The Surprising Reasons Why America Lost Its Ability To Compete

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The Surprising Reasons Why America Lost Its Ability To Compete

Steve Denning , CONTRIBUTORI write about radical management, leadership, innovation & narrative.  

MAR 10, 2013 02:29 PM 



Competitiveness at the Crossroads(2012) is an alarming report with far-reaching implications. Forget the U.S. budget sequester. Set aside the financial bubbles on which the economy currently rests. Pay attention to something much more fundamental: America has lost the ability to compete in the international marketplace.

The report was written by three distinguished professors at Harvard Business School—Michael Porter, Jan Rivkin and Rosabeth Moss Kanter—as part of a competitiveness initiative begun in 2011. As Professor Porter explains, “there was a clear feeling that something different was happening in the U.S. economy—this was not just a deep recession caused by the housing mortgage crisis and so forth… something more was going on.”

The signs of the problem had been visible for some time. Job creation had stalled around 2000. Wages had been stagnating for well over a decade ago. Worse, “virtually all the net new jobs created over the last decade were in local businesses—government, healthcare, retailing—not exposed to international competition. That was a sign that the U.S. businesses were losing the ability compete internationally.”

Let’s ask the Harvard MBA alumni

How had the disaster happened? To find out, the professors had the inspired idea of asking their own Harvard Business School MBA alumni. The results are surprising and, in their own way, illuminating.

The respondents were over 6,000 people “from every sector of the economy, with heavy representation in finance and insurance, manufacturing, and professional, scientific, and technical services. Nearly a third of the 2012 respondents reported a title of chief executive, chair, president, founder, owner, managing director, managing partner, or a similar title at the very top of an organization.”

As graduates of Harvard Business School’s MBA program, they are thus the very crème de la crème of American business, or what the study appreciatively calls “business leaders”.Since the essence of strategy, as Professor Porter has stressed for several decades, concerns coping with competition, those responsible for strategy—business leaders—will surely shed light on what has gone wrong with American competitiveness and how to fix it.The role of management in the loss of competitiveness

The role of management in the loss of competitiveness

In the survey, Harvard’s MBA alumni were asked how American business stacks up against its competition on a variety of issues. The quality of management is obviously one of the most important of those issues: if there are disastrous shortfalls in the ability to compete, then surely the quality of management itself—the art and science of getting things done—must have a lot to do with it. Indeed if there are widespread failures in competitiveness across the whole economy, then it is likely that we have something even more serious: a genericproblem with the strategies being pursued.

So do the business leaders see the quality of their own management as a problem?

Not at all.

Not only do they see management as a relative strength of American business. They see management as “strongly improving”.

Come again?

American business is unable to compete internationally. But management—relative to competitors—is both strong andimproving?

An odd concept of management

What alternate universe are these business leaders living in?

What sort of “management” is it where the quality of management is strong and improving and yet firms can’t compete internationally?

The business leaders indicate in their responses that their high-quality management can’t compete because of government-created constraints, such as the political system, the tax code, the regulations, the legal system, K–12 education, and fiscal policy. In other words, the loss of competitiveness isn’t the business leaders’ fault: “Don’t blame us: we are not responsible!”

Astonishingly, the report itself cites the business leaders’ view that management is strong and improving and the leaders’ own lack of perceived responsibility for causing or resolving these problems, as “good news” and indeed a “great strength” of the U.S. economy (page 6).

The end of “can-do” management?

How can business leaders and the competitiveness report itself be talking about management as strong and improving when firms are consistently failing to compete internationally?

Apparently, this kind of management isn’t about the art and science of getting things done and overcoming constraints, whatever they happen to be. It isn’t the kind of enterprising “can-do” management that opened up the American continent several centuries ago, that constructed the transcontinental railroads in difficult conditions, that won several world wars, that accomplished mission impossible by landing a man on the moon only seven years after setting out to do so, and that invented the Internet and created Silicon Valley from scratch.

High-quality management that can’t compete?

So what sort of “management” is it?

Here the report is helpful. "The basic narrative begins in the late 1970s and the 1980s. Through globalization, it became possible and attractive for firms to do business in, to, and from far more countries. Changes in corporate governance and compensation caused U.S. managers to adopt an approach to management that focused attention on the stock price and short-term performance." (emphasis added)

As a result, "firms invested less in shared resources such as pools of skilled labor, supplier networks, an educated populace, and the physical and technical infrastructure on which U.S. competitiveness ultimately depends."

These management actions in turn gave rise to "serious social problems (loss of jobs, stagnating income, growing inequality) and eventually a decline of the public sector(an inability to fund health and pensions, or investments in “the commons” such as infrastructure, training, education, and basic research, fields that the private sector had abandoned.)"

The report thus accepts that the decline of the public sector and the failure to invest in shared resources are not root causes of the decline in competitiveness. They are the consequence of the focus on the short-term and the stock price.

The concept of management that the leaders and the report is talking about is thus management that is high-quality if it succeeds in firms meeting their quarterly numbers and getting their stock price up, even if it means failing in the larger task of competing internationally.

Strong innovation that can’t cope with competition?

A similar picture emerges on the issue of innovation. The business leaders were asked what how American performance in terms of entrepreneurship and innovation stacks up against competitors. The response was again that innovation and entrepreneurship are strong and improving.

And once again, the report hails this response as “good news” and “a strength” for the U.S. economy.

How’s that?

“Innovation” that can’t cope with international competition is “good news” and “a strength”?

Economists that have studied innovation in depth question the premise that U.S. innovation is strong and improving. Thus Nobel Prize winner Edmund S. Phelps recently pointed to studies showing that in the early 1970s the rate of indigenous innovation (as measured by its estimated contribution to the rate of growth in labor productivity) dropped by about half — to around 1 percent since then, from about 2 percent before then.

The economist Robert J. Gordon has also recently noted a marked slowdown in innovation.

So what sort of innovation could these business leaders be talking about? When a firm is focused on short-term profits and the stock price, it’s possible that managers are innovating, but with innovations related to efficiency and cost reductions. By contrast, value adding innovations, particularly game-changing innovations, are likely to be viewed as too risky and expensive to invest in. The firm will consistently gravitate to safer cost-saving innovations, even if this approach will set the firm on a track that consistently leads to loss of global competitiveness and eventually corporate death.

And this is what has happened. As Allen Murray writes in the Wall Street Journal, “market-leading companies have missed game-changing transformations in industry after industry—computers (mainframes to PCs), telephony (landline to mobile), photography (film to digital), stock markets (floor to online)—not because of ‘bad’ management, but because they followed the dictates of ‘good’ management.”

Profess Phelps concludes: “A return to the productivity growth and broad economic inclusion of the past will require nothing less than a revival of the high dynamism that underpinned that performance. In the business sector, it is necessary to put an end to infighting in established companies and the shortsightedness of chief executives who know they have only a few years in which to haul in some big bonuses. There is a need for a wider embrace of the old ethos of imagination, exploration, experiment and discovery.”

Where did the short-term focus on stock price come from?

Why do business leaders focus on the stock price and the short-term with such disastrous consequences for management, innovation and competitiveness? Where does this thinking come from?

The answer is close at hand. It was outlined by Harvard Business School professor, Clayton Christensen in a talk in November 2011: the thinking comes from the business schools themselves:

“The problem lies with the business schools which are at fault. What we’ve done in America is to define profitability in terms of percentages. So if you can get the percentage up, it feels like we are more profitable. It causes us to do things to manipulate the percentage.  I’ll give you a few examples.

  • There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins. Because if you ever use your money for something that doesn’t pay off for years, the IRR is so crummy that people who focus on IRR focus their capital on shorter and shorter term wins.
  • There’s another one called RONA—rate of return on net assets. It causes you to reduce the denominator, assets, because the fewer the assets, the higher the RONA.

“We measure profitability by these ratios. Why do we do it? The reason the finance people have preached this almost like a gospel to the rest of us is that, if you describe profitability by a ratio, you can compare profitability in different industries. It ‘neutralizes’ the measures so that you can apply them across sectors to every firm.”

In other words, “we have discovered the problem and it is us.” Thus behind the problem of competitiveness lies a concept of management based on short term profits and the stock price that these business leaders learned when they were MBA students at Harvard and elsewhere.

This concept of management, that measures results in terms of short-term performance and the stock price, is still the core of what is taught in the business schools across the country today. To see it play out in detail, just read any of the "consulting casebooks” that business schools use. In case after case, the “right answer” to the business problem at hand is to go for short-term profit, and pay less attention to long-run consequences for the firm or the economy. It is this fundamental thinking that drives the business decisions that Christensen calls “just plain wrong” and that are killing U.S. competitiveness.

Shareholder value morphs into C-suite capitalism

Even worse, this concept of management has morphed into something else: C-suite capitalism. Thus the focus on short-term value and the stock price gained traction in the 1970s and 1980s, supposedly as a way of advancing the interests of shareholders and protecting them against the greed of self-serving managers. It was called shareholder value. But the approach had the opposite effect of what was intended. Maximizing shareholder value turned out to be the disease of which it purported to be the cure.

In his book, Fixing the Game, Roger Martin, Dean of the Rotman School of Management at the University of Toronto, notes that between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990, CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.

Since 2000, the situation has further deteriorated. According to Professor Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School, over-compensation of the C-suite has produced a giant financial incentives bubble that is inexorably pushing the US economy into decline. His 2012 HBR article shows how it is having disastrous business consequences, including a serious mis-allocation of capital and talent, repeated governance crises, rising income inequality and a lack of international competitiveness.

Fiddling with symptoms while ignoring root causes

One might have expected that this new report on competitiveness, having identified a focus on short-term results and the stock price as a root cause of the loss in competitiveness, would explore with the business leaders whether they recognize this to be the case, and if so, what they are doing to change it.

Instead, the focus of the conversation with the business leaders was on fixing the symptoms of the loss of competitiveness—particularly rebuilding the talent pool (through training, apprenticeship, community colleges), improving the business context (participating in initiatives like regional clusters, research, startup incubators, or political advocacy) and exploring more local sourcing of products.

Not surprisingly, given the failure to address the root cause of the competitiveness problem, not many firms are actively pursuing these issues. Only 8 percent of respondent firms are “heavily involved”.

In the overall scheme of things, this result is discouraging but perhaps not so important. Even if those measures were being implemented more energetically by business leaders, they wouldn’t resolve the loss of competitiveness. As Professor Porter has reminded us for several decades, if a strategy is misconceived, more talent or more research won’t help: the talent and the research will end up being wrongly directed on short-term gains, not redressing competitiveness.

Not surprisingly, reshoring—which requires rethinking the very basis of competition—was the least-supported action by these business leaders.

What government must do

Consistently with the business leaders’ own viewpoint that the loss of business competitiveness is not the fault of business, the main thrust of the Harvard report on competitiveness is less about what business leaders themselves should do, and more about “the general consensus about what Washington must do”, including controlling federal spending, reforming the tax code and streamlining regulations.

The issue here is not that the report's recommendations for government are misguided. They are important and necessary. The issue is that they will do little to resolve the problem of competitiveness, so long as business leaders focus on the short-term and the stock price. They are contributory issues, not root causes of the problem.

Missing in action: the customer

Yet the most staggering aspect of the Harvard report on competitiveness is the total absence of the customer. The word “customer” never appears in the entire report.  Even once. The report thus gives no recognition to another key issue underlying the loss of competitiveness: the fundamental shift in the balance of power in the marketplace from seller to buyer. This shift flows from globalization and customers’ access to reliable information on the Internet.

The shift is critical because it short-circuits the current business focus on the short-term and the stock price: if firms don’t delight their customers with continuous innovation, their customers vanish and the firms die. Several decades ago, being just a bit more efficient than the local competitor might have been enough to get by. Not any longer. Now in order to survive, firms have to excel with their customers on a global basis.

The only solution to the new dynamic of the customer-driven global marketplace is to adopt a different kind of management with a new corporate bottom line in which value-adding innovation is a necessity, not an option. Instead of focusing exclusively on short term gains and efficiency innovations, the very goal of the firm has to shift to delighting customers through continuous value-adding innovation.

The only valid purpose of a firm: creating customers

As it happens, this thinking isn’t entirely new. Back in 1973, Peter Drucker showed us the way to dealing with competitiveness, by getting back to first principles and addressing the question: why do we have private sector firms in the first place? He wrote:

To know what a business is, we have to start with its purpose. Its purpose must be outside of the business itself. In fact, it must lie in society since business enterprise is an organ of society. There is only one value definition of business purpose: to create a customer…

More recently, Roger Martin writes in Fixing the Game:

We must shift the focus of companies back to the customer and away from shareholder value. The shift necessitates a fundamental change in our prevailing theory of the firm… The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.

If you take care of customers, writes Martin, shareholders will be drawn along for a very nice ride. The opposite is simply not true: if you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either. In the real market, there is opportunity to build for the long run rather than to exploit short-term opportunities, so the real market has a chance to produce sustainability and competitiveness.

Similarly in Reorganize for Resilience, Harvard Business School professor Ranjay Gulati writes:

Those companies built around an inside-out mind-set—those pushing out products and services to the marketplace based on a narrow viewpoint of their customers that looks at them only through the narrow lens of their products—are less resilient in turbulent times than those organized around an outside-in mind-set that starts with the marketplace, then looks to deliver creatively on market opportunities. Outside-in orientation maximizes customer value—and produces more supple organizations. Embracing an outside-in perspective—focusing on creatively delivering something of value to customers instead of obsessing over pushing your product portfolio—builds an inherent flexibility into organizations.

Competitiveness at the Crossroads: Choosing the Future Direction of the Russian Economy
By  Michael E. Porter and Christian Ketels,
with Mercedes Delgado and Richard Bryden
2.1. The Concept of Competitiveness 6
2.1.1. Created versus inherited prosperity 6
2.1.2. Indicators and enablers of competitiveness 8
2.2. Determinant of Competitiveness 9
2.2.1. The Microeconomic Business Environment 12
2.2.2. State of Cluster Development 13
2.2.3. The Sophistication of Company Operations and Strategy 16
2.2.4. The Influence of Sub-national Regions 18
2.2.5. Economic Coordination with Neighboring Countries 19
2.3. Competing in a Changing Global Environment 20
3.1. Russia’s Economic Performance 24
3.1.1. Standard of Living 24
3.1.2. Decomposing Prosperity 26
3.1.3. Indicators and Enablers of Productivity 30
3.1.4. Overall Performance Assessment 38
3.2. Russia’s Endowments: Legacy, geography, and natural resources 40
3.2.1. Legacy 40
3.2.2. Geography 41
3.2.3. Natural Resources 42
3.3. Russia’s Macro, Political, Legal, and Social Context 43
3.4. Russia’s Microeconomic Competitiveness 46
3.4.1. The Russian Business Environment 46
3.4.2. Cluster Development in Russia 62
3.4.3. Company Sophistication 65
3.4.4. The Role of Sub-national Regions 69
3.4.5. Economic Integration with Neighboring Countries 72
3.4.6. Public-Private Collaboration in Economic Policy 73
3.5. Russia’s Inconsistent Aspirations 74
4.1. Priorities for Russian Economic Policy 80
4.1.1. Defining an Overall Economic Strategy 81
4.1.2. Upgrading Russian Competitiveness 82
4.1.3. Growth and Diversification of the Russian Economy 90
4.2. Priorities for Research on the Russian Economy 97
Competitiveness at the Crossroads:
Choosing the Future Direction of the Russian Economy
Page 3 of 112 © Michael E. Porter
1. Introduction
In early 2006, the Center for Strategic Research (CSR) in Moscow commissioned
Professor Michael Porter and his team to conduct a review of the existing evidence on
Russian competitiveness. The objective of this report is to synthesize, interpret, and draw
implications about Russia’s economic progress, applying the Porter competitiveness
framework1 and drawing on learning from dozens of other national competitiveness
projects. This review is part of a Strategic Audit of the Russian Federation, a broader set
of research activities coordinated by CSR to provide a sound analytical basis for long-
term economic policy planning in the Russian Federation.2
The Russian economy has been studied by numerous international organizations,
academics, and other analysts. This report draws on these studies, but differs in three
main respects: First, it focuses on the microeconomic underpinnings of competitiveness
at the level of firms, clusters, and the business environment in which firms compete.
Existing studies tend to focus on macroeconomic policies, the legal system, and other
broader aspects of economic context. Second, we offer an overall, strategic perspective
focusing on overall priorities for the future. Existing studies tend to concentrate on
detailed assessment of individual policies. Third, this report is intended not only for a
technical audience but to inform both policymakers and the broader Russian community
about the state of the economy during a very complex historical transition.
There are strongly divergent views about the state of Russian competitiveness. Strong
economic growth, fiscal surpluses, and reforms in some areas of the business
environment are juxtaposed with huge continuing challenges in doing business in Russia
as well as rising government intervention in the market, especially in energy. This mixed
evidence has been interpreted very differently. Within Russia (including many foreign
companies operating in the country), there is optimism about the progress of the nation’s
economy just ten years after the 1998 crisis. Outside of Russia, there is deep skepticism
about whether the current economic success of Russia extends beyond high oil prices,
and whether the increasing concentration of economic (and political) power in the central
government has changed the course of Russia’s reforms for the worse. There is some
Competitiveness at the Crossroads:
Choosing the Future Direction of the Russian Economy
Page 4 of 112 © Michael E. Porter
truth in each of these perspectives, but a deeper analysis is needed to truly understand
where Russia stands and to guide future policy.3
Figure 1: Divergent Views on Russian Competitiveness
Copyright 2006 ©P rofessor Michael E. PorterRussia Competitiveness Assessment DRAFT 07-30-06 CK
Russian Competitiveness in 2006/07
• Strong economic growth
• Solid growth in GDP per capita
• Strong fiscal position
• Improved macroeconomic
• High labor utilization
• Improving foreign direct
investment inflows
• Strengthening overall world
export market shares
• Foreign IPO’s of Russian
• Growth has been significantly driven by
oil prices and the availability of idle
production capacity in the economy
• Deteriorating non-oil budget balance
• Productivity level remains moderate
• FDI inflows primarily related to accessing
natural resources and (recently) serving
local demand, not expanding exports
• Export positions outside natural
resources remain weak
• Capital stock is aging
• Financing constraints for domestic
Russian companies
• Patenting rates far below potential
The Positives The Negatives
The report is organized in three sections. First, it outlines an analytical framework to
understand the medium- and long-term foundations of Russian prosperity in today’s
global economy. Globalization, technological change, and widespread economic reforms
in other countries have shifted both the imperatives and opportunities for
competitiveness. Second, we assess Russia’s current competitiveness, highlighting the
roles of the country’s legacy, its broad economic context, microeconomic conditions, and
current economic policies. Third, we offer overall recommendations for policymakers,
along with priorities for further research, that seek to address the real complexities the
country is facing. We are well aware that Russian leaders have to conduct economic
Competitiveness at the Crossroads:
Choosing the Future Direction of the Russian Economy
Page 5 of 112 © Michael E. Porter
policy in an environment of many distortions and complexities, where generic advice
based on simple economic models is insufficient.
While our report draws on the large body of literature on the Russian economy, it
supplements this review with a variety of new sources. With the help of CSR, we
conducted a series of interviews with experts on the Russian economy. We also analyzed
Russian performance and the business environment using proprietary data and methods
developed by Professor Porter at the Institute for Strategy and Competitiveness. While
this report does not aim to substitute for an in-depth country study by Russia experts, we
hope that it will inform and complement such studies.
Competitiveness at the Crossroads:
Choosing the Future Direction of the Russian Economy
Page 6 of 112 © Michael E. Porter
2. Competitiveness and Competition among Locations
2.1. The Concept of Competitiveness
Competitiveness remains a concept that is not well understood, despite widespread
acceptance of its importance.4 To understand competitiveness, the starting point must be
to understand the underpinnings of a nation’s prosperity. The central economic goal of a
nation is to improve the sustainable standard of living of its population. Standard of
living is the true goal, not the absolute size of the economy, the level of foreign reserves,
or the trade balance. Standard of living must be evaluated for all citizens, not just a few,
and to improve standard of living is open to all groups.
A nation’s standard of living is determined by the productivity of its economy, measured
by the value of goods and services produced per unit of the nation’s human, capital, and
natural resources. Productivity is what allows a nation to support high wages, attractive
returns to capital, and a strong currency, and with them a high standard of living.
Productivity depends both on the efficiency of production but also the value of the
products and services produced, measured by the prices they can command in open
markets. True competitiveness, then, is measured by productivity.
Prosperity can be inherited or created. Inherited wealth comes from natural resources
such as minerals, oil, arable land, and a fortuitous location. Inherited wealth has a
positive direct effect on a nation’s prosperity. However, the experience of many resource-
rich countries has shown that inherited wealth can make it harder to create wealth.
2.1.1. Created versus inherited prosperity
Created wealth arises from the ability to create products and services that can be
produced productively and sold domestically and internationally at a profit. Wealth can
only be created by companies. Created wealth can include products and services that
draw on inherited resources, but enhance their value. Created wealth is limited only by
the innovativeness and dynamism of the business enterprises operating in the country.
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Choosing the Future Direction of the Russian Economy
Page 7 of 112 © Michael E. Porter
Government cannot create wealth, but has an important role in putting in place the
conditions which allow wealth creation to take place or work against it.
Many resource-rich countries (including Russia) have failed to achieve the level of
prosperity of countries with far fewer inherited resources. This is because the availability
of resources creates complexities in developing the non-resource economy. These go well
beyond Dutch diseases and elevation of domestic costs which price the country out of
diversifying into new resource markets. Abundant resources can create governance
structures and incentive structures (e.g., competition) that impede competitiveness.
Resources also allow governments to support non-economic policy choices, such as
subsidies and unproductive employment (see Figure 2). In addition, natural resource
wealth tends to place government and its role in distributing wealth at the center of
economic policy instead of the private sector, worsening the environment for wealth
Figure 2: Inherited versus created prosperity
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Choosing the Future Direction of the Russian Economy
Page 8 of 112 © Michael E. Porter
2.1.2. Indicators and enablers of competitiveness
The process by which productivity grows and an economy upgrades works through a
series of enablers, which also serve as intermediate indicators of competitiveness.
Exports allow a country to grow its most productive activities beyond the demand in the
local market. Imports allow a country to access goods that it cannot produce
productively, provide access to foreign technology embedded in capital goods, and
increase the level of rivalry on domestic markets. Domestic investment is critical to
improving the productivity of companies and infrastructure. Inward FDI brings added
capital as well as technology, skills, management, market access, and competitive
pressure. Outward FDI fuels the international growth of local companies while tapping
external capabilities. Innovative output fuels productivity growth.
Figure 3: Indicators and Enablers of Competitiveness
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Each of these enablers depends, in turn, on underlying competitiveness. Investors will not
invest unless the country offers an attractive value proposition compared to local wages,
for example, while exports cannot grow unless products are of high quality and can be
produced efficiently. Moreover, if exports, investments, or patenting rates are the result
of direct subsidies, they do little to improve productivity and might actually undermine it.
2.2. Determinant of Competitiveness
Competitiveness arises from the interaction of three broad levels of influence:
endowments, context, and microeconomic competitiveness (See Figure 4).
Endowments including natural resources, geographic location, and historical legacy can
have a major influence on overall competitiveness. They are essentially ‘given’ and not
the result of current policy choices. However, their influence on prosperity can be heavily
influenced by countries’ underlying competitiveness, and whether the country pursues
policies that realize their potential.
Natural resources in the form of favorable mineral deposits, growing conditions, etc. can
offer exports and productivity directly. However, natural resources can also create risks
of retarding competitiveness improvements, a challenge that especially emerging
economies like Russia are struggling with.
Location can be divided into two areas. Location bears on logistical costs, for example
through proximity to the ocean and navigable waters. Location also sets the
neighborhood, or the bordering countries. The wealth and size of neighbors can be a
major impact on competitiveness because neighbors are the most natural trade and
investment partners.
The historical legacy of a country is embedded in the structure of companies, government
agencies, and beliefs about competitiveness. Russia’s inefficient company structures and
poor experience with privatization in the early stages of transition, now inhibits further
reforms towards competitive markets.
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Figure 4: Determinants of Competitiveness
The macroeconomic, political, legal, and social context is the second important
determinant of a nation’s overall competitiveness. This array of policies and institutions
creates the overall setting in which companies, citizens, and government operate.
A sound overall context creates the potential for prosperity, but does not itself create
prosperity. Policies in terms of overall context, especially in the areas of macroeconomic
policy and governance, have dominated the literature on economic development.
However, sound policies in these areas are necessary but not sufficient. Wealth is actually
created at the microeconomic level—in the ability of firms to create valuable goods and
services using efficient methods. Government or other societal institutions cannot create
wealth; only firms can.
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The most important level of influences on productivity is the microeconomic
competitiveness of the economy. This is contained in three areas: the quality of the
business environment, the state of cluster development, and the sophistication of company
operations. The business environment includes the myriad of inputs, rules, incentives,
and supporting entities that directly influence productivity and innovativeness of
company competition. The state of cluster development captures the powerful linkages
and externalities that occur across co-located firms, supporting industries, service
providers, and associated institutions in a particular field.
The sophistication of company operations captures the capabilities, operating practices,
and management choices within companies themselves. No matter how good the business
environment or the strength of the cluster, it is companies that actually achieve or fail to
achieve productivity.
There are important differences between context and microeconomic competitiveness.
Context is shaped largely by the government, through a limited number of policy
decisions. There is widespread agreement about what constitutes ‘good policy’ in areas
such as monetary policy and legal reform. Choices in terms of context can in many cases
be made and implemented relatively quickly, like the adoption of a flexible exchange rate
or, in the case of Russia, the creation of the Stabilization Fund to collect and invest the
government’s share of oil revenues.
Microeconomic competitiveness, in contrast, results from the complex interplay of
circumstances and choices of companies, government entities, and many other
institutions at multiple levels of geography. Microeconomic progress arises in hundreds
and even thousands of discrete areas, from the types of workers trained, to specific
regulations, to infrastructure, to the presence of supporting companies. Priorities and
appropriate choices vary across clusters and regions. Progress often takes a long time to
implement, making priorities and sequencing essential. Countries that try to change
everything at once inevitably fail. Microeconomic upgrading cannot be solely top down,
but requires the engagement of the private sector and numerous other parts of society.
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2.2.1. The Microeconomic Business Environment
The microeconomic business environment consists of four interrelated areas collectively
known as the diamond.5 The diamond framework (see Figure 5) provides an analytical
tool to analyze the strengths and weaknesses in the business environment and set action
Figure 5: Quality of the Business Environment: The Diamond Framework
Factor conditions relate to the quality and availability of factor inputs, including
government services and public infrastructure. The context for firm strategy and rivalry
encompasses the rules and incentives governing the nature of competition in the country.
Related and supporting industries capture the presence of suppliers, services providers,
and collaboration partners that create opportunities to specialize activities. Demand
conditions are the needs and pressures emanating from domestic customers to design
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products, improve productivity, and innovate. Demand conditions can be influenced by
government standards and consumer protection laws.
Strengths and weaknesses in each part of the diamond interact in systemic ways; they do
not just add up cumulatively. For example, access to a well educated labor force provides
more advantages if local competition is intense and domestic customers demand new and
differentiated products and services.
2.2.2. State of Cluster Development
A manifestation of the diamond framework is the widespread existence of clusters, which
are geographic agglomerations of companies, suppliers, service providers, and associated
institutions in a particular field. Figure 6 on the next page provides the example of the oil
and gas cluster in Houston, Texas. Clusters cross the divide between manufacturing and
services, a distinction that is becoming increasingly meaningless in the modern economy.
Cluster formation is driven by externalities and spillovers of various types, such as
knowledge spillovers, supplier relationships, the use of common skills, and transactional
efficiencies. Some externalities apply to co-located companies within a single industry,
though most are amplified or created by co-location with suppliers, related industries, and
specialized institutions.
Clusters are a natural manifestation of the role of specialized knowledge, skills,
infrastructure, and supporting industries at a particular location in enhancing productivity,
innovation, and new business formation. They reflect modern approaches to company
operation, which focus on core activities while outsourcing to suppliers and other
partners. Also, the increasing importance to innovation of open networks6 of companies
and research institutions has raised the importance of clusters. Clusters support “local”
outsourcing, rather than vertical integration or reliance on distant suppliers involving
transaction costs and delays.
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Figure 6: The Houston Oil and Gas Cluster
Clusters reflect the location paradox that has emerged in global competition. Anything
accessible from a distance is no longer a competitive advantage because it is available to
competitors anywhere. Unique local assets and relationships, then, become more
important to competitive advantage in a more globalized economy.
Clusters can emerge under many different circumstances, for example where business
environment conditions provide cluster-specific advantages, a geographic location creates
advantages, or where entrepreneurs have created an anchor firm that becomes the source
of spin-offs. Clusters also often develop from related clusters already present in a region.
All clusters are good. A location’s prosperity depends on whether it reaches high
performance in those clusters in which it has significant positions, not on whether these
are so-called ’high-tech’ or otherwise ‘strategic’ clusters.
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The availability of systematic data about the economic geography is growing. The
Cluster Mapping Project, initiated by Professor Porter in the late 1990s, has created the
first consistent and statistically derived set of cluster definitions.7 Cluster mapping
proceeds in two stages: First, the distribution of industry employment across geography is
used to distinguish “traded” industries that are geographically concentrated and “local”
industries that are spread relatively evenly across locations, using detailed industry-level
employment data across regions. Traded industries compete across regions and countries,
where different competitors have access to different business environment conditions.
Local industries compete primarily to serve the need within their region, and regional
competitors share the same business environment.
The second stage of the methodology is to group traded industries into clusters based on
co-location patterns across geography, supplemented with indicators of cross-industry
linkages. Applying this procedure resulted in the delineation of 41 traded clusters, each of
which consists of a number of individual industries.
Clusters overlap when individual industries are part of more than one cluster. Such
linkages occur because of common skills, technology, suppliers, and so on. Figure 7 on
the next page provides a schematic representation of the relationships between the 41
clusters, with overlaps representing the most extensive relationships. Regions that have
positions in overlapping clusters can harness stronger positive externalities, and tend to
register better economic results. Overlaps between clusters also provide a systematic way
to identify development paths for regional and national economies, because they reveal
the potential for progression from established clusters into related ones.8
Clusters work more effectively if they include institutions for collaboration (IFC). Such
organizations—such as cluster initiatives,9 trade associations, entrepreneurs networks,
standard setting agencies, quality centers, technology networks, and many others—are
neither conventional government agencies, educational institutions, nor private firms. They
play an essential role in connecting the parts of the diamond and fostering efficient
collective activities within and across clusters to upgrade competitiveness in a location. IFCs
are often overlooked in analyses of economic development. However, they are particularly
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important in emerging economies like Russia, in part because they enable a better dialogue
between government and the business community.
Figure 7: Clusters and Cluster overlap, Schematic Representation
2.2.3. The Sophistication of Company Operations and Strategy
The competitiveness of a nation or region ultimately rests in the competitiveness of local
companies and foreign subsidiaries that operate there.
Competitiveness at the company level depends on the operational efficiency with which
the companies undertake these activities compared to best practices, and on the extent to
which companies distinguish themselves in creating value for customers.10 The Value
Chain11 provides the conceptual framework to analyze the state of company activities in
any industry or location.
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Figure 8: The Value Chain
In emerging economies like Russia, companies suffer significant weaknesses in their
value chains. Low levels of efficiency in individual activities are widespread, as
companies operate far from the frontier of best practice. Often, companies are narrowly
focused on a few primary activities within the industry value chain, lacking capabilities in
areas such as design, marketing, or customer service. In developing economies,
companies are often overly integrated into supporting activities in which they are not
efficient. Most companies fail to distinguish their products and services to create
competitive advantages, competing instead on low factor costs.
Also important to company competition in emerging economies is the nature of business
groups. In advanced economies, business groups tend to contain business units in related
fields that reap overall advantages through synergies. In developing economies, business
groups are often unwieldy conglomerates, a reaction to business environment
weaknesses.12 Inefficient capital markets, shortages of managerial talent, and the
importance of political access are root causes for diversification into many unrelated
businesses and approaches to competing largely based on political and economic power.
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Russia is an extreme example, given the flawed privatization process through which the
oligarchs arose. Productivity, in such circumstances, usually suffers.
The dissolution or restructuring of conglomerate business groups is both a cause and a
result of successful economic development: Groups need to restructure in order to allow
individual business units to become more productive. Restructuring becomes more likely
and feasible when improvements in the business environment make some of the past
roles of groups obsolete, such as improving public capital markets. For a country like
Russia it is important to assess the progress that has been made in restructuring business
groups that have largely been a drag on competitiveness.
2.2.4. The Influence of Sub-national Regions
Competitiveness is affected by government at multiple geographic levels: national, regional,
and local.13 Policies and circumstances at all of these levels affect the quality of the business
environment and the development of clusters.
While context is often determined largely at the national level, microeconomic
competitiveness varies substantially across regions within countries. This includes numerous
aspects of the business environment, cluster composition, and company sophistication. As a
result, there are often striking differences in economic performance within countries, which
can be as great or greater than differences across countries. This holds true for Russia as it
does for many other countries.
The importance of regions creates added complexity for economic policy. National
governments find it challenging to set appropriate policies that distinguish the needs of
individual regions. Decentralization and the appropriate allocation of roles in economic
policymaking among different geographic levels become essential, especially for large
countries like Russia. Creating regional governance structures that are capable of defining
regional strategies is particularly challenging if there is no strong legacy of independent
regional governments, a problem Russia shares with countries like the UK.14
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2.2.5. Economic Coordination with Neighboring Countries
Productivity is also enhanced, or eroded, by the nature of economic relations with
neighboring countries. Economic cooperation and coordination among neighbors is an
important tool for expanding trade and investment, improving the business environment,
and linking clusters with complementary strengths.
Neighboring countries usually provide the most natural markets in which the competitive
advantages of a country can be applied, because of needs and market conditions that are
often similar. This situation applies to Russia’s relationships with its many neighbors, most
of whom were formerly part of the Soviet Union.
Groups of neighboring countries that simplify cross-border transactions widen the market
and become more attractive as investment locations for foreign companies. Linkages
between clusters in neighboring countries can exploit the existence of differences in factor
costs and complementary strengths in the business environment. This is an approach
adopted by the Italian footwear cluster which has established a sister cluster in Romania,
and by telecommunication equipment and life sciences clusters across countries in the Baltic
Sea Region.15
Coordination of policies with neighbors can significantly improve many aspects of the
business environment for all the involved countries, including areas such as transportation
infrastructure, customs procedures, energy networks, and many others. Yet most regional
initiatives focus solely on trade barrier reduction, to their detriment.
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2.3. Competing in a Changing Global Environment
Globalization, with its diminution of barriers to cross border competition, has
dramatically increased the importance of productivity as the central determinant of
national prosperity in the medium and long run.
One of the most visible reflections of these changes is the growth of the emerging
economies.16 China and India, in particular, have opened to the world economy by
opening markets, upgrading infrastructure, and inviting foreign companies to invest. In
the past, China, India, and other emerging economies were relegated to compete solely on
low-skill activities, slowly working their way up towards products of higher skill-
intensity. In the new competitive environment, these nations can quickly enter
international markets by integrating themselves in the global value chains of
multinationals—assimilating management and technology from around the world while
taking advantage of low-cost labor and improving infrastructure at home.
With large and growing populations and a more business-friendly economic policy
environment, emerging economies offer significant new markets for global enterprises
and launch pads for globally competitive products, processes, and services to serve both
emerging economy customers and more advanced markets.
A key driving force behind globalization is the emergence of the global enterprise and the
globalization of value chains. Activities along the global value chain have become
increasingly disintegrated and allocated to those locations and companies best suited for
each individual activity. Multinational corporations play a critical role in this process by
investing abroad, by engaging new foreign suppliers, and by specializing in activities in
which they have specific competitive advantages. They have created vast networks in
which small and medium-sized companies that provide specialized inputs and services
are integrated globally.
In the changing global competition, services and intangibles become prominent drivers of
value creation. In disintegrated value chains, innovation is increasingly the source of
value and competitive advantage, as is managing processes and partners represents a
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growing part of value creation. Manufacturing remains an essential component of global
trade, but many manufacturers can be located in low wage locations access to every
competitor. Value increasingly comes from the ‘service wrap’ and the ideas bound up in
products. Critical investments are not only those made in new fixed assets, like
machinery and real estate, but investment in logistical systems, after sale support
networks, knowledge development, branding, and other softer assets.
The changes in global competition have a profound impact on the strengths and
weaknesses of countries. On the supply side, the increasing intensity of competition
between locations creates pressure to provide business environments that can support
high productivity, unique positions, and strong regional clusters. This favors small
countries with an institutional structure to pursue such strategies, while large countries
like Russia often find it challenging because of the complexity of dealing with multiple
regions with varying circumstances.
The integration of large emerging countries has created an abundance of low-skill labor,
making it increasingly harder for countries like Russia to copy the Asian models of
growing non-natural resource exports based on low labor costs. At the same time, rapid
technological change and growing skill intensity in many activities has increased the
returns to knowledge and education. Locations that provide access to skills and strong
clusters conducive to knowledge development and innovation can capture increasing
value, while locations that provide only low-cost labor may generate employment but
only little prosperity.
On the demand side, quickly growing populations and income catch-up—a consequence
of internal policy reforms—have made emerging economies significantly more important
drivers of global economic growth. The profile of their demand, consisting of lower
income populations and more biased towards needs for inputs and capital goods to
support investment-driven development, has fueled growth in these product categories.
Russia and other natural resource-rich economies have benefited, as well as traditional
suppliers of capital goods like Germany.
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Competition in the new global economic environment is getting increasingly intense; this
process has been under way for some time and is continuing. Only a productive business
environment with strong clusters can deliver competitiveness and prosperity; artificial
distortions like preferential market access, protection, and subsidies no longer suffice.
Regional clusters are getting increasingly important to productivity. Clusters appear to
becoming more specialized, concentrating on specific segments and roles within the
global value chain and trading with complementary clusters in other locations. Many
locations today offer the same generic business environment conditions. Increasingly, it
is a location’s unique cluster profile that has more to do with success.
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3. Assessing Russian Competitiveness
Russia’s generally good overall economic performance can be a source of confusion,
given the special circumstances that have driven it. An objective and realistic assessment
of Russia’s current position has become particularly urgent since the past drivers of
success may well not persist.
Our assessment of Russian competitiveness consists of several stages. First, we review
Russia’s economic performance, focusing in particular at the standard of living and
indicators/enablers of productivity. Second, we discuss Russia’s endowments, the set of
historical factors, natural resource assets, and geographic conditions that have a strong
effect on its current economic situation. Third, we examine Russia’s macroeconomic,
political, legal, and social context which provides the broader environment for
companies. Fourth, we examine Russia’s microeconomic competitiveness, on which its
future prosperity will depend. Finally, we examine the relationship between Russia’s
position and its aspirations, and the resulting implications.
Russia is currently entering a stage where the central challenges for economic policy are
increasingly microeconomic. While some success has been achieved on context,
especially in macroeconomic policy, the greatest barriers to further progress are now
Appropriate policy choices must be grounded in an analysis of the actual microeconomic
conditions present in Russia. A theoretical debate about the appropriateness of policies
such as special economic zones or government ownership of firms, is a popular Russian
pastime beyond the point of serving a useful purpose.
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3.1. Russia’s Economic Performance
3.1.1. Standard of Living
Prosperity, measured by GDP per capita adjusted for purchasing power parity, has
experienced a dramatic turn-around since the crisis of 1998 and is now approaching pre-
transition levels. Overall GDP growth has been strong, despite a modest slowdown from
7.3% in 2003 to an estimated 6.4% in 2007.17
Figure 9: Long-Term Trends in Russian Prosperity
Prosperity in Russia has grown even more strongly than GDP growth as a result of a
shrinking population (See Figure 9). Since 2000, Russia’s population has shrunk by about
780,000 inhabitants per year, falling to 140m in 2007.
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Despite this progress, Russia’s GDP per capita growth has been no higher than in
comparable countries. Kazakhstan and Azerbaijan, for example, two former Soviet
republics, achieved higher growth rates, also based heavily on oil and gas exports.
Within Russia, differences in prosperity across regions are greater than in Europe and the
United States and show few signs of diminishing.18
Inequality of prosperity has risen rapidly in the early phase of transition and remains
high. Inequality in Russia is higher than in most other transition and western European
economies, and roughly comparable to the United States, the United Kingdom, and
Australia.19 Income improvements have been most pronounced in the highest income
groups:20 for example, the top 10% of the population by income registered 21% income
growth in 2005, versus an overall growth rate of 14.3%.
Some other economic and social indicators show significant improvement across large
segments of the Russian population. Poverty levels are dramatically lower, for example,
although groups like migrant workers from other parts of the former Soviet Union face
legal uncertainties and social deprivation.21
However, many key social indicators, especially in terms of health and safety, continue to
be low relative to peers.22 Life expectancy, especially of men, is lagging with potentially
severe economic consequences. The country also registers a very low level of births;
many younger Russians seem wary about the future despite the recent economic
improvements. A particular challenge is the financial situation of pensioners. The real
value of pensions remains low compared to other countries and is only now approaching
the level of before the 1998 crisis.23
In the Human Development Index calculated by UNDP, Russia ranks 65 out of 177
countries; six ranks below its GDP per capita rank. Russia has improved in the Human
Development Index since 1995 but remains below its 1990 level. Progress on human
development has been slower than in the average rate of country progress in all world
regions except Sub-Saharan Africa.24
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Figure 10: Russia’s Position in the Human Development Index
3.1.2. Decomposing Prosperity
GDP per capita in an economy is made up of three main elements: (1) the productivity of
employees, i.e., the real GDP produced in an hour of work; (2) the mobilization of the
labor force, i.e., the share of the population working and working hours; and (3) domestic
price levels, i.e., the amount of consumption that can be sustained for the income level
Russia’s growth in GDP per capita continues to rely on high labor force mobilization and
low local prices—two factors that are certain to erode. Russia has weaknesses in labor
productivity, the core measure of competitiveness and a major cause for concern.
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As in many other formerly communist countries and some Nordic countries, Russia has a
high share of labor market participation, driven by high female participation rates.
Russia’s current demographic profile of few children and low life expectancy leads to a
high share of working-age people in the overall population. Russia also enjoys a
moderate unemployment rate, which has fallen as the economy has grown.
However, Russia’s demographic profile will become dramatically less favorable in the
coming years, as the share of older citizens will grow rapidly. After reaching a low point
in 2006, the dependency ratio, i.e., the ratio of people that are not of working age relative
to those that are of age, will increase rapidly.25 Productivity Measures
Russian labor productivity is a serious concern, only achieving the level of the weaker
Central European countries and just slightly ahead of Russia’s neighbors in the
Commonwealth of Independent States (CIS). Russia’s ranking on total factor
productivity, the share of productivity not directly explained by the quantity of labor or
capital used, also ranks only in the middle of transition economies, and much lower than
the advanced economies that Russia aspires to become.
Russian productivity growth has been at 6.8% per year between 2000 and 2007, but this
is below the rate achieved by other countries at similar productivity levels.26 Both labor
and total factor productivity growth have been positively affected by increasing capacity
utilization as the economy rebounded after the 1998 crisis. This type of improvement is
unsustainable. Consistent with this, productivity growth has been highest in
manufacturing and lowest in market services, where little capacity existed and new labor
had to be hired to meet demand.27
Controlling for capacity utilization, total factor productivity has been an important driver
of Russian productivity growth.28 But while this indicates that real improvements are
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occurring in business practices of Russian companies, the current rate of improvement is
likely to be unsustainable: Research from other transition countries suggests that
productivity growth tends to be strong during an adjustment period where entry and exit
rates are high and where market shares are dramatically shifting in the favor of more
productive companies.29 These effects weaken over time, making changes within
companies relatively more important drivers of productivity growth. Russia’s entry and
exit rates and rates of restructuring show signs of being lower than in other transition
countries due to policy failures and governance issues. 30
Figure 11: Labor Productivity, Russia and Selected Peer Countries, 2000-2007
Measured aggregate Russian labor productivity is significantly increased by the inclusion
of the oil and gas sector, which accounted for roughly 20% of GDP31 in 2007 but less
than 1% of employment.32 Labor productivity in the oil and gas sector is close to 30 times
higher than the rest of industry. Interestingly, labor productivity growth has been slower
in the oil and gas sector than elsewhere because the sector has added employment at a
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much higher rate than production. There are also indications that publicly owned
companies in the oil and gas sector register significantly lower productivity than privately
owned companies, raising serious issues about Russia’s current policy direction.33
Detailed analyses at the industry level in Russia have revealed large divergences of
productivity levels across companies.34 This is a sign that competition is weak, because
underperforming companies are not forced to improve or exit. The exit of less productive
firms tends to be among the most powerful drivers of overall productivity growth in an
economy together with entry of new firms and migration of output towards more
productive sectors of the economy.
Figure 12: Wages relative to Sales per Employee, Russia and Selected Peer Countries
Russian wages are higher relative to its level of productivity than other large emerging
economies, notably China or India, a danger sign.35 This is likely due to the influence of
the natural resource sector in buoying economic activity.
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Productivity growth in Russia has not been sufficient to keep pace with wage increases:
Unit labor costs—the wage costs per one unit of output—have risen, and grown faster
than in comparable economies like the Ukraine.36 Local Prices
Price levels in Russia remain relatively low in terms of national averages, but there are
significant regional differences that make average prices increasingly less meaningful.
The large differences in prices across regions point towards a lack of mobility and
competition across geographies.
Prices for energy and public utilities remain below comparable world market prices due
to subsidies. This is entrenching inefficiencies in the Russian business environment and
company practices. Increasing levels of competition in most consumer markets, together
with real exchange rate appreciation, have moderated local prices and benefited Russian
consumers. However, in the large cities, particularly Moscow and St. Petersburg, prices
are much higher.37 Real estate prices have risen dramatically. Moscow has been ranked as
the most expensive city in the world for expatriate employees.38 In these metropolitan
regions, the growth of standards of living will be increasingly offset by the declining
purchasing power of income.
3.1.3. Indicators and Enablers of Productivity
Russia’s overall world export share of 1.8% has only recently surpassed the pre-crisis
level. Russia’s export share is four times higher than its average share in unprocessed
natural resources and two times higher in semi-processed natural resources, while only
about half the average in processed goods and services.39 Oil and gas exports alone
account for 52% of total exports.
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The recent growth in Russia’s export share was entirely driven by unprocessed natural
resources. Within natural resources, export quantities have remained roughly stable while
export prices have gone up significantly.40
Further insights into Russian export performance can be gleaned from examining the
cluster composition of exports. Using data developed at the Institute for Strategy and
Competitiveness,41 we profile the exports of 163 nations in 42 clusters (36 covering
goods exports and 6 covering service exports). Unfortunately, service export data is more
aggregated than in goods, and prevents the integration of goods and services within
clusters than is possible with U.S. data. The 42 international trade clusters can be
subdivided into 212 subclusters, or subgroups of closely linked industries within a
cluster. The data set also provides information about the natural resource-content and
destination of exports.
Figure 13: Russia’s World Export Market Shares by Cluster Category
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The cluster specialization of Russia’s exports revealed in Figure 12 is worrisome to say
the least. Russia has lost market share in many clusters inside and outside of natural
resources, including some of its most important clusters. The exceptions are coal and
briquettes, construction services, forest products, furniture, and transport and logistics.
Overall, Russia has only maintained its overall world export market share despite rapid
economic growth because its few resource-intensive clusters have grown, largely because
of rising commodity prices.
Russia registers a revealed comparative advantage (RCA > 1)42 in six cluster
categories—oil and gas products, coal and briquettes, metal mining, forest products,
construction services, and electricity and electricity generation equipment. In four of
them—oil and gas products, coal and briquettes, metal mining, and forest products—
Russia ranks among the top 20 countries in the world by RCA.
At the subcluster level, Russia has additional strengths outside of these four cluster
categories: In agricultural products (fertilizers, crude fertilizers), chemicals (inorganic
chemicals), jewelry (diamonds), plastics (rubber), power generation equipment (nuclear
reactors), heavy machinery (railroad equipment), analytical instruments (search and
navigation equipment), and production technology (fabricated plate work) comparative
advantages exist in a narrower range of products. These are competitive positions that
potentially can be built upon.
Russia’s export portfolio exhibits two crucial challenges: First, the cluster overlap map
(see Figure 7) reveals that there are few linkages between the four clusters in which
Russia is strong. This limits the ability to leverage complementarities across these
clusters and makes it harder to create truly unique market positions within them. Second,
the four clusters have relatively weak linkages with other clusters;43 metal mining has
significant linkages to three other clusters (aerospace engines, automotive, and
production technology), oil and gas to two (chemical products and plastics), and forest
products to none. This limits the ability to broaden Russia’s export positions by growing
into related clusters where existing skills and competencies could be applied.
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At 14.1% of GDP in 2006, Russia’s import share is small compared to most other
countries (see Figure 14); only Brazil and Japan, both of which have productivity
challenges, report lower levels. Over the last decade, Russia was one of the few countries
that saw its import share in GDP fall. The statistical analysis reveals that economies of
larger absolute size and of higher levels of GDP per capita import more. Given its size
and prosperity level, Russia should register an import share of GDP of about 25%, 10%
of GDP higher than the actual value.44 This suggests that significant barriers to imports
remain in the Russian economy.
Figure 14: Imports as a Share of GDP, Russia and Selected Countries, 1996-2006
Since 2003 Russia’s imports have grown strongly; imports in 2006 where 41% higher
than in 2005. About 20% of the import growth between 2005 and 2006, the last year for
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which comparable data is available, was accounted for by higher automotive imports
(17% of all import growth between 1996 and 2006). The import pattern has shifted
towards consumption goods, while imports of investment goods that add to the country’s
capital stock and drive prosperity have developed less dynamically. Foreign Direct Investment (FDI)
Inward FDI accounts for a relatively modest share of Russian GDP and total investment,
especially compared to other Eastern European countries with similar circumstances (see
Figure 15).
Figure 15: Inward FDI, Russia and Selected Peer Countries, 2002-2005
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Of recent FDI inflows into Russia, 55% went into the oil and gas sector alone. Foreign oil
companies have increasingly been required to reduce their stakes in Russian oil projects,
most recently BP in the Shakalin-2 project, or been motivated to keep Russian partners
involved in order to reduce political risks.45 It remains to be seen how recent policy steps
will affect future FDI inflows in natural resources. An important emerging area for
inward FDI has become the electricity sector.
Given the growing domestic market and large untapped natural resource positions, FDI
inflows fall short of Russia’s potential, despite the significant recent improvements.46 Investments
Russia has a low domestic capital investment rate (see Figure 16 on the next page), which
makes FDI inflows even more important. Low investment rates are a major concern for
the Russian economy. Capital investment has not been sufficient to offset the aging of the
largely obsolete capital stock.47 Some research indicates that due to relatively high prices
for investment goods in Russia, even these low investment numbers overestimate that
effective build up of the capital stock relative to other countries.48
Other countries with similar shares of gross capital investment to GDP have a far higher
accumulated capital stock from past investments. In such economies, investment patterns
have shifted towards investments in innovation and intangibles (branding, etc.) that are
not captured in gross investment figures.
Strikingly, Russia’s investment rate is low despite real interest rates that are close to zero
for those companies that have access to domestic credit. The recent upswing in domestic
investment is positive, but it remains to be seen whether it is a reaction of companies
making incremental investments as they hit capacity constraints or a sign of true
upgrading to modern capacity.
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Figure 16: Investment Intensity, Russia and Selected Peer Countries, 2000-2005 Foreign Direct Investment (FDI)
Russian companies have recently become more active in outbound FDI.49 Companies like
Gazprom, Lukoil, NorilsNickel, and Severstal are among the largest owners of foreign
assets from emerging economies.50 Compared to other countries at a similar stage of
development, Russia has a significantly higher ratio of outward to inward FDI.51 The vast
majority of these investments have been related to Russia’s traditional strengths in
resource-intensive industries, which is understandable. The objective has been to better
access foreign markets, increase control over downstream activities in the value chain, or
gain control over additional resources. There is also speculation that some outward FDI is
a reaction to uncertainty about property rights in Russia.
Russian outbound investments are to a large extent in neighboring countries that were
part of the Soviet Union. In a much more limited number of cases, Russian companies are
actively looking to acquire new technologies and skills abroad. In some of these cases,
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the government has played a significant role, politicizing corporate decisions. State-
owned Vneshtorgbank acquired 5% of EADS (the European aerospace group that owns
Airbus), for example, raising speculations about possible links to the government-driven
consolidation of the Russian aerospace market.52
Innovative activity is a crucial driver of productivity growth, especially for countries that
have already reached moderate prosperity levels. Russia ranks low on most indicators of
innovation output, especially in relation to the human and financial resources devoted to
science and technology.53
Russian patenting intensity remains relatively high compared to other emerging
economies but is eroding, especially versus Asian and Eastern European EU countries
(see Figure 17 on the next page). Large research institutions connected to the Academy of
Science or universities are not among the top Russian U.S. patentors, a missed
opportunity and a danger sign. These institutions remain important to the Russian
innovation system but have yet to create linkages with the international scientific
community or with the private sector.
Interestingly, a number of foreign companies feature among the top Russian-based
patentors, suggesting that Russia is an attractive place to conduct research even if local
companies and research institutions lack the ability to capitalize this potential. Unlocking
this scientific and technological potential must become a central part of Russia’s
economic strategy.
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Figure 17: U.S. Patenting Rates, Russia and Selected Peers, 2000-2005
3.1.4. Overall Performance Assessment
Russia’s good economic performance since the 1998 has been driven by a succession of
factors that are mostly temporary.54 In the initial aftermath of the 1998 crisis, the collapse
of the Rouble created opportunities for exports and growth in import competing sectors.
The fall in GDP created unused production capacity that could later be brought into
production at low marginal costs.
As these early benefits began to be offset by an increasing real exchange rate and rising
production, Russia started to enjoy dramatic improvements in its terms of trade (since
2004), notably the oil price. With natural resource prices now stabilizing, most observers
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expect a slow down in the Russian growth rate. Some expect a more painful correction,
especially in Russia’s financial markets.55
Russia has registered improvements largely from improving macroeconomic conditions
and growing oil revenues. Performance indicators measuring underlying improvements in
productivity or productivity growth are far weaker. Hence it may not be surprising that
various observers arrive at very different views on the strength of the Russian economy.
Russia’s significant natural resources, combined with prudent macroeconomic
management, offer the country the prospect of reasonable prosperity for the immediate
future. But these factors alone will not be sufficient if the country has ambitions to be a
serious player in the global economy. Moreover, if Russia truly wants to overcome the
significant political and economic costs of natural resource dependence, it will need
major economic and political transformation. Russia urgently needs to upgrade its
microeconomic competitiveness if it wants to fully leverage the potential of its natural
resources and develop a more diversified and more dynamic economy.
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3.2. Russia’s Endowments: Legacy, geography, and natural resources
Russia faces complex endowments that create unusual challenges for competitiveness.
These challenges—some of them unique to Russia given its recent history while others
which are typical for many countries at this stage of development—must be confronted
head on in economic strategy. Otherwise the performance of the country will remain
below its potential and the political sustainability of economic reforms will suffer.
3.2.1. Legacy
Russia’s history as a planned economy left the country with an economic legacy that still
reflects political decisions instead of economic efficiency.56 Companies grew up at
locations determined by political and security considerations, rather than the efficient
economic geography. Company units were often too large in terms of productive
capacities at a given stage of the value chain, but too small in terms of presence and
capability across the value chain. Also, competition has been difficult to introduce into a
system built on monopolies.
Population and with it demand patterns also reflected political decisions, not individual
choices. With citizens strongly influenced to live in the far north and east as well as in
rural regions and smaller cities, a substantial population reallocation was inevitable.57
Greater urbanization has important potential economic and social benefits for Russia, but
the transition will be painful.
Russia’s Soviet past, however, left the country with important assets that it can build
upon. The general skill level of the population is high, and education is held in high
esteem. The science system consists of a large number of research institutions employing
a significant number of highly educated scientists and engineers, especially in natural
sciences and technologies related to military uses. The basic physical infrastructure of the
country also provided a good base to build upon, though it is now increasing inadequate.
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Russia’s history as a communist system left the country with a governance legacy that
includes a highly politicized public service and legal institutions that have been tools of
political leadership. In the communist system, party decisions could overrule decisions
based on government rules or laws. This legacy persists, and shapes attitudes and
expectations within Russia. It has made it hard for transparent regulations and due
process to take hold.
Unfortunately, Russia’s early steps towards economic reforms, especially the
privatizations of the mid-1990s,58 has left the population with a deeply cynical and biased
view of the market economy. In Russia, the market economy has become associated with
private monopoly, not competition. Private ownership and wealth are seen as the result of
political connections and criminal behavior, not entrepreneurship and value creation. This
is one of the reasons why the population is strongly in favor of government actions that
intervene and reign into the power of business. Unfortunately, there is little public
support or pressure for the government to create more room for private entrepreneurship
or ensure equal treatment of all companies.
The economic crisis and instability of the 1990s undermined the political standing of
Russia in the global community and was a blow to many Russians suddenly facing
economic hardship. The crisis has had continuing repercussions for economic policy.59
The economic growth since 2000 is now accompanied by public demand for a strong
government role in the economy and a more nationalistic stance towards foreign
governments and companies in economic relations.
3.2.2. Geography
Russia’s huge geographic area creates the need for effective regional governance
structures to improve the business environment at lower levels of geography. However,
weak regional institutions and a history of highly centralized decisions have made it
difficult to decentralize policies in a way that leads to effective policies and avoids
widespread corruption.
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Russia’s location between Europe and Asia puts it in a potentially beneficial position
alongside major trade routes. However, the inaccessibility of Russia as a transit country
in the past and the weaknesses in its current business environment have left this
opportunity untouched. Most global trade flows are far away from Russia. Russia is also
a country with only a limited share of its population in coastal regions that could easily
connect to the global economy.
Russia’s neighbors are largely former Communist countries that share many of the same
challenges Russia is facing. But Russia also borders to the European Union (through
borders with Finland, the Baltics, and – through Kaliningrad - Poland) and China;
countries offering interesting economic opportunities if Russia can take advantage of
them. So far, relationships with neighbors have been mostly negative instead of seeking
opportunities for win-win economic collaboration.
3.2.3. Natural Resources
Russia’s significant natural resource wealth has fueled rapid wealth extraction but
created political and economic challenges. Russia’s oil exports per capita were at $935 in
2005, and oil production per capita at about $1290.60 Russia has proven reserves of about
74m barrels oil (6.5% of total global reserves) and 48trill m2 natural gas (equivalent to
300m barrels oil; 26.7% of total global reserves),61 and these reserves represent an annual
value of $3,900 per capita for the next 50 years assuming an average oil price of $75 and
a stable population.
This level of resource wealth is substantial, and has fueled a boom since 2000. However,
even this level of resources will not itself make Russia a wealthy country. At the same
time, economic volatility, due to unpredictable changes in world commodity prices and
upward pressure on the real exchange rate, can easily undermine business investment and
the emergence of a vibrant private sector outside of natural resources. Moreover, natural
resource wealth of this size creates huge incentives to capture and utilize the power and
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wealth that resource abundance provides, putting pressure on Russia’s fragile political
structures and government institutions.
3.3. Russia’s Macro, Political, Legal, and Social Context
Russia’s context has improved, but continues to restrain competitiveness.
Macroeconomic management has significantly improved and is the greatest success story
of the Russian economy since the 1998 crisis. Burgeoning oil revenues have clearly been
important, but much improved fiscal policy (including the tax reform of 200162) has been
a central factor as well.63 Russia has registered significant budget surpluses over the last
few years. The current account surplus in 2006 stands at about 9.5% of GDP, and foreign
currency holdings approached $420bn in mid-2007. Russia has been able to repay its
foreign debt to the Paris Club ahead of time (summer of 2006). Inflation has been slowly
receding to about 10%.
The rapidly rising revenues from Russia’s oil and gas exports are clearly the key driver of
these remarkable improvements. However, Russia has been able to implement a fiscal
policy regime that is much more restrained than in many other resource-rich economies.
While a sudden fall in oil prices would clearly hurt the Russian public sector finances,
sensitivity analyses indicate that Russia is not in danger of an economic meltdown even
in such a negative scenario.64 The recent policy choices governing the stabilization fund
commit future governments (as much as possible) to continue on the path of fiscal
Overall, it is an impressive achievement that Russia has secured stable fiscal policy
despite the oil price bonanza. The repayment of foreign debt and build-up of foreign
exchange reserves have created a cushion that, according to several analyses, can shelter
Russia from a new crisis, even if the oil price should drop or another external shock
should occur.
The pace of overall growth is now widely expected to slow down. With oil prices
stabilizing on a high level, export growth has fallen behind import growth and the current
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account surplus is shrinking. This will test the ability of Russian policy makers to sustain
stable public finances in the face of less benign macroeconomic trends.
Russia’s political system has achieved short-term stability, but its long-term stability and
the efficiency of the policy process remain problematic. The President has created a level
of stability yearned for by citizens after the volatile Yeltsin era. However, this has been
achieved through concentrating powers in the Presidency while limiting dissent in the
political process and in the media.66 While these changes have had their benefits in the
short-term, their medium- to long-term implications are more uncertain. Russia still lacks
the stabilizing effect of independent and professional political institutions, and
uncertainty remains about the process of political transition itself. There are significant
uncertainties about future direction as the Presidential term approaches its end.
Figure 18: Political and Legal Context, Russia, 1996-2006
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The government also faces structural challenges to sound economic policy. Decisions
taken by different parts of governments—different ministries or different government
levels—are often inconsistent. Rivalry between different parts of the government was a
tool used in the past to secure overall control by weakening rivals and keeping them
unclear about their ability to count on Presidential support. This unhelpful legacy seems
to linger on.
The Russian government is also burdened by the view that it is solely responsible, and
can fix everything. The current mindset in the general public, and within much of
government itself, overburdens the government with unrealistic expectations that it may
never be able to meet. Microeconomic competitiveness relies not just on the central
government but on independent decisions by many institutions—companies, universities,
government agencies at different levels, etc. As Russia’s main challenges are increasingly
microeconomic, the weakness of many of these institutions, their low level of effective
collaboration, and the government-centric mindset of the public at large become ever
more important barriers to success.
Russia’s legal system remains a profound weakness (See Figure 18 above). The quality of
laws is improving in some cases but implementation is often ineffective. The legacy of a
judicial system that was a tool for the executive branch, not an independent part of
government, still impedes legal effectiveness.
Social conditions in Russia have improved, but the country is facing a number of
complicated challenges that will need to be addressed over time. While strong economic
growth has led to significant reduction in poverty, inequality in Russia has risen over
time, especially in the early phase of the transformation process.67 Significant divergence
across regions and income groups remains a serious problem for achieving consensus on
sound economic policies.
Access to basic health care and education, a hallmark of the Soviet Union, suffers from
severe issues of quality. Russia ranks low on many health and accident indicators. More
recently, concerns about the treatment of ethnic minorities have grown, a key concern
given the significant number of non-Russians that live in Russia.
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In 2004-05, government took steps towards a social system based on monetary instead of
in-kind benefits to improve the efficiency of social policies, though public protests
reduced the scope of changes that were ultimately implemented.68 In 2006, the
government also launched four national projects (education, health care, agricultural
development, and affordable housing) overseen by a new national body chaired by the
President.69 These projects have received significant funding, equivalent to 10% of the
funds allocated in the regular government budget to these policy areas.70 The projects are
an interesting and important step in the right direction, especially the creation of a new
institutional structure that has the potential to by-pass the inefficiencies of existing
government structures.
3.4. Russia’s Microeconomic Competitiveness
Microeconomic competitiveness will be the single most important long-term driver of
Russia’s prosperity. Weaknesses in microeconomic competitiveness remain the country’s
central challenge. While there have been some improvements in the last few years, we
have concerns, shared by others, that Russia lacks a coherent competitiveness strategy to
guide its policies. Nor is Russia successfully tackling the most pressing problems.
Demands on the business environment are increasing, but Russia’s investments in
infrastructure, skills, and other dimensions of microeconomic competitiveness are not
keeping up. Government policies and agencies frequently work at cross-purposes to each
other in micro reform, blunting effectiveness and creating significant uncertainty about
the course that government policy will take. Company investments and upgrading is
3.4.1. The Russian Business Environment
Russia’s overall business environment quality is ranked 71 out of the 127 countries
covered by the 2007 Global Competitiveness Report, significantly worse than Russia’s
rank of 52 on GDP per capita adjusted by purchasing power. Russia ranks below
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countries like Croatia, Mexico, and the Philippines and ranks at about the same level as
Egypt, Kazakhstan and Romania. Clearly, Russian prosperity has depended heavily on its
natural resources, not true competitiveness.
The Global Competitiveness Report (GCR), co-chaired by Professor Michael Porter
and Professor Klaus Schwab, is an important source of information about the drivers of
competitiveness across countries. Based on an annual survey of 11,000 company
executives from more than 120 countries, the GCR provides the best available systematic
data on the relative levels of business environment quality and company sophistication.
While survey data is inherently subjective, it represents the opinions of business leaders
that base their on decisions on these perceptions. Validity tests indicate that the survey
responses are a meaningful indicator of actual conditions in companies and the business
environment. The Business Competitiveness Index71 aggregates countries’ individual
results for 59 individual indicators into an overall ranking of microeconomic
competitiveness, and component rankings for different dimensions of the business
environment. We employ this data extensively in the discussion that follows.
Russia has significant strengths in factor conditions, especially its science and technology
assets, human resources, and physical infrastructure (see Figure 19 on the next page).
Russia also enjoys the extensive presence of related and supporting industries, a legacy of
the planned economy. This creates the potential for cluster development.
The most significant Russian weaknesses are in extent of competition and administrative
rules and procedures. In these areas, Russia ranks among the bottom 25 countries in the
Relative to 2001, related and supporting industries (cluster development), market
incentives, and human resources have become relatively weaker, while capital markets
have improved. Administrative complexity, Russia’s greatest weakness as of 2001, has
deteriorated further relative to other dimensions of the business environment.
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Figure 19: Russia’s Relative Business Environment Strengths and Weaknesses Factor Conditions
Factor conditions in Russia remain relatively strong, but are eroding with the exception of
financial markets.
Physical infrastructure is inefficient and not keeping pace with demands of a growing
economy, particularly in high-growth regions like Moscow. Weak infrastructure also
reduces the degree of effective local competition and cross-regional specialization within
the Russian economy. Even where physical infrastructure is present, a lack of specialized
service providers and efficient government services reduces productivity. This is evident
in areas like logistics, where Russia has solid physical assets but much weaker service
providers such as trade forwarders and other logistics companies.72
To address the emerging infrastructure problems, government introduced the National
Investment Fund in the 2006 budget that was designed to solicit competitive bids for
large infrastructure projects for which the Fund would provide co-financing.73 President
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Putin announced major plans to invest in energy, roads, and ports in his 2007 address to
the Parliament. Over the last few years, however, the main challenge in upgrading
Russia’s infrastructure has not been the lack of available capital or plans, but weaknesses
in administrative procedures and implementation.
Figure 20: Factor (Input) Conditions, Russia’s Relative Position Based on the
Business Competitive Index, 2007
Russia also faces significant weaknesses in the availability of electricity supply. The
state-owned monopoly, RAO United Energy System of Russia (UES), is responsible for
both electricity production and transmission. It has in the past failed to invest enough to
keep pace with the electricity demands of the growing economy. Recently, aggressive
plans for new investments have been announced, but implementation remains a question.
Legislation in 2003 initiated a process of restructuring and eventual privatization of UES.
The company was restructured in 2005, and a number of power plants were listed on the
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stock exchange in 2006. Plans for the further liberalization of the sector have been
approved.74 The government will remain the owner of the power grid and control nuclear
generation and most hydroenergy capacity, representing about 70% of the total energy
generation capacity.75 Whether these steps will encourage sufficient investment and lead
to competitive prices remains to be seen.76 The initial experience with the sale of power
plants to foreign investors is encouraging. The reform of the electricity sector is an
example of how Russia’s competitiveness could be accelerated by strengthening
connections with companies from abroad rather than pursuing government led solutions.
This approach should be spread to other policy areas.
Administrative efficiency remains perhaps the major weakness and a fundamental
challenge to Russian competitiveness. Legendary bureaucracy, corruption and favoritism
by public officials inflict huge direct and indirect costs on Russian businesses and
citizens.77 Administrative failures also block competition and industry restructuring,
further reducing productivity.
Russia remains at the bottom of the international corruption perception index, even after
slight improvements between 2001 and 2007 (see Figure 21 on the next page). Indeed,
the president of the American Chamber of Commerce in Russia noted that there is rising
‘boldness in trying to extort money”.78
The cost of doing business is unnecessarily increased by the unpredictable behavior of
government agencies: In his 2005 State of the Nation address, President Putin urged
government’s agencies to stop terrorizing companies on taxes.79 Some studies report
slight improvements in the administrative burden for small companies, but serious
problems remain.80 Russia has failed miserably in making government effective and
professionalizing the bureaucracy.
In Russia, the application of rules, regulations, and permitting processes is perceived as
having more to do with political objectives than with due process. This has been widely
noted in the context of the Yukos affair, but also in the application of environmental
regulations faced by foreign investors in the Russian oil sector and, most recently, in tax
evasion charges against a U.S. bank.81
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Russian agencies are regularly acting at cross purposes to make the Russian economy
world class, and putting other goals ahead of the well-being of citizens.
Figure 21: Corruption Perception Index, 2007
To be fair, administrative reform has been on the government agenda since the beginning
of the Putin administration in 2000.82 The presidential decree of July 2003 sought to
reduce the number of rules and regulations affecting businesses, and rationalize the
federal executive bodies. While there has been some progress, however, the overall
improvement in administrative capacity has been disappointing to say the least. The
number of government employees has actually increased.83 Civil service reform, and
equipping civil servants to meet the needs of a democratic market economy, has been
progressing slowly since 2000. The extent of real change, however, has been limited.
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In late 2005, the government approved an ambitious new Concept for Administrative
Reform for 2006–08. The plan introduces performance-based management and
budgeting, the development of formal standards for the quality of public services, and
measures to increase the transparency of actions taken by government agencies. While
this new plan has many positive aspects, we do not believe it is sufficiently radical to
achieve meaningful change. It essentially tries to improve how the public administration
is doing the things it is already doing. It is not reassessing whether it is doing the right
things, nor tackling the structural reasons for the existence of the current problems.
Administrative reform will not be truly effective, for example, when the judicial system
remains weak and eroding and civil society institutions are impotent.84 This is why past
reforms failed, and why current reforms will fail if they do not become more ambitious.
In the area of human resources, skill shortages are emerging throughout the economy
despite the high level of formal education of the Russian labor force.85 The growth of the
Russian economy has far outpaced the ability to provide employees with the needed
skills, and problems in recruiting and retaining employees with the appropriate skills
have become one of the major growth constraints for companies operating in Russia (see
Figure 22 on the next page). The labor hoarding of the past has transitioned to poaching
of workers. High staff turnover is endemic.86
Yet government spending on education is low, as are training expenditures by companies.
There is no evidence that Russia has a clear strategy to fundamentally reform its
educational system and align it with the needs of a modern economy.
Skill shortages have led a number of private sector initiatives to start new Russian
business schools. However, there is insufficient focus on reforming the educational and
training system overall, whether by government or through public-private collaboration.
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Figure 22: Major Constraints to Competitiveness for Russian Companies, 2006
Russia’s financial sector is growing rapidly based on improved regulations and the
increasing presence of foreign companies.87 This is an area of policy success. However,
the size of the financial sector remains limited for an economy in Russia’s position.
While large companies and recently consumers have access to loans and other sources of
capital, small and medium size companies still find it hard to get financing. The financial
sector also remains dominated by government-owned banks that have a virtually
monopoly especially outside of Moscow and St. Petersburg. Foreign banks have
increased their position in the Russian market and have not viewed government policies
or the behavior of the state-owned banks as a problem.88 This is a positive sign.
Nevertheless, Russia will need to develop a clear strategy for how to transition from a
financial system dominated by few state-owned banks to a competitive, private sector
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Government is taking steps to develop the Russian equity market by requiring Russian
companies that list on foreign exchanges to also list on the Russian stock market. To
attract growing interest from foreign and domestic investors, however, fiat will not be
enough. It will be increasingly essential to continue the path towards strong and
transparent regulation. This will put the Russian market in a better position to deal with
the inevitable volatility of financial markets in an emerging economy.
The government is also trying to improve the availability of risk capital through
launching public venture funds. There is little evidence that a public dominated model
will be successful, and public investment is rarely effective unless it is invested jointly
with private managers. The bulk of risk capital in Russia will need to come from private
sources. Private risk capital funds are still small in Russia not because of lack of interest
by the private sector, but because of inexperience and weaknesses in the business
environment, especially regulation and bureaucracy. This is another area where attracting
foreign expertise will provide immediate benefits to Russian competitiveness.
Finally, the science and technology system in Russia has significant legacy strengths, but
there is a real danger that these strengths will erode over time.89 Overall, Russia has solid
innovation inputs but weak outputs. Russia’s research and development (R&D) spending
as a share of GDP is high relative to its level of economic development, a legacy of past
policies. A major share of this spending, however, is government spending on a large
number of public research institutions with little connections to education and business.90
Government spending is biased toward personnel instead of modern research
infrastructure. Companies still spend relatively little on R&D, content to grow with the
domestic market.
Academic research is not well integrated with Russian companies and with research
internationally. Low levels of academic publications and patenting indicate that Russian
researchers have not yet integrated into international science and technology networks.
There are also problems with intellectual property protection, where science and
technology suffers from the broader weaknesses in Russia’s legal context and
administrative systems.
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The list of current top Russia-based U.S. patentors indicates that foreign companies are
already an important user of Russian science resources, while Russian companies are less
active with only two of them among the top 25 (see Figure 23 on the next page). Boeing,
for example, has 1,000 Russian engineers employed at its Moscow Design Centre where
a significant share of the development work for the recently launched Boeing 787 and a
cargo version of its Boeing 747 were done. Samsung’s research center in Moscow has
been an important source of technology used in the company’s mobile phones.
Figure 23: U.S. Patents by Russia-based Inventors, 2000-2004
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The Russian government has launched a number of initiatives to strengthen innovation,
particularly in companies. One policy thrust has been the creation of special geographic
zones in which innovative activities are encouraged. Four technical-innovation zones,
each focused on a specific cluster or technology, have been created sine 2005.91 In these
zones, investors have access to tax advantages, streamlined administrative procedures,
and special infrastructure. The government also plans to create eight technoparks (smaller
than special economic zones and without tax advantages) and a number of so-called
science towns, both with a strong presence of local research and educational institutions.
These areas will benefit from investments in specific infrastructure but not from tax
incentives.92 These efforts are welcome and can provide real benefits. But their effects
will be limited to the companies located in the designated areas. Russia needs a broader-
based effort to make innovation more attractive for all Russian companies, wherever they
are located.
Three separate ministries have launched venture funds that will invest about 4bn Rouble
(about $160m)—largely through other funds—in small innovative companies. About half
of the funds are earmarked for the information and communication technology sector.
There are also discussions to review the tax treatment of R&D expenditures that currently
is unfavorable compared to other countries. These initiatives are a start but deeper
reforms will be needed in institutions and rules if Russia is to be able to translate its
scientific potential into higher competitiveness and prosperity.
The Innovative Capacity Index provides some additional perspective on the challenges
facing current policy initiatives.93 The Index explains a country’s rate of innovation,
measured by patenting intensity, through a combination of indicators including factor
inputs (scientists and engineers), innovation policy (intellectual property rights, R&D
incentives, trade barriers, and administrative burden for start-ups), cluster development
(availability of specialized research facilities), university-industry interaction, and the
demand for innovation from companies (based on their strategic positioning).
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Figure 24: Innovative Capacity Index, Russia’s Relative Position, 2004
Russia’s position in the Innovative Capacity Index is 35 and suffers from serious
imbalances across different aspects of innovative capacity that undermine overall
performance.94 Moreover, Russia registers 7.5% fewer patents than predicted by the
model based on the independent variables, one of the worst results among the 74
countries analyzed. The current initiatives do little to address the underlying weaknesses
in company behavior, i.e., the way in which Russian companies compete. Most
companies are not willing or able to focus on innovation. Improvements in efficiency are
currently dominating their attention, especially given the rapidly growing domestic
market that puts a premium on expanding capacity.
Weak protection of intellectual property rights (IPR) is cited by companies as a critical
obstacle towards commercializing R&D outputs. A survey by the Russian
Interdepartmental Analytical Center found 50% of companies citing weak IPR as a major
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problem for innovation.95 Russia ranks 113 among 120 countries on IPR protection in the
Global Competitiveness Report. The WTO accession process has led to improvements,
but these were focused on trademarks and copyright issues rather than patents.
Infringement of IPR has been common and it will take time for companies to build trust
in a more robust Russian IPR system.
Russian innovation policy draws on policy tools and initiatives that have worked well in
western countries where the overall business environment for companies is very different.
These policy tools do, however, little so far to address the circumstances of Russian
companies. for Strategy and Rivalry
The rules and incentives governing competition are a key weakness in the Russian
business environment. Government rules and regulations significantly raise the costs of
doing business in Russia relative to peer countries, while limiting the intensity of
competition. Overall, Russia ranks 106 among 178 countries in the World Bank’s 2007
Doing Business report versus a 54th rank in GDP per capita.96 Not only are costs high, but
there is uncertainty about the predictability and application of rules and regulations.97
While there have been some policy improvements, implementation of reforms is often
weak.98 There are also significant differences across Russian regions in the
implementation of regulatory reforms.99
Russia’s average tariff level is comparable to other countries at similar stages of
development.100 However, the effective openness to foreign trade and investment is
reduced by the complexity of tariff classes and the way they are interpreted by
government authorities, both of which create uncertainty. This adds to the costs of
conducting cross-border business.101 Companies from the Baltic Sea Region report that
technical rules create high barriers to trade with Russia that have slightly worsened over
the last five years.102 As a result of such administrative barriers and inadequate logistical
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services, Russia is less open to the global economy than, for example, China.103 Russia
pays a high price in terms of domestic efficiency.
Figure 25: Doing Business Index, Russia’s Relative Position, 2007
The intensity of internal competition is low in large parts of the Russian economy, which
is holding back restructuring, entrepreneurship, and innovation.104 In many industries,
there are dominant market positions in narrow regional and product markets. Regional
concentration levels are high, and there is insufficient competition across regions.105
One reason for limited rivalry is artificial barriers to entry created by government,
especially regional governments. Regional governments have been willing to protect or
subsidize large employers in order to keep them afloat.106 New, more efficient companies
find it hard to enter, and face competitors who set uneconomic prices based on marginal
costs and fully written-off assets.
Russian companies have higher prices and margins than in peer countries,107 despite
some moderation in recent years.108 Higher margins reflect less contested market
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structures. While the surge in local demand led to some new entry, competition is often
me-too competition based on price. Russian companies have been slow to develop
differentiated products and services.
Public policy towards competition has moved in the wrong direction. The Russian
government has in the last two years taken a significantly more active and direct role in
the economy. It has designated strategic sectors in which foreign ownership is limited.
Government-owned companies like Gazprom and Rosneft have taken over the assets of
private rivals, notably Yukos,109 and gained a dominant position in their industries. The
Russian government has facilitated the creation of national champions in areas like
aerospace, where it has consolidated the industry in a single company under government
control. Government has taken majority stakes in the dominant domestic players in
sectors like the automotive industry. Proposals currently under discussion in the lower
house of the Russian parliament, the Duma, could restrict the openness of a significant
number of other industries to foreign investors. There is no evidence, in Russia or
elsewhere, that national champions succeed and that these policies will enhance
competitiveness or encourage new business formation or innovation.
Figure 26: Context for Strategy and Rivalry, Russia’s Relative Position, 2007
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There is a need for structural change in many industries, but state ownership solutions
have failed time and time again to produce real restructuring. While increasing the public
ownership stake in natural resource industries may redress past exploitation to private
domestic and foreign interests, the solution chosen by the Russian government has been,
and will be, detrimental to the country’s competitiveness. The government has mixed the
roles of resource owner, regulator, and market participant, with predictable negative
The path of Russian policy towards competition will limit Russia’s participation in the
global economy. Russia will find it increasingly hard to export outside of resources and
commodities. Domestic Demand Conditions
Demand sophistication and domestic segmentation are not yet important influences on
Russian competitiveness. The recent increase of purchasing power has led to rising
sophistication of Russian consumer demand. This is an important strength. It is likely that
many Russian-based companies and subsidiaries are also starting to become more
advanced in their purchasing activities.
However, government procurement is not encouraging quality, and consumer-protection
standards are weak. Government has also failed to set demanding regulations in
environmental impact, safety, energy efficiency, and other areas as a tool to drive
productivity and innovation. Related and Supporting Industries
As a large country that historically was not well integrated into the world economy,
Russia has a high presence of local suppliers and supporting industries. The evidence
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suggests, however, that such industries have rarely developed into functioning regional
clusters that drive productivity and innovation.
3.4.2. Cluster Development in Russia
Russia faces weaknesses in cluster development, even for a country at its income level.
Historical location patterns worked against clustering, rather than encouraged it. Russia’s
economy is still paying the price.
We utilize a new data set that applies the cluster definitions developed by Professor
Porter to Russian data on employment and other indicators by Russian region. The cluster
definitions reflect the actual co-location patterns of industries that exist in the United
States, an integrated economy in which companies have long been able to choose their
location based on economic considerations, including the presence of cluster effects.110
Russia has a larger share of its overall employment in the traded sector than in developed
OECD countries. This is probably due to the limited local personal and business support
services available in Russia. Within the traded sector, Russia is relatively specialized in
capital- and resource-intensive clusters as well as in education and knowledge creation.
Compared to more advanced economies, Russia is weak in business services and
financial services. Russia’s legacy is the main reason for this economic structure: The
planned economy focused on manufacturing, regarding service activities as less
important or contained within large vertical integrated firms.
Russia’s employment profile in 2007 (see Figure 27 on the next page) is a consequence
of its history, geography, stage of development and relative factor endowment. Political
choices in the past have favored heavy industry but also education and science relative to
other services. The limited outsourcing of non-core activities by many large companies
sustains this bias. The large physical size of the country is important to explaining the
significant employment in transportation and logistics. As in other countries at a similar
stage of development, clusters such as processed food and areas of manufacturing are
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important. The presence of natural resources, including metals, drives the size of affected
clusters as well as related activities, for example in transportation equipment.
Given the structure of Russian economy versus more advanced economies, it is clear that
restructuring still has a long way to go, both across sectors, within sectors, across
geography, and within companies.
Figure 27: Russian Employment by Cluster, 2005
The June 2005 law on Special Economic Zones (SEZ) is intended to support the
emergence of clusters. Four zones are designated as technical-innovation zones,111 two as
industrial-production zones, and others might be designated as tourism-oriented zones.
This approach is a welcome step towards organizing investment investments and
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government administrative capacities around the needs of a specific regional cluster. But
a small number of SEZs are not sufficient to spur meaningful cluster development across
the Russian economy. And SEZs are not a substitute for cluster initiatives in which
companies and government agencies cooperate in the strengthening of cluster dynamics
in a specific region.
Oil and Gas Cluster. The oil and gas cluster has become an increasingly dominant part
of the Russian economy. While a detailed analysis of individual clusters is beyond the
scope of this report, the increasingly important role of the oil and gas cluster for the
Russian economy demands a few summary observations.
The unit output of the Russian oil and gas cluster has remained more or less stagnant
since 2004. The significant growth in revenues has come entirely from the increase in
world oil prices.112 Yet employment has grown significantly, reducing oil production per
employee. There are few signs of any progress in broadening the value generation of the
cluster beyond the sale of unprocessed natural resources. Government’s policy of state
ownership is thus far failing to enhance competitiveness. Instead, it seems to be reducing
competitiveness as is typical in other countries.
Competition in oil and gas is highly distorted. Prices in the domestic market are heavily
subsidized. Export prices differ significantly across export markets, with Commonwealth
of Independent States (CIS) countries paying prices below the world market level. Prices
are gradually adjusting towards world levels, but the process has become politicized
through government intervention in all affected countries. Price increases have been more
dramatic for countries like Georgia with which Russia had foreign policy disagreements.
In countries like the Ukraine and Belarus, the pricing of oil and gas exports has been tied
to Russian control over the oil and gas pipeline infrastructure. Ultimately, this whole
approach has increased the level of political interference in the cluster and delayed
progress toward true competitiveness.
The re-nationalization of large parts of the cluster has set back competitiveness
improvement even further. The initial privatization of the cluster—with the important
exception of the transportation network113—has been reversed during the last two years.
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Government-linked companies, in particular Gazprom and Rosneft, have taken over the
interests of foreign and private companies.114 Government-linked companies have
focused on controlling markets through acquisitions and long-term contracts, not on
investing into new capacity or achieving higher productivity. Private domestic and
foreign companies now have little incentive to make risky long-term investments in
exploration or innovation, so Russia’s cluster is likely to stagnate. Also, the specific tax
structure applied to the oil sector has further dampened investment incentives.115
3.4.3. Company Sophistication
Companies are the ultimate sources of value creation in any economy. National
productivity depends on the sophistication of company operating practices and strategy.
The productivity of the country depends on the collective productivity of companies
operating in the country. A strong business environment and dynamic clusters allows
companies to compete in more sophisticated ways and increase their productivity, but
ultimately it is companies that must transform themselves.
Many Russian companies have a complex legacy that continues to hamper their policies,
organizational structures, and market behavior more than 15 years after the end of the
planned economy.116
In the planned economy, the capacity of a plant was set to serve a captive market, often
with an exaggerated view of the available economies of scale. Indeed, economies of scale
were the dominant tool for improving efficiency, with the rate of product and
technological innovation all but halted by monopoly control. Elsewhere in the value
chain, such as in marketing or services, companies were often weak or not present at all.
Companies were vertically integrated into supporting activities, rather than outsourcing to
specialists or collaborative local corporate networks.
The process of privatization in Russia did not eliminate these structural distortions, but in
some ways actually accentuated them. Individual plants were privatized, which broke up
the value chains that they were part off. This created companies that were too large in the
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product area in which they were active, but small or not participating in related activities.
Companies continued to be overly vertically integrated.
The Russian privatization process also led to the emergence of business groups with
many unrelated businesses. Acquisitions were made opportunistically, where there were
opportunities to buy assets at low prices. Conglomerate groups failed to reinforce
competitiveness, but concentrated instead on amassing political influence.
In 2007, there is a painfully slow process underway in which these fundamental structural
misalignments are starting to change. While there is yet little systematic data, the
available evidence suggests the following: Company capabilities in core products have
often become either technically obsolete or superseded by the changing needs of the
economy. Weak corporate presence in the value chain remains a significant problem.
While some companies have extended their activities along the value chain, for example
in the steel industry, this improvement in capabilities remains the exception. A low level
of outsourcing in non-core activities is pervasive. There are still too few external
providers offering support services, a significant challenge for foreign companies who
need local suppliers in order to grow in the Russian market.117 Finally, while business
groups are beginning to try to improve efficiency and sell non-core businesses, too many
groups are mainly the result of the past dealmaking, and not justified by genuine
competitive advantages.
Such misaligned corporate structures have important consequences: Companies find it
harder to develop competitive advantages because they cannot draw on the appropriate
network of activities to sustain them. And markets are less competitive because of captive
supplier relationships. There are encouraging examples of Russian companies
successfully outsourcing support functions.118 But the overall evidence suggests that old
legacies persist and that unwinding them remains a key constraint to Russian
Company Strategy. Many Russian companies still compete on price and cost,
based on large scale plants, written-off assets, or preferential access to cheap energy or
natural resources. Russian companies tend to utilize less advanced management
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approaches and make fewer investments in skills and technology, notably foreign
technology, than companies in comparable countries (see Figure 28). Capital spending is
focused on acquisitions to increase market power. An outdated view of competition as a
one-dimensional race to win is common.
In the last few years, Russian companies have become more aggressive, seeking to
participate in rapidly growing markets.119 Operational effectiveness has improved,
investments in foreign machinery have risen, and financial structures have improved.120
Corporate governance has improved as well, relying more on outside board members and
separating ownership from management.121
Figure 28: Company Sophistication, Russia’s Relative Position, 2007
Overall, Russian companies have gotten better at traditional ways of competing, but are
yet to adopt the more sophisticated ways of leading competitors. There is little focus on
unique products and services, little innovation, and little true restructuring. In many
companies, the transparency of governance remains low.122 An important reason for the
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lack of corporate progress is the weaknesses in context and the Russian business
environment that we have described.
Challenges Facing Russian Companies. There are four broad types of companies
operating in Russia with different competitive challenges Large private groups
(sometimes referred to as ‘oligarchs’), which developed during the Yeltsin era, are still a
large part of the Russian economy. A significant number have listed on foreign
exchanges, particularly in London. Their productivity performance puts them ahead of
government-linked and smaller Russian companies, but well below foreign companies.123
These companies have taken the basic steps to improve management sophistication,
including some improvements in governance.124 Large groups are attentive to
government, and have gotten increasingly careful to minimize conflicts with the
government. Many have responded to government pressure to invest in social programs
and other efforts to benefit the regions in which they operate.
Large government-linked groups, the second category, are currently growing rapidly.125
The available evidence suggests that these companies are driven to achieve size and
market power rather than improve productivity.
Small- and medium- sized companies are growing in number but are still
underrepresented relative to comparable economies. They tend to compete using low cost
strategies, and are facing greater rivalry.
Foreign companies have historically seen Russia mainly as a source of natural resources.
In recent years, however, rapid Russian market growth has led to a significant increase in
the foreign companies who serve the Russian market. Foreign companies have brought
advanced operating practices and strategies to Russia, raising the sophistication of
competition in sectors in which they play a significant role, such as financial services,
consumer goods, and retailing. Especially given its legacy, Russia will benefit greatly
from entry by foreign companies. However, foreign companies are facing growing
challenges, especially in sectors with strong government involvement.
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The current Russian business environment, ironically, is relatively favorable for many
foreign companies outside of natural resources based on our interviews and analysis.
These companies enjoy a growing local market but unsophisticated rivals. Infrastructure
weaknesses, corruption, and cumbersome rules and regulations are burdens that are more
easily overcome by large foreign companies that have clout and experience from other
countries with similar circumstances. Russian companies, in contrast, are more
disadvantaged by Russia’s failure to improve rules, regulations, and transparency.
State-linked Russian companies have grown in size and market power but are
uncompetitive. Private groups have improved but are not yet truly competitive
internationally. Russian SMEs, the key to Russia’s future competitiveness, find
themselves the most disadvantaged by the current Russian business environment. They
are exposed to all its weaknesses but lack the capacity, connections, or financial access to
grow, upgrade, and cope with corruption and administrative complexity. Ironically, then,
the development of Russian companies is the opposite of what should be desired by
3.4.4. The Role of Sub-national Regions
As in other countries, there are significant differences in competitiveness across Russian
regions. 126 A recent analysis of eleven Russian regions using the methodology drawn
from the Business Competitiveness Index (BCI) found that the most competitive Russian
region was at a level comparable to BCI country rank 70 (Russia’s comparable overall
rank is 79) and the bottom region at rank 82.127 Interestingly, Moscow, the region with
the highest GDP per capita, did not have the most competitive business environment.
Moscow benefits hugely from government presence and faces serious bottlenecks in
terms of infrastructure and the availability of skilled employees.
Russian regions are more specialized by cluster, in terms of employment, than regions in
North America or Europe.128 In our analysis, specialization is measured using the inverse
of the Herfindahl Herschman Index (HHI); higher values indicate higher levels of
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specialization. Large Russian regions are more specialized than large European regions
and large U.S. regions. Small Russian regions are as specialized as small U.S. regions
and more specialized than small European regions. The U.S. has had a fully integrated
economy for many years which encouraged specialization. Europe’s economic geography
is still shaped by its legacy of barriers to cross-border trade and investment. Russia’s
economy was specialized by fiat, not market forces, an equally bad structure.
Figure 29: Regional Specialization Levels, Inverse of HH index
Russian regions often have high dependence on a small number of clusters. In many
regions, a few companies account for most of the employment within the leading clusters,
a danger sign. Vibrant clusters require competition and collaboration across companies
and institutions, and current Russian regional structures are not conducive to capturing
such externalities and spillovers.
Russian regions differ in the relative strength of their cluster portfolio, with implications
for regional performance.129 As in many other countries, Russian regions with stronger
clusters tend to perform better in terms of prosperity, despite the many distortions that
exist. 130 Further research will be necessary to deepen the understanding of whether this
reflects true benefits in terms of productivity or is just a reflection of the dominant market
positions that individual Russian companies hold in regional product and labor markets.
Russian regions have begun to diverge more in performance. Since 1997 regional
administrations have been headed by elected governors.131 There is case based evidence
that some regions have improved their competitiveness, while others suffered from
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corruption, institutional weaknesses, and policies that favor large incumbent
employers.132 In Russia’s North-West, for example, regions like Leningrad oblast and
Novgorod, traditionally ranked highest on economic reform efforts, have lost their
leading position. The cities of St. Petersburg and Kaliningrad have in the meantime
improved their reform efforts.133
In 2000, President Putin created seven federal districts as a new governmental level
between the regions and the federal government. However, the influence of districts
appears, so far, to be limited. An analysis covering the period up to the end of 2003
indicated that districts and other regional measures by the Putin government, such as tax
legislation to reduce regional tax rebates for individual companies and to limit the capture
of regional governments by local interests, had not been effective.134
In 2003, the Russian government proposed a significant revision of the fiscal relations
between the federal government and regions. These proposals were designed to give the
regions a much larger stake in their own affairs, consistent with notions of efficient fiscal
federalism and potentially beneficial to competitiveness. In 2005, however, the
implementation of these efforts was interrupted as part of the reforms—the monetization
of social benefits—was creating serious unrest.135
In 2004, the Russian parliament adopted a new law that gave President Putin the right to
appoint regional governors. The appointment of governors less likely to be captured by
local interest groups is a positive step,136 and regional policy will benefit from a more
productive relationship with the federal government. However, the danger of this new
structure is the lack of local accountability. It can also limit the ability to mobilize
regional institutions and lead to overdependence on the federal level. There is no political
mechanism to ensure that governors focus on the interests of their regions if there is no
pressure from the President to do so.
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3.4.5. Economic Integration with Neighboring Countries
An important driver of national economic and productivity growth is economic
integration with neighbors. Historically, the Soviet Union was an integrated economic
system, but one based on an ineffective economic model. Cross national linkages
between Russia and its neighbors have grown weaker over time, which is
understandable.137 Russian exports, dominated by natural resources, are largely directed
to global markets. Neighboring countries remain an important destination for Russian
foreign direct investment outflows.138 However, a political overlay to Russia’s trade
relations, and the increasing use of oil and gas for political reasons, is hurting the ability
to force productive economic linkages with neighboring countries.
There have been controversies between Russian energy companies, in particular state-
owned Gazprom, and the Ukraine and Belarus about energy prices and ownership of
pipeline infrastructure. Controversies with Poland have led to a Russian embargo to
Polish meat exports, triggering a Polish resistance to some elements of EU-Russian
collaboration. Relations between the Baltic countries and Russia remain problematic and
have hampered the use of trade links between Russia and Western Europe through the
Baltics, traditionally one of the main logistical corridors for Russia. Georgia was subject
to economic sanctions.
These controversies may be good politics, but they are bad economics. Russia has
employed policies that are not in its economic self interest.139 Productivity enhancing
opportunities have suffered.
Russia is not leveraging the potential of economic ties with its neighbors. Such ties would
have significant benefits, especially for the diversification of the Russian economy. The
experience of the Baltic Sea Region suggests lost opportunities in closer cooperation with
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3.4.6. Public-Private Collaboration in Economic Policy
The nature of interaction between the Russian government and the private sector has
changed for the worse in the last few years, especially since 2004.141 As economic policy
has become more centralized and government-driven, the private sector has reduced its
direct engagement. Industry associations are active in operational issues, but stayed away
from participation in economic policy. In the process, Russia has lost a crucial tool for
economic development.
Russian business associations represent the main categories of Russian companies; the
Russian Union of Entrepreneurs and Industrialists (RSPP) represents the large private
groups but also the state-linked companies. Opora represents small companies. Business
Russia represents the new medium-sized companies. These groups have played some role
in the design of specific policies—RSPP, for example, was active in the discussion of the
new competition law. However, the private sector is not prominent in overall policy.
Foreign companies have associations that tackle on-going operational issues with the
government, but collaboration to improve the Russian business environment is limited.
Ministries are not accountable to the private sector in considering policies.
Business leaders have become reluctant to speak out about economic policy. There is a
National Competitiveness Council under the Prime Minister in which private sector
leaders participate, but this group seems to have limited influence in setting policy
direction. Business leaders have been supportive through philanthropic activities in the
provision of public services, often substituting for regional or local governments
incapable of providing these services.142 Russian companies have been willing to get
engaged in some areas that are important for competitiveness, like the creation of new
business schools. However, there are few if any initiatives like Russia 2015, a project
under way in 2000/2001 where private sector leaders aimed to develop a strategic vision
for Russia’s economic future. Changes in the regulations surrounding non-governmental
institutions have created the perception that independent assessment of policy is not
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Ineffective dialogue between government, companies, and other institutions relevant for
competitiveness in Russia has its roots in the country’s legacy. In the Soviet Union, there
was no role for independent institutions to participate in the policy dialogue. Informal
networks protected the interests of specific groups rather than focusing on building a
more productive economy. In the first decade of economic transition, private business
interests threatened to control the political process.144 In the last few years, the
government has re-established its supremacy over policy and is now taking decisions
without much effective dialogue with the private sector. Government has clearly gone too
far in this direction.
Russia needs to overcome these historical barriers to collaboration between government
and businesses in defining and implementing economic policy. Government is
responsible for making decisions, but must be ultimately accountable to the private
sector. This is particularly critical for the success of microeconomic reforms that address
areas in which the government neither has sufficient knowledge nor the capacity to
implement all the needed changes alone.
3.5. Russia’s Inconsistent Aspirations
Russia has serious competitiveness weaknesses. Some of these—like poor administrative
efficiency and the lack of effective competition—have been enduring. Others—like the
growing inadequacy of skills and available physical infrastructure—have emerged as the
economy has grown, the demands on the country’s business environment have risen to
support more sophisticated competition, and government has proven not to be up to the
Russia’s competitive deterioration relative to the needs of the economy has been masked
by various factors. A combination of external—the rise in global prices for oil, gas, and
other natural resources—and internal—improved macroeconomic policy, excess
capacity, and some company catch-up—have allowed Russia to achieve high rates of
economic growth.
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Russia’s current prosperity is not sustainable given its level of competitiveness, nor is
Russia yet equipped to play a truly greater role in the world economy. Ambivalence
about future direction is reducing Russia’s fundamental economic position compared to
countries such as China and India.
Figure 30: Business Competitiveness, Context, and Prosperity, 2007
Russia’s competitiveness is not high enough to support the level of prosperity that
Russians are currently enjoying and have come to expect. Russia’s natural resources
enable a higher prosperity level than would be possible given the country’s
competitiveness alone. But a significant gap remains even when controlling for Russia’s
endowments and other context (see Figure 30). And the reliance on natural resources,
without improvements in competitiveness, is inhibiting any real progress towards
significant improvements in prosperity and evolution to a more diversified economy.
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Russia’s immediate concern must be the ability to manage the almost inevitable slowing
of the economy; the one-time gains of available slack capacity are largely past. Oil and
gas prices are likely to stay high, but their rate of growth is likely to slow. The
improvements in fiscal policy—if they can be sustained—will allow companies to stay on
a higher productivity growth path. However, the significant gains from the improvement
of fiscal policy are past. Without fundamental improvements in competitiveness, the rate
of improvement in companies will not be high enough to drive growth.
The mismatch between high prosperity and weak competitiveness that was sustainable in
the past period of high economic growth will become a burden as the growth rate slows
down and trade-offs between various political objectives become more binding.
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4. Recommendations
Russia’s economic policy has evolved to address the changing priorities for economic
development, but Russia has not moved boldly enough to significantly increase
competitiveness. The period between 1998 and 2004 was characterized by the need to
achieve stability after the preceding economic and political volatility, a task at which the
government has been very successful through a combination of its own policies and
favorable external circumstances.
After 2004, however, it became increasingly clear that further progress could only be
achieved with deeper structural changes. The government decided that these changes
would require a more active role of the government, because existing institutions were
too distorted or ineffective for a productive economy to emerge naturally, a view also
shared by foreign analysts.145 Our analysis suggests that this policy shift has failed to
produce the changes necessary to significantly enhance Russian competitiveness.
Figure 31: Major Recent Russian Economic Policy Initiatives
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We see three root causes for the disappointing policy results: First, Russia has not made
any real progress in addressing weaknesses in its political and legal context and in crucial
areas of the business environment. These weaknesses continue to be a burden on the
economy. Even more importantly, they seriously undermine the potential of otherwise
sensible policies like investment funds, special economic zones, and cluster efforts to
succeed. Policies will remain largely ineffective as long as context and business
environment weaknesses remain, even with policies that apply best practices from other
countries. Recent policies, such as the newly announced Mid-Term Program146 that
includes many sensible initiatives, are in danger of also being ineffective unless serious
reforms of context take place.
Second, Russia has recently made a number of policy choices that are actually harmful to
competitiveness. The government has reacted to existing structural problems in the
economy in ways that exacerbate these problems, rather than providing effective
− In its relations with the oligarchs—private economic interests that achieved enormous
wealth through uneconomic transactions in early transition—the government has
taken steps to reduce their role and bring their activities in line with national
economic interests. Establishing the authority of the government versus strong private
interests was a logical step.147 But the Russian government applied a mix of non-
transparent measures through different institutions with unclear authority. The threat
to prosecute companies for alleged tax evasion has been a frequent tool to put
pressure on companies. This undermined the credibility of the effort and further
eroded the legal and political context for all firms.
− In a number of industries—automotive, aerospace, and metals—the government has
taken an active role to facilitate restructuring to enhance competitiveness. A strong
government role in this process seems inevitable in the Russian context because the
financial sector is not mature enough to manage such a transformation alone. But the
Russian government has mistakenly tried to exert strong influence on the way
companies are actually run, and placed individuals with strong political links in
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leading positions, rather than to open competition and put in place a transparent
governance process. This threatens to seriously harm competition and productivity by
making the government both a regulator and a market participant.
− In the oil and gas sector, the government has taken steps to increase the government’s
share of oil and gas revenues. Previous contracts had arguably been negotiated when
the Russian government was in a very weak position. Similar steps to increase the
government stake have been taken in other natural-resource rich economies. But the
Russian government has used methods such as the threat to withhold environmental
licenses and the auctioning of former Yukos property in processes that were
perceived to favor government-owned companies. This approach further erodes trust
in due process and the Russian legal and administrative system. In other countries,
governments often maintained private participation while increasing their share of
Third, policies set by different Russian government ministries continue to work at cross-
purposes. While some in government want to create a more competitive business
environment, others want government to micromanage through regulation and create
powerful companies with political as well as economic missions.
Finally, Russian leaders clearly have very different views of what drives competitiveness
and national prosperity. These differences in opinion go beyond the usual policy
disagreements that are present in many governments, and strike to the heart of the goals
of the nation itself. Is the goal politics or prosperity for citizens? There is no clear
mechanism to resolve these incompatible aspirations. Instead, conflicting signals threaten
to cancel each other out and, even worse, create a high level of uncertainty about future
policies. This is a climate in which even good policies have little chance of achieving
their full positive impact.
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4.1. Priorities for Russian Economic Policy
While detailed advice on individual policy areas is beyond the scope of this report, we
offer an overall strategic direction as well as highlight policies that are particularly salient
at this time in Russia’s economic history. We also suggest priorities for research in order
to build consensus around needed directions. In our recommendations, we focus on what
is practical and realistic given today’s circumstances, not on what is theoretically
indicated in ideal circumstances. The Russian policy debate is full of debates about
abstract theory which have done little to advance economic policy in practice.
We have organized our discussion of priorities for Russian economic policy around three
broad themes: First, Russia needs an overall national economic strategy for the economic
direction it wants to take. Second, Russia must upgrade the foundations of
competitiveness through concerted efforts in strengthening context, improving the
general business environment, supporting cluster development, creating competitive
regions, and developing productive economic linkages with neighboring countries. Third,
Russia needs to define a growth path which is based on its strengths and which will
diversify the economy from its extreme natural resource dependence.
Figure 32: Priorities for Russian Economic Policy
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4.1.1. Defining an Overall Economic Strategy
Define an overall economic strategy that sets goals, establishes an overall direction,
and recognizes the priorities among policy areas. Currently, there is uncertainty about
the overall direction of economic policy, and no clear guidance on how to make trade-
offs between competing objectives and policies. The result is government policies that
work at cross-purposes, and companies—both domestic and foreign—that are confused
about future direction in Russia and thus react only cautiously even to well-meaning
government initiatives.
A national economic strategy describes the overall position of a nation in the global
economy. It defines the value it seeks to provide as a business location, the strengths it
will nurture, the path of growth it aims to achieve, and the roles of government at various
levels. An economic strategy identifies those dimensions of the business environment in
which the country needs to excel, versus those in which it seeks parity with competing
A nation will not be successful in the global economy only through limiting weaknesses.
It must nurture or develop real strength for a range of business activity. A national
economic strategy has nothing to do with the five-year plans of the communist past that
attempted to direct the behavior of companies. Instead, it focuses on creating an
environment, rules, and institutions in which businesses operating in the country can
Russia has the potential to be much more than a natural resource-rich economy. The
country’s geographic location between Asia and Europe represents a potential asset. The
high levels of education in Russia, and the deep research base, can become the basis for
strong science-based clusters. The large home market offers opportunities to develop
global exports in areas where Russian demand patterns mirror or foreshadow global
needs. Russia needs to debate these and other ideas about its future opportunities that
could form a national economic direction. Russia’s competitiveness agenda needs to
recognize the priorities that flow from this direction, rather than attempt to tackle
everything at once.
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4.1.2. Upgrading Russian Competitiveness Strengthening Macroeconomic, Political, Legal, and Social Context
Address key weaknesses in context, particularly in the legal system and processes of
government. Russia’s economic development is being held back by very uneven
progress on context. The effectiveness of the legal system has made little or no progress,
and provides only weak protection of property rights against powerful private or public
interests. Political institutions, and the checks and balances among them, need significant
strengthening. The delivery of public and social services is impeding competitiveness
while limiting public support for needed restructuring and modernization. These
weaknesses in context are important barriers which make improvement in microeconomic
competitiveness much harder.
o Create an efficient and independent legal system. Creating sound procedures to
enforce the law and protect individual rights is necessary to increasing the credibility
and impact of government policies. Crucially, the government needs to resist the
temptation to interfere with the judiciary, even when decisions might not go in the
direction it prefers. Given its legal system shortages, Russia should work with
international organizations and agreements, such as the WTO, to ensure credibility of
adherence to policies.
o Improve the capabilities and professionalism of political institutions. Stronger
government institutions, with a system of checks and balances, are the only effective
way to achieve political stability.148 Political reform in this direction will be
complicated but necessary. Ensuring orderly transfers of power, and continuity in
policy direction, are especially crucial.
o Use competitive principles to improve the delivery of public and social services.
Improving public and social services is needed to increase productivity and will be
essential to engaging the support of the majority of Russians for further economic
reforms. One priority is to reform the health care system using value-based
competition principles.149 Among other steps, health care provision could be opened
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up to both public and private providers to drive a step-change improvement in health
care delivery and open up a huge new market for entrepreneurship. Improving the General Business Environment
Without further improvements in the business environment, Russian companies will
remain stuck in low-value competition and restructuring will be limited. While there are
many aspects of the business environment that need to be addressed, the near term
priorities are (1) opening up real competition, (2) simplifying and modernizing the
administrative roles of government, (3) addressing weaknesses and bottlenecks in factor
conditions, and (4) transforming legacy assets in education and research into sustainable
competitive assets.
Increase the level of competition in the Russian economy. Many weaknesses in the
Russian economy such as low productivity, limited and slow restructuring of industries
and companies, and cost-based company strategies are the result of restricted or limited
competition. Russian policy today attempts to address such weaknesses through
government intervention. This treats the symptoms, not the root causes. Competition—far
more than private ownership per se—is at the heart of a functioning market economy.
Without more competition, competitiveness upgrading will languish. 150
o Deepen opening to international trade and investment. Russia has taken important
steps through the WTO accession process to open its markets to the global economy.
Russia is clearly lagging in both imports and FDI, however, further progress now
needs to be made, through tariff reforms, a thorough a review of custom practices and
administrative simplifications, and the active development of supporting and related
industries to facilitate the entry of foreign companies into Russia.
o Strengthen enforcement of competition laws. Russia has taken an important first step
with the approval of a new competition law. Competition policy needs to drive
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structural changes, eliminate dominant market positions, and ensure that competitive
practices are aligned with productivity. The law has to be applied equally to all
companies, including those that are government-owned.
o Enhance competition among regions. Russia need to make targeted investments in
logistical infrastructure and eliminating all restraints and inefficiencies of internal
movement of goods and services. This will expand market size, open competition,
and reduce dominant market positions.
o Strengthen the governance, transparency, and depth of the financial markets. Russia
has made good progress in the development of its financial markets. But these
markets are still small, and vulnerable to global or domestic shocks. A vibrant
financial market will continue to improve the supply of capital and strengthen
competition through a stronger market for corporate control. This will drive
restructuring of companies and industries. More efficient financial markets would
also reduce the role of business groups as internal capital markets, opening
competition further.
Streamline and limit the role of government in the economy. Russia has failed to
achieve sufficient improvement in the administrative rules and processes needed for a
modern economy, while remaining too directly involved in the control of companies.
o Improve administrative transparency, professionalism, and efficiency. With a more
reliable and efficient administration, corruption will decline, the costs of doing
business will fall, uncertainties and delays that hinder investment decisions will be
reduced, and competition will rise. There is an urgent need in Russia to reduce,
simplify, and streamline rules and regulations at all levels of government. Past
incremental approaches to administrative reform have not succeeded.
We recommend that all administrative functions and approvals related to companies
be concentrated in a single new agency which operates in one-stop business
development offices located in each region and city. These offices would have full
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transparency through posting all transactions on the Internet, fixed time limits for
review and approval processes, and a well compensated professional staff. This
approach is already being taken in Russia’s special economic zones, and supported by
new dedicated courts. Such an approach would bypass the problems of existing
o Create a new governance structure for government-linked companies (GLCs).
Without more professional management of GLCs, Russia will see not only
substandard performance but also harm competitiveness of the Russian economy
through uneconomic practices, monopoly power in key sectors, and distortions due to
political influence. Strong independent regulators and full scrutiny of GLCs by
competition authorities are needed to ensure that these companies do not distort
markets and undermine Russia’s productivity.
Government needs to define clear performance objectives for each GLC, provide
transparency in their results, and establish governance structures independent of the
political process. GLCs need to have transparent economic goals to ensure that their
behavior does not get politicized. GLCs need effective boards with members selected
based on their abilities. Management teams need to be hired and evaluated based on
merit and be able to operate free of political interference.
GLCs have rarely succeeded in not harming national competitiveness, much less
contributing to it. Countries with successful GLCs have created clear economic
objectives and governance (Singapore), and ensured that companies were exposed to
a high degree of competition (Singapore, South Korea, Dubai). The lack of
competition and effective governance in Russian GLCs is problematic, much more so
than the presence of government ownership per se.
Address emerging factor condition constraints in the economy. Russia’s infrastructure
is under strain, due to insufficient investment and ineffective management. And the lack
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of structural reforms has hindered the development of supporting services to translate the
potential of infrastructure assets into real value for a modern economy.
o Invest in physical infrastructure to meet growing demand. The Investment Fund is an
important signal that Russia is addressing emerging infrastructure bottlenecks. But it
is important that flagship projects will be accompanied by a more broad-based
investment strategy. A few, competitively awarded large projects are insufficient to
grow infrastructure capacity in line with a growing economy. In the past, concerns
about inadequate administrative capacity and corruption led to hesitance in terms of
making significant funds available for infrastructure upgrading. The answer to this
real concern must be administrative reform, not the abandonment of needed
investments. The recent announcement to aggressively use public-private partnerships
(PPP) in the financing of infrastructure actually increases the need for administrative
reforms in the management of public works programs. 151 The experience of other
countries indicates that PPP concepts can deliver value, but are complex and require
competent public administrators to manage.
o Upgrade the education and training system. Russia lives to a large degree on its
legacy of a well educated workforce. But the demands on the available skills are
rising and the legacy system itself is under pressure in a changing economic
environment. Reforms will need to restructure the education and training system; its
goals, incentives, and institutions. Without such reforms increasing spending on
education and training will have limited effect. It is also important to work closely
with companies to better understand their demand for training and mobilize them as
more active buyer and providers of training services.
Transform legacy assets into competitive advantages. Russia has inherited a strong
position in terms of highly educated citizens and scientific research institutions.
However, these capabilities are in danger of eroding quickly due to inadequate
investment, poor governance, and insufficient connections to economy and business.
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o Strengthen scientific research institutions and better connect them to the economy.
The Russian research system needs to be thoroughly reformed to become a more
attractive partner for Russian companies in the adaptation and transfer of existing
technologies and knowledge, not only leading theoretical research. The traditional
separation of higher education and research into separate institutions is a mistake for
both education and research; new integrated models will have to be found. The
number of research institutions is too large, creating complexity and units that lack
sufficient scale; the concentration of activities is crucial. And too much of financing
is based on institutional support that is not tied to specific performance or activities;
the shift towards merit-based financing of research institutions needs to be
aggressively continued.
o Create a policy to encourage and support spin-offs from universities and research
institutions. Existing Russian companies by and large pursue strategies that do not
leverage the scientific potential of the country. New companies, based on new ideas
developed in the research system, can fill that gap. A policy environment that
provides incentives for spin-offs, supporting business services, and clear rules for
ownership and licensing of intellectual property are essential components of such a
policy. Researchers and their institutions need a stake in the commercialization of
their inventions to take an active interest in building ties to business. Moving to Cluster-Based Development
Move towards a more effective distribution of economic activity across regions and
transform co-locations of related activities into real clusters. Improvements in the
general business environment, especially efforts to increase the level of competition in
the Russian economy, will be an important step in this direction. But more can be done to
support the emergence of clusters and increase their effectiveness in many Russian
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o Adopt a cluster-based approach to investment attraction.152 Foreign direct investment
(FDI) inflows can increase and become more valuable for Russian by organizing FDI
attraction around clusters. Some Russian regions already focus on specific industries
in their FDI attraction efforts. These efforts can be strengthened by mobilizing local
companies as partners in the marketing efforts, targeting investors that can address
critical weaknesses in the cluster structure, and involving foreign investors in the
ongoing discussions on how to upgrade the cluster.
o Create a program to support the outsourcing of support activities from dominant
incumbent firms, An important practical step towards enabling the emergence of
stronger clusters would be a program to support spin outs of support units from large
incumbents. This would improve productivity, reduce the dominance of legacy
companies as regional employers that are too large to fail, and provide entrepreneurial
opportunities for current employees. Strengthen Regional Economic Development
Redefine the role of regions in economic development. Given the huge geographic size
of the country, Russia must encourage decentralization and responsibility for economic
progress at the regional level. National policies set the overall context and define rules
and incentives. Setting priorities and implementing decisions on how to upgrade
competitiveness needs to occur at the regional level because of their widely differing
o Create incentives for regional economic strategies. There are many encouraging
examples of steps taken in regions (oblasts) to improve competitiveness. The federal
government can build on these examples by encouraging regions to set their own
economic strategies and provide performance-based support for implementing them.
Individual programs as well as the general structure of fiscal relations between the
federal and regional level have to be reviewed as to whether they meets the demands.
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o Provide benchmark data on regional economies and policy best practices. The
federal government should play a role in comparing regional performance and
policies. The challenges that many Russian regions face are similar, even though the
specific nature in which they are dealt with will differ. The federal government needs
to provide information, and facilitate change, in addition to its other forms of
involvement. The U.S. federal government and the European Commission provide
useful examples on approaches that can be adapted to the Russian context. Create Productive Economic Relations with Neighbors
Overcome unproductive economic relations with neighbors. Russia is a large country
that can derive important benefits from productive economic ties with its many
neighbors. Mixing up these economic relations with politics is a recipe for reducing
competitiveness, and has led to decisions that hurt Russian productivity. Better economic
relations between Russia and its neighbors will require mutual trust. Trust comes out of
focused steps that create win-win solutions, such as coordinating logistics, simplifying
movement, and expanding markets.
o Encourage regions to collaborate with adjoining countries. Given Russia’s
geography, neighbors will often be more important trading partners with Russian
regions than other parts of Russia. Relations with neighbors need to be de-politicized,
and focused on economics and productivity. The role of other ministries relative to
the Ministry of Foreign Affairs should be strengthened. Regions and municipalities
need to be free to enter into productive agreements without undue interference by
federal authorities.
o Embrace multilateral organizations or treaties to strengthen trade relations in ways
that are more insulated from politics. On a global scale, Russian membership in the
WTO is very positive step. The opportunities for similar but more far-reaching
agreements with groups of neighboring countries offer major opportunities for
expanding trade, improving efficiency, and diversifying the Russian economy.
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4.1.3. Growth and Diversification of the Russian Economy
Russia is unlikely to succeed through the export-led growth approach of Asian countries
based on cheap labor and low production costs. The presence of China and other Asian
countries, together with the upward influence of Russian natural resource endowments on
local costs, have closed this path. Russia’s growth and diversification will need to take a
different path, building on Russia’s strengths.
The natural resource-sector and clusters tied to growing domestic markets represent the
most immediate opportunities for growth. Future growth will come from building export
positions outside of natural resource-intensive industries and on capitalizing on
capabilities in science and research.
Some of these opportunities will develop quickly while others will become economically
meaningful only in the medium- or long-term. It is important that Russia adopts an
economic strategy that addresses both. Politicians need to have a realistic expectation on
the contribution these different sets of opportunities can make to the economy, and
communicate these realities to the broader public.
Russia has the best opportunity to expand exports in fields where it already has existing
strengths. These positions indicate underlying advantages of the Russian business
environment and signal opportunities to draw on related strengths. We offer a new
methodology to identify export potential in three areas: (a) Expanding current niche
positions outside natural resources, (b) broadening exports within clusters in which
Russia is already strong and (c) diversifying into clusters related to current Russian
cluster positions. This approach can guide policy makers to concentrate analysis and
action on areas in which a country has a significant likelihood of export success. Turn National Resources into True Clusters
Natural resources will, for the short- and medium term, remain the most powerful driver
of Russian prosperity. The huge natural resource reserves and the outlook for high energy
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prices in the global economy result in an almost certain inflow of significant export
revenues in years to come. Economic policy towards this sector will, however, need to
change fundamentally for Russia to gain the full potential benefits of its natural resource
Russian policy towards the natural resource-sector can do much more for Russian
prosperity, if it is organized around increasing the productivity of the sector, not just its
market power. Higher productivity will only be achieved, if there is fair and open
competition within the cluster, and if government policies reduce the burden of rules and
regulations on business. While extensive government ownership makes these goals
harder to achieve, it is important to note that the effectiveness of competition is the
crucial question, not ownership per se. If it is possible to separate the role of government
as an owner and market participant from its role as a regulator, competition can still be
effective. For Russia, it would, however, take dramatic changes in government behavior
to convince other market participants that competition is fair. It is important to be aware
of the alternative: a level of investments into exploration and other productive capacity
that remains insufficient and threatens the future wealth of Russia.
Russian policy can also enable much more value creation from natural resources if the
focus shifts from exporting raw materials to developing a cluster. The oil and gas cluster
in Houston, Texas, for example, achieves a very high level of productivity by selling
knowledge and services related to natural resources, not just the raw materials themselves
See Figure 6 on page 14). The oil and gas cluster in Norway has developed world-leading
expertise in deep-sea exploration that makes it an attractive partner for oil-rich countries
with deposits in harsh conditions. Such a position is based on a strong cluster-specific
business environment that provides much more than just the natural resource deposits.
Russia has the natural resources, many skills in engineering, and skills in other related
areas that could—by leveraging complementary skills of foreign partners—become the
platform for the development of a competitive oil and gas cluster. But Russia has created
a market structure and policy environment in which such a cluster is very unlikely to
emerge. Russia would need to address its weaknesses in a highly visible way. Again, it is
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important to be aware of the alternative: A lost opportunity of major proportions to raise
the value captured from natural resources and to start the process of diversification from
commodity exports. Develop Clusters Serving the Domestic Market into Export Platforms
Russia is a large country, and the domestic market for consumer goods and business
inputs provides the other large short- and medium-term opportunity in the Russian
economy. Strong GDP growth has made the Russian market an attractive target for
domestic as well as foreign companies. This domestic market boom provides major
opportunities for diversification. And the efficiency with which this market will be served
is an important determinant of the actual standard of living Russians will be able to enjoy
at a given level of oil and gas export revenues.
The pull of the Russian consumer market has already benefited Russian competitiveness.
Rivalry has increased with the size of the market. Domestic companies have started to
invest in additional capacity—usually by introducing modern technology and
management practices, not just additional machines—and improved their efficiency to
participate in the growing market. And foreign investors have significantly increased
their presence, introducing global strategies and practices to the Russian market. But
Russian economic policy could do more to raise the extent of these positive trends. Such
efforts would not only have a positive short-term benefit on the activities serving the
domestic market but also increase the medium- and long-term opportunities for export
development and the diversification of the Russian economy.
Priorities to capitalize on domestic demand growth involve a number of key areas: First,
determined efforts are needed to reduce the high cost of doing business in Russia through
improving administrative capacity. Corruption, bureaucracy, and frequent changes in
rules and regulations inhibit economic activity, especially the many small- and medium-
sized companies that are important in serving the Russian market and growing exports.
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Second, aggressive new projects should be launched in co-operation with Russian
business groups and foreign investors to spin-off and outsource non-key activities. The
high level of vertical integration in Russian companies is a drag on their productivity.
And the correspondingly weak market for the external provision of supporting activities
is a growth barrier for foreign companies that operate more focused business models.
Third, the attraction of foreign investment to meet domestic market needs should be
reinforced. Targeted contact with foreign companies and specific efforts to improve the
specific business environment conditions important to them will pay dividends.
Fourth, government policy should send a clear signal about the economic importance of
consumption-related services like retailing, distribution, transportation and logistics, and
wholesaling. Russia has a strong legacy of viewing such services as less important than
production, missing a major opportunity. Expanding Niche Positions
Figure 33 on the next page lists the top 25 industries by Russian 2005 export value
outside of natural resources. Outside of natural-resources, Russia had 2005 exports of
58bn US-$. About 20% of these were outside the clusters in which Russia has current
export strengths.
Russia has opportunities to increase export values in niche product categories. This could
happen by moving towards more advanced market segments within these product
categories, by increasing the share of value-added generated in Russia, or by entering
new geographic markets in which these products can be sold.
Fertilizers, nuclear conventional energy, aviation, marine equipment, and rolling stock
stand out as areas of promise. They can potentially expand into clusters, not just isolated
products. Russia should convene companies from these industries to discuss ways in
which this process can be launched or accelerated.
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Figure 33: Leading Russian Non-Natural Resource Export Industries outside of Current
Cluster Positions, 2005
Broadening Positions in Existing Clusters. Russia currently has its strongest
export positions in four clusters: oil and gas products, coal, metal mining, and forest
products. It also has meaningful positions in constructions services and power and power
generation equipment, but does not rank among the leading countries in the world in
these clusters.
Within oil and gas products, metal mining, and forest products there are unexploited
growth opportunities in individual subclusters where Russia’s current export position is
weak. Figure 34 indicates Russia’s export position in the subclusters that belong to these
three clusters. There are many subclusters with below average market shares, some of
which are gaining position. This signals opportunities to develop export positions in these
subclusters more systematically. Russia can convene cluster participants to explore
opportunities to build on existing strengths and capabilities to grow within the clusters
and attract foreign investors. Russia can also make investments in training and research
institutions to support these clusters.
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Figure 34: Growth Opportunities within Strong Russian Export Clusters, 2005
Copyright 2006 ©P rofessor Michael E. PorterRussia Competitiveness Assessment DRAFT 07-30-06 CK
Oil and Gas
Strong Export
Weak Export
Losing Market Share Gaining Market Share
Crude Petroleum
Petroleum Processing
Iron & Steel
Rough and Chipped
Wood (12.5%, 23.6%)
Other Metals
Iron and Steel Mill and
Foundry Products
Wire and Springs
Railway Ties (15.21%)
Pulp and Waste Paper
Paper Mills
Nonferrous Metal Processing
Oil and Gas Machinery
Fabricated Metal Products
Primary Metal Products
Paper Products
Precision Metal Products
Laundry and Cleaning Equipment Paper Industries Machinery
Note: Bubble size is proportional to 2005 Russian export value
Source: International Cluster Competitiveness Project, Institute for Strategy and Competitiveness, Harvard University
Average Russian
world market share
in strong clusters
Growth in Related Clusters. Russia also has opportunities in clusters related to
its current cluster strength. Many clusters have common industries with related clusters
employing similar skills and technologies. Related clusters are often the natural
progression path for export growth.
Figure 35 shows the clusters related to current Russian cluster strengths. Currently,
Russia has weak positions in these related clusters. This is particularly striking for the
clusters related to forest products and metal mining and manufacturing, where Russia’s
RCA is lower than .5 for all of them. Russia’s position in the clusters related to oil and
gas is stronger. This is where the likelihood of export growth appears to be highest. In
chemicals and plastics Russia has already announced its intention to make significant
investments. So far, however, very little has happened and industry observers are
skeptical as to whether this will change anytime soon.153
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It is revealing to look at the position in these related clusters by other countries that have
the same cluster strengths as Russia. In aerospace engines and in chemical products
Russia is already more specialized than the top ten countries in metal mining (for
aerospace engines) and oil and gas (for chemical products). In all other related clusters,
however, Russia export position is lower than that of other countries with similar cluster
strength. The gap is most striking in the clusters related to forest products, where Russia’s
relative position is only 1/5 of other leading countries with a strong specialization on
forest product exports.154 The example of these other countries indicates, that Russia has
large unexploited export potential in these related clusters.
Figure 35: Growth Opportunities in Related Clusters; 2005
Interestingly, production technology is related to two clusters in which Russia is currently
strong. This signals opportunities to expand in production technology, and for production
technology to become a reinforcing link in the Russian cluster portfolio.
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Over the medium- to long-term, Russia’s legacy offers the potential for growth in science
and skill-intensive clusters. Our analysis has indicated that Russia registers a strong
imbalance between existing science resources and Russian businesses’ ability to leverage
the specific skills provided. Russian economic policy has so far been aimed at raising the
demand for science and technology by Russian companies. A focus on attracting foreign
companies looking for research capabilities is more likely to generate demand for the
existing scientific capacity in Russia in the short term. Without such demand, there is a
significant danger that the existing strengths will erode as scientists will leave,
capabilities will atrophy, and government spending will be redirected to other areas.
4.2. Priorities for Research on the Russian Economy
The Russian economy has been the focus of substantial economic research in recent
years, by both Russian and foreign researchers. However, there remains a need for more
applied research that addresses the specific challenges the economy is facing. Research
concentrating on ideological positions or general theoretical arguments is of declining
Overall, we suggest a shift towards more research on the microeconomic foundations of
competitiveness. This is the area where many weaknesses and distortions exist, that can
only be addressed with policies that take account of Russia’s unique circumstances.
Russia’s business environment suffers from a number of weaknesses, often related to
the country’s overall legacy. More research is needed in a number of areas.
o Systematic study of industry structures and performance across a wide array of
Russian industries to document the extent of dominant firms and the vitality of
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o Initiate a research program on strategies of Russian companies. This research would
provide valuable information about the strengths and weaknesses of Russian
companies and their needs in terms of government policies. It would provide insights
into whether company operating practices are a critical barrier to Russian prosperity,
and in what areas.
o Map Russia’s scientific skills and capabilities. This research would inform policies to
understand and leverage the existing legacy assets, and take steps to develop them.
o Document the performance of Russia’s administrative structures versus peer
countries. This research will be invaluable to making further administrative reforms,
moving beyond the current focus on efficiency to encompass effectiveness.
Russia’s legacy creates significant opportunities for cluster development. So far,
however, Russian clusters tend to be weak, with limited supporting institutions. While
there is an increasing research interest in the economic geography of Russia, more
research is needed to capture the current state of Russian clusters.
o Create a Russian cluster mapping data base that provides granular data on regional
specialization, cluster structure, and cluster performance. Make this data widely
available to policy makers at the national, regional, and local level. This data could
provide a much more complete picture of Russian clusters than now exists and inform
economic policy on all levels.
o Document the incidence and roles of Institutions for Collaboration and cluster
initiatives in Russia. This research would contribute to our understanding of the level
and nature of organized collaboration in Russian clusters and regions. It could inform
government policies supporting collaboration rather than direct intervention.
Russia encompasses a huge geographic area including many subnational regions.
Regions will need to devise varying regional economic strategies to address their
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differing circumstances. While some aspects of regional economic development and
policy in Russia have been the subject of existing research, there is a lack of systematic
comparable data across all regions.
o Develop a database that systematically tracks economic policies across Russian
regions, and links it to data on economic performance, specialization, and business
environment quality. Such data could provide a better understanding of the impact of
regional policies on competitiveness. It could also lead to a productive policy
competition between regions.
o Initiate research on large, legacy regional companies that identifies such companies
and their economic influences in their region. Such data would be useful for
understanding cluster development, competition at the regional level, and the
restructuring of dominant companies into more effective economic units.
Russia abuts numerous neighboring countries. For many Russian regions, their
neighbors are closer than most parts of their own country. The legacy of the Soviet Union
has complicated Russia’s ties with many of its neighbors.
o Identify the nature, impact, and obstacles to economic ties between Russian regions
and neighboring regions in other countries. Such research could improve the
understanding of the actual nature of Russia’s relations with its neighbors, and could
inform the potential benefits that a more productive approach to such linkages could
have for the Russian economy.
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5. Conclusions
Russian economic performance has improved since 2000, fueled by strong
macroeconomic management and the oil price boom. However, while Russian
competitiveness at the micro level made progress after 2000, it has stagnated and even
deteriorated since 2004. Government has failed to tackle the country’s most serious
microeconomic weaknesses. Reform has slowed down and government intervention has
risen in unfortunate ways that set back productivity and economic diversification. The
juxtaposition of macroeconomic progress and serious microeconomic weaknesses has
contributed to divergent views about the Russian economy.
Current Russian policies are failing to achieve the country’s goal of creating a strong,
internationally competitive economy. Russia wants to be competitive and to diversify its
economy, but it fails again and again to take the clear steps necessary. For example, the
emergence and growth of small- and medium-sized Russian companies, which are
necessary to drive Russia’s transformation into a truly advanced economy, is being
severely penalized by the current policy regime. Economics and politics have come
together in a way that will limit future economic performance. Similarly, there is a high
degree of uncertainty about the longer-term direction of Russian economic policy, which
will reduce investment in facilities, technology, and skills.
Russia is now facing a crossroads. Russia can proceed on the current path of
intermingling politics with economics, partial reforms, and prosperity largely based on
natural resources. Sound macroeconomic policies would continue, but Russia would
continue to pursue government ownership and state involvement as the means to
restructure the economy while continuing to tolerate the complex and glaring legal,
administrative, skills, and other weaknesses in the business environment. Russia would
become a place for MNCs to access natural resources and tap the local market, but not an
export base in integrated global networks. Russian companies would remain domestically
focused with few exceptions. The likely outcome of this path would be continued growth
but limited progress towards a highly competitive economy. Skilled talent would
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probably continue to migrate abroad. The level of economic, political, and social risks
would likely rise.
The other path for Russia is to adopt competitiveness as the driving principal for
economic policy, including in natural resource industries. Russia would maintain its
commitment to sound macroeconomic policies, but commit to addressing weaknesses in
its business environment. It would finally tackle bureaucratic inefficiency, corruption,
and legal reform. It would achieve consensus on the role of government as focusing on
the environment for competition. It would truly commit to open both domestic and
international competition. And, it would base choices, including resource development,
on productivity rather than near term political considerations or nationalism. With
Russia’s strong human resources and technological skills, this path could well produce an
increasingly open, pluralistic, and diversified economy. Russia could become a center of
innovation, a center of commerce, and a center of culture. Population migration would
likely stabilize.
While not all observers will see the choices facing Russia in this way, there is no denying
that inconsistencies and contradictions have emerged in Russia’s commitment to a
competitive economy. Russia’s stated goals and its actual behavior are simply
The signs are increasing that the economic tailwind of the past several years is
weakening. Long-term investments are needed in Russia that companies are still reluctant
to make. The phase of easy progress is over. The current policy approach needs to change
because it will fail to deliver on Russia’s ambitions, not because some foreign observers
disagree with it. While the Russian government seeks to build the position and
importance of the Russian economy and Russian companies, for example, current
policies hurt Russian companies while foreign multinationals have the experience to
navigate Russia’s complex business environment far better. Small- and medium sized
Russian companies suffer most from business environment weaknesses that the Russian
government has failed repeatedly to address.
Competitiveness at the Crossroads:
Choosing the Future Direction of the Russian Economy
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1 The framework was introduced in Michael Porter (1990). A seminal description of the cluster concept, a
key element of the competitiveness framework, is Michael Porter (1998)
2 Preliminary results were discussed with German Gref, Minister of Economic Development and Trade of
the Russian Federation, other high-level representatives of the Russian government, and the leadership of
CSR in Moscow during a visit by Professor Porter and Dr. Christian Ketels in the fall of 2006.
3 See the op-ed by Klein/Kostin(2007), business leaders from the U.S. and Russia respectively, that make a
similar observation.
4 See for a longer discussion Michael E. Porter with C. Ketels and M. Delgado (2006)
5 The diamond was first introduced in Michael Porter (1990)
6 Henry Chesbrough (2003)
7 See the Cluster Mapping Project (http://www.isc.hbs.edu) and Porter (2003) for a more detailed
description of the data and methodology.
8 For a related finding see Hausmann/Klinger (2006)
9 See Lindqvist et al. (2003)
10 Porter (1996)
11 Porter (1985)
12 Khanna/Yafeh (2007)
13 See the Clusters of Innovation report (Porter, Council on Competitiveness, and Monitor Group, 2001;
further reports on five U.S. regions are available at www.compete.org.
14 Porter/Ketels (2003)
15 Ketels/Sölvell (2006a)
16 The following paragraphs draw heavily on work done for the U.S. Council of Competitiveness published
in Council of Competitiveness (2007) where more data and background can be found.
17 IMF, World Economic Outlook, April 2007,
18 Nadezhda Mikheeva (1999); Laura Solanko (2003); Goohoon Kwon/ Antonio Spilimbergo (2005)
19 UNDP (2006). UNDP provides a number of different measures of inequality based on income or
expenditure data.
20 Kiseleva/Kononova (2007)
21 Economist (2006)
22 UNDP (2005)
23 Graddy (2007)
24 UNDP (2006)
25 OECD (2006)
26 Groningen Growth and Development Center/The Conference Board, 2007 Total Economy Dataset, April
27 Kuznetsov/Schaffer (2006)
28 IMF (2005)
29 See Badia/Skaarup (2007)
30 See Badia/Skaarup (2007)
31 Published figures put the share at below 8% but Kuznetsov/Schaffer (2006) calculate that taking account
of transfer pricing leads to more credible estimates of about 20%
32 In our calculations of labor productivity the non-oil Russian economy, we assumed a share of the oil
sector of 10% in 2000 and 20% in 2007, reflecting the share of oil production in GDP, IMF (2007)
33 See, for example, Aron (2006)
34 Kuznetsov/Schaffer (2006)
35 World Bank (2006)
36 OECD (2007) – Ahrend et al.
37 Some research suggests, however, that price dispersion across Russian regions is falling. See Konstantin
Gluschenko (2004)
38 See Mercer Human Resource Consulting (2007), Cost of living press release, 18 June 2007.
39 Institute for Strategy and Competitiveness (2007), calculations based on UNCTAD/WTO data
40 OECD (2006)
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41 Institute for Strategy and Competitiveness (2007), web access at http://data.isc.hbs.edu/iccp/index.jsp
42 RCA is defined as the share of a country’s exports in world exports in a given product category, divided
by the country’s total exports in total world exports. A RCA larger than one indicates a relative
specialization in the measured product category.
43 Using a different methodology to identify the linkages between export categories, Hidalgo et al. (2007)
present data in the website (http://www.nd.edu/~networks/productspace/) accompanying their article that
leads to a similar conclusion.
44 This assessment is based on the authors’ analysis done for this report.
45 Gregory White/Jeffrey Ball, Exxon goes with the flow in effort to maintain its Russian interests, The
Wall Street Journal, 7 May 2007.
46 Paul Hare et al. (2004); OECD (2006)
47 Kuznetsov/Schaffer (2006)
48 See Gaddy (2007)
49 UNCTAD (2005)
50 See Kalotay (2007)
51 And the outward FDI figures for Russia might significantly underestimate actual outflows. See Vahtra
52 Nicola Clark/Andrew E. Kramer, Russian state bank buys share of EADS, International Herald Tribune,
11 September 2006
53 Christian Gianella/William Tompson (2007)
54 OECD (2006)
55 Stefan Wagstyl, Russian boom will end in pain, says banker, Financial Times, 24 April 2007.
56 World Bank (2005)
57 Fiona Hill/Clifford G. Gaddy (2003), World Bank (2005)
58 Sergei Guriev/Andrei Rachinsky (2005)
59 Munro (2006)
60 Calculated based on the estimate of the U.S. Energy Information Administration, see
http://www.eia.doe.gov/cabs/opecnon.html accessed 23 August 2007.
61 BP Statistical Review, 2007
62 Anna Ivanova et al. (2005)
63 Antonio Spilimbergo (2005)
64 Center for Strategic Research, Implications of Possible Decline of World Oil Prices for the Russian
Economy, April 2007
65 Neil Buckley, Russia forgets hand to mouth past as petrodollars provide for fiscal rainy day, Financial
Times, 25 April 2007.
66 See World Bank governance indicators (2007)
67 Andrei Shleifer/Daniel Treisman (2005)
68 OECD (2006), p. 32
69 OECD (2006), ibid.
70 Kiseleva/Kononova (2007)
71 Michael E. Porter with C. Ketels and M. Delgado (2007)
72 Sofizade/Hrekh/Pesotsky (2006). According to industry experts, a significant share of Russian imports is
shipped through non-Russian ports because of weaknesses in infrastructure, supporting services, and
government inefficiency.
73 OECD (2006), p. 33
74 Craig Mellow (2007)
75 Jim Balaschack (2006)
76 Russell Pitman (2005)
77 The problem seems to be most severe at the medium level of government. But as the controversy around
the alleged ownership position of the Minister of Telecommunication in a large Russian mobile phone
provider shows, it also reaches the highest levels of government. See Stephen Fidler, Arkady
Ostrokovksy, and Neil Buckley, “MegaFon diplomacy: a disputed stake pits and oligarch against a Putin
ally,” Financial Times, 24 April 2006.
78 Quoted in Steven Lee Myers, Business as usual, Russia-style, International Herald Tribune, 14 June
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79 Putin’s promise of propriety, Financial Times, 26 April 2005.
80 CEFIR (2005)
81 Russia reopens US bank tax case, Financial Times, 18 May 2007.
82 See for a detailed description OECD (2006), chapter 3.
83 Evgeny Gavrilenko/Anton Stroutchenevski (2006)
84 William Tompson (2007)
85 Gimpelson (2005) suggests that skill shortages were the result of companies’ unwillingness to raise
relative wages during 2003. While this might have played a role at that time, the skill shortages now
appear real and not the result of wage inflexibility.
86 Vladimir Gimpelson et al. (2006)
87 IMF (2005)
88 Banking regulation has been one of the problems that delayed the WTO agreement between Russia and
the United States. U.S. banks saw the the rules in question less as a problem than U.S. negotiators.
89 See for a detailed description OECD (2006), chapter 4.
90 See Gokhberg (2004), Dezhina (2005), and UNDP (2004).
91 The four selected zones are in Moscow districts of Zelenograd (microelectronics) and Dubna, in Tomsk,
and in St. Petersburg. See Gianella/ Tompson (2007) and Lisitsyn (2007).
92 Lisitsyn (2007) provides details on the example of Peterhof close to St, Petersburg.
93 Porter/Stern (2004) provides more detail on the methodology used.
94 Unpublished research by Porter et al. (2006) based on Porter/Stern (2004).
95 Gianelli/Tompson (2007)
96 World Bank (2007)
97 OECD (2004)
98 CEFIR (2005)
99 Yakovlev/Zhuravskaya (2007)
100 Simola (2007)
101 OECD (2005)
102 Henrik Isakson (2007)
103 OECD (2005)
104 See Tshuklo (2007) for the use of survey data to track the changes in competition until 2002.
105 Christian Gianella/William Tompson (2007)
106 Irina Slinko et al. (2003)
107 Jurgen Ahrend et al. (2007)
108 IMF (2005)
109 See Goldman (2004) for an early assessment. Scores of articles have followed the auctioning off of ex-
Yukos assets, a process that has been regularly described as opaque.
110 For more detail on the methodology see Porter (2003) and http://data.isc.hbs.edu/isc/cmp_overview.jsp
111 The four selected zones are in Moscow districts of Zelenograd (microelectronics) and Dubna, in Tomsk,
and in St. Petersburg. See Gianella/ Tompson (2007) and Lisitsyn (2007).
112 Vladimir Milov, Possible Future of Russian and CIS oil production, presentation at the OECD, June
113 Daniel Berkowitz/ Yadviga Semikolenova (2006)
114 Catherine Belton, Yukos finally expires, victim of its battle with the Kremlin, Financial Times, 11 May
115 Krivoshchekova/Okuneva (2006)
116 World Bank (2005)
117 This is a point made to us in a number of interviews with foreign executives in Russia during our visits
in late 2006.
118 We were told that SeverStal has outsourced some of its logistical functions, selling them to the
managers. Within the course of one year, the new logistics company gained significant business from other
companies as well.
119 See for an early account Dolgopyatova (2003)
120 IMF (2005)
121 See Lazareva et al. (2007)
122 See Kochetygova,/Shvyrkov (2006)
Competitiveness at the Crossroads:
Choosing the Future Direction of the Russian Economy
Page 112 of 112 © Michael E. Porter

Competitiveness at the Crossroads: Choosing the Future Direction of the Russian Economy (PDF Download Available). Available from: https://www.researchgate.net/publication/239754427_Competitiveness_at_the_Crossroads_Choosing_the_Future_Direction_of_the_Russian_Economy [accessed Jan 17 2018].

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