Putin at Mid-Term: Where Should Economic Reforms Go From Here? A Commentary by John Odling-Smee, Director of the IMF's European II Department, and Poul M. Thomsen, IMF Senior Resident Representative in Moscow

April 15, 2002

Putin at Mid-Term: Where Should Economic Reforms Go From Here?
A Commentary
By John Odling-Smee, Director, European II Department, IMF and
Poul M. Thomsen, IMF Senior Resident Representative in Moscow
April 15, 2002

As President Putin approaches the half-way mark of his current term in office, observers have been taking stock of his administration's record of economic reforms. As always when it comes to Russia, the pendulum of public opinion swings wide and fast. From disappointment less than a year ago about Putin's perceived failure to capitalize on a landslide election victory, to enthusiasm about achievements following a flurry of activity last summer and fall, to renewed skepticism in recent months. There are even reports that Putin himself has asked his advisors to come up with a bolder strategy before his upcoming state-of-the-nation address. In this regard, there are calls for renewed experiments with state intervention.

Based on a snapshot of the economy, pessimists can indeed find much to support their views-a crumbling infrastructure and social services, widespread poverty and low life expectancy, intrusive government and incestuous relations between crony capitalists and corrupt officials, to name but a few of many ills.

While the snapshot is accurate and the task ahead daunting, we, like others, fully recognize the impressive forward movement. Achievements in 2001 include far-reaching tax and legal reforms, the replacement of Soviet-era Labor and Land Codes, a deregulation package, and a new pension system. Compared to these big headline reforms, the agenda for 2002 is narrower and more technical, but nevertheless important. The focus is on areas such as bankruptcy legislation, a new customs code, the law on standardization and certification, small business taxation, and electricity sector reform. Adoption of these reforms would make 2002 another good year.

But little is happening in some of the areas that are most important for Russia's efforts to maintain rapid economic growth in the next few years. These are also the areas where vested interests opposing reforms are most deeply entrenched. Thus, continued progress will depend critically on the ability to overcome such opposition. While the government's long-term program envisages ambitious reforms in most of these areas, implementation periods are long, and many of the most crucial measures are delayed until after the 2003-04 parliamentary and presidential elections. We believe that President Putin's reported search for a bolder strategy should involve early implementation of these reforms.

Why are reforms in these areas so important?

The Russian economy remains dominated by large enterprises that are often focused on using monopolistic market positions to gain excessively high profits, protected from competition and pressure to develop new products. Experience from other former socialist economies shows that rapid and self-sustained growth depends on the emergence of new small and medium-sized enterprises, and that economic policies succeed mainly when they break down barriers hampering such enterprises. But the share of such dynamic enterprises in the Russian economy remains low and shows little sign of growing. Unless Russia does better in this regard, the current recovery will fade once the spare capacity in the nonoil sector is used up-which is happening fast-and economic fortunes will continue to be hostage to volatile oil prices.

The biggest obstacle to the establishment and expansion of new enterprises is the still exceptionally intrusive role of government, especially at regional and local levels. A pervasive system of licensing, inspection and authorization requirements, and large-scale energy and transportation subsidies to favored companies allow corrupt officials to extract exorbitant bribes from those wishing to set up new businesses, or from those wishing to keep out new competitors.

What are the priorities for reform?

· Civil service and administrative reforms. These are indispensable for reversing crony capitalism and decisively improving conditions for new enterprises. Such reforms should include the abolition of overlapping government functions, a big reduction in employees and much higher salaries for those who remain. Without them, deregulation and tax reforms will not decisively improve the investment climate.

· Reforms of natural monopolies. Perhaps the most prevalent source of huge profits for insiders is the access to energy and railway transportation at a fraction of the normal price. This creates insurmountable competitive barriers for outsiders and diverts entrepreneurial activity away from genuinely productive activities. The new leadership at Gazprom and the railways ministry have taken much needed steps to stop mismanagement. But there remains much opposition to fundamental reforms of these and the electricity sectors, especially among local governors and powerful oligarchs.

· Trade liberalization. With early WTO membership now a political priority, opposition from enterprises surviving behind protective barriers is mounting. The recent decision to impose prohibitive tariffs on the import of used cars is an example of the strength of such opposition. This is an area where the government's resolve to stand up to vested interests will be tested sector by sector in the coming years.

· Developing a sound banking system will take a long time, but the government must begin by reforming the still-dominant state banks, which continue to channel available resources mainly to large-often politically well-connected-companies as exemplified by recent huge loans to Gazprom and the electricity company RAO UES. This practice diverts resources away from small and medium-sized enterprises.

Until the actual implementation of such reforms is well underway, the reforms undertaken so far are unlikely to generate the investments needed to maintain rapid economic growth. President Putin's search for a bolder strategy must therefore translate into a determination by the government to press ahead with these reforms, overcome the vested interests opposing them, and advance their implementation. With the fundamental problem still being insufficient progress in ridding the economic system of the pervasive influence of government, it would be ironic and regrettable if the search for quick solutions were to lead to renewed experiments with state intervention, even in its less draconian forms.

Taking on vested interests is of course no easy task, especially in the run-up to elections, and Russia's young democracy should not be held to unrealistically high standards. At the same time, however, the fact that such interests are holding up the most important reforms in Russia means that progress depends critically on the willingness to take on this task.


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