ECONOMICS ANDSECURITY

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NATO Parl iamentary Assembly

SUB-COMMITTEE ON EAST-WEST ECONOMICCO-OPERATION AND CONVERGENCE

THE RUSSIAN ECONOMY UNDERPRESIDENT PUTIN

REPORT

HARRY COHEN (UNITED KINGDOM)RAPPORTEUR

International Secretariat November 2003

Assembly documents are available on its website, http://www.nato-pa.int

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TABLE OF CONTENTS

I. INTRODUCTION – SURMOUNTING THE ECONOMIC LEGACY OF SOVIET RULE....................1

II. BANKING AND FINANCIAL REFORM.........................................................................................4

III. SOCIAL POLICY........................................................................................................................6

IV. MACROECONOMIC POLICYMAKING AND FINANCE AND MICROECONOMIC REFORM......7

V. ENERGY SECTOR......................................................................................................................9

VI. IMPROVEMENTS IN CORPORATE GOVERNANCE...............................................................10

VII. WTO ACCESSION AND OPENING UP THE RUSSIAN ECONOMY.........................................11

VIII. CHANGE IN THE RUSSIAN STATE.........................................................................................12

IX. INSTITUTIONAL AND LEGAL CHANGE..................................................................................14

X. RECOMMENDATIONS..............................................................................................................16

APPENDIX 1.....................................................................................................................................19

APPENDIX 2.....................................................................................................................................19

Bibliography.......................................................................................................................................20

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I. INTRODUCTION – SURMOUNTING THE ECONOMIC LEGACY OF SOVIET RULE

1. Several years ago, this Sub-Committee undertook a study of the economic situation in Russia in the wake of a potentially devastating financial crisis that shook that country in 1998. At that point, there was a great deal of pessimism about Russia’s economic prospects as well as its political stability. Since then Russia has undergone a remarkable set of changes that seem to be putting Russian growth and transition on a more sustainable foundation. The process is hardly complete and Russia clearly has a long way to go both in its economic and political development. Members of this Committee felt that it was essential to revisit the situation in this very large, strategically important country. Accordingly, this report seeks to provide an overview of the state of the Russian transition and to identify the issues on which the government and parliament have made important progress and those on which more work is needed. The Rapporteur would like to extend his special thanks to Mr. Victor Voitenko for his active support for this project and for his substantive suggestions for this report, as well as to the Russian delegation to the NATO PA for organising and hosting a very interesting and useful Sub-Committee visit to Moscow and St. Petersburg in September 2003.

2. Russia has paid an inordinately high price for seventy years of Communist rule and the Cold War. The Soviet Union was clearly overextended, its imperial obligations were enormously costly and its economic system was wasteful. The reigning paradigm of Soviet economic life from the late Brezhnev period onward was inexorable capital depletion - a condition largely due to the internal contradictions of centralised planning and the heavy stress laid on armament production. Critical consumer, agriculture and service industries were capital-starved and sometimes purposely underdeveloped. This unbalanced economy could not sustain itself, and this, in turn, was a central factor in the Soviet Union's collapse.

3. The effects of that long and unhappy experience persist. The early years of the transition under the stewardship of Boris Yeltsin further eroded the quality of life for many Russians. The state's authority diminished but not in an orderly fashion. An institutional crisis borne of a genuine power vacuum set in, and neither Russian civil society nor the marketplace managed to fill the void. This provided the context for a sweeping privatisation programme that has subsequently been characterised either as a massive asset seizure by a group of powerful insiders, or as the flawed but essential step needed to put Russia on the road to economic revival. At the very least, that sell-off managed to pry away from a highly inefficient state an array of commercial assets, which have subsequently provided the foundation for Russia's transition to a real market economy. But that massive asset transfer and the method in which it was carried out also left Russia vulnerable to a financial crisis in 1998 and made evident the consequences of a weak post-Soviet state.

4. Russia's current government had to work in a decisive fashion to overcome the legacy of Soviet misrule and the mixed results of the first chaotic years of transition. This has not been an easy task. Nevertheless, the end of an unlikely empire, the collapse of the ideology that animated it, and a financial crisis that demonstrated the need for proper governance and greater transparency provided the background for the current government’s effort to build a more coherent market-oriented economy. Russia’s economy is no longer seen simply as a means to undergird national military power. It is now charged with bringing prosperity and broad social and cultural development to the Russian people.

5. In some important respects, President Putin is a watershed figure in Russian history, having made several important breaks with the past. He has established a place for Russia in the international order that is no longer simply defined against the West. His government is working to accede to the WTO, is active in the NATO-Russia Council, and plays an important role both in theG-8 and in the “Quartet” group which has sought to broker a workable peace in the Middle East. Russia has also used its ample oil and gas reserves to link itself ever more tightly to the global economy. After nearly forty years of seeking to divide North America and Europe, Russian leaders

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discovered during the Iraq crisis that such divisions require it to make choices it would rather not make. Russia leaders now recognise their own stake in Western comity, and in several very important ways, Russia has become a bridge builder within the West itself.

6. President Putin's government has undertaken significant changes in domestic economic policies, is enacting fundamental changes in the legal code, and has advanced vital changes in the civil service, tax system, labour and land codes, and the pension system. These changes coupled with strong growth have helped restore investor confidence in this new Russia. Since the financial collapse of 1998, the economy has expanded at 5-8% per year, and 7% in the first six months of 2003. The government aspires to push growth to 10% a year in order to move the country on a path to converge with living standards already enjoyed in the West. That is a tall order indeed, and success here will depend partly on the state’s capacity to implement key reforms.

7. Indeed, serious problems continue to beset Russia: crumbling infrastructure, inadequate social services, widespread poverty and a widening gap between the rich and the great mass of Russians who live either near or below the poverty line. The emerging middle class remains small. Shortening life spans, lower birth rates and an inexorably falling population are among the most alarming features of Russia's demographic trends. AIDS, alcohol, drugs and tobacco abuse also pose serious challenges to policy makers.

8. Large enterprises exercising oligopolistic powers continue to dominate Russia’s industrial landscape. Dynamic small and medium-sized enterprises, which have proved so instrumental to economic growth and social development in the most developed former socialist countries, remain relatively rare in Russia (Odlin-Smee). Intimidation of independent media, particularly in television, the weakness of Russia's emerging political parties, inadequately developed judicial systems and the persistence of certain Soviet attitudes and methods in some of Russia's regions and in the bureaucracy are also complicating Russia’s economic development. With the exception of the important media problem, however, a dialogue is underway about how to address these daunting challenges. That dialogue, however positive, has also revealed the continuing absence of a broad consensus on Russia's fundamental economic policies, political direction, enduring weakness in Russia's civil society, and persistent problems in Russia's regions.

9. Russia’s divisions are regional as well; Moscow’s per capita GDP is at least five times greater the national average and Russia’s vast hinterland is far less well off (Wines). The war in Chechnya is the most violent and dramatic manifestation of the tension between Moscow and certain regions, but it is hardly the only one. In some regions, for example, where suspicion toward outsiders persists, local patriotism, the persistence of old Soviet thinking, and genuine economic vulnerability have fostered a climate of insularity and stasis. These are hardly attributes that inspire entrepreneurship, particularly when such sentiments are combined with strong inclinations to shield local plants from the strictures of the marketplace and the rules of the federal government. This has had the effect of discouraging both domestic and foreign investment in much of Russia’s hinterland. It also puts pressure on the centre to erode the authority of the regions to ensure that Federal reform is properly implemented. This inevitably leads to political problems.

10. Despite these serious problems, Russia is now better placed than it ever has been to deepen its economic development by embracing the global market economy from which it had long excluded itself. President Putin is evidently set on making the Russian economy more resilient and growth more sustainable. He is doing this not simply to placate the international lending community but also to restore Russia's place in the global order. A key question, though, is whether growth will improve the material conditions of enough Russian people to give them a solid sense of ownership in the transition process and the many tough decisions that still need to be made to advance this process.

11. President Putin has displayed a tough-minded willingness to take difficult but necessary measures. Early in his term, he resisted the temptation to default on outstanding debt service - a

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financial "nuclear option" that would have dramatically lowered Russia's standing in global financial markets and gravely reduced its capacity to borrow in the future. In 2000 the government had not factored debt repayment into the budget, and the plan was to go to the Paris Club to negotiate payment deferrals. President Putin, however, decided that this was too risky a course, and the government’s decision to continue payment allowed Russia to claw its way back to good financial standing - a development obviously facilitated by higher oil prices.

12. International confidence in Russia now appears to be on the rise. President Putin has helped restore a much-needed sense of stability to his country, and this has had important spillover effects on the business climate. Foreign investment is rising, although not at rates that some feel Russia’s potential would merit. But there remains a degree of uncertainty among the investor community. Russian and American business leaders told members of this Sub-Committee that poor infrastructure, a still uncertain legal climate, unpredictable administration and frequent changes in tax and customs laws have all kept investment levels below what they should be. That said, investment seems to rise as the government addresses some of these concerns; Russia's apparent stability, improving business climate and continued economic growth are generating renewed interest among investors (NATO PA Secretariat Report).

13. The balance of payments illustrates the very positive trends of the last several years. Capital is starting to flow into the economy as a result of enormous oil and gas revenues and foreign investment. Russia's reserve position has consequently improved so dramatically that the IMF is convinced that the government will no longer need to borrow from the Fund to underwrite its payments position. Russia’s debt to the IMF has fallen from US$20 billion to US$5 billion over the past several years (Committee visit to Russia, September 2003).

14. The Russian economy remains highly dependent on raw material sales including energy, timber and various metals. Its resource wealth certainly confers enormous advantages as well as a steady stream of foreign exchange earnings. But generous resource endowments could also represent a potential vulnerability, particularly if energy extraction and sales are conducted at the expense of the rest of the Russian economy. Not surprisingly, the government considers economic diversification to be a top priority.

15. Fluctuations in commodity prices - and particularly sudden changes in oil and gas prices - invariably affect the broader Russian economy. Recent oil and gas price trends have proven highly beneficial, allowing Russia to service its debt while operating a budget surplus. But were oil prices to fall to US$10 a barrel, for example, the pressures on public finance would be severe, although international lending officials now believe that the development of other sectors has reached the stage where Russia could manage even if prices were to fall to US$15 a barrel. The 2004 budget calls for the introduction of a stabilisation fund for oil revenues. Similar to the Chilean and Norwegian models, the Russian stabilisation fund would collect "surplus" tax revenue coming from higher-than-planned oil prices and invest it in securities without passing through the budget. The government could only access the fund in exceptional situations such as when oil prices fell below a threshold price for an extended period. At that point, the government could access these reserves to underwrite a deficit and support the budget (Lambroschini). If properly managed, this fund should provide Russian officials with a means to cope with the adverse consequences of a commodities price fall on the budget.

16. Very high oil prices over the medium to long term potentially would also have adverse effects, even though this would likely introduce a windfall of foreign exchange into Russia's coffers. An oil price explosion, for example, could spark a precipitous appreciation of the rouble that would render Russia's struggling but perceptibly growing commercial and industrial sectors uncompetitive in world markets. One way to counteract this vulnerability over the long term is to ensure that the national economy is sufficiently diversified to insulate it from the more pernicious effects of single

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commodity price fluctuations. Boom-bust cycles are hardly conducive to steady and broad-based economic development.

17. Among the industries that need nurturing, and which stand to lose should the rouble fluctuate too violently, are the automotive, food and agriculture, telecom and aerospace sectors. Of course, Russia also needs full access to Western markets and this has proved problematic, particularly in certain sensitive sectors like steel and agriculture. Here Western countries need to do more to provide Russia with an outlet for its industrial base.

18. There is a second and perhaps more psychological downside to an oil windfall linked to skyrocketing prices. Such a windfall might reduce federal authorities' incentive to engage in painful but much needed reform efforts. It could have the same effect on regional governments, where the reformist impulse is already substantially weaker and, in many instances, non-existent. Regional and local governments have been known to use locally generated energy earnings and central government funds simply to subsidise local industries. If prices do rise dramatically (and this is not expected over the short term), it could prove more difficult for Russian leaders to justify a range of tough policies needed to put growth on a more sustainable foundation and to diversify the economy.

19. One of President Putin's chief economic ambitions, therefore, is to build up industrial and commercial sectors in Russia in order to reduce the relative weight of the oil and gas sectors. In recent months the Kremlin has taken up the notion that small and medium-sized firm development will be critical to Russia’s long-term economic growth and social stability. But it is a measure of the inherent complexity of economic transition that little can be done for this vital but underdeveloped sector without overhauling Russia's still highly inadequate banking and financial sectors.

II. BANKING AND FINANCIAL REFORM

20. Building a strictly regulated, modern, two-tiered banking system, consisting of an independent central bank and a network of commercial banks serving the economy's fundamental financial needs, is therefore essential. Banking systems function best when they forge strong mediating links between savers and investors that facilitate the flow of capital to potentially profitable commercial ventures. This is a tall order for any transition society, and it has taken Russia a decade to begin to coherently address many of these challenges.

21. The financial crisis of 1998 compelled Russian leaders to begin to remedy inadequate policies and structures that had allowed the country's financial situation to get out of hand. Yet banking reform is unfolding at a very slow pace. Prior to the financial crisis many banks were operating more as "pyramid schemes" than mediating financial institutions. The state itself subsequently assumed direct ownership of the banks, and the head of the Central Bank was fired. The goal now is to sell the state's shares in these banks to the private sector, but this is proving politically delicate particularly in an election year. Virtually all analysts believe that Russia will have to move quickly on banking reform or else the economy will be at risk of a second financial crisis. Obviously ensuring financial transparency, competition and good corporate governance will be a central element to any successful reform.

22. While Western banks have partly compensated for Russia’s banking inadequacies, Russian banks are simply not playing a catalytic role in the country's development. Big Russian banks are almost exclusively focused on serving the very largest Russian firms like Gazprom and Lukoil. Yet, these institutions do very little in terms of mediating between savers and investors in potentially dynamic but lesser known firms, and start-up firms have virtually no access to bank capital. Russia continues to suffer from a genuine paucity of medium-term finance - a deficiency that is proving a bottleneck to Russian development, and as suggested above, there is little investment capital available for small and medium-sized enterprises.

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23. The European Bank for Reconstruction and Development (EBRD) has helped plug this gap and is engaged in a wide range of financing projects including financing Russian aerospace industries, agro-food companies, service sector projects and a number of transportation projects. The work of the EBRD, however, is animated by a number of goals that most commercial banks would not take on board. For example, it is actively seeking to erode Russia's monopolistic industrial and financial sectors by promoting commercial competition. It does this by stipulating that firms to which it lends should procure supplies from a broad range of Russian sub-contractors. This is designed to give a much-needed boost to Russia's small and medium businesses. Obviously though, the EBRD cannot alone fill the void left by an inadequate and poorly structured banking system.

24. Monetary policy was tightened up after the 1998 crisis but the return to growth has allowed the Central Bank to ease off somewhat. The Bank's monetary policy guidelines for 2003 envisage broad money growth of 20-26% and an inflation rate somewhere between 9-12% [Economist Intelligence Unit (EIU), Country Profile]. In mid-February, the Central Bank's governor Sergey Ignatiev shifted the target of monetary policy from the external value of the rouble to a desired inflation rate. The rouble strengthened immediately on the news that the Central Bank would reduce dollar purchases. High oil prices have also increased demand for the rouble, boosted dollar inflows and pushed up the value of Russian money (Bank of Finland). The Central Bank is therefore walking a tightrope in its stewardship of the currency; a rouble collapse would stoke inflation while overvaluation would penalise Russian exporters. IMF officials, however, have been very impressed with the capacity of the bank to manage the currency.

25. Foreign reserves have recovered significantly over the past three years, helped by a persistent and rising current-account surplus, mounting inward investment, new multilateral lending and high international oil prices. As of 1 May 2002 foreign reserves (including gold) had reached US$60 billion. Russian savings have deepened substantially. Yet the poorly developed banking sector makes it difficult to channel these savings into investment.

26. As long as the Russian economic environment was seen as highly risky or bereft of investment possibilities, Russian capital holders were exporting money at extraordinarily high rates. Although part of this outflow reflected the need for Russian black marketers to hide or launder ill-gotten gains, much of the capital flight consisted of legitimate transactions made by savers, official banking sources and corporate heads. That outflow, however, slowed from a high of 12% of GNP several years ago to roughly 8% last year. Today more capital is flowing into Russia than out. The fact that Cyprus is the second largest investor in Russia suggests that Russians, who were exporting savings to that country, are now happily repatriating funds either to underwrite purchases or invest domestically (NATO PA Secretariat Report).

27. The fact that Russian growth rates are outpacing those of most Western economies partly explains this change. Yet additional investment opportunities and a more secure investment climate are needed to keep an even higher share of Russian capital in Russia itself. Foreign capital inflows may prove helpful in this regard, both because this conveys a degree of Western confidence in Russia and because Western investment invariably introduces vital financial and commercial skills that are in short supply in Russia.

28. The EBRD is the largest single lender to Russia. It seeks to earn a reasonable return on its investment and will not make loans where there are few prospects for a profitable return or where those loans will not somehow advance the broader prospects for national economic development. It is therefore revealing that whereas in 1997 the EBRD made US$700 million in commitments to Russia, by 1999 that figure had plunged to US$217 million because the economic environment after the financial crisis was so fraught with uncertainty and risk. In 2000, however, EBRD commitments climbed to US$560 million and in 2002 the bank lent US$1.3 billion to underwrite

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26 projects. The bank’s goal now is to invest US$1 billion a year over the coming years. This reflects a burgeoning sense within that institution and among the private operators whom they finance that the Russian business climate has improved substantially. Foreign investors also seem increasingly willing to invest in Russia’s non-oil industries including the consumer, machine good, defence, aerospace and timber sectors.

29. Once Russian firms are able to achieve the transparency needed to allow lenders to undertake broad due diligence, they will be in a position to attract even higher amounts of investment. In September 2002, the Russian Marketing Association surveyed representatives of 340 foreign companies. 75% saw today’s Russia as an attractive if nonetheless unpredictable place to invest. In recent months, the scale of foreign investment appears to be rising. British Petroleum, for example, recently announced a huge new investment project worth some US$6.75 billion, a watershed project that appears to be inspiring other foreign investors to plunge into the market (Jach and Behr). During an energy summit this past June, Britain and Russia also signed a memorandum of co-operation for the construction of a gas line under the Baltic Sea from Russia into the rest of Europe (Dullea).

III. SOCIAL POLICY

30. Russia confronts a broad range of social challenges, some of which the old Soviet system never addressed and all of which have been exacerbated by Russia’s budgetary and financial difficulties.

31. The pension crisis is one of the most glaring of these problems. Russia’s population is aging rapidly because of falling birth rates and shortening life spans. But the pension system inherited from the Soviet Union proved unsustainable, and the government has been forced to contemplate fundamental reforms including the introduction of accrual based private and public pension funds. A proper regulatory framework and a more orderly and deeper financial system must be in place before such a profound reform is adopted. Otherwise, there is a real threat that pension funds could vanish as a result of mismanagement, poorly articulated financial structures or even corruption. For that reason, World Bank and IMF officials have warned Russian authorities to move slowly on this front, and Russian officials recently delayed implementation to ensure that proper safeguards are in place.

32. As Russia’s alarming demographic trends make evident, Russia also suffers a range of shortcomings in its public health system. Traditionally that system has been geared toward treating sickness rather than engaging society in preventive health care. Relatively few resources are disbursed on promulgating good nutritional habits, practising safe sex, or discouraging alcohol and tobacco abuse. The nation’s health care system is under-financed and inefficient. A potentially explosive AIDS crisis and the sheer inadequacy of Russia’s hospital system make systematic change vital. But specialists are concerned that not enough is currently being done, partly because of deeply entrenched interests dedicated to defending the status quo. Russia still lacks the managerial know-how, appropriate institutional framework and resources to meet these rather daunting challenges.

33. Unlike many developing countries, Russia is a highly educated society with a 99% literacy rate and an educational system that requires every student to remain in school for 11 years. Russia’s needs lie more in developing the organisational structures and applied knowledge to put its skills and basic knowledge to good use in a market context. Russia is particularly lacking in modern managerial skills both in the private and in the public sectors. One problem has been that many tenured university professors and administrators resist innovation (NATO PA Secretariat Report).

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34. Perhaps the most potentially explosive social problem lies in the growing gap between so-called “new Russians” who are flourishing in the current economic climate and the millions of citizens who are not. Roughly one quarter of the population is living below the poverty line, while 7% are living in what the World Bank characterises as conditions of extreme poverty on an income of US$2 or less a day (NATO PA Secretariat Report). As long as this income gap is widening, there will be a risk of a political backlash against the reform process and Russia’s developing democracy. Many Russians feel that reform has resulted in their immiseration; this could result in a strong performance of less reform-oriented parties in the coming parliamentary elections.

35. Russia’s environment poses yet another set of compelling economic and social challenges. The Soviet Union simply ignored environmental risks and bequeathed Russia a legacy of pollution, which, in some cases, will take decades to ameliorate. These problems are not abstract and impinge on the quality of life for millions of Russians, while bearing real economic costs. Russia has not yet signed the Kyoto agreements even though it is currently producing far less greenhouse gas than in 1990- the emissions level-setting year contained in the agreement. Russia would very likely be in a position to sell off its greenhouse gas emission rights at some profit. Yet it is withholding its signature for other economic concessions from those states most anxious to put this agreement into effect.

36. While President Putin has tailored his rhetoric to recognise the need for co-operation with civil society, important elements within the state and the Kremlin itself sometimes seem to fear this critical aspect of democratic life. The struggle against the media is a case in point (Zolotov). The general insularity and inaccessibility of the civil service only exacerbates the problem.

37. A genuine transition to Western style democracy will ultimately require the emergence of social trust and an articulated civil society that reflects that trust. The experience of the last ten years, however, has not produced an abundance of confidence, at least in the pace of change. Russia’s emerging middle classes do seem to embrace the "democratic" norms of social, political and economic association. Nevertheless change in this area will be very difficult and slow as long as so many feel that further reform will leave them worse off. Many of those working in the state sector and in declining industries, for example, harbour these types of concerns, as do those depending on state pensions.

IV. MACROECONOMIC POLICYMAKING AND FINANCE AND MICROECONOMIC REFORM

38. Building functioning macroeconomic institutions and getting the policy mix right pose some of the most formidable challenges to those leading the transition process. Governments must reduce the state's economic role in the economy while engaging in profound budgeting reforms. Modern tax systems relying upon value-added levies, corporate and individual income taxes, sale taxes, and public compliance are all essential.

39. Perhaps as a result of approaching parliamentary and presidential elections in 2003-2004, the Russian government has recently loosened fiscal policy. The 2003 budget nevertheless projects a surplus of 0.6% of GDP. That is less than the 1.6% originally planned for 2002, but a sharp contrast with budget conditions prevailing throughout much of the OECD. The Economist Intelligence Unit estimates that the 2004 surplus will be roughly 0.4% of GPD (http://www.economist.com).

40. Russia has long needed fundamental tax reform and President Putin managed to push through changes at the start of 2001 that included: the introduction of a 13% flat personal tax; the replacement of various social levies with a unified social tax; and the abolition of turnover taxes. At the beginning of 2002 a new corporate law came into force, which reduced the maximum corporate profit tax from 35% to 24%. It abolished numerous loopholes while improving the deductibility of

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regular business expenses. Many companies preferred the loopholes with the higher corporate tax to the current system, arguing that the reforms have increased their tax obligations. The government has responded by looking into a range of tax incentives designed to encourage investment. The government is using tax policy to bring the grey and black economies out of the shadows and to encourage broader investment in the country's industrial sectors. The government also plans to ease the tax burden further for the manufacturing sectors of the economy, although it will not do so for the flourishing extractive industries. This aligns the government with IMF calls for higher taxes on the energy sector and lower tax rates on the emerging industrial, commercial and service sectors, all of which are struggling.

41. The government still needs to address problems on the expenditures side of the budget. Housing, pensions and other social expenditures are largely unreformed. Most analysts suggest that current systems are too expensive and poorly targeted. If not restructured this spending poses potential long-term budgetary problems. Utilities subsidies not only cost the state dearly but also distort prices and lead to serious resource misallocation problems. Of course, there are compelling political reasons for subsidising energy use in an energy rich country, which in many other respects is very poor. Russian officials are also quick to point out that cheap energy is essential to the survival of millions living in the far north and Siberia. One problem is that these subsidies are also extended to a range of companies in a particularly non-transparent fashion, and Russia's trade partners see this as constituting a hidden subsidy. This has become a critical sticking point in Russia’s negotiations for WTO accession. These subsidies, moreover, do little to encourage conservation and have real costs in terms of foregone foreign exchange earnings.

42. The cornerstone of a market economy is private ownership and a price structure that reflects relative scarcities. While privatisation is fundamental to transition, it is not sufficient to ensure positive development, particularly if a proper regulatory framework is not in place (Gregory and Stuart).

43. Russia's mass privatisation programme of 1992-94 transferred ownership of over 15,000 firms to private operators. Yet it initially failed to spark substantial firm restructuring. Russian officials had hoped that secondary share trading would introduce outside ownership, and that more transparent methods would be used in the second wave of privatisation of firms still in state hands. Neither hope was fulfilled. Insiders were wary of relinquishing control; workers feared the cost cutting that might occur under outside control; and some managers found it easier to keep enterprises alive by lobbying the state for subsidies than boosting firm competitiveness. A second wave of privatisation employed the so-called "loans-for-shares" scheme, but it also systematically favoured parties with ties to government interests (Rogoff).

44. Russia's wealthy and powerful were therefore the main beneficiaries of what many saw as an insider's seizure of the nation's most valuable assets (Sonin). This remains a source of great bitterness in Russia, where some political forces will always be tempted to revisit that flawed privatisation. The potential danger of doing so, however, was made evident when the head of the Yukos oil company Mikhail Khordokovsky was arrested for corruption charges related to the means by which he acquired his massive holdings in the oil industry. The arrest has raised new concerns about the stability of Russian capitalism. Russia’s equities markets have reacted as if the government were on the verge of revisiting the entire privatisation scheme. A flight of capital followed on the heels of the arrest and a rather deep fall occurred in what has otherwise been a very strong stock market (Ostrovsky and Wagstyl). Some analysts see the Yukos case as part of a campaign to exploit the oligarchs’ unease about the long-term status of their property rights in order to “leverage” funding for certain political parties and discourage the funding of others (Aslund). If this is the case, the implications for Russian democracy and Russian markets are ominous. Russian authorities would be best advised to levy fines for any past transgressions and not undermine a flawed but nonetheless important privatization that at the very least has created a private and steadily expanding market. 45. The government has since gone out of its way to explain that the Yukos case is unique and the

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charges against it very specific. Russian authorities stress that this is not the opening salvo in a war against Russia's industrialists, and there has been a campaign to create a three-year statute of limitations on privatisation-related property disputes, in order to provide greater reassurance to market players that property cannot simply be arbitrarily seized. The market seems to have taken some of these reassuring signals to heart, but the Yukos case has revealed the sensitivities surrounding what was clearly a flawed but ultimately essential privatisation.

46. There are also those within the state bureaucracy who have never supported privatisation and who are prepared to resume control over these valuable assets. Renationalisation, however, will do nothing for Russia’s long-term development. Other measures are needed to reverse the growing welfare gap and address the problem of highly entrenched interests within state institutions. MIT economist Rudi Dornbusch has written that the Russian reformers "privatised without much care for niceties ... Yet, in the end, it worked. The massive privatisation and restructuring of state enterprises is paying off ... Now you can begin to think about attracting foreign capital. Would that have been possible if Russia was advised by someone who would still be drawing perfect privatisation schemes in his head?" That said, ameliorating the worst aspects of what was not a fair and open privatisation remains an important government obligation.

47. A number of industrial leaders who acquired their firms through questionable methods are now endeavouring to legitimise their operations in the eyes of their Western counterparts. The dubious practices of the early and mid-1990s, such as asset stripping, are less common today, and there seems to be more energy going into wooing investors and opening up account books. This transition is hardly complete; some of what is occurring is more form than substance and there are countless exceptions to the general trend, but at least the management practices of Russian industry seems to be improving. Russian leaders thus need to ensure that proper governance laws are in place and that they are universally and not selectively enforced.

V. ENERGY SECTOR

48. The energy sector is the lifeblood of Russia's economy and in the eyes of country's leaders, the glue that holds together this vast and diverse country. Most of Russia's economic success in recent years has been linked to its strong position in oil and gas markets. Russian oil production has increased by 25% over the past three years. Today Russia is the world's second largest oil exporter after Saudi Arabia, but its reserves are expected to last only an estimated 30 years, which is one reason why it is so important for Russia to diversify its economy today (NATO PA Secretariat Report). Privatisation, foreign investment, new technology and the introduction of modern capitalist managerial techniques have played an instrumental role in driving production upward. Proposed new pipelines to China, Japan and Murmansk will extend the industry's reach even further and potentially trigger a massive infusion of investment capital (Yergin, Fackler).

49. The networks holding together the gas, oil and electrical industries are indeed critical sources of coherence. Western economists have long suggested that Russia break up the central energy grid into regional and separately owned systems, while hiving off production and distribution to private investors. President Putin has done the opposite by preserving the national grid while selling off local and regional electricity production units to private actors. He intuitively understands that in his vast and highly diverse country, infrastructure grids are among the very few things holding the country together. The government fears that breaking up those networks would risk exacerbating Russia's already dangerous divisions. Put bluntly, in a country where millions live in the frozen tundra of Siberia, to lose power is to die, and the sense in the Kremlin is that this is a burden the state must ultimately shoulder. Not doing so, in their view, threatens the power of the centre and the coherence of the whole.

50. In January 2003 a package of six bills on power sector reform passed through the Duma. The reform split up the state power energy monopoly, UES, into state controlled enterprises responsible

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for the power grid and transmission, while allowing private enterprises to handle generation and distribution. Power prices on wholesale markets will remain regulated at least until July 2005. Consumer price controls could last until 2008. Energy trade in parts of Russia will be gradually liberalised to accommodate market players to the new modalities of operating in deregulated energy markets.

51. Reform of the gas sector has been slower. Gazprom has resisted privatisation and in the current electoral climate, significantly restructuring this industrial giant is unlikely, particularly as it generates so much revenue for the state. The company, however, has consented to plans that will allow independent producers to export Russian gas by 2008. This will clear the way for more investment in and output from the world's largest gas reserves. Last year, Gazprom's output rose a scant 2.3% after a string of annual declines, and there is increasing pressure on the company and its political overseers to expose the gas market to more competition. The company has also been involved in discussions with Conoco about entering the American gas market—a step that would require billions of dollars of investment in gas liquefaction infrastructure. These preliminary talks are part of mounting US and Russian efforts to broaden co-operation on energy matters (Whalen and Raff).

52. The currently stymied gas sector overhaul, together with the restructuring of the Unified Energy Systems (UES) electricity monopoly, are part of a Russian "big bang" of energy reforms, the outcome of which hinges on how far the government pushes Gazprom beyond the baseline of its plan. There are concerns as well that independent producers will still be locked into dealing with Gazprom for pipeline space and transit tariffs, allowing the company to maintain its grip on the market. If this is the case, then opening up gas markets to genuine competition will prove most difficult (Lelyveld).

VI. IMPROVEMENTS IN CORPORATE GOVERNANCE

53. The government has also made important progress in constructing a legal framework for improved corporate governance. Created in 1994, Russia's Federal Commission for the Securities Market (FCSM) regulates securities markets and issues licenses for investment funds as well as institutions that render services to them. A 2000 decree grants the Federal Commission authority to review cases where investor rights are violated. The Commission appears to be working effectively. It is preparing amendments to the Criminal Code for securities market manipulation and is introducing a computerised system of securities market monitoring to thwart insider trading (Birzhevykh manipulyatorov v Rossii budet lovit' komputer). There have already been several successful insider-trading prosecutions, but significantly higher levels of corporate transparency are still essential (Na rossiyskom rynke nashli pervogo insaidera).

54. In 2001, the federal government directed the FCSM to prepare a corporate code of conduct with assistance from the European Bank for Reconstruction and Development (EBRD) and private sector monitoring groups. The goal was to improve corporate transparency, accountability and predictability. The FCSM has no means of enforcing the code; but publicly traded Russian companies are under pressure to change their charters to conform to it. Some critics have suggested that by promulgating a code for the conduct of private enterprises, the government is intruding inappropriately in business matters. On the other hand, the government effort is raising public consciousness of corporate ethics and could help bring about a positive change in the business climate. Business leaders from both north-west Russia and the United States recently reported to members of this Committee their sense of a marked improvement on this front (NATO PA Secretariat Report). VII. WTO ACCESSION AND OPENING UP THE RUSSIAN ECONOMY

55. Russia is in the midst of WTO accession negotiations. Prospective accession holds out substantial potential benefits. Membership would certainly help Russia further cement its links to the

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international community. But taking on board the WTO's myriad obligations is also fraught with potential dangers. Industry will certainly have to gird itself for higher levels of openness and competition. Membership could further galvanise substantial reform of Russia's political system, develop and cultivate a new managerial class, strengthen small and medium-sized firms and inspire greater Russian willingness to invest in Russia.

56. Membership would also accord Russia leverage in shaping world trade rules, and grant it access to the WTO's powerful dispute resolution mechanism - the panel system - from which it is currently excluded. This would help regularise the settlement of Russian trade disputes while putting it on an equal legal footing with its trading partners. Undoubtedly, this would also reinforce Russian co-operation with the EU and the US and provide it with somewhat greater leverage vis-à-vis those two trading powers.

57. Finally and perhaps most importantly, membership would provide a large boost to Russia's internal reform. In a sense, membership in the WTO would introduce a kind of aquis that could push Russia to adopt best practices in business, government and finance that it might otherwise not be inclined to accept or at least adopt with the necessary alacrity. Of course, this aquis is not as stringent as that of the EU, but it is nonetheless sufficiently comprehensive to broaden the reform effort in Russia. Partly in response to the need to meet WTO standards, the government has adopted a new customs code, passed a range of product standards and adopted a body of internationally acceptable intellectual property laws. All of this moves Russia's commercial legal code that much closer to those of the West.

58. Both the EU and the US have recognised that Russia is now a market economy. This is a precondition for eventual WTO membership, but a number of questions must first be settled. As suggested above, energy pricing poses a formidable problem. The EU and the US have objected to the fact that Russian domestic energy prices are lower than international prices, and this segmentation, which some international lending officials suggest are not administered in a very transparent fashion, allegedly allows Russia to subsidise domestic industries. Russian officials have responded that local energy prices reflect Russia's capacity to sell a cheaply acquired commodity at low prices in local markets. Yet they also intimate that this pricing system offers the only means to offset the high potential costs Russia’s cold climate imposes on investors. Some members of parliament are convinced that no foreign investors would build facilities in Russia if they were obliged to pay world prices for energy. This argument is not universally accepted among Western economists. On the other hand, some economists acknowledge that Russia's domestic energy prices partly reflect real marginal costs, so this apparent segmentation might not be an outright violation of trade rules. Many Western officials also privately acknowledge that it will be difficult for Russia to unite domestic and international energy prices quickly because of serious political sensitivities. One potential solution would be for Russia simply to adopt a pricing system that is more transparent (NATO PA Secretariat Report).

59. Russia's large industrialists are somewhat divided over the pace at which Russia should accede to the WTO, although most recognise, at least publicly, that it should eventually join. Obviously those in favour of a go-slow approach represent industries that have the most to lose from rapid accession. In some respects, the issue will likely inspire some of the campaign rhetoric in the coming Duma elections. President Putin's approach at this juncture is not to accord the WTO question high visibility, as it could become a political lightning rod. Because WTO rules cover virtually all industries, those sectors that are in particularly bad condition, such as mining or the Russian airlines, could rally around an anti-WTO coalition. This is precisely what President Putin wants to avoid, and so further movement on this issue is unlikely until next year.

60. Agriculture will be a central issue on Russia's trade agenda. Russia's farming sector is woefully under invested and uncompetitive, but it nonetheless has great potential. For that potential to be unleashed, however, Russia will need to alter the legal structure governing agriculture, attract

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substantial capital investments, and nurture a new market-oriented ethos in a countryside where such ideas have no roots whatsoever. But it will also need improved access to world markets. Once in the WTO, Russia is likely to join those countries that are demanding changes in those aspects of the EU and US agricultural systems, which discriminate against foreign producers generally.

61. Private land is one of the cornerstones of a market economy. Russia has been slow to acknowledge this, but change is now afoot. In October 2001 President Putin signed a land reform bill that allows private ownership of urban land. Owners of buildings gained the exclusive right to sell or lease land plots under their buildings. The state cannot transfer land to any other party. The law has accelerated economic reform and significantly reduced the discretionary power of corrupt officials who wielded the state's control of land for personal gain. The new law grants non-Russians equal rights with regard to urban land ownership.

62. A second law signed in June 2002 provides a legal framework for Russians to buy and sell land on the free market. Most of Russia's agricultural land is now privately owned, but there is no effective rural land market. The new law will enable buyers to consolidate many small plots into marketable parcels and will enable owners to use land as collateral for financing. A crucial obstacle for implementing the new law had been the lack of a proper land registry, but that has now been created. Registries are urgently needed for demarking the physical boundaries of land parcels and creating a market-oriented ethos in the countryside.

63. Steel is another important sector for Russia and one in which it may enjoy certain comparative advantages internationally. Russia is capable of producing high quality steel at comparatively low costs. It has therefore strongly objected to recent US steel protectionism. Several steel towns like Chelyabinsk have been particularly hard hit by the decision to impose tariffs on Russian steel.

64. The service sector is likely to grow as Russia’s economy expands, but Russia has protected its fledgling service sector. Both Europe and the United States have sought to open this market up and have been particularly focused on gaining greater access to Russia's financial and insurance sectors. Telecommunications is another sector in which permitted foreign ownership is very low. On intellectual property rights, the Russians have accepted international standards. The problem here, as with many of the other reformed legal codes, lies in enforcing the law. Passing a good law is not the same as implementing one and this is where Russia still confronts problems.

65. Interregional barriers to trade are also a source of concern. There are indeed countless local and regional obstacles to free commerce within Russian territory. Regional governments are frequently dominated by large local businesses, many of which are not competitive either by Russian or global standards. Thus even formal international agreements undertaken by the federal government to open markets may have little impact at the regional level. Russia has numerous firms and plants that are simply not competitive. If exposed to international competition, they are unlikely to survive. Yet closing these capital-consuming plants is a politically very delicate matter, particularly in Russia's many "one company towns", and could trigger the kind of political backlash that might set back the broader reform agenda.

VIII. CHANGE IN THE RUSSIAN STATE

66. Liberalisation, stabilisation and privatisation are not sufficient to create conditions for successful economic transition. A coherent functioning state is also needed to oversee and channel the process, or else no market economy is possible. This is a paradox to some, but self-evident to all but a handful of the most radical free market liberals. Suffice it to note that a range of liberal economists from Adam Smith to Milton Friedman have recognised the central importance of a sovereign law-bound state to flourishing and free markets.

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67. The problem in Russia has been that the Soviet state was so antithetical both to democracy and the market that successive governments have had to navigate between destroying the structures of the old state, and fighting the kind of anarchic free-for-all characteristic of the Yeltsin years. The Russian state today combines elements of the old Soviet state with new more democratic and modern features, and the balance seems to be ever shifting. Nor are all the trends positive; although economic governance has improved, in some instances dramatically, the structure of the media has shifted in a direction that very few would characterise as democratic.

68. Yeltsin's most glaring shortcoming was that he failed to build a viable state apparatus upon the dysfunctional remains of the old Soviet state. This led to a power vacuum effectively allowing private actors to invent rules of the game solely to advance their very narrow interests. In such circumstances, building the preconditions for a market-based economy proved most difficult. What emerged were a private economy dominated by a narrow oligarchy, on the one hand, and the decayed vestiges of state owned, capital burning and unprofitable industry, on the other. Corruption was rampant and gravely complicated the reform effort and the construction of a genuine market. The oversized state's weakness was further exacerbated by a fiscal crisis linked to plunging tax collection rates and the inefficient administration of high budget programmes like defence and social services.

69. From his first days in office, President Putin has sought to consolidate the federal state's power and restore a modicum of stability to national political and economic life. Enjoying an impressive margin of support in the state Duma, he moved quickly against competing power centres - the regional barons, the oligarchs, the media, and the Duma - to reassert Kremlin authority. Among his most notable steps were a decree establishing seven federal districts headed by presidential representatives, known as super-governors, who act almost as federal prefects. He has also restructured the Federation Council and introduced a law empowering the president to dismiss regional leaders and dissolve legislatures guilty of enacting laws in conflict with the federal code. Regional authorities have hardly welcomed these initiatives, and some have characterised the effort as fundamentally undemocratic. On the other hand, a number of observers argue that this has helped to limit the arbitrary authority some regional governors have exercised, and complicated their efforts to resist reform efforts driven from the centre.

70. The administration has also made a great effort to infuse the public with a sense of pride in post-Soviet Russia. President Putin has not hesitated to employ potent symbols both from the Czarist and even Soviet times to that end. In the eyes of some critics, however, his tendency to rely upon images that recall imperial glory is difficult to square with the contemporary Russian reality. It keeps alive a set of national priorities that do not jibe well with Russia's democratic transition (Graham).

71. Fiscal relations between the federal government and the regions are evolving in favour of the centre. The transfer of wealth between the different layers of the government has been highly inefficient and opaque. The Putin administration has reallocated revenue from regional budgets to the federal government in order to bolster Moscow's leverage over the regions and to reduce waste. President Putin has replaced traditional bilateral bargaining between regional governments and federal authorities with a universal revenue-sharing formula. Since most social expenditures are made at the regional and local levels, however, the shift in spending power to the centre raises the spectre of further funding shortfalls in already under-funded social support programmes (EIU, Country Profile).

72. While the federal government has had some successes in the regions, the greatest challenge has been in Chechnya where the Russian state has sought to squelch a secessionist uprising, and in the process, destroyed large swathes of that republic and alienated many of its inhabitants. The city of Grozny has been levelled and rendered virtually uninhabitable. The war has effectively spread to Moscow where Chechen terrorists have perpetrated terrible acts of terrorism. The government

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maintains that the armed conflict in that beleaguered republic is all but over. Recent events suggest, however, that this is hardly the case. The terrorist theatre siege in Moscow in October 2002 left 129 dead, and deadly clashes between Russian and rebel forces in the Chechen theatre continue. Human rights violations in Chechnya are continually reported although it is not easy for monitoring groups to operate there.

73. Many hoped that this October’s presidential elections might move the country toward stability and peace, but many observers have been sceptical about the fairness of those elections. Akhmad Kadyrov, the Chechen administration head, was the Kremlin’s candidate for the Presidency. A number of Russian human rights organisations such as the For Civil Rights Committee, Civil Assistance Committee, and the For Human Rights Movement refused to send observers to the elections. Their spokespersons lamented the fact that several of the most viable candidates had withdrawn from the elections. Critics of the elections have also suggested that it is virtually impossible to hold genuinely democratic elections in the midst of a war. Russia’s human rights community therefore did not want to “support the illusion of the legality of the elections of the first president of the Chechen republic in October 2003" and refused to send observers (Pravda, September 25, 2003). Although Kadyrov is widely expected to win, the new President’s exact powers are not year clear. Russian authorities and parliamentarians are discussing granting Chechnya substantial autonomy, but no decision has been made (International Herald Tribune October 6, 2003). The hope is that the election will help civil order return after five years of war. The pessimists argue that no progress is possible without engaging the separatists in a genuine dialogue about the republic’s future.

IX. INSTITUTIONAL AND LEGAL CHANGE

74. Functioning legal institutions are essential to economic transition because they introduce rules structuring market competition. Criminal, civil, economic, and administrative laws are all needed, as are constitutional protections for private property, antitrust statutes, commercial codes, bankruptcy laws, and foreign investment guarantees. Functioning courts, arbitral tribunals, and mediation committees are critical to a law-bound society, as are legal training and the dissemination of broader legal consciousness to the greater population.

75. The business community has long complained about Russia's poor judicial system and the arbitrariness of certain court rulings that pointed to real weaknesses in the legal system, the persistence of corruption and the still widespread use of bribery. These deficiencies were almost inevitable in light of the Soviet legal tradition, which had no concept of an autonomous judiciary. Russia's reigning legal culture has tended to discourage investment; business particularly dislikes operating in a climate of legal uncertainty. Yet, here too, there are signs of improvement. Where before there was no genuine legal system and only a system driven by expediency, the adoption of the civil code of 1994 was the beginning of a process of a slow and in many instances real transformation of the legal culture. The challenge now lies in implementing these reforms so that the judiciary is truly autonomous and dedicated to defending the new legal codes.

76. The highest courts now seem more immune to corruption. For this reason, some investors have suggested that to have a case judged fairly, it is frequently wise to appeal lower court rulings to higher courts in that hope that cases there will be judged on legal merits. This is hardly optimal but it did represent an improvement. Ideally of course, that kind of recourse should be available in the lower courts as well; but this will take time and vigilance.77. President Putin's government has clearly embraced the concept of judicial reform, although it is hampered by a number of roadblocks. Recent judicial reforms are premised on making the courts system a viable third branch of government, independent of administrative and legislative control. The president of the Russian Federation appoints judges for life and the state cannot remove a judge. Recent laws allow judges to exercise exclusive control of judicial discipline and court

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administration. Moreover, the courts' jurisdiction now extends into areas such as constitutional jurisprudence, judicial review of administrative acts, and resolution of commercial disputes between private firms.

78. This is part of a broader effort to create a court system that supports the needs of a market economy. Russia has established courts of arbitration for handling litigation between business entities. In May 2002 the Duma approved a Code of Procedure for Commercial Courts, which will reduce the scope for interference in commercial disputes by the courts of general jurisdiction (EIU). New criminal and administrative law codes went into effect in July 2002. The codes extended protection to defendants and imposed some restrictions on law enforcement officials. As of January 2003, 70 of Russia's regions had adopted jury trials, which are guaranteed by the Constitution of Russia. Jury trials for the rest of the country will be phased in throughout the next two years, although such courts will not function in the Chechen republic until 2007 (Johnson's Russia List).

79. Despite these improvements, the judicial system remains riddled with problems: funding is woefully deficient, judicial training is inadequate, federal-regional legal ambiguities remain, inept bailiffs fail to enforce judicial decisions, and a local political culture based on personal power can and frequently does trump judicial deliberations particularly in the lower courts.

80. The government has also introduced a new labour code that recognises the right to strike, grants a minimum wage, and regulates the power of employers to hire and fire. The new code replaces a body of law that Soviet leaders initially introduced in 1970. Opponents, however, say these laws are too heavily weighted to employers and cut too deeply into employee rights and genuine trade unions in Russia (The Business Review Journal).

81. Russia's transition challenge does not lie solely in macro and microeconomic policies, investment, etc., but also involves profound cultural change as well as state-building processes. There is a clear need to build faith in institutions and trust in public and private authority, but the public also must be convinced that these institutions merit their trust. The Soviet system destroyed an already weak compact between state and society that existed in Russia, and the challenge for post-Soviet leaders has been to build trust on a very different foundation.

82. One of the more important developments over the last five years has been the emergence of a more active and responsible parliament. When the current legislature was first elected, many of the new deputies, particularly in the New Unity Party, were virtually unknown. To its credit, this legislature has played a positive role in supporting several critical reforms promoted by the administration. Its committees have displayed a growing capacity to assist the administration in fleshing out the details of key reforms. President Putin is now openly supporting this party in the coming elections in order to deepen his support in the parliament.

83. That said, the Russian party system remains weak, and the parties closest to President Putin still seem to lack a shared outlook or ideology. A not always transparent relationship continues to exist between certain influential industrial oligarchs and some members of the parliament.

84. Moreover, the kinds of debates that most Western parliaments would never refrain from conducting, are sometimes squelched in Russia for reasons of national security or from a fear of embarrassing those with the greatest power in Russia. For example, the Duma backed away from scrutinising the government's handling of the terrorist take-over of a theatre in central Moscow, despite the facts that dozens of Russians were killed when the police used a sedative gas prior to storming the theatre. A fully articulated parliament would normally not hesitate to conduct a post-facto examination of such an operation, even if the goal were simply to take on board the lessons of that experience. More disturbing still was the very restrictive media law that the Duma passed in the wake of that siege, which the president himself subsequently vetoed.

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85. That particular intervention, however, has not convinced numerous observers of Russian political life, who continue to cite the problem of the state’s subtle intimidation of the media. Some suggest, for example, that Russian television news increasingly has the feel of Soviet television, at least in style and content. Russian authorities need to be prepared to allow the media to play a more critical role in Russia’s democratic life. This is not always welcome by elected officials, but ultimately it helps them to do a better and more accountable job. There is no reason for this acute sensitivity about media criticism, and Russian leaders are creating problems for themselves when their initial instincts are to muffle criticism rather than engage it.

86. The Russian parliament still does not exercise two fundamental functions of the legislative branch: automatic participation in government and oversight of the executive branch. As a result, the executive branch remains far stronger than the legislature. Another problem is that the line between political and administrative functions remains relatively undefined. Ministers drive policy in their respective areas, and there are still too few mechanisms for democratic oversight of ministerial activity. Implicit restrictions on the freedom of speech and the press and the still weak judiciary further exacerbate the problem (Ryzhkov).

87. The government has initiated civil service reform in an effort to reduce red tape, and improve civil service conduct, which has been riddled by contradictions, corruption and inefficiency. Yet serious problems remain. In August 2002 President Putin signed a Draft Code of Ethics for Civil Servants. The Code draws upon the Council of Europe's Model Code of Conduct for public officials. It establishes ethical standards for civil servants including conflicts of interest regulation; sets restrictions against using an official position to take employment outside of public service; and imposes requirements pertaining to basic honesty, impartiality and efficiency in performing public service. Given the sheer dimensions of the problem, however, Russia needs to undertake more far-reaching reforms and further deregulation in order to construct a streamlined and modern civil service. In Russia members of this Committee were told that the size of Russia’s bureaucracy has changed little since Soviet times, and this enormous structure hangs like Damocles’ sword over many critical reform initiatives. As long as the state exercises so much authority in so many fields and is not fully accountable to civil society and its representatives, it will be difficult to counter the arbitrary interventions of faceless bureaucrats. Bureaucratic reform that raises the level of transparency and accountability is therefore essential to the transition process. The hope is that the government will address this problem more systematically after the election cycle.

X. RECOMMENDATIONS

88. Russia is in the midst of a profound transition that one Russian lawyer described as akin to America one day waking up to discover that a Marxist Leninist government had been put into place, and everyone and every institution suddenly had to adjust accordingly. Perhaps that is somewhat overstated, but it should help us to understand why the undertaking is still a long way from completion. It should also help us appreciate how much the Russians have accomplished over the past decade. In the early 1990s, Russia had no company laws, no private banking law, and no civil laws to meet market needs. These laws now exist, and, however fitfully, are being implemented with some success. Russia now has viable investment fund legislation on the books, tax reform has made great progress, the current account and budget are in very good shape and the non-energy sector is coming to life.

89. Serious problems remain, however. The country's infrastructure needs further investment, and the banking sector requires fundamental reform, as do the country’s natural monopolies. While Western advice and investment will be vital to successfully surmounting these challenges, Russian authorities have ultimate responsibility for conceiving and implementing a reform agenda that is ambitious, comprehensive, and at the same time understood as Russian in origin. Half measures

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and partial changes will fail to trigger the kind of changes Russia needs if it is to consolidate the real gains it has made over the last decade.

90. Perhaps the single greatest contribution Western governments can make to Russia's transition, beyond investment, lies in the area of practical training. Russia still lacks a critical mass of managers and financial experts, and though the situation in improving, this shortage constitutes a bottleneck to reform and modernisation. Funding Russian training programmes, supporting Russian students in the West, and encouraging all manner of exchange programmes will help fill this gap, while deepening the links between Russia and its European and North American partners. Direct investment offers the best means to provide the kind of training Russia most needs. American investors, for example, contribute an estimated 40 thousand man-days of training per year to Russian workers (NATO PA Secretariat Report).

91. Although the government and the parliament have made great strides in introducing a range of critical structural reforms, there is still a great deal of work to be done, both in terms of new legislation and implementation. The banking sector is in clear need of restructuring, and this reform will be the prerequisite for building a broader small and medium-sized business sector and putting the country on a more sound financial foundation. More creditor protections are needed. The government recognises this, but has so far been reluctant to move quickly. It will probably feel that it has to do so after the coming election cycle has passed. Meanwhile, the EBRD reports repayment rates of roughly 90% for loans ranging from US$100,000 to US$300,000. This suggests that there is a real market for financing small business, which, in turn, will add depth to Russia’s economic recovery.

92. The civil service and public sectors are also in dire need of reform. Government bureaucracy interferes in economic life at all levels and often does so through informal means. This impedes growth and development. For example, although bribery has diminished somewhat, according to representatives of the St. Petersburg commercial community, businesses still feels compelled to pay bribes in order to make the machinery of state work properly (NATO PA Secretariat Report). The government needs to overhaul this sprawling apparatus so that the Russian state is better able to support free markets and democratic practices. Here too Western experience can be valuable. Those countries of Central and Eastern Europe, which have made great progress in this area, should also be encouraged to share their transition lessons with their Russian counterparts. The EU has also been deeply involved in the transition process with the acceding states and now that accession is near completion, it might be able to use its wealth of experience to assist the Russians in revamping some of its more archaic state structures.

93. Reform of Russia’s so called natural monopolies is also crucial. These huge and often inefficient firms are burdening the economy and choking off more broadly based development. Natural monopolies are often well connected politically and this has discouraged reformers from moving more quickly. Yet officials openly acknowledge that they do not want an economy structured around huge holding companies. The challenge now is to ensure that Russian business is managed in a transparent manner, and that obstacles are not created to the emergence of new firms that can compete with those already operating on the market.

94. Poverty relief programmes are both economically and politically essential in Russia. Transition often leads to greater social differentiation—a condition that involves great political risk. Societies can sustain these changes when there is a sense that conditions are improving for all people and all-important social groups. But when this is not the case, there is a genuine threat of backlash. Political demagogues flourish in such environments and they can do great damage. For this reason, the West must also deepen its support of Russian efforts to alleviate poverty.

95. Western governments should continue to encourage Russia to sign the Kyoto Protocol both so this agreement becomes legally binding on all signatories, and because Russia will derive important economic and environmental benefits.

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96. Western governments should deepen their commitment to assist Russian authorities in reforming and restructuring the health care system, so that it is positioned to deliver better care and to cope with several of the serious health issues Russia confronts, including a potential AIDS epidemic.

97. Western governments should work to support Russian accession to the WTO. This may mean conceding Russia leeway on the question of energy subsidies, while nonetheless insisting on greater pricing transparency. This is a highly sensitive question in Russia and likely cannot be resolved immediately. Russia should also be encouraged to embrace service sector liberalisation. Western governments, in turn, should be prepared to open their markets to Russian production, including Russian agricultural goods and steel products, provided, of course, that these products meet basic Western standards, which they increasingly do.

98. The West should recognise that Russia is potentially an agricultural producer of some importance and be prepared to extend it greater market access, particularly as Russia is moving swiftly to meet Western product standards in a range of industries. The same should hold true for the Russian steel sector and other so-called sensitive products in which it holds a potential comparative advantage.

99. The development of an articulated, trust-based civil society in Russia will be of critical importance to Russia's transition. Contact between like-minded, democratically-oriented, civil organisations in Russia and the West should be encouraged. This is sometimes seen in Russia as a threatening involvement in internal affairs. But the flowering of international civil society and media contacts are mutually enriching and are a normal part of democratic life, as is media scrutiny of public officials and the actions of the state. Media criticism is never easy to accept, and tensions between the media and elected officials is a constant feature of democratic life. That said, it is essential that democratic leaders in the West as well as in Russia support a culture that accords a free media an honoured place in society.

100. Western governments must work to assist the Russians and the Chechens resolve their disputes a viable solution to a situation, the negative effects of which continue to radiate well beyond that republic. The government’s recent concessions on a new division of labour between the Federal and Chechen governments suggest that President Putin has tacitly recognised that a new approach is needed to cope with this tragic situation. Insofar as it is possible, Western governments should encourage further dialogue with various representatives of the Chechen body politic, while offering support for the reconstruction of that war-torn republic.

101. Russia should be encouraged in its efforts to battle corruption, build a law-bound state, and take on those mafia and terrorist groups that undermine economic transition. These require international as well as domestic efforts and Russia and its Western partners must work together to cope with this shared set of challenges.

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APPENDIX 1

Table 1. Russian Federation: Selected Indicators of Economic Activity, 1995-2002

1998 1999 2000 2001 2002 1/

(Annual Percentage Change)Gross Domestic Product -4.9 5.4 9.0 5.0 4.3Industrial Output -5.2 11.0 11.9 4.9 3.7Agricultural Output -13.2 4.1 7.7 7.5 1.7

Source: Goskomstat

1/ Preliminary data

APPENDIX 2

Table 2. Russian Federation: Basic Data

Sources: Russian authorities; and Fund staff estimates.

1/ Preliminary data (some data were received after the projections for SM/03/129 were finalised)2/ On a commitment basis

1998 1999 2000 2001 2002 1/

General government finances 2/ (In billions of roubles)Overall balance(in percent of GDP)

-215-7.8

-150-3.2

2002.7

2723.0

690.6

Balance of payments (In billions of US dollars)Total exports (in billions of US dollars) 74.4 75.6 105.0 101.6 106.3Total Imports (in billions of US dollars) 58.0 39.5 44.9 53.8 60.9Current account balance (in billions of US dollars)

-2.1 22.2 44.6 32.4 30.4

Official reserves (in months of imports of goods and services)

2.5 2.4 4.6 5.1 6.3

Exchange rate, roubles per US dollar, end-period

20.7 27.0 28.2 30.1 31.8

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Andrew Jack, "IMF warns Russia on Growth need for Reform", FT.com, February 13, 2003.

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Victoria Lavrentieva, "GDP grows by 6.1% in first two months," Moscow Times, March 24, 2003.

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150 ECEW 03 E rev.1 21

Michael Lelyveld, "Russia: Gazprom Seeks Investment, Promises Reforms," Radio Free Europe, March 4, 2003.

Na rossiyskom rynke nashli pervogo insaidera. http://www.newsru.com. February 23, 2003.Arkady Ostrovsky and Stefan Wagstyl, “They picked on the biggest and most powerful to show that if they can break Yukos, they can break anyone,” Financial Times, July 31, 2003.

Arkady Ostrovsky, “World Bank Warning: Russia’s dependence on oil price threatens Putin’s growth aims,” Financial Times, August 21, 2003.

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Ella Pamphilova, “Presidential Elections in Chechnya and Russian Human Rights Organizations,” Pravda, September 25, 2003, http://english.pravda.ru/main

"Putin's cover-up Referendum in Chechnya is a sham," Sacramento Bee, January 17, 2003.

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Kenneth Rogoff, "Has Russia Been on the Right Path? A Commentary," Vedomosti, August 28, 2002.Vladimir Ryzhkov, "No Modernization Without Representation,” Moscow Times , March 22, 2002.

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Constantin Sonin, "Inequality, Property Rights and Economic Growth in Transition Economies: Theory and Russian Evidence,” Working Paper, No 2K/02, Economics Education and Research Consortium

Jeanne Whalen and Anna Raff, “Gazprom seeks natural-gas pact with Conoco,” Wall Street Journal Europe, September 23, 2003.

Fred Weir, "Russia's Fledgling Civil Society," Christian Science Monitor, July 30, 2002.

Daniel Yergin, "Gulf Oil, How Important is it Anyway," Financial Times, March 22, 2003.

Michael Wines, “Boom trickles from Moscow,” International Herald Tribune, April 11, 2003.

Andrei Zolotov Jr, "Civic Activists Storm the Kremlin," Moscow Times, November 22, 2002.