear, when they announced on 
April 1 their $24 billion assistance package, that Russia 
needed to qualify for a regular IMF standby loan before it 
could gain access to those resources.
    Agreement on the terms of the shadow program had been 
greatly eased by Yeltsin's prior announcement that the road to 
transition for Russia should lead through fundamental reforms 
to a new market-oriented economic system. There might have been 
little room for discussion between the Yeltsin government and 
the IMF if he had advocated some ``third way'' between the 
market and central planning or a more democratic continuation 
of the old system of state economic control. On February 27, 
after discussions with the IMF, the Russian Government 
announced that it was putting a new economic program into 
effect. A few days later, on March 31, the IMF endorsed the MOU 
embodying the government's plan. In many ways, the economic 
blueprint embodied in the shadow program was the first real 
economic plan the government had adopted. It was more specific 
than the government's prior announcements and it addressed a 
number of key issues on which the government had been vague in 
the past.
    Most of the provisions of the shadow program were based, 
however, on plans or policy goals the government had announced 
earlier. It said that inflation would be reduced and the 
government's budget deficit would be cut to 1 percent of GDP, 
mainly through reductions in military spending and subsidies to 
enterprises. The government would adopt a program of targeted 
social subsidies to help the worst off and unemployed. CBR 
monetary and credit policies would be tightened. Most remaining 
price controls on goods and services would be lifted by the end 
of March, except for rents, transport, and domestic gas and 
energy. (The government had removed price controls for most 
products in January.) Domestic oil prices would be freed on 
April 20. The value added tax (VAT) of 28 percent--introduced 
in January but later withdrawn--would be restored and would be 
applied to imports after July 1. A unified regime of export 
taxes on energy and raw materials would be established. A 
progressive tax on pay increases by state firms, which exceeded 
specific norms, would be levied. In June, as promised, the 
Russian Government created a unified exchange rate for the 
ruble, dropping the old system of multiple exchange rates. In 
November 1992, the ruble was made convertible for Russian 
residents' foreign trade transactions.

                         russia joins the ifis

    The Soviet Union never joined the World Bank or the IMF. It 
was a founding member (1991) of the EBRD, but by agreement the 
amount it could borrow from the EBRD was no larger than the 
amount it had contributed. In January 1992, the Bush 
Administration announced that it supported membership by Russia 
and the other former Soviet republics in the IFIs.
    In early May 1992, soon after the IMF had endorsed the 
Russian shadow program, the executive boards of the IMF and 
World Bank invited Russia and the other former Soviet republics 
to join. Russia became a full member of the both institutions 
in June, with seats of its own on their executive boards. It 
received a 3.2 percent quota share in the IMF, making it the 
ninth largest member. It got a 1.82 percent voting share in the 
International Bank for Reconstruction and Development (IBRD), 
the World Bank's near-market-rate loan facility, making it--
along with Brazil--the fourteenth largest member. Russia joined 
the Bank's other affiliates at this time. The amount a country 
may borrow from the IMF is determined by the size of its quota. 
This is not so for the multilateral banks. In early 1992, the 
Soviet Union ceased being a member of the EBRD and the 12 
successor states became members in their own right. (The three 
Baltic states joined in 1991.) Russia got a seat of its own on 
the EBRD board.

                        ifi operations in russia

The IMF
    Between 1992 and 1999, as Figure 1 illustrates, the IMF 
approved six loans to Russia with a total value of SDR (special 
drawing rights) 33.73 billion (about $42.69 billion by the 
current exchange rate). Of this, half (SDR 16.16 billion or 
$20.45 billion) was disbursed. Access to the rest was 
terminated due to non-compliance with loan terms.

                    FIGURE 1._IMF LENDING TO RUSSIA

               [Special drawing rights (SDR) in millions]
[GRAPHIC] [TIFF OMITTED] T6171.049

The World Bank
    Likewise, during the same period, as Figure 2 indicates, 
the World Bank approved loans to Russia totaling $12.21 billion 
from the IBRD. It also approved $412 million in loans or equity 
investments from the IFC, its private sector assistance 
facility, as well as $249 million in guarantees for foreign 
investment through the Multilateral Investment Guarantee Agency 
(MIGA). The IBRD makes loans to government agencies or with 
government repayment guarantees on near-market-rate terms. As 
Figure 3 indicates, more than one-third of the funds approved 
for IBRD loans to Russia have not yet been disbursed. According 
to data provided by the World Bank's office in Moscow, $2.79 
billion of the total was canceled. The remaining $1.75 billion 
is awaiting disbursement as work on the relevant projects or 
programs goes forward. Table 1 lists the projects the IBRD 
approved in Russia in the past decade and the disbursement 
status for each.

            FIGURE 2._WORLD BANK AID TO RUSSIA (COMMITMENTS)

[GRAPHIC] [TIFF OMITTED] T6171.046


     FIGURE 3._IBRD LOANS TO RUSSIA (COMMITMENTS AND DISBURSEMENTS)

[GRAPHIC] [TIFF OMITTED] T6171.047


                                TABLE 1.--WORLD BANK LENDING TO RUSSIA, 1992-2001
                                          [In millions of U.S. dollars]
----------------------------------------------------------------------------------------------------------------
               Date                       Purpose                Status        Commitment  Canceled  Undisbursed
----------------------------------------------------------------------------------------------------------------
8/5/92...........................-----------IMF approves first credit tranche loan------------------------------
----------------------------------------------------------------------------------------------------------------
8/06/92..........................  Rehabilitation 1.....  Closed.............     $600.0   ........        0.0
11/24/92.........................  Employment Services/   Closed.............       70.0      $14.4        0.0
                                    Social Protection.
12/17/92.........................  Privatization          Closed.............       90.0        4.0        0.0
                                    Implementation
                                    Assistance.
6/17/93..........................  Oil Rehabilitation 1.  Closed.............      610.0      196.0        0.0
----------------------------------------------------------------------------------------------------------------
6/30/93..........................  IMF approves Systemic Transformation Facility (STF) loan, releases first
                                                                            tranche
----------------------------------------------------------------------------------------------------------------
2/17/94..........................  Highway                Closed.............      300.0       19.2        0.0
                                    Rehabilitation &
                                    Maintenance.
----------------------------------------------------------------------------------------------------------------
3/22/94..........................          IMF releases second tranche of STF loan
----------------------------------------------------------------------------------------------------------------
5/19/94..........................  Financial              Active.............      200.0       59.5      $66.7
                                    Institutions.
                                    Development.
6/16/94..........................  Ag Reform              Extended...........      240.0      118.2        4.1
                                    Implementation
                                    Support.
6/16/94..........................  Land Reform            Active.............       80.0   ........       41.8
                                    Implementation.
                                    Support.
6/21/94..........................  Enterprise Support     Active.............      200.0   ........      163.1
                                    Project.
6/29/94..........................  Oil Rehabilitation 2.  Closed.............      500.0      153.4        0.0
11/8/94..........................  Environment            Active.............      110.0   ........       55.5
                                    Management Project.
12/15/94.........................  Management and         Closed.............       40.0   ........        0.0
                                    Financial Training.
2/16/95..........................  Portfolio Development  Active.............       40.0   ........       19.0
                                    Project.
3/7/95...........................  Housing..............  Active.............      400.0      150.7       71.5
3/9/95...........................  Tax Administration     Closed.............       16.8        0.1        0.0
                                    Modernization.
----------------------------------------------------------------------------------------------------------------
3/11/95..........................          IMF approves first regular standby loan
----------------------------------------------------------------------------------------------------------------
4/25/95..........................  Emergency Oil Spill    Active.............       99.0   ........        5.2
                                    Rehab/ Mitigation.
5/2/95...........................  Energy Efficiency      Active.............      106.5       36.5       51.0
                                    Project.
5/16/95..........................  Urban Transport......  Active.............      329.0       77.6        4.4
6/6/95...........................  Rehabilitation 2.....  Closed.............      600.0   ........        0.0
11/30/95.........................  Standards Development  Extended...........       24.0   ........        3.7
----------------------------------------------------------------------------------------------------------------
3/26/96..........................  IMF approves first extended fund facility (EFF) loan
----------------------------------------------------------------------------------------------------------------
3/28/96..........................  Bridge Rehabilitation  Active.............      350.0      195.3       30.3
                                    Project.
4/30/96..........................  Community Social       Active.............      200.0       56.5       78.3
                                    Infrastructure.
5/7/96...........................  Enterprise Housing     Active.............      300.0       43.6      215.8
                                    Divestiture.
5/30/96..........................  Capital Market         Active.............       89.0       33.8       35.9
                                    Development Project.
6/4/96...........................  Medical Equipment      Closed.............      270.0       46.5       14.1
                                    Project.
6/13/96..........................  Legal Reform Project.  Active.............       58.0   ........       32.6
6/27/96..........................  Coal Sector            Closed.............      500.0   ........        0.0
                                    Adjustment 1.
6/27/96..........................  Coal Sector            Active.............       25.0   ........        8.8
                                    Restructure
                                    Implement Asst.
3/27/97..........................  St Petersburg City     Active.............       31.0   ........        7.5
                                    Ctr Rehabilitation.
6/5/97...........................  Education Innovation.  Active.............       71.0        3.0       57.6
6/5/97...........................  Health Reform Pilot    Active.............       66.0   ........       49.6
                                    Project.
6/5/97...........................  Bureau of Economic     Active.............       22.6   ........        6.8
                                    Analysis Project.
6/5/97...........................  Enterprise             Closed.............       85.0       85.0        0.0
                                    Restructuring
                                    Services Project.
6/5/97...........................  Structural Adjustment  Closed.............      600.0   ........        0.0
                                    Loan (SAL) 1.
6/5/97...........................  Electricity Sector     Active.............       40.0   ........       37.9
                                    Reform Support
                                    Project.
6/25/97..........................  Social Protection      Closed.............      800.0   ........        0.0
                                    Adjustment Loan
                                    (SPAL).
10/7/97..........................  Social Protection      Active.............       28.6   ........       18.0
                                    Implementation
                                    Project.
12/18/97.........................  Coal Sector            Active.............      800.0   ........      150.0
                                    Adjustment Loan 2.
12/18/97.........................  SAL2.................  Closed.............      800.0   ........        0.0
----------------------------------------------------------------------------------------------------------------
7/20/98..........................  IMF approves second EFF loan and Compensatory and Contingency Financing
                                                               Facility (CCFF) loan
----------------------------------------------------------------------------------------------------------------
8/6/98...........................  SAL3.................  Closed.............    1,500.0    1,100.0        0.0
12/22/98.........................  Highway                Closed.............      400.0      400.0        0.0
                                    Rehabilitation &
                                    Maintenance 2.
5/13/99..........................  State Statistical      Active.............       30.0   ........       29.0
                                    System Development.
----------------------------------------------------------------------------------------------------------------
7/28/99..........................                 IMF approves second standby loan
----------------------------------------------------------------------------------------------------------------
12/22/99.........................  Regional Fiscal TA     Active.............       30.0   ........       28.0
                                    Project.
5/23/00..........................  Sustainable Forestry   Active.............       60.0   ........        NYE
                                    Project.
12/21/00.........................  Water Supply and       Active.............      122.5   ........        NYE
                                    Sanitation Project.
2/6/01...........................  Moscow Urban           Active.............       60.0   ........        NYE
                                    Transport Project.
3/27/01..........................  Municipal Heating      Active.............       85.0   ........        NYE
                                    Project.
5/24/01..........................  Education Reform       Active.............       50.0   ........        NYE
                                    Project.
6/7/01...........................  Northern               Active.............       80.0   ........        NYE
                                    Restructuring Pilot
                                    Project.
----------------------------------------------------------------------------------------------------------------
                                   Not Yet Effective. Loan approved by executive board but final contract is not
                                                                        yet signed.
----------------------------------------------------------------------------------------------------------------


    The IFC makes loans to and equity investments in firms in 
developing countries in order to promote growth and strengthen 
the private sector. It also provides technical assistance and 
other forms of operational advice. It does not require 
government guarantees, and it charges essentially market rates 
for its aid. At some point, when a firm has grown and its stock 
has appreciated in value, the IFC will sell it shares. If the 
IFC is an investment bank, the MIGA is an insurance company. It 
guarantees investors, for a fee, against various types of non-
economic risk, such as expropriation, restrictions on 
international currency transfer, and damage from war or civil 
strife.
The European Bank for Reconstruction and Development (EBRD)
    The EBRD reports that, between 1991 and 2000, it approved 
loans or equity investments for Russia totaling =3.41 billion 
(about $4.43 billion according to the dollar/euro exchange rate 
for 1995 and $2.79 billion according to the rate for 2000). Of 
this amount, about =733 million is awaiting disbursement and a 
major portion of the balance appears already to have been 
repaid. The EBRD charges commercial or near-commercial rates 
for its loans and does not require government guarantees. The 
current official figures are somewhat at variance with data 
taken from the EBRD annual reports. When aggregated, the annual 
figures show that the EBRD approved =4.32 billion in assistance 
to Russia (about $5.61 billion by the 1995 exchange rate and 
$3.97 billion by the 2000 rate). The difference between this 
and the total published by the EBRD is probably explained by 
cancellations or by funds which were not needed for the 
completion of approved projects. It is impossible to determine 
the years to which the difference should be assigned. Figure 4 
shows the annual amounts the EBRD approved for Russia during 
the 1990s.

   FIGURE 4._EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT (EBRD) 
                          ASSISTANCE TO RUSSIA

                         [In millions of euros]

[GRAPHIC] [TIFF OMITTED] T6171.048


               composition of the ifi assistance programs

    Most of the programs the IMF and World Bank supported in 
Russia during the past decade sought to promote macro-economic 
stability and structural reform. All of the IMF's loans have 
supported these goals and provided balance-of-payments support. 
The IMF does not fund projects. For the World Bank, in terms of 
the number of loans, most of those for Russia went for 
investment projects or programs of technical assistance and 
institutional reform. In terms of the amounts of money lent 
overall, however, most of the Bank's assistance to Russia took 
the form of balance-of-payments support aimed at promoting 
broad-based reform in Russia's economic policies and the 
structure of its economy. Figure 5 shows that between 1992 and 
2001, over half the funds IBRD committed and nearly 65 percent 
the funds it disbursed went to these ``big picture'' loans. 
Loans to strengthen the oil and gas industry (a major source of 
exports and tax revenue) comprised another 10 percent of the 
approvals and 11 percent of disbursements. Loans promoting 
change in the organization and operations of industry, the 
financial sector, the housing market, agriculture and land 
ownership, and technical procedures accounted for about 16 
percent of commitments and 10 percent of disbursements.

                     FIGURE 5._IBRD LOANS TO RUSSIA

[GRAPHIC] [TIFF OMITTED] T6171.050


    For most active World Bank projects, a large part of the 
undisbursed balance will be paid out eventually as 
implementation proceeded. By contrast, most of the ``big 
picture'' adjustment loans approved in the past decade were 
fast disbursing, the proceeds being made to the borrower as 
each loan allotment or tranche became effective. Bank-funded 
investment projects may take 8 to 10 years for full completion. 
The proceeds from the loan are gradually disbursed as work on 
the project is completed and the bills from contractors or 
suppliers are received. Most disbursements occur during the 
middle years of that period. It is worth noting, though, that 
many of the projects for Russia approved in the early 1990s--
for example, the loans for financial institutions development, 
land reform, enterprise support, environmental management, and 
housing in 1994--have used only a small portion of the amounts 
originally approved. In several cases, a large portion of the 
loan commitment was later canceled due to changes in context or 
problems in implementation. In some cases, it seems the Bank is 
still waiting for the government to take steps or to implement 
policies which it endorsed in the original loan agreement. In 
some instances, it appears that necessary legislation has not 
yet been passed making it eligible for release.
    The IMF's programs generally specified the overall goals 
and priorities for macro-economic and structural reform in 
Russia. The Bank's adjustment loans often reinforced those 
objectives and sought to apply them in particular areas. Many 
of the Bank's projects loans also addressed issues of 
particular concern. These included, in addition to enterprise 
reform, privatization, and capital markets development, other 
concerns such as agricultural reform and improvements in tax, 
legal, and technical systems. The World Bank had considerable 
difficulty implementing many of these loans. (See the amounts 
canceled or not yet disbursed on Table 1.) This reflects the 
problems the IFIs have encountered generally in their efforts 
to promote structural reform in Russia.
The IMF
    The principal goals of the IMF's programs in Russia 
included fiscal reform (controlling expenditures, increasing 
tax collections, reducing the budget deficit), monetary 
stabilization (reducing the rate of inflation), and a series of 
structural reforms (for instance, accelerating privatization, 
restructuring the banking and finance systems and corporate 
governance, and implementing legal reform). The Bank's 
adjustment programs in Russia had similar goals.
    Stabilization and adjustment loans provide a direct 
infusion of foreign exchange. This helps bolster a country's 
balance of payments, relieving pressure and potentially 
promoting growth. However, this is only a temporary effect. The 
underlying concept behind these loans is the expectation that a 
borrower country can improve its economic situation only if it 
makes basic changes in its macro-economic policies and it 
adopts structural reforms to enhance the efficiency and 
productivity of its economy. In effect, a country cannot reach 
its goals unless it is willing to change its course. Generally, 
the key government authorities in the borrower country want to 
make these changes (that is, they have some degree of 
``ownership'' of the project plan.) However, they often face 
stiff resistance from other power centers in their country's 
decisionmaking system. Some of the proceeds from the loan are 
available right away. The remainder is available only when the 
borrower country achieves certain pre-set reforms or 
performance standards. Such conditionality meets both the 
lender and the borrower's needs. The lender knows that the 
agreed goals of the program are being achieved and the borrower 
knows in advance that it will receive access to additional 
funds if it does certain specified things. Among other things, 
this presumably helps to strengthen the hand of the reformers 
in their country's internal policy debates.
The EBRD
    By contrast with the programs supported by the IMF and 
IBRD, most of the assistance provided to Russia by the EBRD, 
IFC, and MIGA has sought to encourage the growth of the private 
sector and to strengthen private firms. According to data 
provided by the EBRD, less than 18 percent of the funds 
committed through June 30, 2001 for Russia went to state 
institutions.\3\ This includes 8 loans to firms predominantly 
owned by government and three to government agencies. It also 
appears to include loans to firms which have been privatized 
but where (for example, many natural monopolies) the government 
still own a significant share of the stock.
---------------------------------------------------------------------------
    \3\ EBRD signed projects in Russia (table) as of 30 June 2001. 
Available from the EBRD Web site at http://www.ebrd.org/english/opera/
country/rusproj.htm under the general heading ``EBRD signed projects in 
Azerbaijan.''
---------------------------------------------------------------------------
    Initially, the EBRD put strong emphasis on technical 
assistance in connection with its loans and investments. By 
late 1993, though, it had shifted its attention mainly to 
projects. The EBRD began its operations in Russia expecting to 
finance projects throughout the Federation. However, with 
experience, it shifted plans and consciously focused much of 
its assistance to regions more open to reform and foreign 
investment. It has also limited the scope of its activities to 
areas where it believed it has a comparative advantage.
    Figure 6 shows (without regard to public or private 
ownership) the sectors of the Russian economy that received 
EBRD assistance. The finance sector got the largest share (29 
percent). The EBRD put much effort into strengthening Russian 
banks, finance and insurance companies and in facilitating new 
entries (mostly foreign) in this area.

                 FIGURE 6._THE EBRD'S RUSSIAN PORTFOLIO

[GRAPHIC] [TIFF OMITTED] T6171.045


    Major shares have also gone to the oil and gas sector (19 
percent) and manufacturing (19 percent). The latter includes 
privatization, food, and agro-industry. Most of the EBRD's 
approvals for oil and gas production took place in the first 
half of the decade, when Russia's balance-of-payments situation 
was very tight. Most of the EBRD's loans or equity investments 
in manufacturing were approved after 1995. All loans for mining 
were aimed at the extraction and production of metals. None 
were made for coal. The EBRD did not specify the sector for 
several loans it had approved for Russia.
    The EBRD manages a Russia Small Business Fund which 
provides funding to small and medium size enterprises in 
Russia. The loans are entirely private sector, with no 
government guarantees or guidance, and are implemented through 
the private banking system. The fund is supported by the G-7 
countries, by the EU, and by Switzerland, with an overall 
capitalization of $300 million. Of this, $50 million is set 
aside for technical assistance. Since inception, the Fund has 
disbursed $431 million through 36,720 loans.
    The EBRD also has a special Legal Transition Program which 
provides policy and technical assistance to improve the legal 
and regulatory environment for commerce. The EBRD says that it 
has been very successful in generating proposals for regulating 
legal entities and for reforming markets and many of its 
initiatives have been adopted. It is also focusing increasingly 
on issues involving corporate governance.
The IFC
    The IFC began its work in Russia in 1991, focusing on the 
privatization of state-owned firms and farms near Nizhny 
Novgorod. At the request of Russian authorities, it prepared a 
manual on privatization, based on its experience with small-
scale privatization in that city, for use elsewhere in the 
country. This led, the IFC reported, to the privatization of 
some 80 percent of the small enterprises in the country It also 
says it helped with the sale of 1,100 medium and large 
enterprises as well as the privatization of the trucking 
industry in many parts of the country. The IFC says that its 
land privatization and farm reorganization program had helped 
several hundred state and collective farms distribute land and 
property to their members.
    In June 2000, the IFC's portfolio in Russia consisted of 
$194 million in loans and $117 million in equity investments. 
Manufacturing accounted for 55 percent of the total, followed 
by financial markets (21 percent), oil and gas (10 percent), 
and other activities (14 percent) (Figure 7). The financial 
crisis of 1998 seriously undermined many of the IFC's 
investments in Russia, particularly those in the banking and 
financial services sectors. By January 2001, however, the IFC 
had strengthened its portfolio in Russia by restructuring two 
large problem projects and writing down the value of several 
others.

                 FIGURE 7._THE IFC'S RUSSIAN PORTFOLIO

[GRAPHIC] [TIFF OMITTED] T6171.044


   Five Stages in the Transition from Special Case to Normal Country

    During the past decade, the EBRD, IFC, and MIGA have 
expanded the size of their operations in Russia as conditions 
permitted. Except perhaps for special effort to identify good 
project opportunities in Russia, these three agencies did not 
treat Russia as a special case and they did not change their 
standards or orientation as conditions changed. Their 
activities have focused on the private sector. Funds have been 
committed and disbursed for projects which the international 
agencies believed had substantial prospects for growth. For the 
most part, the level and scope of the three agencies reflect 
the changing attitudes of domestic and foreign investors in 
Russia. Total commitments grew rapidly in the first half of the 
decade, peaking in 1997. They fell rapidly in 1998, however, as 
the prelude to the August financial crisis and the crisis 
itself--with default on foreign debts and a major devaluation 
of the Russian currency--caused a major shift in commercial 
conditions and investor attitudes. Since the crisis, the EBRD, 
IFC, and MIGA have considerably reduced the size of their 
operations in Russia. Most observers agree, however, that as 
conditions stabilize in that country commercial prospects will 
improve and the volume of activity for the three agencies will 
increase.
    By contrast, the operations of the IMF and World Bank in 
Russia have been attuned much more acutely to the policy 
environment. The Fund and Bank have worked much more closely 
with the Russian Government in the design and implementation of 
macro-economic and structural policy change. In some ways, 
their programs in Russia have been both counter- and pro-
cyclical. When things were becoming difficult in Russia, it 
seems, the IMF lent money to try to counter the undesirable 
trend. Then, when things seemed to be going better in Russia, 
the IMF lent more money to try to encourage the desirable 
trend.
    When the economic situation was most precarious early in 
the decade, the IMF and World Bank lent substantial sums. The 
conditions for their loans during the first several years were 
relatively easy and they seem to have disbursed with limited 
regard to whether the Russians were complying with 
conditionality. In mid-decade, as prospects seemed to improve, 
the IMF and World Bank lent larger amounts in order to 
consolidate and accelerate the reform process. In 1995, the IMF 
and World Bank increased their assistance, their attention to 
compliance was more strict, and Russia met most of the loan 
terms. The IMF and World Bank continued to lend substantial 
sums during the next 3 years. However, they again seemed to be 
operating counter-cyclically. They disbursed funds even as the 
economic situation was becoming increasingly questionable and 
compliance with conditionality was incomplete. After the 
financial crisis of 1998, the IMF and World Bank seem to have 
reconsidered their approach to Russia. Except for project 
loans, they canceled all their outstanding loan commitments and 
they pared back the scope of their operations. In the future, 
the IMF and World Bank say they will treat Russia the same way 
they treat other large middle-income developing countries. As 
such, they will likely be reluctant to put large sums into 
Russia mainly to encourage the transition process and they will 
likely be more rigorous in their requirements for future loans.

                     disburse regardless: 1992-1994

Synopsis
    Between 1992 and 1994, the IMF and World Bank seem to have 
disbursed funds to Russia with few restrictions and little 
serious conditionality. During these 3 years, the IFIs 
committed themselves to lend $7.73 billion to Russia--$4 
billion from the IMF, $2.64 billion from the World Bank (of 
which $1.96 billion is from IBRD and $680 million is from the 
IFC), and $1.09 billion from the EBRD. Of this, $5.71 billion 
was disbursed almost right away--$4 billion by the IMF and 
$1.71 billion by the World Bank. Many of the conditions which 
the IMF and World Bank attached to their loans for Russia 
during these years were not very rigorous or demanding. Those 
for the World Bank were easily met and the IMF seemed to have 
disbursed without strict attention to Russia's performance vis-
a-vis the standards in its loan agreements. On some occasions, 
the targets were changed or performance standards were adjusted 
in order to permit disbursement to continue.
IMF programs: 1992-1994
    In 1992, the World Bank and IMF were under considerable 
pressure from the Bush Administration and other major 
governments to begin lending in order to stimulate the 
transition process and strengthen the hand of the Russian 
reformers. This put the IFIs in a difficult spot. It was 
increasingly clear that Russia could not qualify for regular 
IMF or IBRD loans. Russia's macro-economic situation was 
deteriorating. It was not in compliance with the modest goals 
of the shadow program. In mid-1992, the Yeltsin government 
pulled back from its program of reform in the face of strong 
opposition. Key members of the reform team were sacked, to 
assuage the opposition and maintain some headway on reform. The 
new president of the Central Bank of Russia, Viktor 
Gerashchenko, appointed in mid-1992, turned out to have 
theories of monetary policy which led him to flood Russia and 
other members of the ruble zone with cheap credit. This boosted 
inflation and lessened the pressure that market forces might 
have exerted toward enterprise reform.
    Nevertheless, on August 5, 1992, the IMF approved a SDR 719 
billion ($1 billion) first credit tranche loan to Russia. The 
amount countries can borrow from the IMF is a multiple of their 
quota. Russia's quota in the IMF, at the time of its joining, 
was SDR 2.96 billion (then about $4.3 billion). As countries 
move into the higher credit tranches, the conditions for access 
to IMF funds and the performance criteria for disbursement 
become increasingly stringent. This loan was not unprecedented. 
Most countries will want to borrow more than the first credit 
tranche can provide. However, some have limited their requests 
to this level. By borrowing only the amount allowed for a first 
credit tranche loan, countries need to meet only modest 
requirements for conditionality and they do not need to 
demonstrate compliance in order to receive loan disbursements. 
Even so, in the case of Russia, the negotiations for the first 
tranche loan dragged. To facilitate agreement, the Managing 
Director of the IMF, Michel Camdessus, flew to Moscow just 
before the start of the G-7 Summit Meeting in Munich in early 
July.\4\ The proceeds from the loan were made available right 
away. Russia agreed to reduce its budget deficit from 17 
percent to 5 percent, but disbursement was not dependant on its 
achievement of this goal. This was less stringent than the 1 
percent target in the shadow program. Russia also agreed to 
reduce its monthly inflation rate from 15 to 20 percent to 10 
percent.\5\
---------------------------------------------------------------------------
    \4\ For the IMF's statement on the loan, see its press release 
number 92/60 dated August 5, 1992.
    \5\ For a detailed chronology of IMF loan programs in Russia from 
1992 to 1999, see: U.S. General Accounting Office. International 
Monetary Fund: Approach Used to Establish and Monitory Conditions for 
Financial Assistance. Report to Congress NSIAD-99-168, June 1999, pp. 
136-158. It provides a detailed summary of the goals of each program, 
Russian compliance, and actions taken by the IMF executive board. For a 
detailed review of the assistance programs in Russia sponsored by the 
IFIs, United States, and Europeans, see U.S. General Accounting Office. 
International Efforts to Aid Russia's Transition Have Had Mixed 
Results. GAO-01-8, November 2000.
---------------------------------------------------------------------------
    It was not intended that the IMF's first tranche agreement 
with Russia would cause the G-7 countries to release the $24 
billion aid program they had announced. Officially, the $24 
billion assistance package--and the $6 billion ruble 
stabilization fund which it contained--would be available only 
after Russia successfully negotiated a regular standby loan 
program with the IMF. Russia drew down the resources for the 
first credit loan by the end of 1992 and added them to its 
reserves. Russia's budget deficit and inflation rate did not 
shrink as planned, however, and Russia was almost immediately 
out of compliance with the terms of its first IMF loan. This 
severely constrained its eligibility for future IMF loans.
    The IMF noted, in early 1993, that the economic problems 
confronting Russia were comparable to those faced by Japan and 
Germany after 1945.\6\ Russia's need for external assistance 
was also comparable. ``Equally important,'' the IMF reported, 
however, ``Russia must be willing and able to pursue economic 
policies that ensure that the external assistance has the 
desired effects.'' In particular, these included ``measures to 
achieve macro-economic stability and rapid progress on a wide 
range of systemic reforms.'' Success in those areas, it said, 
would ``create the conditions in which market mechanisms will 
eventually grow.''
---------------------------------------------------------------------------
    \6\ John Odling-Smee and Henri Lorie. The Economic Reform Process 
in Russia. WP/93/55-EA, July 1, 1993. Odling-Smee heads the office at 
the IMF responsible for Russia. The report seems to have been prepared 
for presentation to the IMF executive board earlier in the year.
---------------------------------------------------------------------------
    The IMF continued to resist pressure from its major member 
countries for expanded assistance for Russia. Russia was not in 
compliance with the goals of the first tranche loan and there 
were doubts at the time that Russia would be able to comply 
with any meaningful conditions the IMF placed on future loans. 
The IMF also was reluctant to set a precedent where the normal 
rules and standards governing lending were openly waived in the 
case of emergencies affecting ``important'' countries. Fund 
management worried that other large developing countries would 
claim that they too were ``important'' and they too faced 
crucial emergencies.
    The G-7 found a way around this problem. During their 
meeting in Tokyo on April 14 and 15, 1993, the deputy finance 
ministers of the G-7 countries announced that a new IMF loan 
facility--the Systemic Transformation Facility (STF)--would be 
established.\7\ The STF was a response to the concern, as the 
G-7 carefully put it, that the IMF's regular loan 
conditionality did not provide enough flexibility for a 
positive response to the borrowing needs of Russia and other 
formerly socialist states. Though designed originally to 
benefit the Soviet successor states, eligibility was broadened 
to include other non-market economies (Albania, for example) as 
well.
---------------------------------------------------------------------------
    \7\ Tokyo Summit Economic Declaration: A Strengthened Commitment to 
Jobs and Growth. Tokyo, July 9, 1993. The G-7 urged the international 
agencies, in the strongest possible terms, to provide more assistance 
to Russian. Available from http://www.g7.utoronto.ca/g7/summit/
1993tokyo/communique/job.html.
---------------------------------------------------------------------------
    The STF provided quick-disbursing loans to facilitate 
stabilization during the early stages of the transition 
process. The eligibility criteria were vague. Countries could 
borrow if they were experiencing ``severe disruptions in their 
trade and payments due to a shift in world market pricing.'' 
The conditions for access to STF loans were also easier than 
those for regular loans. Countries had to demonstrate that they 
were trying to solve their balance-of-payments problems and 
curb inflation and they had to submit a written statement 
describing the goals of their reform program and the steps they 
planned to take to attain those goals. The proceeds would be 
disbursed in two tranches--the first immediately and the second 
within 6 to 12 months.
    On June 30, 1993, the IMF executive board approved an SDR 
2.156 billion ($3 billion) loan to Russia from the STF. The 
first tranche--SDR 1.078 billion ($1.5 billion)--was disbursed 
right away. Conditions seemed to be improving in Russia at the 
time. In December 1992, Yeltsin had won a referendum and this 
gave the reformers some political clout to cut spending. In May 
1993, the Russian Finance Ministry and CBR reached an agreement 
aimed at reducing the rate of inflation. Steps were also afoot 
to tighten the ruble zone. The CBR told other countries they 
must either leave the ruble zone or allow the Russian 
Government tight control over their monetary policies.
    The Russian Government agreed, under terms of the STF 
agreement, that it would reduce its budget deficit to 5 percent 
of GDP and its monthly inflation rate to a ``low single-digit 
level.'' These were, in effect, the unmet goals of the 1992 
shadow program and the first tranche loan. The government and 
CBR promised not to make loans to clear inter-enterprise 
payment arrears. The government also agreed to accelerate 
reform in the areas of foreign trade, privatization, and the 
legal framework.
    In March 1994, when the time came to release the second 
half of the STF loan, Russia was not in compliance. 
Nevertheless, Camdessus and Prime Minister Chernomyrdin reached 
agreement on terms for releasing the second tranche of the STF 
loan. Reportedly, Camdessus overruled his staff, which was his 
prerogative. He had strong backing from six of the G-7 
governments, including the United States. The Russians agreed 
they would take strong action to implement the planned macro-
economic and structural reforms. The inflation rate would be 
lowered to 7 percent monthly by the end of the year. The IMF 
relaxed (from 5 percent to 7 percent of GDP) the target for 
reducing the budget deficit. The government promised to improve 
its supervision of commercial banks, to establish a budgetary 
system devolving responsibilities to the regions, and to 
continue privatization. It also promised that, by July, shares 
would be auctioned for cash rather than vouchers and new 
commercial rules would be announced.
    In December 1994, Camdessus outlined the Fund's views on 
the transition process in a speech before an economics meeting 
in Madrid.\8\ Gradualism was not an effective strategy for the 
transition to market economies, he said. Rather, rapid movement 
to liberalization, stabilization and structural reform was 
needed and those countries that moved furthest would come out 
best. Nevertheless, he acknowledged, the achievement of 
structural reforms would take a number of years and the 
transition process would have to take place within an imperfect 
framework. ``The market economy must, as it were,'' he said, 
``move into a house that is still under construction.''
---------------------------------------------------------------------------
    \8\ Michel Camdessus. ``Supporting Transition in Central and 
Eastern Europe: An Assessment and Lessons from the IMF's Five Years' 
Experience.'' Second Annual Francisco Fernandez Ordoez Address, Madrid, 
December 21, 1993. IMF document 95/2.
---------------------------------------------------------------------------
    The following March, Camdessus made another speech, 
expressing the view that Russia's transformation effort had 
reached a turning point. Progress to date on structural reform 
and macro-economic stabilization had been less than 
disappointing, he admitted.\9\ However, he said he had 
confidence that the Russian authorities would move vigorously 
in 1995 to reverse that trend.
---------------------------------------------------------------------------
    \9\ Michel Camdessus. ``Russia's Transformation Efforts at a 
Turning Point.'' Address to a Conference of the U.S.-Russia Business 
Council, Washington, DC, March 29, 1995. IMF document 95/5.
---------------------------------------------------------------------------
World Bank programs: 1992-1994
    The World Bank's first country assistance strategy (CAS) 
for Russia, approved by the executive board in 1993, specified 
that three areas should be given special emphasis in the Bank's 
loan program.\10\ Programs to promote private sector 
development, privatization and enterprise reform should be 
given high priority. Strong emphasis should be accorded to 
policy reform and the development of an agreed framework with 
the Russian Government into which future operations could be 
fitted. Finally, the 1993 CAS said that the Bank should work 
with the Russian authorities to develop programs that would 
help protect the most vulnerable members of society from the 
full pain of the transition process. These were all key 
structural reform included in the IMF loan programs approved 
during these years.
---------------------------------------------------------------------------
    \10\ The World Bank was unable to provide a copy of the 1993 CAS 
for Russia. The summary reported here is based on statements in press 
releases and other Bank documents issued between 1993 and 1997.
---------------------------------------------------------------------------
    Despite the terms of the CAS, most of the funds the World 
Bank lent to Russia during this period went for balance-of-
payments support or to increase oil production and oil exports. 
The day after the IMF made its first loan to Russia, the World 
Bank approved a $600 million loan to ease Russia's balance-of-
payments difficulties by financing needed imports. To qualify 
for disbursement, Russia merely had to demonstrate that $350 
million from the loan would be used for humanitarian imports 
and the other $250 million for imports needed by the private 
sector. In June 1993, the World Bank approved a $610 million 
loan for Russia to help rehabilitate its oil industry. A 
similar $500 million loan was approved in June 1994.
    All but $160 million of the $1.33 billion in project 
assistance the World Bank agreed to provide Russia at this time 
was approved about the time the second STF tranche was released 
in 1994. Of this, $810 million sought to encourage enterprise 
reform, privatization, agricultural reform, land reform, and 
the development of financial markets. Many of these loans, 
however, ran into serious difficulties and many of the funds 
were not disbursed. One loan in 1992 sought to alleviate social 
needs through the establishment of unemployment insurance and 
employment services. It also encountered problems with 
implementation. A $300 million loan for highway maintenance and 
rehabilitation, however, was completed without major delay. In 
late 1994, the Bank approved two other modest-sized loans. One 
for management and financial training was fully implemented but 
another for environmental management ran into serious problems 
and remains only half disbursed.

                     disburse with compliance: 1995

Synopsis
    In 1995, the IFIs disbursed substantial sums to Russia and 
Russia substantially complied with their loan conditionality. 
In 1995, the IFIs approved loans for Russia totaling nearly 
$9.5 billion. Of this, $6.8 billion came from the IMF, $1.62 
billion from the IBRD, World Bank, and $1.06 billion from the 
EBRD. Of this, $7.4 billion was disbursed, including all the 
funds committed by the IMF and $600 million fast disbursing 
assistance approved by the World Bank. The international 
agencies believed, at the time, that Russia had turned a corner 
and that economic growth would soon follow. Russia met most of 
the requirements of the 1995 IMF standby loan. In the blush of 
success following the perceived success of that program, the 
IMF approved a $10 billion loan for Russia in February 1996. 
That loan (discussed in the next section) was much less 
successful. During 1995, the IFC approved $65 million and the 
EBRD approved $1.06 billion in assistance to Russian firms.
IMF operations: 1995
    On April 11, 1999, the IMF executive board approved an SDR 
4.31 billion (then about $6.8 billion) standby loan of for 
Russia, a 12 month program. The IMF noted in its announcement 
that Russia's economic performance in 1994 was 
``disappointing.'' Efforts to reduce the budget deficit and 
inflation rate were ``significantly off track'' and the target 
for accumulating new foreign reserves was missed ``by a wide 
margin.'' In fact, the budget deficit and inflation rate were 
twice the levels anticipated by the STF second tranche 
agreement. The IMF noted that the CBR had tightened monetary 
policy in late 1994 and early 1995, but it said this would not 
be sustainable unless major improvements were made in fiscal 
policy. In a very unusual step, the IMF specified that Russia's 
progress under the new loan plan would be monitored monthly and 
funds would be disbursed only with the consent of the IMF 
executive board.
    The goals of the new standby loan echoed those earlier 
plans. Inflation was to be reduced to 1 percent monthly by the 
end of 1995. Credit and monetary policy would be tightened 
further and the government's budget deficit would be reduced to 
6 percent of GDP. The government promised to use non-
inflationary sources of financing in the future to cover the 
deficit. In 1994, Russia's real GDP declined by 15 percent. The 
new plan hoped to cut the decline to 9 percent in 1995.
    The government also pledged to make a major effort to 
accelerate action on a wide range of structural reforms. 
Prominent were measures to liberalize the trade regime and oil 
sector. In particular, the restrictions on oil exports would be 
abolished. The government and CBR promised once again that they 
would not extend credits or loans to clear inter-enterprise 
debts. The government would find other means of resolving those 
pressures and breaking up the logjam hampering the mutual 
settlement of debts which Russian firms owed to one another. 
The government promised to continue cleaning up non-performing 
centralized credits and to more tightly monitor the financial 
situation of banks. It also promised to accelerate the process 
of land reform and to increase the efficiency of its social 
spending programs.
    In March 1996, the IMF announced that it was very pleased 
with the success of the 1995 loan. Reflecting the high hopes it 
then had for the future, the IMF executive board approved a new 
SDR 6.9 billion (about $10 billion) loan for Russia. 
Disbursements would take place over a 3 year period (1996-1998) 
and the repayments would stretch over a decade. This was the 
largest extended fund facility (EFF) loan the IMF had ever made 
and the second largest overall. The largest was the SDR 12.1 
billion loan to Mexico approved in February 1995. After Mexico 
made an early repayment on that loan, Russia became the IMF's 
largest borrower, accounting for nearly one-fourth of the IMF 
loans and credits outstanding at the end of July 1996. Russia's 
compliance with the EFF loan is discussed in the next section 
of this paper.
    The IMF reported that Russia's performance the previous 
year under the 1995 loan program had been quite satisfactory. 
Inflation had fallen to low single digit monthly rates by the 
end of 1995, the IMF reported. Signs of industrial recovery 
were visible. Real GDP remained nearly stable, shrinking only 4 
percent in 1995 (not the 9 percent anticipated.). The IMF noted 
that Russia's balance-of-payments surplus (current account) had 
widened from $3.4 billion in 1994 to $4.7 billion in 1995. 
Moreover, it said, the establishment of an exchange rate 
``corridor'' for the ruble had helped stabilize exchange rate 
perceptions and was ``generally judged to have been a 
success.'' On the structural front, the IMF acknowledged that 
Russia's performance was more uneven. The process of 
restructuring the banking sector was slow and the pace and 
scale of privatization was below expectations. Nevertheless, it 
concluded, Russia's overall progress had been significant. 
Stanley Fischer observed in June 2001 \11\ that Russia's 
compliance with the terms of the 1995 standby were 
``exemplary'' and ``for 9 of the 12 months Russia essentially 
met all the conditions.'' Previously an economic professor at 
MIT, Fischer had become First Deputy Managing Director of the 
Fund in September 1994. He became acting Managing Director of 
the IMF in early 2000.
---------------------------------------------------------------------------
    \11\ Stanley Fischer. The Russian Economy: Prospects and 
Retrospect. Speech at the Higher School of Economics, Moscow. June 19, 
2001. Available from the IMF Web site.
---------------------------------------------------------------------------
    In a paper published in early 1996, Fischer wrote \12\ that 
1995 had been the key stabilization point for the Russian 
economy. According to his research, he said, growth usually 
occurs 2 years after the stabilization point is reached. 
However, he cautioned in the 1996 paper, governments must 
continue pursuing stabilization policies and structural reforms 
if growth is to continue. Establishing a pegged exchange rate 
for the currency was helpful, once stabilization had occurred, 
he said, but the situation was not sustainable without prudent 
government policy and further cuts in the fiscal deficit. In 
July 1995, Fischer noted with approval the Russian Government's 
decision to institute an exchange rate system where the value 
of the ruble would be kept within a certain range in relation 
to the dollar.\13\ He observed later, however, in his June 2001 
retrospective on the IMF's programs in Russia, that ``the 1995 
loan was very successful, but it did put in place the crawling 
band exchange rate that was a source of trouble in the 
future.''
---------------------------------------------------------------------------
    \12\ Stanley Fischer, Ratna Sahay and Carlos A. Vegh. 
``Stabilization and Growth in Transition Economies: the Early 
Experience.'' Journal of Economic Perspectives, 10:2 (Spring 1996), pp. 
45-66.
    \13\ IMF Management Welcomes Economic Progress Made by Russia; 
Exchange Rate Action Designed to Support Program. News Brief 95/17, 
July 6, 1995. Quotes positive remarks by Fischer.
---------------------------------------------------------------------------
World Bank operations in Russia: 1995
    In March 1995, 1 month before the IMF approved the new 
standby loan, the World Bank commenced a large new program of 
lending to Russia. That month, it approved a $400 million loan 
to help restructure the housing sector in Russia through the 
establishment of a new marketplace for housing. During the 2 
months following announcement of the IMF loan, the World Bank 
approved another $1.13 billion in loans. This included a $600 
million loan on easy compliance terms to ease Russia's balance 
of payments by financing needed imports and $99 million to 
address a major oil spill problem. All told, during 1995, the 
Bank approved $1.62 billion in loans for Russia, its largest 
annual total to date.
    The Bank's project loans in 1995 sought to promote growth 
and address key structural problems. In addition to the loan 
which sought to create a marketplace for housing, the Bank lent 
$107 million to promote energy efficiency and $329 million to 
improve urban transportation. It also approved two smaller 
loans to develop standards, identify prospective new loan 
projects, and to improve and modernize tax administration. As 
in 1992 through 1994, the World Bank did not accelerate its 
disbursements on these loans nor did it disburse regardless of 
compliance. However, in retrospect, it appears that--as in the 
earlier period--many of the Bank's projects were approved 
before conditions had matured to a point where they could be 
successfully implemented. A major portion of the funds for the 
housing and energy efficiency loans were canceled or never 
disbursed and most of the funds for the urban transport loan 
seem not to have been disbursed until 1998 or after. Likewise, 
a major portion of the funds for standards development or 
development of the Bank's loan portfolio were not spent until 
1998 or remain unspent today.

               disburse despite resistance: 1996-mid 1998

Synopsis
    Between 1996 and mid-1998, the IFIs disbursed substantial 
sums to Russia even though its compliance with conditionality 
was limited and their efforts to promote reform met with 
considerable resistance. Heavy spending before the 1996 
election expanded Russia's fiscal deficit and stoked inflation. 
Yeltsin was reelected but the opponents of reform were 
strengthened also. The government's ability to deliver on its 
commitments for stabilization and structural reform diminished. 
Nevertheless, despite major difficulties with compliance, the 
IFIs provided Russia with substantial sums of balance-of-
payments support. Between approval of the EFF loan in early 
1996 and the onset of the financial crisis in mid-1998, the IMF 
disbursed approximately $6.78 billion to Russia. The IMF 
suspended disbursements for the EFF program on several 
occasions, releasing funds only when the Russian Government 
complied with certain conditions of the loan. That compliance 
often came slowly and in the face of considerable domestic 
resistance. Some of that compliance seems more technical than 
substantive. Meanwhile, the World Bank approved nearly $5.14 
billion in new loans for Russia. SALs accounted for $3.5 
billion of this total, all the proceeds being disbursed during 
1996 and 1997. The Bank approved project loans totaling $1.64 
billion during these 2 years, mainly in 1996. In retrospect, an 
unusually large proportion of those loans encountered serious 
problems with implementation and the disbursement of a 
substantial share of their proceeds was canceled or 
considerably delayed. Meanwhile, during 1996 and 1997, the IFC 
approved $28 million and the EBRD approved $2.36 billion in 
assistance to Russian firms.
IMF programs: 1996-1998
    The IMF agreed in March 1996 to lend Russia SDR 6.9 billion 
($10 billion) over the next 3 years. Disbursements for the new 
EFF loan would be monitored monthly, as had been the case for 
the prior loan. After October 1997, during the second year of 
the program, they would be made on a quarterly basis, as is 
usual for most IMF loans. Disbursements would be front-loaded, 
with 41 percent being available upon compliance in the first 
year, 34 percent in the second, and 25 percent in the third. 
The Russian Government said it did not intend to borrow again 
from the IMF once this program was completed.
    The goals of the EFF program were basically the same as 
those for the previous IMF programs in Russia. There was more 
emphasis, however, on the need for structural or procedural 
reforms and--because it was a 3 year program--it was thought 
that Russia would have enough time to implement those reforms. 
Events proved, however, because of increased inflation as well 
as stronger resistance by the opposition, that achievement of 
these goals would remain a difficult task.
    In the area of macro-economic policy, the government 
announced that it would take strong action to reduce the rate 
of inflation and the size of its budget deficit. Inflation 
would be reduced to a 1 percent monthly rate by year's end and 
would decline further, to a single-digit annual rate, in 1997. 
The government also declared that it would take the steps 
needed to maintain medium-term stability in Russia's balance of 
payments. Real GDP growth was expected to accelerate to 2.3 
percent annually in 1996 and 5 percent in 1998 and 6 percent or 
more thereafter. Consequently, it was expected that Russia's 
current account balance of payments would swing into the 
negative in 1998, when higher growth would lead to more 
purchases from abroad. The Russian authorities said they would 
take measures to manage the expected situation without 
encouraging inflation. Further cuts in the government's budget 
deficit were a critical element of this strategy. The Russians 
agreed to reduce the deficit from 5 percent of GDP in 1995 to 4 
percent in 1996 and 2 percent by 1998. They also agreed that it 
would take major steps to improve tax collections and reduce 
delinquencies and exemptions. This would require special 
efforts to overcome the political connections and favoritism 
which often facilitated tax evasion and tax avoidance of this 
type.
    On the structural side, the government said it would make 
trade liberalization and accession to the World Trade 
Organization (WTO) a high priority. It would strengthen the 
banking system through improvements in the regulatory framework 
and closer attention to the financial health of banks. It would 
accelerate privatization while assuring greater transparency 
and fairness of the process. It would pursue agricultural 
reform, reducing the uncertainties of private farmers, 
expanding land reform, and allowing the full private ownership 
of land. The security markets would be reformed, improving the 
legal framework, reorganizing weak firms, and increasing the 
protection for outside investors. The government also announced 
that it would strengthen the social safety net by targeting 
assistance more specifically to those who needed it and using 
the resultant savings to enhance other social programs.
    Despite these plans, most of the IMF's efforts in Russia 
during this period had to do with the government's difficulty 
in achieving the macro-economic goals of the EFF program. The 
government made some efforts toward addressing structural 
reform issues. However, the results achieved were not 
proportional to the goals outlined in the EFF program. The Fund 
was less vigorous in its efforts to secure Russian cooperation 
with the targets for structural reform than it was for those 
involving macro-economic stability.
    In 1996, Russian economic performance and the government's 
economic policies fell well short of the expectations in the 
EFF plan. By July, the budget deficit was well over target. The 
IMF raised the annual target to 5.25 percent. Government 
spending had increased rapidly in the just-concluded 
presidential election campaign. There was little alternative 
but to increase the size of the federal budget to accommodate 
the higher cost of the government's earlier debt and the new 
debt payment obligations recently incurred.
    In 1997 and 1998, however, the Russian Government continued 
to have problems with its fiscal deficit. Budget figures seemed 
to be prepared more to meet the IMF's deficit targets than to 
meet real budgetary needs. For example, the budget signed by 
Yeltsin in February 1997 projected a deficit equal to 3.5 
percent of GDP. This was within the deficit target. The IMF 
urged the Russians, however, to include money in the budget to 
cover the government's accumulating unpaid interest obligations 
and federal wage and pension arrears. This would have widened 
the budget gap to nearly 7.5 percent of GDP, well over the 
target. The Russian authorities were not convinced by the IMF's 
approach to budgetary accounting.
    The IMF suspended disbursement of the January installment 
of the EFF and Russia received no disbursements for the rest of 
the first quarter 1997. The most important threat to fiscal 
stability was not rising expenditures but shortfalls in tax 
receipts. The IMF suspended disbursements on the EFF loan in 
July and August 1996 until the government adopted a package of 
measures to increase revenues. The October 1996 tranche was 
delayed until December, when revenues increased by 38 percent. 
The November and December disbursements were delayed until 
February 1997, when the government showed that it had met the 
December monetary and fiscal targets and had taken steps to 
improve tax receipts. By the end of April 1997, though, Russia 
had drawn SDR 2.34 billion ($3.22 billion) from the EFF line of 
credit. By April 1998, it had borrowed another SDR 1.5 billion 
($2.04 billion) and it got another SDR 1.12 billion ($1.52 
billion) in August 1998.
    In May 1997, the government received word that tax receipts 
would be even lower for the year than expected. This would push 
the deficit well over the EFF target. The government 
sequestered (freezing or withholding from expenditure) more 
than one-fifth of the funds in the national budget in order to 
bring down spending. Tax evasion, inefficient collection 
methods, and widespread exemptions were taking their toll. To 
increase revenues and reduce the deficit, the government 
accelerated the privatization process. Income from this source 
more than doubled. However, many of the sales were beset with 
doubts about corruption and serious concern whether the prices 
paid reflected the underlying value of the firms.
    By the end of 1997, with these increased receipts and the 
major spending cuts taken earlier, the government's budget 
deficit was 5.5 percent of GDP, slightly higher than the 
revised IMF target. The inflation rate for 1997 was 11 percent, 
down by half from the previous year but higher than the single-
digit goal of the EFF program. Most analysts agreed that 
sequestering expenditures was not a sufficient method for 
achieving those targets. Among other things, expenditures on 
social programs had been slashed substantially. Most agreed 
that the shrinkage in budgetary outlays could not be sustained.
World Bank programs: 1996-1998
    As noted, the World Bank reached new heights in the size of 
its loan program for Russia in 1996 and 1997. However, the 
overall composition of the Bank's program shifted as it put 
increased emphasis on programs addressing the needs of the 
overall economy and less on project loans.
    In May 1996, Bank President James Wolfensohn echoed the 
view that Russia had turned a corner in its transition process. 
He told the press that conditions in Russia were much improved 
and the Bank would be active ``supporting the major economic 
reforms which must be sustained for Russia to achieve 
transition to a market economy.'' \14\ A year later, the tone 
of the Bank's enthusiasm was somewhat subdued. Nevertheless, in 
September 1997, Johannes Linn, the World Bank's vice president 
for Europe and Central Asia, reported--while Russia's 
performance had been below its potential--the Bank was still 
optimistic about its prospects.\15\
---------------------------------------------------------------------------
    \14\ World Bank. James Wolfensohn. Statement to the Press. Moscow. 
May 23, 1996.
    \15\ World Bank Optimistic About Russia's Growth. (Announcing the 
SAL1 loan.) News Release No. 98/1492ECA. September 26, 1997.
---------------------------------------------------------------------------
    In 1997, the Bank added a new component to its Russian 
program. Adopting a new CAS to replace that earlier adopted in 
1993, the Bank said there should be more stress on structural 
adjustment and policy reform.\16\ Emphasis should also 
continue, though, on enterprise reform, institutional reform, 
and improvements in education and health. More effort should 
also be given to programs protecting the most vulnerable 
members of society from the effect of transition and sustaining 
the government's budget for social programs. Linn announced 
that the Bank's new emphasis on policy reform and adjustment 
lending in Russia would ``demonstrate our clear recognition and 
full endorsement of the reform measures that are currently 
being implemented by the [Russian] government.'' \17\
---------------------------------------------------------------------------
    \16\ World Bank Announces Russia Strategy for the Next Two Years. 
News Report No. 97/1379/ECA, June 6, 1997. The 1997 CAS was also not 
released to the public but its main outlines were described here.
    \17\ World Bank Supports Russia's Reforms. December 19, 1997.
---------------------------------------------------------------------------
    In 1997, the World Bank approved three large structural 
reform loans for Russia totaling $2.2 billion. Two were regular 
structural adjustment loans (SALs) and the other was a social 
protection adjustment loan (SPAL). The two SALs were nearly 
identical, in their form and purpose, to the loans approved 
earlier by the IMF. The $600 million from SAL1 was disbursed 
right away. The $800 million for SAL2 was disbursed in two 
tranches, a few months apart.\18\ Russia agreed that it would 
take steps to accelerate privatization, private sector 
development, changes in bankruptcy law, reductions in the 
budget deficit, improvements in tax administration, reform of 
the banking and financial sectors, and improvements in the 
social safety net. The World Bank has not reported what Russia 
needed to do in order to have access to these loans. Given the 
speed with which they were disbursed, however, one may suspect 
that the performance requirements were not particularly 
demanding. It does not appear that Russia made major steps 
toward structural reform at the time it received disbursement 
of these funds.
---------------------------------------------------------------------------
    \18\ World Bank Announces Russia Strategy for the Next Two Years. 
News Release No. 97/1379/ECA, June 6, 1997. Project Information 
Document PIC5759. Russia-Second Structural Adjustment Loan (SAL2), 
December 23, 1997.
---------------------------------------------------------------------------
    The requirements for the SPAL were somewhat more rigorous. 
This loan was aimed at protecting the weakest members of 
Russian society against potential injury from the adjustment 
process. At $800 million, it was the largest single loan ever 
made in the Europe and Central Asian region. It sought to 
strengthen Russia's social safety net and improve the way 
Russia targeted and implemented those programs.\19\ To qualify 
for disbursements, Russia had to demonstrate that a certain 
amount of social spending was included in its budget and those 
expenditures were being used effectively. In effect, the SPAL 
was a balance-of-payments support. The government could use the 
money from the SPAL to generate the rubles needed to fund the 
qualifying social expenditures, but it was not required to do 
so. The SPAL did not increase the amount spent for social 
programs, but it did help protect the existing programs against 
budget cuts. Social spending took a disproportionate share of 
the hits, in 1997 and 1998, as the government sequestered 
budget authority in order meet the IMF's targets on the budget 
deficit. Russia had some difficulty meeting all the 
requirements of the SPAL. The final $250 million tranche, which 
had been scheduled for release in early 1998, was not disbursed 
until after 1999.
---------------------------------------------------------------------------
    \19\ World Bank Loan Supports Russia's Social Reforms. News Release 
No. 97/1408/ECA, June 25, 1997. Project Information Document PID5638. 
Russia-Proposed Social Protection Adjustment Loan (SPAL). June 12, 
1997.
---------------------------------------------------------------------------
    The World Bank also made two loans, totaling $1.3 billion, 
to help restructure the Russian coal industry.\20\ The first of 
these (Coal 1), for $500 million, was approved in 1996. In 
part, the two loans sought to ease pressure on the government's 
budget. Subsidies to the coal industry had been a major 
contributor to the deficit. In 1993, these subsidies had 
amounted to 1 percent of GDP. By 1995, they had been cut to 
one-sixth that level. The new coal loans aimed to reduce them 
substantially further. The loans aimed to create a competitive 
and sustainable coal industry by promoting commercialization 
and privatization of the mines. The loans were not intended to 
offset losses or to refurbishment of capital stock in the 
mines. To qualify for disbursement, the government would need 
to adopt a socially sustainable framework of assistance for 
coal communities, including social services and efforts to 
improve labor mobility. As with the two SALs and the SPAL, the 
government could use the proceeds from the Bank's two coal 
loans for any purpose if it could demonstrate that it was 
making the appropriate expenditures (in rubles) to sustain the 
specified service programs. The second tranche of Coal 2 was 
contingent, however, on satisfactory macro-economic 
performance. It was delayed for 2 years (until the end of 1998) 
and media reports in December 2001 indicate that the last 
portion was just being released.
---------------------------------------------------------------------------
    \20\ The PID for Coal 1 is not available. However, the program's 
objectives are discussed in another publicly available technical 
document. World Bank Helps Reform Russia's Coal Industry. News Release 
No. 97/1225/ECA. Technical Annex T-6865-RU. Coal Sector Restructuring 
Implementation Assistance Project, June 25, 1996. The goals for Coal 2 
are discussed in the PID for that program. Project Information Document 
PID5852. Russia-Coal Sector Adjustment Loan II. October 29, 1997.
---------------------------------------------------------------------------
    Parallel with the new emphasis on adjustment loans, the 
World Bank also approved many project loans for Russia during 
1996 and 1997 which addressed key concerns identified in the 
IMF's loan program and in the 1993 and 1997 country strategy 
documents. In 1996, $1.27 billion was approved and in 1997 
another $286 million was authorized for this purpose. All told, 
$608 million was approved for projects addressing social 
issues, such as education, health, and community social 
infrastructure. Another $514 million was approved for projects 
aimed at private sector development and market reform, 
including loans for enterprise reform, enterprise housing 
divestiture, capital market development, and reform of the 
electrical sector. An additional $350 million was approved for 
bridge rehabilitation and $87 million for improvements in the 
country's legal system and its capacity for performing sound 
economic analysis.
    It appears, however, once again, that the World Bank's 
efforts to encourage structural reform with projects may have 
been somewhat in advance of the projects' feasibility. All the 
major project loans approved during 1996 and 1997 encountered 
serious difficulties. In several instances, the resistance to 
reform was substantial. Several projects were terminated 
without ever being put into effect. Of the total amount 
approved, $462 million was canceled outright and $575 million--
for some projects, almost the entire proceeds of the loan--
remained undisbursed at the end of June 2001. Many of the 
issues the Bank sought to address through these loans--
corporate governance, reform of the legal system, privatization 
of large enterprise, and the reform of banks and capital 
markets, for instance--were issues on which there remains today 
much disagreement between the Russian reformers and their 
opponents.

                   commit in the face of crisis: 1998

Synopsis
    In 1998, the IMF and World Bank committed themselves to 
lend very large sums in a vain effort to prevent a looming 
economic crisis. By 1998, the Russian economic situation was 
precarious. Despite past commitments the government had made to 
the IFIs, Russia's fiscal and monetary performance was 
questionable and progress on structural reform was slow. Doubt 
grew in the market about Russia's economic prospects and 
pressure against the ruble increased. Previously, when the IMF 
and World Bank had approved major loans for Russia, they had 
strong reason to believe that the government would seek to 
implement the reform provisions of their loan agreement, even 
though they knew this effort might face stiff resistance. In 
1998, however, the IMF approved new loans totaling $11.2 
billion and the World Bank agreed to lend $1.5 billion--the 
largest credits either institution had ever approved for 
Russia. They did this, moreover, with little evidence that the 
government would be willing or able to pursue its planned 
program of reform. Very soon after the IMF and World Bank loans 
were approved, Russia defaulted on its debts and devalued its 
currency and the IMF and World Bank suspended disbursements on 
their recent loans. Despite Russia's economic troubles, 
investors retained some interest. In 1998, the IFC approved $91 
million in assistance (most of it likely, however, in the 
first--July to December 1997--half of the IFC fiscal year.) 
Approvals by the EBRD in calendar 1998 fell to $304 million, by 
contrast, one-third the level of the prior year.
IMF programs: 1998
    The Russian Government's budget plan for 1998 projected a 
fiscal deficit amounting to 4.8 percent of GDP, a figure that 
was again within the EFF deficit target. However, many outside 
experts questioned the assumptions underlying its projections 
and noted that the planned spending level was about the same as 
that for the 1997 sequestered budget. The government announced 
plans for strong new efforts to increase revenues and to cut 
federal spending further. It also announced plans in the 1998 
program for major structural reforms.\21\
---------------------------------------------------------------------------
    \21\ Joint Communique of the Chairman of the Russian Federation and 
the Managing Director of the International Monetary Fund. February 19, 
1998. Available from the IMF Web site.
---------------------------------------------------------------------------
    By mid-year, however, Russia was enmeshed in a major 
economic crisis. Many analysts doubted whether the government 
had the capacity or the will to pursue its announced plans. 
Revenue continued to fall; the government resorted to a 
pyramid-type borrowing scheme to cover the deficit. World oil 
prices declined, removing a major source of Russia's tax 
revenue and export income. The financial system was buffeted by 
uncertainty. Market confidence was deteriorating, in response 
to the country's precarious domestic conditions and contagion 
from the Asian financial crisis. The ruble was under heavy 
pressure in foreign exchange markets and the CBR was having 
great difficulty maintaining the specified exchange rate in the 
face of that pressure.\22\
---------------------------------------------------------------------------
    \22\ Cf. William Cooper, Russia's Economic Performance Entering the 
21st Century, supra this volume.
---------------------------------------------------------------------------
    On June 11, the IMF made an announcement \23\ clearly aimed 
at calming the market. The IMF executive board would meet in a 
week, a spokesman said, to release of the next tranche of the 
EFF loan if Russia took certain unspecified steps. It was also 
strongly implied that substantial new flows of IMF assistance 
would also be coming soon. Nine days later, the IMF executive 
board released the last tranche of the 1996 EFF loan. It also 
approved a new loan package for Russia totaling SDR 8.5 billion 
($11.2 billion). This included a new EFF loan for SDR 6.3 
billion ($8.3 billion) and an SDR 2.16 billion credit from the 
Compensatory and Contingency Financing Facility (CCFF).\24\ The 
new EFF money would be available subject to regular EFF 
conditionality. The CCFF money would be available with little 
conditionality. Russia drew those funds right away.
---------------------------------------------------------------------------
    \23\ Russian Authorities and IMF Reach Understandings on 1998 
Economic Policy Statement. News Brief 98/20, June 11, 1998.
    \24\ IMF Approves Augmentation of Russia Extended Arrangement and 
Credit under CCFF; Activates GAB. IMF press release No. 98/31.
---------------------------------------------------------------------------
    The United States and other major member countries strongly 
supported the new loan program. One measure of their support 
was the source of the funds supporting the EFF credit. Instead 
of using its regular funds to finance the new EFF loan for 
Russia, the IMF was authorized to draw SDR 4 billion ($5.3 
billion) of the total from the General Agreement to Borrow 
(GAB). To activate the GAB, the IMF must have the explicit 
consent of its member countries. The United States provides 
one-fourth of those funds and other advanced industrial 
countries provide the remainder. This would be the first time 
the GAB had ever been activated for use by a non-
participant.\25\
---------------------------------------------------------------------------
    \25\ See the IMF's description of the new Russian loan program in 
its 1999 Annual Report, p. 79.
---------------------------------------------------------------------------
    The Russian authorities promised to take vigorous steps to 
address the turmoil in the financial markets and to restore 
public confidence. It would tighten the budget still further, 
bolster the CBR's foreign exchange reserves through new foreign 
financing, stretch out the maturity of its short-term debt, and 
secure the legislature's approval for numerous key structural 
reforms.\26\
---------------------------------------------------------------------------
    \26\ IMF Management Welcomes Executive Board Support for Russia. 
News Brief 98/26, July 20, 1998. Fischer was then serving temporarily 
as acting Managing Director of the IMF.
---------------------------------------------------------------------------
    All of this, however, was to no avail. The government took 
none of the steps it had promised the IFIs. It had not even 
recommended to the legislature that key measures in its reform 
plan should be adopted. The government's budget difficulties 
continued to mount. Market confidence in government policy and 
the Russian economy continued to fall. Market pressure against 
the ruble reached new heights. The government was faced with a 
choice between unilaterally restructuring its debt or devaluing 
the currency.\27\ Ultimately, it had to do both. On August 17--
despite contrary assurances it had given to the international 
agencies and after it had pocketed the first disbursements on 
the new IFI loans--the government announced that it was 
suspending payment on its commercial and official debts and the 
CBR would no longer to support a specific value for the ruble. 
Quickly, the currency fell to about one-third its prior value. 
The Russian stock market collapsed. Most private savings were 
virtually wiped out. Inflation jumped, as prices sought to 
catch up with the new lower value of the ruble, and by December 
the rate had reached 84 percent for the year.
---------------------------------------------------------------------------
    \27\ In fact, the two choices are interlinked, as the Argentine 
crisis of November 2001 has demonstrated. Fischer observed in his June 
2001 retrospective review that ``You couldn't restructure the debt 
without being forced to devalue, and you couldn't devalue without being 
forced to restructure the debt.''
---------------------------------------------------------------------------
    Shocking many investors and creditors, the IMF did not step 
in as expected with major new infusions of cash to sustain the 
ruble and cover Russia's debts. Rather, it suspended 
disbursements on its existing loan agreements for Russia. On 
March 25, 1999, the existing arrangements were canceled ``at 
the request of the Russian authorities,'' as the IMF delicately 
phrased the news. At their termination, some SDR 1.12 billion 
remained undrawn from the 1996 EFF program and nothing had been 
used from the EFF loan approved in 1998.
World Bank programs: 1998
    The World Bank's efforts in Russia during 1998 paralleled 
those of the IMF. On April 1, Wolfensohn told the U.S.-Russia 
Business Council that there had been real movement toward 
reform. ``We're not only positive,'' he said, ``but we are 
supporting our positive view with real financial resources and 
real commitment.'' \28\ On July 13, 2 days after the IMF had 
made its announcement, World Bank management made a public 
statement aimed at quieting the markets. It announced that it 
would be accelerating disbursements on its existing projects in 
1999 and its plan to award a large new adjustment loan for 
Russia in the very near future.
---------------------------------------------------------------------------
    \28\ James Wolfensohn. Address to the U.S.-Russia Business Council, 
April 1, 1998. Press Release No. 98/1711/ECA
---------------------------------------------------------------------------
     On August 6, the World Bank executive board approved a 
$1.5 billion structural adjustment loan (SAL3) for Russia. It 
was the biggest loan the Bank had ever made in the Europe and 
Central Asian region.\29\ Vice president Linn said the new loan 
would ``generate greater transparency, secure greater fiscal 
accountability, foster competition, and improve corporate 
governance, all of which should help rebuild the confidence 
essential for achieving sustained growth in Russia.'' Even so, 
the Bank's country director for Russian programs cautioned that 
``strong implementation'' of the reforms specified in SAL3 
``will now be key to creating confidence in Russia's economic 
prospects.'' The new loan required that Russia push ahead 
vigorously with key structural reforms in several areas. 
Progress with the implementation of these reforms would improve 
the stability and productivity of the Russian economy and help 
instill new market support for the government's policies. 
Eleven days later, however, without implementing any of the 
promised SAL3 reforms, the Russian Government defaulted on its 
debts and devalued its currency. The Bank immediately suspended 
further disbursements under the loan.
---------------------------------------------------------------------------
    \29\ World Bank Approves Largest-Ever Loan to Russia for Structural 
Reforms. News Release No. 99/1919/ECA, August 6, 1998.
---------------------------------------------------------------------------
    The World Bank approved one project loan for Russia in 
1998, a $400 million highway rehabilitation and maintenance 
credit approved in late December. Previously, transportation 
loans of this sort had been implemented with little serious 
difficulty, notwithstanding the problems the Bank might be 
encountering with its other structural reform loans. This 
project, however, was different. A key condition of the loan 
required an independent audit of the government's road fund and 
other similar trust accounts. Little progress was made in 
pursuit of the project and it was soon canceled without making 
any disbursements having been made from the account.

                       reconsideration: 1999-2001

Synopsis
    After 1999, the IFIs began to seriously reconsider their 
approach to Russia. They terminated many of their loan programs 
and substantially curtailed their future plans. In 1999, the 
IMF and World Bank each made one more effort to encourage sound 
macro-economic policy and structural reform in Russia. The IMF 
approved a $4.5 billion standby loan for Russia and the World 
Bank disbursed $100 million from the large SAL it had approved 
the previous year. Russia almost immediately fell out of 
compliance with both, however, and further disbursements were 
terminated. The IMF made no further loans. The World Bank 
approved project loans totaling $698 million during the next 3 
years. Most were for technical and institutional reform or for 
humanitarian and social purposes. Almost nothing ($3 million) 
has been disbursed on these loans, however, and only two have 
become effective. New approvals by the IFC and EBRD remained 
low, reflecting the cautious view that investors were taking of 
the situation. The IFC approved $123 million in new assistance 
during these 3 years while the EBRD approved $582 million in 
1999 and 2000. (Data for 2001 are not yet available.)
IMF programs: 1999-2001
    The Russian economy rebounded in 1999, spurred by those two 
classic remedies for economic stagnation--devaluation and 
increased export income. The balance of payments (current 
account) had shifted from a $2.7 billion deficit in early 1998 
to a $4.8 billion surplus in early 1999. In September 1999, the 
IMF staff reported \30\ that ``the period since the last 
Article IV consultation with the Russian Federation [1998] has 
witnessed perhaps the greatest contrast in the fortunes of the 
economy since Russia became an independent state in 1992.'' 
Article IV of the IMF Articles of Agreement provides that the 
IMF will hold discussions annually with each of its members 
concerning economic conditions and economic issues affecting 
its economy.
---------------------------------------------------------------------------
    \30\ Russian Federation: Recent Economic Developments. IMF Staff 
Country Report 99/100, September 1999.
---------------------------------------------------------------------------
    On July 28, 1999, the executive board of the IMF approved a 
new SDR 3.3 billion ($4.5 billion) standby loan for Russia.\31\ 
It would be a 17 month program, with seven equal disbursements, 
the first being released immediately. The board noted, in 
approving the loan, that it believed the crisis of 1998 was 
mainly due to failure by the government to come to grips with 
its fiscal problems and to implement structural reforms. The 
current situation gave Russia a promising opportunity to move 
forward with reforms. The board noted that the new loan program 
would have strict requirements in both areas. The government 
and CBR agreed that they would comply with the measures 
specified in the 1996 and 1998 EFF arrangements.\32\ The IMF 
stated later, in an article \33\ designed to respond to 
skepticism, that ``Russia's current economic policies are 
deserving of IMF support.'' It noted that several of the 
reforms included in the 1998 plan had been put into effect by 
Russia's more recent governments.
---------------------------------------------------------------------------
    \31\ IMF Approves Stand-by Credit for Russia. Press release 99/35, 
July 28, 1999.
    \32\ Statement of the Government of the Russian Federation and the 
Central Bank of Russia on Economic Policies. July 13, 1999. Available 
from the IMF Web site under the title Russian Federation Letter of 
Intent.
    \33\ ``Why resume lending? Russia's current economic policies are 
deserving of IMF support.'' IMF Survey 28:17, August 30, 1999, pp. 273-
274.
---------------------------------------------------------------------------
    The IMF executive board indicated, in a commentary released 
at the same time, that it believed Russia should try to 
normalize relations with its creditors. The IMF demonstrated 
again, as it had in 1998, that it would not be the debt 
collector or guarantor for foreign creditors. The IMF noted 
that Russia did not have enough resources to pay its defaulted 
debts and to service its foreign debt under present 
circumstances and it urged Russia to approach its Paris Club 
and London Club creditors for rescheduling and new debt 
relief.\34\
---------------------------------------------------------------------------
    \34\ IMF Concludes Article IV Consultation with Russia. PIN 99/67, 
August 2, 1999. The IMF board approved the actions reported in this PIN 
on July 28, 1999.
---------------------------------------------------------------------------
    Sensitive to criticism that it was lending new money to a 
country that had just recently defaulted on its debts, the IMF 
announced that proceeds from the new loan could only be used to 
cover loan payments which were due to the IMF in the following 
18 months. In effect, the money would not leave the IMF 
building but would be moved from one account (disbursements) to 
another (payments due) when appropriate. This announced 
procedure was mainly symbolic. Only if the IMF had actually 
expected the Russians to default on their IMF debt payments 
would the described scenario have been real. Money being 
fungible, the proceeds from the 1999 loan would have allowed 
Russia to use a comparable amount from its existing resources 
for other purposes.
    The new standby lasted 2 months. Only about $644 million--
the initial first tranche--had been disbursed before the IMF 
suspended and then canceled the program.. Russia was out of 
compliance with the terms of the July 1999 agreement almost 
immediately. On December 7, 1999, Camdessus reviewed the status 
of the Russian program. Important progress had been made on the 
macro-economic side, he reported, but this had not been matched 
by similar progress in the area of structural reform. Several 
structural benchmarks set for the end of September remained 
unmet.\35\ ``When these remaining issues have been 
satisfactorily resolved,'' Camdessus announced, ``I expect to 
recommend completion of the review to the Executive Board.'' In 
effect, this suspended further action on the 1999 standby. The 
IMF executive board is very unlikely to initiate a program 
review or approve a disbursement without such a recommendation 
by IMF management.
---------------------------------------------------------------------------
    \35\ In particular, he noted, the Russian Government needed to let 
contracts for financial management reviews (meeting international 
standards) of the Pension Fund, Social Insurance Fund, Medical 
Insurance Fund, and Road Fund. It needed to submit to the Duma draft 
legislation for reforming the bankruptcy law to prevent abuses and 
eliminate related forms of bank fraud. The Duma also needed to pass 
such legislation. These and several other matters were actions the 
government had pledged to take in connection with the 1999 standby loan 
but which were not yet completed.
---------------------------------------------------------------------------
    In April 2000, the Russian authorities began making public 
suggestions that it might be time for the IMF to approve a new 
loan. The Russian press quoted Fischer as saying that the IMF 
hoped a new program of assistance to Russia might resume ``in 
the near future.'' \36\ Russian officials indicated that they 
believed there should be ``a change of conditions of the very 
principles of borrowing'' from the IMF and World Bank, implying 
that new agreements should require less conditionality and more 
cash.\37\ Russian press reports even suggested that IMF 
officials were already in Moscow working on the details for a 
new loan.\38\
---------------------------------------------------------------------------
    \36\ ``Putin's aide says Russia does better without IMF credits.'' 
ITAR/TASS, April 14, 2000, p1008104t6721.
    \37\ ``Russians to address new World Bank borrowing principles.'' 
ITAR/TASS, April 17, 2000, p1008106t6932.
    \38\ ``IBRD, IMF experts to fix cooperation programs with Russia.'' 
ITAR/TASS, April 24, 2000. P1008114t7733.
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    On April 28, World Bank vice president Linn diffused any 
speculation that a new IFI loan program was imminent. Russia's 
current economic recovery was due to temporary conditions he 
said. Over the long run, though, it needed to carry out reforms 
if it wanted to attract domestic and foreign investors. If 
Russia does not do this, he concluded, it should not expect to 
receive major new credit from the IFIs.\39\ Most observers were 
quick to note that, if Russia were unable to arrange a new loan 
agreement with the IMF, it would not be able to secure debt 
relief through the Paris Club from its official creditors, the 
former being a prerequisite for the latter.
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    \39\ ``Russia needs structural reform for steady economic growth.'' 
ITAR/TASS, April 28, 2000, p1008119t8442.
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World Bank programs: 1999-2001
    The World Bank also reduced the size of its loan program 
for Russia substantially after 1998. Exploring whether the 
Russian Government might be inclined to move ahead cautiously 
with the promised program of structural reforms, the Bank 
disbursed $100 million in 1999. As with the IMF program, 
however, the Russians rapidly fell out of compliance with the 
revised terms of the SAL3 program. The World Bank suspended and 
then canceled the program with no further disbursements.
    In mid-1999, the World Bank adopted a new CAS for Russia, 
replacing the one approved in 1997.\40\ In effect, the new CAS 
repudiated its predecessor's heavy emphasis on adjustment 
lending and balance-of-payments support. Instead, the CAS said 
the Bank should put more emphasis on re-establishing the 
foundations for growth and reducing institutional barriers to 
growth. Responsibility should be shifted from the IBRD to the 
IFC for operations where funds are lent to commercial firms and 
for other commercial lending. There should be fewer investment 
projects, more emphasis on institutional development, and 
greater efforts to improve the performance of the Bank's 
existing portfolio, which had dipped alarmingly after August 
1998. The Bank should sharpen its focus on poverty reduction. 
It should also strive to improve its understanding of the 
Russian economy in order to improve the quality of its future 
policy advice.
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    \40\ Memorandum of the President of the International Bank for 
Reconstruction and Development and the IFC to the Executive Directors 
on a Country Assistance Strategy of the World Bank Group for the 
Russian Federation. Report No. 19897-RU, December 1, 1999.
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    Between 1999 and 2001, the World Bank approved eight 
projects for Russia totaling $689 million, all of them strictly 
in accord with the goals of the 1999 CAS. Sixty million dollars 
was approved for improvements in official statistical and 
fiscal procedures. Another $338 million was approved for 
projects with a social or humanitarian focus, such as clean 
water and sewerage, education, municipal heating, or 
amelioration of conditions for people living in depressed 
areas. Another $60 million each was also authorized for 
sustainable forestry and urban transport. Only two of these 
projects--those for institutional reform--have become effective 
and only $3 million has been disbursed. Most of the projects 
have not yet been officially signed. In some cases, it appears 
that necessary Russian legislation has not yet been adopted. 
The Bank seems to be putting a good deal of its effort in 
Russia into implementing the projects for Russia it approved in 
earlier years. Many of these address key structural reform 
issues and require the adoption of new policies or procedures 
before they can be fully put into effect.
    Figure 5 shows that disbursements for World Bank project 
assistance in Russia have been proportionally smaller than 
those for Bank adjustment loans. In some respects, however, 
this gives an incomplete picture of the situation. Many of the 
Bank's projects have been delayed for technical reasons or 
because key policy changes have not yet been adopted. However, 
in most instances, Bank and Russian authorities believe these 
problems will be overcome and most of the proceeds for these 
loans eventually will be disbursed. If and when this occurs, 
the disbursement shares for these projects shown on Figure 5 
will rise.

                  Treating Russia as a Normal Country

    In February 2000, at his last press conference as Managing 
Director, Camdessus observed that the illusion of quick 
transformations in Russia had been shattered.\41\ The strength 
of the resistance to reform there was unique. The IMF had been 
repeatedly disappointed, he noted, by insufficient efforts of 
the Russian authorities to implement agreed economic measures 
and by the lack of support from the state Duma. In April 2000, 
Fischer took a somewhat more positive but still skeptical view 
in his first major statement on Russia as the new IMF Acting 
Managing Director.\42\ He listed a number of needed reforms, 
noting that many or most had already been elements of prior 
programs financed by IMF loans. Russia's poor effort at 
implementation, he said, stemmed from a ``failure to overcome 
fierce resistance from vested interests in the face of weak 
government consensus.'' There was no lack of good ideas about 
reform, he observed. ``What is needed now is to translate this 
knowledge and energy,'' he said, ``into a coherent reform 
strategy that is backed by strong public consensus and 
leadership, and that is implemented.'' (Emphasis in the 
original.) If that happens, he concluded, the IMF and the rest 
of the international community will be ready to help.\43\
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    \41\ Press conference by Michel Camdessus, April 8, 2000. 
Washington, DC Reported by ITAR/TASS News Agency, February 14, 2000, 
p1008039t0176.
    \42\ Stanley Fischer. Russian Economic Policy at the Start of the 
New Administration. Remarks to the conference at the State University: 
Higher School of Economics, Moscow, April 6, 2000.
    \43\ For further discussion along this line, see: Russian 
Federation: Staff Report for the 2000 Article IV Consultation and 
Public Information Notice Following Consultation. IMF Staff Country 
Report No. 00/145, November 2000; IMF Concludes Post-Program Monitoring 
Discussion on the Russian Federation. PIN No. 01/68, July 18, 2001; and 
Russian Federation: Post-Program Monitoring Discussions-Staff Report; 
and Public Information Notice on the Executive Board Discussion. IMF 
Country Report No, 01/102, July 2001. All are available from the IMF 
Web site.
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    In July 2001, World Bank vice president Linn summarized the 
Bank's current views on the Russian situation.\44\ In 2000, he 
noted, Russia had high economic growth (over 8 percent), large 
budget and trade surpluses, and a major increase in its 
international reserves. However, he noted, the situation was 
not sustainable, because it was being supported by high oil 
prices and a strongly undervalued currency. When oil prices 
fell and the ruble appreciated more toward a more appropriate 
value, he predicted, Russia's growth rate would decline. Over 
the long run, Linn urged, Russia needed deep institutional 
reform in its economy in order to achieve the high investment 
levels necessary for broad-based productivity and employment 
growth.\45\
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    \44\ Johannes F. Linn. Economic Situation and Outlook in Russia and 
Central Asia. Keynote Speech, 6th Berlin Financing Conference, Berlin, 
Germany, July 21-22, 2001. Available from World Bank Web site.
    \45\ In particular, Linn noted that more progress was needed with 
reforms in six areas. For the most part, they were the same structural 
reforms the IMF and World Bank had been stressing for years. They 
included (1) further reforms in the tax administration, treasury, and 
debt management systems, (2) better corporate governance, including 
improvements in creditor and shareholder rights, (3) more predictable 
legal and regulatory treatment of foreign investors, (4) less 
involvement by government agencies-- especial local and provincial 
authorities-- in commercial and business matters, (5) a more effective 
judicial system, and (6) improvements in the banking and finance 
system. The government would also need to take steps to encourage 
foreign investment and curb the continued flight of Russian capital.
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    Linn observed that the role of the international agencies 
in Russia would likely be much smaller in the future than it 
has been in the past. ``Today,'' he asserted, ``Russia requires 
much less foreign financial support than it did in the 1990s.'' 
Therefore, he said, the World Bank would focus more on 
analytical, legal, technical, and institutional concerns. In 
effect, Linn indicated, there would be fewer projects for 
infrastructure and enterprise reform and no broad loans for 
structural adjustment. The levels of World Bank aid seen in 
prior years were not likely to be seen again.
    At some point during 1999, it appears, the IFIs and their 
major member countries changed their basic perception of 
Russia. Certainly, they had grounds for being disillusioned and 
disappointed by Russia's default and devaluation in 1998. 
Despite the willingness of the IFIs and others to pledge large 
sums to bolster their determination, the Russian Government, 
gave way and failed to change course or to pursue promised 
reforms. The echos from the shock in Russia reverberated around 
the world, putting many other emerging market economies--
Brazil, for example--in peril and requiring major new 
commitments of funds by the IFIs.
    Camdessus observed, in the month prior to the 1999 loan, 
that Russia needed to decide whether it wanted to complete its 
transition to a full market economy.\46\ Many key structural 
reforms remained to be accomplished, but there seemed to be 
reservations in some parts of Russian society as to whether 
they should be pursued. In this, he said, Russia was not 
unique. Russia had some special economic and political 
challenges as it emerged from 70 years of Soviet economic 
management. Nevertheless, he observed, ``Russia faces a similar 
range of economic problems--macro-economic imbalances, 
incomplete structural reforms, weak system of governance, and 
heavy use of external borrowing--that were found in differing 
degrees in other countries in crisis.''
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    \46\ Michel Camdessus. Russia: In Search of a Vision to Revitalize 
Reform. Address to the St. Petersburg Economic Forum, Russia, June 16, 
1999.
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     Russia needed to take steps in several areas, he said, if 
it were to surmount its current difficulties. It needed to 
surmount the barter system and the culture of non-payment. The 
government needed to make a ``clear and unambiguous 
commitment'' to equity in society. Even more central, the state 
needed to adopt a role for itself that was more compatible with 
the needs of a market economy. Instead of trying to be the 
central actor in the economy, the state should establish and 
uphold of the laws and be the ultimate source of basic social 
protections. It should be the creator of the legal framework 
and the key regulator and monitor of the market's standards and 
practices. Equally important, he said, Russia needed to more 
clearly distinguish between the government and the institutions 
of the economy. In this, Camdessus observed, Russia was not 
alone. Many of its problems reflect ``an almost universal 
syndrome of incestuous relationships between governments, banks 
and enterprises.'' Those who think that Russia is unique, he 
said, should look at the newspapers. All around the world, he 
observed, one sees demonstrations against ``corruption, 
collusion, nepotism,'' criticism of ``crony capitalism'' and 
denunciations of ``oligarchism.''
    Some of the change in the IFIs' view of Russia may have 
arisen as a consequence of the Russian Government's uncertain 
responsiveness to concerns arising from the FIMACO affair.\47\ 
The CBR seemed to show little concern about whether its 
activities had credibility for major foreign countries. In late 
September 1999, as consideration was being given to a possible 
new disbursement on the 1999 IMF loan, the G-7 called for new 
mechanisms to monitor Russia's use of foreign loans. 
Specifically, it asked the CBR to undertake quarterly audits of 
its reserves. CBR Governor Gerashchenko reportedly said that he 
thought the idea was ``stupid.'' \48\
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    \47\ In that situation, the CBR diverted $1.2 billion of money lent 
by the IMF to an offshore account in the Channel Islands. In 1996, the 
funds were reportedly converted to rubles and used to purchase Russian 
Government bonds. The government was able to use the revenue from those 
bonds to avoid insolvency and to pay wage and pension arrears and make 
other key expenditures during the presidential election campaign. The 
CBR deceived the IMF as to status of that account, saying it could be 
counted among the country's foreign exchange reserves. Some critics are 
deeply concerned that money may have been stolen or used to benefit 
rich speculators. Other critics worry whether it is proper for IMF 
resources to be used improve President Yeltsin's election prospects 
during a period when it seemed he might be defeated in his bid for 
reelection. CBR Governor Gerashchenko did not inspire confidence in his 
explanation of the affair, when he told the Duma that the placement of 
funds in FIMACO was merely an effort by the CBR to evade paying Russian 
taxes on the earnings, to hide assets from creditors who might 
otherwise be able to collect by lawsuit, and to get a better return on 
the money than it could get if the CBR managed the account itself.
    \48\ Russia is Told to Sell its Offshore Banks--IMF Demand is in 
Wake of '96 Underreporting of Central-Bank Funds. Wall Street Journal, 
October 1, 1999, p. A13.
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    In June 2001, the author interviewed the key managers of 
the IMF responsible for its Russian programs \49\ in order to 
solicit their views on the current situation. They sought to 
minimize the suggestion that the Russians might have been 
seeking new loans the year before. They were merely inquiring, 
the IMF managers said, whether the IMF might be willing to 
resume implementation of their earlier loan program. The 
Russian situation was complicated. On one hand, they observed, 
its current macro-economic situation and its balance-of-
payments surplus are strong. It seems unlikely that Russia will 
need to approach the IMF for assistance or that the IMF would 
find such assistance appropriate. On the other hand, they 
agreed upon inquiry, the IMF is unlikely to lend until Russia 
begins implementing some of the structural reforms agreed to 
earlier.
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    \49\ Interview with John Odling-Smee, Director, European II 
Department, and his deputy, Gerard Belanger, by the author at the IMF, 
June 14, 2001.
---------------------------------------------------------------------------
    This raised questions about the IMF's basic approach to 
Russia. Wasn't it vital that Russia move through the transition 
process, even if this meant compromise on structural reforms? 
Had the IMF limited its leverage and lessened its capacity for 
promoting change by its announcements that new loans would be 
available only when Russia began implementing needed structural 
reforms? Does this mean that--as long as it can keep its macro-
economic situation strong--Russia would be able to postpone any 
further action on structural reforms? The IMF managers 
disagreed with the underlying premise of these questions. 
``Russia is a normal country,'' they reported. It is not unique 
and the IMF does not need special standards for its programs 
there. Many other countries are also postponing any need for 
action on structural reforms through good macro-economic 
performance. Several major countries were mentioned. Some day, 
the IMF managers noted, these countries may find that their 
economic situation is deteriorating and they may ask the IMF 
for financial assistance. In that situation, for Russia and for 
other countries, the issue of structural reform will come up 
again, they said, and the prospective borrowers will know what 
they ought to do.

                          Concluding Comments

    It seems likely that Russia will not be receiving major 
infusions of assistance from the IMF and the multilateral banks 
in the near future. In December 2001, the IMF's chief spokesman 
announced that Russia's current situation is ``sustainable 
without need for recourse to the Fund or other points of 
external support.'' The Russian Finance Minister agreed that 
``We will not need IMF credits. Russia has enough of its own 
financial instruments which will be used to fulfill the 
budget.'' \50\
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    \50\ ``IMF does not expect Russia will need loans.'' Reuters, 
December 6, 2001.
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     After their disappointment of 1998, the international 
agencies may harbor some reservations about Russia's 
willingness to address the hard problems which remain. Russia's 
macro-economic situation is reasonably good, but it has not yet 
implemented many of the structural reforms it agreed to pursue 
in connection with the 1999 loan. The World Bank will continue 
funding projects, mainly those addressing social needs or 
institutional reform. According to its latest strategy paper, 
however, the Bank does not intend to pursue broad systematic 
reforms or major adjustment programs. The EBRD will be lending 
or investing where it sees opportunities, but is assistance 
will mainly target the private sector and not government 
programs. Much will depend in the future on the policies the 
Putin government pursues and the steps it takes toward 
structural change.
    There continues to be substantial debate as to whether 
Russia benefitted or suffered from its relationship with the 
IFIs. In large part, the question depends whether one believes 
that a market economy is preferable or whether some type of 
state-managed economic system is more to be desired. The IFIs 
played a significant role in the past decade urging Russia to 
move toward the former goal. Among the G-7 and other foreign 
aid donors, they helped assure that there was some minimal 
coherence in goals and expectations. No other donor sponsored 
an alternative program of economic policy reform with contrary 
goals or norms. During the 1990s, the IMF in particular sought 
to persuade the Russians to reduce the size of their budget 
deficit, to limit inflation, to improve fiscal and monetary 
procedures, and to undertake a broad range of structural 
reforms. The latter included privatization, elimination of 
subsidies for large former-state firms, closer regulation of 
the financial health and stability of the financial system, 
land and agricultural reform, and other matters. Most of these 
were at the heart of the political struggle then going on 
between Russian reformers and the opposition. Demonstrably, 
Russia failed to comply with the performance criteria in most 
of its IFI stabilization or adjustment programs. Toward the 
latter part of the decade, the budget deficit and rate of 
inflation came down substantially but macro-economic stability 
was still precarious. Achievement of many of the key structural 
reforms was often partial or incomplete.
    Since late 1999, the IFIs have decided that Russia no 
longer needs special treatment. From the perspective of the 
IFIs (and from that of many of their major member countries), 
Russia is now a ``normal'' country and should be treated by the 
IFIs in the same manner as they treat other middle-income 
developing countries. Russia's current macro-economic situation 
is such that it does not need new IFI stabilization or SALs. 
Its performance in recent years with structural reform--the 
unmet commitments from prior loans--is such that it would 
likely not qualify for such loans even if it needed them. The 
IFIs will probably give substantial consideration, in any 
future discussion of new assistance plans, to the level of 
progress Russia will have made in the future with the 
implementation of such structural reforms.

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