Russian Reform Is in a Rut

Putin's own political agenda is hurting efforts to fix the economy

Shadows under his eyes, hands in his pockets, former economics professor Andrei Illarionov paces his third-floor Kremlin office. It's nearly 11 p.m., and the 39-year-old Illarionov, an avid proponent of free markets and Russian President Vladimir V. Putin's top economic adviser, is trying to stay awake in the midst of a typical marathon workday. As ever, he's anxious--worried about an economy that's slowing as a rapid currency appreciation squeezes industrial production. But there may be a bright side. As he impishly notes: "Crises are conducive to economic reforms."

Russia needs some kind of jolt. On Apr. 3, hours before Illarionov shared these thoughts, Putin repeated his campaign pledge to push for key economic reforms vital for improving the investment climate and stimulating growth. Trouble is, the Putin administration has so far accomplished little other than a tax reform package passed nine months ago. Although there are now some stirrings of action, including a package to make it easier for businesses to obtain licenses, prospects for big-ticket items remain dim. Banking reform: Forget about it. The restructuring of energy monopolies: Glacial. Privatization of farmland: Maybe later.

BLEAK PROSPECTS. Last year, the government could be somewhat forgiven for complacency. Buoyed by high oil prices, the economy expanded a robust 7.7%. But gross domestic product is expected to grow 4% at best this year, and industrial production rates are at their lowest in two years.

It's a grim picture. As oil prices retreat and domestic manufacturers lose the advantage afforded by the ruble's devaluation after Russia's August, 1998, financial meltdown, the long-term prospect looks weak for an economy still shackled by state controls and subsidies and currently losing an estimated $20 billion annually in capital flight. Inflation rose 7% in the first three months of 2001, further cramping industrial growth. The production decline threatens to sap tax revenues, crimping Russia's ability to pay state salaries and pensions and reduce its $150 billion debt.

Putin knows he has to regroup fast: That's why he's expected to restructure the government in May. His big moves may even include the ouster of Prime Minister Mikhail Kasyanov, a veteran technocrat who has failed to build momentum for reforms. "The country still has an unfavorable investment climate," Putin declared in his Apr. 3 speech. "If we don't take active steps--in particular, to implement structural reforms--we may get long-term stagnation."

POLITICAL TOOL. There's a dangerous paradox here: So far, it's the President himself who seems one of the biggest obstacles to progress. His reform rhetoric notwithstanding, former KGB spy Putin appears to view Russia's economic assets chiefly as a political tool for accomplishing his top objective, the restoration of the nation's standing in the global political arena. Thus his emphasis on increasing arms sales to China and Iran and on leveraging Russia's energy resources to bring former Soviet republics such as Georgia to heel.

Putin is no doubt mindful that the public is not clamoring for Western-style economic reforms. Many Russians identify reforms with the severe hardships that followed former President Boris Yeltsin's pursuit of a shock-therapy program in the early 1990s. "It's not something that's going to get you votes," acknowledges Yegor Gaidar, who as Yeltsin's Prime Minister was the program's architect. Besides, the market policies advanced by such Western institutions as the International Monetary Fund are held in little esteem these days. On Mar. 28, Putin's government rejected a one-year standby agreement offered by the IMF, saying it had no wish to be under the bank's thumb.

In this atmosphere, the likeliest advance on the liberal front is a modest package on land reform. Now pending in the Duma, it would legalize the private ownership of commercial and residential land. Putin hopes gradually to move toward farmland privatization by giving wary regional leaders the lead in determining its pace and scope.

Other initiatives are on the table. Kremlin policymakers want to put an end to the stranglehold bureaucracy has on business. "The system defends its rights to receive its so-called dues--to put it bluntly, bribes and kickbacks," Putin said on Apr. 3. The restructuring plan expected in May likely will sharply cut the numbers of officials at many ministries and may eliminate the Fuel & Energy Ministry. "The government is so top-heavy with bureaucrats now it can barely function," says Oleg V. Vyugin, chief economist at Moscow brokerage Troika Dialog and a former Deputy Finance Minister.

A new plan to impose royalty taxes on energy and metal giants that store most of their profits in accounts abroad could bring in $5 billion to $7 billion annually. Those taxes would go to a fiscal stabilization fund to protect the country against the perennial threat its resource-based economy faces from swings in commodity prices. To gain the acquiescence of commodity moguls on the tax front, the President is supporting an Illarionov-backed initiative to liberalize draconian currency regulations. The Soviet-style restrictions are widely evaded and tend to impede trade.

DISTANT HOPE. But there is no active push to break the logjam on such pivotal issues as banking reform. Improved state supervision of banks and the creation of deposit insurance would tilt lending to viable business prospects rather than politically connected cronies and give a boost to the economy. The main obstacle is Central Bank Chairman Viktor Gerashchenko, a former Soviet bank chief who has been reluctant to shake up the status quo. And a long-delayed restructuring of Russia's gas and electricity monopolies to introduce competition in these markets remains a distant hope in the face of Putin's unwillingness to wipe out subsidies with a large, politically painful hike in tariffs.

The optimistic view is that Putin is delaying reform until he has the political strength to pull it off and the time to explain any big change to the electorate. After all, the Yeltsin-Gaidar group probably set back the cause of market reform with a rushed approach that was not adequately explained to the public.

Indeed, if his current popularity holds--polls now show him topping 70% public approval--Putin looks like a sure bet for a second four-year Kremlin term. "It's more important that Putin holds on to his political capital than fight a quixotic battle to get everything done quickly," says Goldman Sachs & Co. economist Alasdair Breach. But what if Putin never makes his big move on reform? "Some people say we're moving too fast, others say too slow, and I ask, `Are we moving at all?"' says the ever-skeptical Illarionov. It's a good question.

By Paul Starobin, with Catherine Belton, in Moscow

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