4 September 2018

Vladimir Putin’s top priority is not foreign adventure, but restoring Russia’s economy


Coverage of Russia may be dominated by the Kremlin’s overseas entanglements, but Vladimir Putin has his hands more than full on the domestic front too.

Laying out the agenda for his upcoming presidential term last May, the Russian president singled out economic modernisation as his top priority. Russia, he said, “ranks among the world’s leading nations” yet it has “not reached the required level in the context of guaranteeing people’s quality of life and prosperity”.

To deliver on those promises, Putin has big plans to expand digitalisation in government, build new infrastructure, increase exports and spend more on public services. By 2025 he wants Russia to become one of the world’s five largest economies based on purchasing power parity (PPP) with an annual rate of GDP growth exceeding the world-average.

Recent announcements suggest the Kremlin is shifting its focus back to domestic affairs. After the 2012 presidential election, Putin cut a rather lacklustre figure – a tired leader hampered by tanking ratings and a sclerotic economy. The invasion of Crimea in 2014 turned him into a patriotic hero for ordinary Russians to rally behind. Four years later the “Crimea effect” is on the wane, while Moscow’s feats in Syria remain too distant to impress ordinary Russians.

As a result, the Kremlin has no choice but to pay closer attention to people’s everyday concerns over public services and the cost of living.

How should Putin proceed? Broadly speaking he has two options – invoking the power of state through public works and subsidies, or adopting a more laissez-faire approach designed to bolster the private sector, while increasing state revenues in the process.

In Russia, the economic modus operandi has traditionally been skewed in favour of the ‘extractive’ model – collecting taxes and conscripting labour to then channel them into state-run projects and subsidies. Chronic stagnation, caused by endemic government corruption and lack of private rights, has been punctuated by periods of state-driven activism.

This was how Peter the Great – whose European cultural tastes did little to mitigate both his absolutism and control-freakery – made Russia into a world-class military power via issuing direct orders and using forced labour. The Soviet industrialisation was as blistering in pace as it was bloody. Only during periods of the 19th century Tsarist rule were there signs of civil society asserting its independence.

Nevertheless, the emergence of Post-Soviet settlement gave a degree of hope to those who argued for private initiative as the basis for Russia’s development. In the early 2000s the government implemented large-scale tax cuts and put in place basic property rights guarantees, while the Central Bank tightened monetary policy to keep inflation stable. Thanks to high oil revenues, the government was able to avoid taxing companies and citizens too heavily to balance the books. Prices for goods are determined in the market, not by the state.

Put together, those factors have so far allowed Russian business, if not to flourish, then at least to manage their affairs in a sustainable fashion. But whether those islands of entrepreneurship can prosper further – or even survive – is unclear.

Distrust towards businesses from officials and the security services is an old problem. Since 2001 Putin has been steadily renationalising the country’s big capital for fear of businesses financing his rivals and the opposition media. The moves saw state-controlled enterprises proliferate but did not drastically affect small and medium-sized companies.

This may soon change, as the Kremlin’s political concerns are now being compounded by economic problems. Putin clearly intends to mobilise even more capital within a state-supervised framework. Hence the instruments of his modernization drive: awarding infrastructure contracts to personal friends, limiting foreign imports and placing hand-picked champions into particular industries to increase production.

All that requires money. The cost of implementing Putin’s May Decrees is estimated at 2530 trillion rubles. Officials claim that most of that can be found within the parameters of the next budget, but that still leaves a hole of about 5-10 trillion rubles.

How can it be filled? The 1998 default and subsequent dealings with Western creditors have left Putin wary of borrowing. Reducing defence spending is also a non-starter in the current climate, especially given Moscow has already had to somewhat limit its ambitions in this sphere. Nor can Putin cut down on rent-seeking without destabilising a regime that compensates its loyalists with generous financial rewards and immunity from the law.

The only options the Kremlin is left with, it seems, are raiding social security and pensions or raising taxes. In search for more money, the government has already announced a VAT increase. It is now also planning to raise the retirement age.

Had those been the only steps taken to boost the state budget, that would have been reasonable enough. However, there may be more revenue-raising measures down the line. For a start, Putin has already given the nod to his adviser Andrei Belousov’s idea of retrospectively expropriating windfall profits from the country’s biggest metals, mining and chemicals companies. The campaign of tackling the ‘shadow economy’, too, is being ramped up. Finally, while Putin has so far steered clear from raising either corporation or income taxes, those principles are not set in stone (especially given Russians’ reluctance to endure social security cuts).

Can Putin’s economic plan bring positive results? The Kremlin’s promises of reigniting Russia’ growth may not be so far-fetched. Measuring GDP in PPP rather than in real or nominal terms, although problematic, gives Russia a head-start in the economic league tables (it is placed sixth in the World Bank rating). Stable growth may be sustained by government-sponsored investment. Nor will it be a huge surprise should Putin unleash an infrastructure splurge some time towards the end of his term which translates into above-world-average growth, if only for a year or two.

What matters more, however, is whether this dash for growth can prove sustainable. Government activism will inevitably relegate the importance of structural reforms, including guaranteeing property rights, in favour of hoovering up as much money for state projects as possible. Moreover, the government’s protectionist instincts are hardly likely to foster competition on a level-playing-field. New tax rises may also suppress consumer demand.

Those issues are especially pertinent for independent small and medium enterprises. Compared to larger state-supported firms, SMEs face greater uncertainty and tighter margins, yet demonstrate market behaviour and tend to reinvest their profits, according to a report by Natalia Akindinova, a researcher at the Russian Higher School of Economics.

Her research specifically points at SMEs’ greater vulnerability to fiscal pressure compared to larger companies in both the commodity and non-commodity sectors. While the government’s intensive fight against off-the-books salaries may bring extra revenue in the immediate term, it will result in lost jobs and bankruptcies over the long run.

One does not have to be sympathetic to Putin’s politics to appreciate the challenges he faces. Russia has a genuine need for an infrastructure upgrade as well as for greater health spending (a top priority among most citizens). Yet the Kremlin must be careful in its activism as to not to crowd out the private sector. Getting this balance right – and not squabbles with the West or geopolitical battles – will be the most decisive factor in determining Russia’s future.

Evgeny Pudovkin is a journalist and a staff writer at RBC, a Russian business daily