The Surprising Reasons Why America Lost Its Ability To Compete

 

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 

https://www.forbes.com/the-surprising-reasons-why-america-lost-its-ability-to-compete

 

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

 

Contents

 

1. INTRODUCTION 

2. COMPETITIVENESS AND COMPETITION AMONG LOCATIONS 6

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. ASSESSING RUSSIAN COMPETITIVENESS 23

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. RECOMMENDATIONS 77

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

 

5. CONCLUSIONS 100

 

 

Competitiveness at the Crossroads:

Choosing the Future Direction of the Russian Economy

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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

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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

 

2

Copyright 2006 ©P rofessor Michael E. PorterRussia Competitiveness Assessment DRAFT 07-30-06 CK

Russian Competitiveness in 2006/07

Summary

• Strong economic growth

• Solid growth in GDP per capita

• Strong fiscal position

• Improved macroeconomic

management

• High labor utilization

• Improving foreign direct

investment inflows

• Strengthening overall world

export market shares

• Foreign IPO’s of Russian

companies

• 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

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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.

 

 

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Choosing the Future Direction of the Russian Economy

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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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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

creation.

 

Figure 2: Inherited versus created prosperity

 

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Choosing the Future Direction of the Russian Economy

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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

priorities.

 

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

microeconomic.

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

achieved.

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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3.1.2.1. Labor Participation

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

 

3.1.2.2. 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

 

3.1.2.3. 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

3.1.3.1.Exports

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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3.1.3.2.Imports

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.

 

3.1.3.3.Inward 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

 

3.1.3.4.Domestic 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

 

 

3.1.3.5.Outward 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

 

3.1.3.6.Innovation

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

prudence.65

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

stunted.

 

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

world.

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

 

 

3.4.1.1. 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

system.

 

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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.

 

3.4.1.2.Context 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

consequences.

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.

 

3.4.1.3. 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.

 

3.4.1.4. 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

competitiveness.

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

policymakers.

 

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

neighbors.140

 

 

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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

welcome.143

 

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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

task.

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

solutions.

− 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

revenues.

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

locations.

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

excel.

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

4.1.2.1. 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.

 

4.1.2.2. 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

agencies.

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.

 

4.1.2.3. 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

regions.

 

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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.

 

 

4.1.2.4. 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

circumstances.

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.

 

4.1.2.5. 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.

 

4.1.3.1. 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

wealth.

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.

 

4.1.3.2. 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.

 

4.1.3.3. 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

 

34

Copyright 2006 ©P rofessor Michael E. PorterRussia Competitiveness Assessment DRAFT 07-30-06 CK

Metal

Manufacturing

Oil and Gas

Forest

Products

Strong Export

Share

Weak Export

Share

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%)

Copper

Pulp and Waste Paper

Paper Mills

Nonferrous Metal Processing

Oil and Gas Machinery

Hydrocarbons

Fabricated Metal Products

Primary Metal Products

Fasteners

Pumps

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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4.1.3.4. Build Science and Skill-Intensive Clusters

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

usefulness.

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

competition.

 

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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

inconsistent.

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.

 

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Endnotes

 

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

2007

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

(2006).

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

2006.

 

 

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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

2006.

113 Daniel Berkowitz/ Yadviga Semikolenova (2006)

114 Catherine Belton, Yukos finally expires, victim of its battle with the Kremlin, Financial Times, 11 May

2007.

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)

 

 

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