Russia's Crony Capitalism

by Anders Aslund

  Putin is undoubtedly deeply committed to the KGB, but his enchantment seems to be with its methods, information, and power rather than with its values. Putin’s selection of top officials appears based on one criterion: trust. He prefers men whom he has worked with for many years. He does not care much about their views, as long as they obey. Until his rejuvenation of top cadres started in 2015, Putin clearly preferred men of his own age. His new cadres tend to be technocrats in their forties without strong political views but highly obedient.

  The three closest aides of Putin in the national security sphere appear to be Sergei Ivanov, Nikolai Patrushev, and Alexander Bortnikov, who are all KGB generals. One after the other has served as chairman of the FSB following Putin, forming a tight FSB circle. These three men form one of Putin’s rings of power. They are all the same age and from the KGB in Leningrad and are on first name terms with Putin.

  Yet these three men could challenge Putin’s political power. The members of the FSB circle are living very well, but they might not be profiting from the great larceny around Putin as much as the cronies and the state enterprise managers. They have strong views on foreign policy, which they show in their rare publications, and the rumor is that these three men together with Putin decided the annexation of Crimea. When things are not going well, they might object to Putin.

  The dossier composed by the former British intelligence officer Christopher Steele contains very interesting information. On August 5, 2016, Sergei Ivanov was reported to be “angry at the recent turn of events. He believed that the Kremlin ‘team’ involved, led by presidential spokesman Dmitriy peskov, had gone too far in interfering in foreign affairs” with the hacking of the Democratic National Committee server and the wider pro-Trump operation. Ivanov “was determined to stop peskov playing an independent role in relation to the US going forward.” On August 10, Ivanov was reported to have expressed his dismay that “putin was generally satisfied with the progress of the anti-clinton operation to date.” Two days later, Ivanov was sacked as Putin’s chief of staff, but he has managed to survive politically as the Russian hacking scandal has mounted in the United States. It would be strange if his sacking were not connected with this conflict over interference in the US election campaign in the Kremlin.83

  Putin’s two big political tasks have been to build a vertikal of power and a dictatorship of law. He has done so successfully, subordinating both the executive and judicial powers to him. Like many authoritarian leaders, he encourages competition among his law enforcement agencies, so that they cannot overthrow him, but rivalry could split and destabilize the security forces. The big drawback is that systematic deinstitutionalization has created a political and judicial system that does not allow secure property rights and thus cannot lead to significant economic growth.

  Clearly, Putin is in charge. It is not credible that he is just manipulated by his aides, because few select their aides more carefully than Putin. The Security Council remains the only authoritative top-level policy forum.84

  T • H • R • E • E

  Conservative Fiscal and Monetary Policy

  Contemporary Russians have experienced many shocks. The greatest was the collapse of communism and the Soviet Union. The financial crash of August 17, 1998, delivered a second great blow. In 2008, the global financial crisis hit them again, and the halving of the price of oil in 2014 amounted to a fourth crisis.

  Russia is particularly prone to crisis because of its dependence on oil and gas. When prices were high, they accounted for two-thirds of its exports, half of its federal revenues, and about one-fifth of GDP. A reasonable assessment is that when oil prices were high, they contributed about half of the economic growth. Russians talk a lot about the need for diversification of the economy to make it more resilient, but the country’s comparative advantages in oil and gas production are indisputable. The best way to diversify the economy is to grow so that other industries, notably the service sector, expands.1

  Since the Russian economy is so prone to crisis, the population greatly values macroeconomic stability. Few people understand that better than Vladimir Putin, who praises economic stability almost constantly. The collapse of the Soviet Union and the Russian crash of 1998 taught him that macroeconomic stability is vital for political stability.

  After the financial crash of August 1998, the Russian economy experienced an extraordinary turnaround. In a single year, it was transformed from an apparent basket case with steadily falling output to one of the most dynamic economies in the world. Many changes occurred simultaneously, rendering it difficult to distinguish the cure, and answers depend on preconceptions.

  Fiscal conservatives argued that the switch from a loose to a conservative fiscal policy cured the economy. All macroeconomic indicators improved—budget balance, public debt, inflation, trade balance, and current account balance. At long last, a critical mass of markets, financial stability, and private enterprises had been attained. As enterprises faced hard budget constraints and a more level playing field, growth took off.

  Another idea was that commodity prices were the dominant cause. The world of crude oil rose from a low of less than $10 a barrel in 1998 to a peak of $147 per barrel in 2008, generating an enormous windfall for Russian oil producers and, through taxation, the Russian state (fig. 3.1). Natural gas and metal prices surged in parallel.2

  Fig. 3.1 Crude oil price, 1989–2017. Source: US Energy Information Administration, Short-Term Energy Outlook April 2018

  A third related view was that the large devaluation that cut the dollar value of the ruble by three-quarters in the fall of 1998 jumpstarted the Russian economy. Exporters of commodities benefited the most and drove Russia’s economic recovery.3

  A fourth suggested cause was that the crisis itself created opportunities for the political resolution of the underlying economic problems. Society came together only when it realized how costly a steady large budget deficit was and slashed it. What had been politically impossible suddenly became conventional wisdom.4

  Fifth, Yegor Gaidar argued that Russia had arrived at the end of its revolution and was ready for postrevolutionary stabilization and recovery. After the revolutionary passion of the 1990s had abated, politics would allow sensible economic policy, and plenty of free capacity was at hand.5

  A sixth explanation is that economic reforms instigated and promoted by President Vladimir Putin turned Russia around, but the strong growth started in 1999, before Putin was appointed prime minister, so he cannot have caused the initial growth. All these explanations have some merit, and they are largely complementary. Many factors coincided and contributed to high economic growth.

  Since Putin came to power in 2000, great stability has prevailed on the top financial posts. His close associate from the mayor’s office in St. Petersburg, Alexei Kudrin, was finance minister from 2000 until 2011. His like-minded deputy Anton Siluanov succeeded him. Kudrin’s former first deputy Sergei Ignatiev was chairman of the Central Bank of Russia (CBR) from 2002 to 2013. When Ignatiev retired, former minister of economy and Putin aide Elvira Nabiullina, who harbored similar views, took his place. All these people are respected as competent professionals and people of integrity. They have been strong supporters of market economic reforms and are called “systemic liberals,” that is, liberals who work within the system.

  The crash of 1998 had an extraordinary impact on Russian society, economy, and politics. After the voucher privatization in the early 1990s, the Russian stock market had boomed prematurely, multiplying six times in 1996 and 1997, although the economy had not started growing. On August 17, 1998, the Russian economy crashed monumentally. The ruble was suddenly devalued, soon to one quarter of its prior dollar value; the government defaulted on high-flying domestic treasury bonds; and bank payments were frozen for three months.6

  The fundamental cause of the financial crash was a stubbornly large budget deficit of 8–9 percent of GDP from 1993 to 1998. The government was politically unable to cut this l
arge budget deficit, but international donors, led by the International Monetary Fund (IMF), realized that the public finances were unsustainable and refused to provide financing. Weirdly, private investors kept the Russian government afloat with large international portfolio inflows into Russian domestic treasuries, whose real yields were obscenely high, reaching at 100 percent, at great cost to the Russian treasury, reminiscent of a Ponzi scheme. In 1997, Russia received no less than $46 billion in private portfolio inflows, or 10 percent of GDP. Although this was legal, it was speculation at its worst. The situation was obviously untenable, but the purchasers of domestic Russian treasury bonds could make fortunes as long as they got out before the crash.7

  The cause of Russia’s large budget deficit was political. In October 1997, an unholy alliance of Prime Minister Viktor Chernomyrdin, representing the old state enterprise managers, the leading oligarch, Boris Berezovsky, and the communists in the State Duma, agreed to increase the budget deficit to 8 percent of GDP at the worst possible time. Days later contagion from the East Asian financial crisis spread to the Russian stock market like a viral outbreak. On October 28, 1997, the Russian stock market plummeted by 19 percent. Since the government had just expanded the budget deficit, it was too embarrassed to retreat.8

  In early 1998, the crisis seemed to have abated. In March, President Boris Yeltsin finally sacked the inert Chernomyrdin, but it took another month before his successor, the young technocrat Sergei Kirienko, was confirmed as prime minister by the Duma. Kirienko, thirty-five, looked even younger and was known as kinder surpriz (literally, child surprise, or prodigy). However smart he was, he lacked authority and needed another month to form a government. At the end of May, Russia was hit by a full-fledged financial crisis. Foreign investors no longer wanted to purchase risky Russian treasuries, but the youthful government did not understand the severity of the crisis.

  In 1996–1997, the IMF had been rendered redundant by the large private capital inflows, but when private funds dried up, it reentered the stage with force. In July 1998, together with the World Bank and Japan, the IMF composed a stabilization package with credits totaling $22.6 billion. Its key condition was that the regional governments accepted to pass on a larger share of their revenues to the federal government, but the cabinet was too weak to persuade the Duma. On July 18, the State Duma decided to refute such legislation. The IMF made one big disbursement of $4.8 billion but then dropped Russia like a hot brick. The financial crash was only a matter of time, but the young newly appointed ministers did not understand that and went on vacation.9

  In the first half of August, the crash was obviously coming. The business magnate George Soros understood that perfectly well. We communicated daily before the crash. When Soros failed to get relevant Russian policy makers to listen, I encouraged him to publish an article in the Financial Times to clarify the depth of the crisis. He did so. On August 13, the Financial Times published his letter. Market panic erupted, and four days later the Russian financial crash was a fact. Soros had acted to salvage Russia, but speculators thought he was in the market, which he was not. Thanks to Soros’s letter, Russia did not run out of reserves as it had in 1991, which facilitated its recovery. The reserves of more than $10 billion were sufficient to stop a free fall of the ruble and hyperinflation.10

  On August 17, all hell broke loose. The ruble collapsed. The Russian banks closed their doors to people desperate to get cash, and half the banks went bankrupt. The Central Bank halted international bank payments for three months, but all bank payments stopped. The government defaulted on some $70 billion of domestic treasuries, though not on its external debt. The immediate economic effects were devastating. Once again middle-income Russians lost two-thirds of their bank savings in the absence of deposit insurance. Inflation surged with the sharp devaluation, arousing fears of renewed hyperinflation, though it stopped at 48 percent for 1998.11

  In the middle of September, I organized a high-level international conference in Moscow. We had to carry $40,000 in cash to pay for rooms in an American hotel and for restaurants, since credit cards no longer worked. President Boris Yeltsin was forced to appoint a government under the old-style communist Yevgeny Primakov with a few communists in leading economic positions. The New York Times Magazine published an article by veteran Moscow correspondent John Lloyd with the devastating headline “Who Lost Russia?” blaming the reformers. Were market reforms over?12

  In September 1998, somebody put up anonymous billboards in Moscow with the text: “Nobody will save Russia apart from ourselves.” In jest one of the posters had been signed “Michel Camdessus,” the forceful managing director of the IMF. Russia’s self-confidence had hit a low.13

  But something unexpected happened. Since nobody was ready to lend the Russian government any money, it had no choice but to cut expenditures sharply, because the population could not be forced to pay significantly more taxes in the short term. Russia switched from more than a decade of excessive budget deficits to a decade of budget surpluses.

  The sudden tightening of fiscal and monetary policy had a major positive impact on the economy. Output fell by 4.8 percent in 1998, but then it bottomed out. Inflation leveled off faster than expected. Half of the banks closed for good, though after three months of actual bank holidays, the surviving banks started working again. The state established a bad bank facility for selling off the assets of bankrupt banks. It took years to settle the defaulted treasury bonds, but the final outcome was a write-off of about $60 billion, sharply reducing Russia’s public debt. Since the bonds were subject to Russian jurisdiction, foreign investors could not sue the government.

  Contrary to general expectations, the crash of 1998 initiated a decade of high growth. It had leveled the playing field and imposed hard budget constraints on all enterprises. The large distortive subsidies and nonpayment of taxes were wiped out. The period 2000–2003 represented the height of Russia’s market economy. This was a time of macroeconomic balance and competitive markets. The private sector thrived as never before or after. State subsidies were minimized, and the result was a high growth rate averaging 7 percent a year from 1999 to 2008 (see fig. 1.1). Russia had never grown faster.

  The financial crash brought about Joseph Schumpeter’s famous creative destruction. From 1988 to 1994, young new businesspeople had made their fortunes on commodity trading, buying oil for 1 percent of the world market prices and selling it abroad for the global market prices. They financed their trade by establishing banks, which borrowed money cheaply from the Central Bank, while inflation eliminated their interest costs. Before the crisis, they had bought high-yielding Russian treasuries.14

  Now they were punished both for holding large amounts of Russian treasuries and for having borrowed in foreign currency. Eight of the ten biggest private banks went under, notably Menatep, Oneximbank, SBS-Agro, Bank Rossiisky Kredit, Inkombank, and Most Bank. The only exceptions were Alfa Bank and MDM, which had wisely sold their domestic treasuries in the summer of 1998, sensibly using their returns to pay off their foreign loans.15

  The oligarchs had bought many enterprises at the voucher auctions without knowing what to do with them. Now they sold most of them. The foremost oligarchic group, Menatep, headed by Mikhail Khodorkovsky, had set up a holding company called Rosprom (an abbreviation for Russian industry), controlling some two hundred old, mismanaged companies in 1994–1995. After the crash of 1998, Menatep sold them at almost any price to concentrate its resources on the jewel in its crown, the oil company Yukos. The loss to the oligarchs was also reputational. In the years of budding capitalism, many ordinary Russians admired the oligarchs for their apparent smartness. Suddenly, they did not seem all that clever, only arrogant, upsetting people over their usurpation of state power.16

  Most old state enterprise managers had carried out insider privatization of the companies they had managed in Soviet times, having no clue how to operate in a market economy, while being too proud to ask for advice. They went bankrupt on a m
assive scale, which eliminated barter and most arrears, while their assets were sold off.

  Productive assets that had been petrified by unimaginative state enterprise managers were taken over by daring young entrepreneurs, such as Mikhail Khodorkovsky (Yukos), Roman Abramovich (Sibneft), Oleg Deripaska (Rusal), and Andrei Melnichenko and Sergei Popov (SUEK). Young men in their thirties revived Soviet giants that were competitive in raw material production. The new low ruble exchange rate and rising commodity prices helped them, but their success was based on ruthless enterprise restructuring with the assistance of the foremost international consulting companies, notably McKinsey.17

  In parallel, the newly enriched Russian consumers drove consumer demand. Swiftly, new large private Russian retail chains developed, confusingly similar to Western department stores. Some Western companies also made it big, notably French Auchan, Swedish IKEA, German Metro, and Austrian Billa. The Russian mobile phone market developed briskly, with three private mobile phone companies, Vimpelcom, MTS, and MegaFon, competing hard by offering excellent service and prices.

  The regional governors had thrived on barter, in collusion with businesspeople who could extract public contracts from regional governments, while diverting tax revenues from the federal government. Until August 1998, barter had increased persistently, but then it collapsed, when the federal government insisted on cash payments of taxes. The elimination of these subsidies leveled the playing field for Russian business. When the federal government was strong enough to insist on payments in cash, it could also ensure that a larger share of total taxes went to the Federal Treasury. Minister of Finance Mikhail Kasyanov and his first deputy Alexei Kudrin were the authors of this policy.18