President Medvedev’s vision of Russia Future:

Words are not everything

 

November 13th, 2009

 

Jacques Sapir[1]

 

President Medvedev’s speech of November 12th, 2009 has certainly attracted a lot of interest. He made out for a « modernization » drive of the Russian economy. This has not been the first speech made on this topic, either by Medvedev or by Putin, and this speech certainly elaborated on his “Go Russia” article. Still, delivered as the solemn “Address to the Nation”, it has a very significant content.

We are here to quickly review some of the main points of this speech.

 

General assessment

 

President Medvedev’s speech is certainly to be noted for the emphasis he was putting on the “modernization” concept. That can’t be doubted and certainly there are a lot of very positive things said in this speech. But the most important point was the vision behind the message.

 

The foundation of my vision for the future is the firm conviction that Russia can and must become a global power on a completely new basis. Our country’s prestige and national prosperity cannot rest forever on past achievements. After all, the oil and gas production facilities that generate most of our budget revenue, the nuclear weapons that guarantee our security, and our industrial and utilities infrastructure – most of this was built by Soviet specialists. In other words, it was not we who built it. It is still keeping our country afloat today, but it is rapidly depreciating both morally and physically. »

 

This kind of statement has been frequently made since 2000, but it probably was the first time it was said with such a force. Russia has been and still is living on the legacy of the former Soviet Union. The so-called “transition period” has been unable to promote the modernization it has been expected.

This was strengthened by no less important words:

 

Last century, at tremendous cost and effort, an essentially illiterate country was transformed into what was at that time one of the world’s most influential industrial powers, a leader in creating advanced technology in the space, rocket and nuclear fields. But the closed society and totalitarian political regime made it impossible to hold onto this lead. The Soviet Union, sadly, remained an industrial and raw materials giant and proved unable to compete against post-industrial societies. »

 

One can still argue that Soviet Union was creating “advanced technology” and there is some unfairness to label it in the following sentence as an “industrial and raw-material giant”. One could certainly prove that the importance of the hydrocarbon sector, and generally speaking the commodity sector was much more the result of the first 10 years of post-Soviet Russia. Industry, and most specifically high-technology sectors have suffered to a considerable intent. There was a process of de-industrialization and – sorry for the neologism – detechnologisation of the economy, something frequently confused with the creation of a postindustrial society.

 

However, there are no doubts that production and exports of commodities have assumed too large a role in the economy. There are no doubts that the process of innovation, and the process of bringing innovation in the productive sphere, are not enough developed today in Russia.

 

There was too a focus on energy efficiency but also on the anti-corruption measures in this speech. This certainly is to be welcomed.

 

The Russian economy is wasting energy on a giant scale, and the President rightly acknowledged this. For everyone involved in energy efficiency these words are certainly important. The turn toward a true energy-efficiency strategy is an important one for Russia and, to the contrary to what is frequently thought, is certainly to be much profitable. Energy wasted today could be sold tomorrow.

By the same token nobody is to deny that corruption had been widespread in Russia.

Certainly, the time when the most ugly crimes were done in relation to the economy is a time of the past. But corruption has been and still is a burden for Russia.

 

President’s speech made too a reference to the social dimension of the economy. Pensions are to be significantly raised (even if it is not clear if the 150% figure relates to nominal or real income), the unemployment benefit, which has been already risen by 1.5 times is still to be increased, and the President pledged a massive financial support to the so-called “singleindustry Cities” where nearly 16 millions people live and to the war veterans. These measure have been part of the so-called “anti-crisis plan”. President Medvedev made a significant mention of the support the government gave to the industry, clearly stating out that only innovative industry were to be supported in the future.

 

Last but not least, it is the interactive dimension of the President’s speech, which is attracting a lot of attention. This speech is coming on the heels of the “Go Russia” paper. It seems that a huge movement contributing to this paper has been used in drafting the November 12th speech. If true, this would be one of the first examples of an interactive process going up to the decision-maker.

 

Some unanswered questions.

 

For all its positive content, there are many points unanswered for and many questions left open.

 

First of all, the speech embarked onto the now fashionable opposition between “old” and “smart” industries. But things are much less clear-cut. There are considerable reserves for innovations and high-technology processes in so-called “traditional” industry. In the production of steel or aluminium one can introduce modern and even high-tech technologies. The development of biotechnologies does not take place in isolation from agricultural production. Biotechnologies are extremely important in the development of new ways of processing food, but also in deriving new products from traditional ones like combination between alimentation and medicine.

It is also obvious that in some industrial sectors, like car building and the air & space one applications of new technologies is extremely important.

 

As a result, the necessary drive toward new, high value-added, technologies is not to take place in isolation with the development of “traditional” industries, but much more

complementarily with them.

Here, it is important to have a look on productivity growth in the Russian economy. To the contrary to the image one can get from the President’s speech, the Russian industry has not been stagnant, nor has it been only driven by the development of commodities export.

 

Table 1

Productivity growth since 2003

 

Source: ROSSTAT

 

It is quite interesting to see the very high productivity growth in the non-extractive industry and in construction. For similar sectors the comparable rate of growth has been of 130% in the industry (not-extractive) and 120% in construction in developed economies.

Of course, the lag between developed economies and Russia is still pretty large. Russia is actually catching-up, but it is doing so pretty fast and specially in non-extractive sectors.

 

This is raising the issue of the current crisis. President Medvedev rightly points out to Russian specific factors to the crisis. It is true that the drop of oil and gaz prices cannot explain through its effects, direct and indirect, the severity of the crisis. We are back, as November 2009, to the level of autumn 2007 (75 USD a barrel).

 

However factors specific to Russia are probably much subtler than what he said.

First, it is to be known that Germany and Japan have suffered too a sharpest drop in

production. In Japan, it reached –15% for the first months of 2009, and the Japanese industry is not an especially backward one. In Germany too the drop has been significant if on a lesser scale than in Japan. Such a large drop in the industrial production was the result of contracting markets elsewhere. Russia has been hit by this problem but, would the Russian industry have been truly “modernized”, as the Japanese and the German one, it would have been hit too.

This crisis highlighted the issue of depending too much on exports, whatever the nature of exports, and not having developed enough the internal market.

Second, Russian industry structure certainly has played a role in the crisis, the government policy too and especially the policy of the central bank and the ministry of finance. When the crisis flared up, and the currency began to drop, the Central Bank brutally raised its main interest rates at a time when all Central Bank in developed countries haves lowered their rates. This had produced a considerable “credit-crunch” in Russia, which affected not just investment but much more significantly the day-to-day operations of enterprises. This was plainly avoidable, would the Central Bank and the Ministry of Finance have chosen a different policy.

 

Figure 1

 

 

Source: Central Bank of Russia

 

What we are seeing now is the beginning of a rebound. It is particularly interesting to see the index of the railway freight, which is quite robust an indicator rebounding sharply. However, and this is an important issue to be dealt after, investment is so far not rebounding.

 

President Medvedev stated in its speech that:

The banking system is in a satisfactory condition today, taking the crisis year into account of course. Lending is starting to grow again and the amount of overdue debt has stabilised. Now that inflation has come down and the currency market has stabilised interest rates are also gradually starting to fall. The Central Bank is now playing in full its part as lender of last resort. But from the innovative development point of view the financial sector is still weak. It has insufficient capitalization and is not able to provide a full range of needed services to our people and companies”.

 

This is true, but is only part of the truth.

The responsibility of the Central Bank in the credit crunch has been one of the main points strengthening the crisis. It is always more pleasant to posture as a modernizer than to proceed to a global review of the government’s policy. But, the truth is that the crisis is not rooted in the backward nature of the Russian economy, or in its commodity-exports orientation.

We then have to turn toward the real curse of the Russian economy. As we have seen in figure 1, the investment is not rebounding at the same level than other data. This is an obvious problem, and one contributing to the possible duration of the crisis.

 

How to engineer a new development model?

 

The issue of the “new development model” is certainly a central one. President Medvedev rightly made it a central point of his speech.

He targeted the State Corporation in the following terms:

 

Regarding state corporations, I think that this legal form of enterprise has no future overall in the modern world. The corporations with a lifetime set by law should wind up once their purposes are accomplished, and those operating in a competitive business environment, should be eventually transformed into joint stock companies under government control. In the future, they should either remain in the public sector in cases where necessary, or should be sold to private investors.

 

We also need to carry out an independent audit of [state] corporations and of large companies with state participation, introduce modern corporate governance models in them, and peg the pay of their managers directly to performance results in cost-cutting, energy efficiency, raising labour productivity and introduction of new technology and innovation.”

 

There was here two different points he made out. One is the reference to “modern corporate governance” and the like. This certainly is a key point. The question of State enterprise efficiency is certainly a crucial one and one is to spare nothing to try to improve it.

However, the second one is clearly an ideological statement. When President Medvedev states that “, I think that this legal form of enterprise has no future overall in the modern world” he moves on a very unstable ground.

 

First, on has to wonder why Russia has developed these State Corporations after having privatized most of its industry in the earlier decade. The reason is quite simple. Private investors have been unable and/or unwilling to develop these industries. One can discuss the reason why, but it is a fact. The development of some key industries is to be done by the State or not at all.

Second, one has to reckon with a simple fact: in Russia only the State has the financial power to develop some activities. We can understand why we ended in this situation. Population savings have been destroyed twice in the 1990’s. They could not support large investment funds. Savings are made only through export revenues, which are either directed directly to the state through taxes or indirectly through state enterprises. This is a quite typical “Russian” situation. The very weakness of private savings and private investments has explained why the State has played prominent a role in the industrialization and the modernization of the country since 1860. This was true under Witte’s time, this was true under the Soviet regime and this is still true.

Third, the possibility of floating State corporations looks very remote today. Foreign investors are to be much more interested by short-term investment. By the way, some of these corporations are much too strategic to be left to foreign investors. As far Russian investors, they are already “crowded out” by different source of investment and they don’t display real interest in these industries.

Then, the only option left open seems to be improving the governance model of these State Corporations, but keeping them under the State hat.

 

The reason behind the reluctance of investors to commit to medium to long-term investment in Russia is pretty simple to understand: the over-valuation of the Ruble.

 

Figure 2

Nominal and Real exchange rate vs USD and Euro

 

Source: Central Bank of Russia.

 

One can see in figure 2 the movement of the exchange rate against the US Dollar and the Euro, both in nominal and real terms. Two facts are here worth to note.

The first one is the general trend toward the over-valuation of the Ruble. It implies a loss of competitiveness of the industry and explains why we had less investment than necessary in this sector. Private investors are not philanthropists. They invest where they see an opportunity of profit. By the same token, without tariffs now in place protecting the Russian industry, this would have been even worse.

The second fact is the notorious up-down-up again movement the real exchange rate. This is particularly obvious for the exchange rate against the US Dollar. Once again, there is nothing really surprising here. From September 2007 up to June 2008 we had a massive inflow of “hot money” in Russia, that is speculative capital, which is usually denominated in US Dollars. Russian enterprises had the incentive to massively borrow from the outside and they increased their indebtedness position. This was the time when the Minister of Finance was speaking of a Russia as a “financial heaven”[2].

 

In fact this was the perquisite to massive a destabilization of the Russian economy. With the world liquidity crisis the Lehman Brothers collapse induced, this “hot money” flowed out of Russia rapidly. The exchange rate collapsed, but not for very long. Today, we are seeing again the trend of overvaluation manifesting itself (figure 3).

 

The fact is that the Central Bank policy, pledging inflation targeting, has completely collapsed last winter.

 

Figure 3

 

Real exchange rates vs USD and Euro, and FOREX reserves

 

 

Source Central Bank of Russia

 

The truth is that the current model with a strong state sector trying to compensate for theexports-induced overvaluation of the Ruble in a liberalized convertibility environment (the so-called capital account convertibility) is the only coherent one. May be has it not been implemented in a consistent way but there is no other option. This is may be not a pleasant fact, but it is a fact.

Of course, President Medvedev could have announced that Russia was to give away this liberalized convertibility and was to implement some kind of capital-flow regulations. Would Russia adopt a convertibility system similar to China, with a much lower real exchange rate, this would considerably modify the incentive for investment. Actually, only a return to a current-account only convertibility system, with some exceptions for long-term foreign investment is able to support the modernization policy on the scale and scope envisioned by President Medvedev. But, he has been silent on this issue…

 

Conclusion.

 

President Medvedev’s speech is to arouse considerable hopes in Russia, and to some extent rightly. He has a vision of the future of Russia worth to be supported as a modernized and democratic country.

However his analysis of the current situation is faulty on several key points. It is certainly easier to speak for “radical reforms” than to try to improve the system as it works now. But the basis for such “radical reforms” are lacking in Russia in the current context. By ignoring what it has been done in the previous 10 years he is severely undermining his own position.

 

The issue of the real exchange rate captures actually the essence of a change in the Russian model of development. Till he will make his mind on this topic we are to wait for an economic policy more coherent than the current one.

 


[1]Professor of Economics at EHESS-Paris, Director of the CEMI-EHESS. sapir@msh-paris.fr

 

[2] Sapir J., « Vozmozhnosti i Riski ‘ Gavani Stabil’nosti’ » [ Possibilités et risques d’un « havre de stabilité »] in Rossija v Global’noj Politike, n°2/2008, mars-avril. Consultable aussi sur le site, http://www.globalaffairs.ru/numbers31/9482.html