Select Committee on European Union Third Report


46.  The Committee's attention was drawn to advances already apparent in the transformation of the Russian economy. Nevertheless, witnesses also recognised, as have President Putin and the reformers, that the Russian economy is growing at too slow a rate to compensate for chronic under-investment since the mid-1970's. Indeed, Russia needs to grow at least twice the current rate (less than 4 per cent) to catch up with the poorer countries within the EU. Russia is classified by the World Bank as a "lower-middle-income economy" alongside countries such as Albania, Peru, Guatemala and Egypt. Its gross national income per capita (GNI), for instance, now stands at one half that of Portugal.[29] It is equally apparent that the level of growth pivots precariously on the production of raw materials (most notably oil and gas), whose prices are subject to world market volatility, rather than the more stable axis of manufacturing and services.

47.  Moreover, the task of modernising the economy has been complicated by the need simultaneously to sustain electoral support among a population sceptical that the sacrifices required will result in the promised reward. The tension between these Russian attitudes and the needs of the country creates a major challenge to the political leadership. The path of reform will be long and difficult; but a great deal is at stake.

48.  A crucial element underpinning the resurgence of the economy since the financial crisis of 1998 has been the emergence of political stability under President Putin. The Head of the Russian Business Unit at BP Mr. Scott Kerr advised: "The biggest move over the past few years has been to economic and political stability in Russia, which has allowed people to invest in very long-lead projects such as oil and gas and be assured of a return." (Q357) The Director of Sovereigns Group, Fitch Ratings, Mr. Edward Parker went further: "the consolidation of the power of President Putin over the Duma, over the regions, over the business oligarchs, and, perhaps, less encouragingly, over the media, have been an important factor in improving stability in Russia and reducing political and economic risk." (Q322) Russia's Fitch Rating[30] is currently BB-, this is three notches below investment grade. (Q319)

49.  Much has therefore come to depend upon Putin's presence and his persistence in accelerating change. In turn his own continuation in power has come to depend upon the success of reform. This symbiosis is both reassuring and worrying. Putin's close identification with change will, we hope, ensure its success. Nevertheless if the reform process yields mass unemployment and social deprivation he will become vulnerable to any credible opposition. The political hurdles of parliamentary elections (due in December 2003) and presidential elections (spring of 2004) have to be overcome before the more radical elements of the reform programme can attain their full potential.

50.  For the President the present institutional obstacles to economic progress are critical. In his annual address in 2002 he railed against "the cumbersome, clumsy and ineffective state apparatus" which was blocking the "colossal potential of the country." It was, he argued, "conducive to corruption...Any administrative barriers are overcome with the help of bribes. The higher the barrier, the more bribes and the more officials that take them."[31]

51.  President Putin's focus on bribery was echoed in evidence we heard. Professor Archie Brown of Oxford University told the Committee that "Business tycoons find it much more reliable to buy state officials, whether in the presidential administration or in ministries, than to rely on the law courts." He added that this was "a huge disincentive to foreign direct investment because foreign companies do not have the same contacts, they may have a greater unwillingness to bribe officials, and they will then see themselves at a disadvantage in the Russian market." (Q6) Former Deputy Prime Minister and Finance Minister of Russia Dr. Boris Federov recalled that the Swedish furniture chain IKEA spent several unrewarding years negotiating for land with the local authorities in Moscow. "Basically, everybody was asking for bribes. These people did not want to pay, and that means they started their shop four years later than they could have done. I think that is damaging the Russian economy." (Q507)

52.  At present bad practice in Russia is easy to hide. Managing Director of Lazards Mr. John Shakeshaft cited the "wonderful letter from Anatoly Chubais, who has, after all, been described by Federov as 'the darling of the West' on privatisation, refusing to disclose his salary as President of Unified Energy Systems of Russia (UES)[32] on the grounds that it is a state secret." (Q329) It was initially expected that greater integration with the West would improve standards. Never the less significant problems remain, as instanced by the gas monopoly, Gazprom. Seven of its companies (Purgaz, Rospan, Tarkosaleneftegaz, Sibneftegaz, Achimneftegaz, Vostokogaz and Severneftegaz) accounting for nearly 10 per cent of its reserves and worth $5,805 million to Gazprom were sold off for a mere $325 million (a loss of $5,480 million). As a result investors called for an independent audit. Instead Gazprom requested a confidential audit from its own auditors, PricewaterhouseCoopers who, it is reported, remarkably, gave it a clean bill of health.[33] [34] This was not the only example of doubtful practices highlighted by concerned Western investors.[35]

53.  In calling for the rule of law the Kremlin is fully aware, after a decade of mixed results from extensive legislation, that "adopted laws often contradict each other."[36] Moreover, laws without enforcement are useless. The problem in Russia, former ambassador to Moscow Sir Rodric Braithwaite told the Committee, "is that getting good laws is not difficult; getting good laws implemented is very difficult" (Q88) even though President Putin has stressed the importance of cracking down on "racketeering, administrative lawlessness and corruption, the protection of the rights of owners and manufacturers."[37]

54.  A further problem for economic growth has been the chronic weakness of the banking system. Atomised and under-capitalised, it is "one of the most disappointing areas…in terms of economic reforms." (Q311) Progress has begun, however, with the resignation of Mr. Viktor Gerashchenko and the appointment of Mr. Sergei Ignatiev as head of the Central Bank. Ahead lie the introduction of compulsory International Accounting Standards in 2004, followed by a mandatory deposit insurance system and the raising of capital requirements (10 per cent by 2005).

55.  Reluctant investors from abroad mostly allude to the above issues when explaining the low level of inward investment and the persistence of outflow, including illicit capital flight.[38] Capital is in short supply in the Russian market. This has mostly been due to capital flight since the collapse of the Soviet Union and the breakdown of stringent controls on external trade and foreign currency movements. Professor Mario Nuti of the London Business School estimates flight as "of the order of $25 billion a year" since 1994. (Q5) Initially this appeared to indicate widespread anxiety lest the Communist Party regain power and drive Russia back into the command economy. Since the end of the 1990's and with the consolidation of democracy, reforms had advanced sufficiently to ensure that the route back to Communism was securely blocked. Dr. Federov assured the Committee that "Since 1996 the chances of really going back have been absolutely nil. The question is, how quickly and comprehensively and how civilised the progress will be." (Q489)

56.  All in all, it would be a mistake to conclude that no progress has been made. Larger Western companies like BP, which can deal at governmental level, are now confident that they can operate in the new climate. Even smaller companies such as software producer Delcam Plc, which centres its activities in Ekaterinburg in the Urals, can work to profit "if one plays the game right and knows who one is dealing with…", according to its Managing Director Mr. Hugh Humphreys. (Q227) Expert assistance from the embassy in Moscow has played its part. It is, however, a cause for regret that Britain is less of a presence among small and medium size enterprises in Russia compared with Germany and other European competitors.[39]

57. The continuation of capital outflow has logically to be taken as a lack of confidence in the ability of the economy to deliver profit rather than fear of reversion to the past. Improvement here, however, is now noticeable. Professor Philip Hanson of Birmingham University told the Committee "that at the margin what we are seeing is a stabilisation or even slight fall in that capital flight, and a considerable increase in domestic investment." (Q4) Thus, as reform succeeds, capital will return. The market, in that sense, rules. The EU, therefore, can do little directly to help. It is through indirect means—by bolstering the platform of reform—that the EU and Member States can do most to facilitate greater inward investment.

29   World Bank Development Indicators Database (World Bank, August 2002). Back

30   Fitch Ratings is an international rating agency with a presence in 75 countries. International credit ratings assess the capacity of states, for example, to meet foreign currency or local currency commitments. Investment grade ratings of international long-term "AAA" to "BBB" categories indicate a relatively low probability of default, while those in the "speculative" or "non-investment grade" categories, international long-term "BB" to "D", either signal a higher probability of default or that a default has already occurred. Back

31   Annual Address by President Putin to the Russian Federal Assembly, Moscow, 18 April 2002.  Back

32   Unified Energy Systems of Russia-Russian joint stock company established 1992. Back

33   Gazprom Gifts to ITERA "Review of PWC Audit of Itera", March 2002. William F Browdes, Chief Executive Officer, Hermitage Capital Management. Back

34   Meeting Report "Gazprom and Itera: A Case Study in Russian Corporate Misgovernance" - Carnegie Endowment for International Peace 22 March 2002.  Back

35   For details: Carnegie Endowment for International Peace, Meeting Report-Gazprom and Itera: A Case Study in Russian Corporate Misgovernance, 18 March 2002. Available at Back

36   Annual Address to the Duma by President Putin, 18 April 2002. Back

37   Annual Address to the Duma by President Putin, 18 April 2002. Back

38   National Investment Council, The Problem of "Capital Flight" from Russia and Ways to Repatriate it to Russian Economy, ed. S Glinkina et al. (Moscow 2002). Back

39   The range of obstacles created by over-regulation remains formidable. The details of an extensive survey can be found in a recent publication from the Center for Economic and Financial Research and the World Bank, Monitoring of Administrative Barriers to Small Business Development in Russia, Round 1. Back

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