If Russia fails to begin its modernization today, then tomorrow it risks becoming a third-world country.

The bankruptcy of Lehman Brothers is considered to mark the start of the world financial crisis, which later turned into a global economic crisis.

It was officially announced on September 15, 2008. New sentiments began to gain momentum in the world economy. There were times when it seemed that the “snowballing” crisis would not slow down any time soon.
Nearly a year has passed. In mid-August, chief IMF economist Olivier Blanchard declared that the economic recovery had begun, but that it would not be simple: “The crisis has left deep scars, which will affect both supply and demand for many years to come.”

Life is coming back…

Second quarter results brought us the first tangible positive news. An Organization of Economic Cooperation and Development (OECD) statement notes that its member nations’ economies had stabilized in the second quarter compared to the previous one.

According to preliminary data, the OECD zone’s GDP fell by only 0.002 percent compared to the first three months of the year, when the slow-down had reached 2.1 percent.

At the same time, the overall GDP of the G8 countries (Canada, France, Germany, Italy, Japan, Britain and the United States) fell by 0.1 percent. Britain’s GDP fell by 0.8 percent, that of the United States – by 0.3 percent, and that of Italy – by 0.5 percent. And after two quarters of recession, the Japanese economy even demonstrated a growth of 0.9 percent. France and Germany also registered higher GDP, gaining 0.3 percent each. The latest business activity indicators, meanwhile, allowed Federal Reserve System (Fed) Chairman Ben Bernanke to announce on August 21 that the world economy was beginning to recover from its recession in response to the “aggressive” measures taken both by governments and central banks.

“Business activity appears to be leveling out, both in the United States and abroad, and the prospects of a return to growth in the near term appear good.”

Similar “melodies” were being simultaneously sounded in the assessments of Russian officials. First Deputy Prime Minister Igor Shuvalov, Deputy Economy Minister Andrei Klepach, and First Deputy Central Bank Chairman Alexei Ulyukayev were unanimous at the start of the third ten-day period of August – the “bottom” of the crisis had passed.

The grounds for these types of conclusions came from the country’s socioeconomic development results for the first seven months. There were recovery trends evident in industrial production and freight turnover, and the decline in fixed capital investments had come to a halt. The results is that, according the Ministry of Economic Development and Trade, discounting for seasonal factors, GDP had continued growing for the second month in a row – it increased by 0.5 percent from June to July.

The Ministry of Economic Development and Trade expects that positive GDP gains will continue into the third and fourth quarters. The outlining trends have afforded the grounds for a 2010 forecast revision: GDP will grow by 1.6 percent (it had previously been expected to rise by 1 percent), industrial production – by 1.4 percent instead of 0.8, investments – by 1 percent against 0.4. Exports will grow as well – by 32 billion dollars to 308 billion. Inflation, meanwhile, will stand at between 9 and 10 percent.

The average annual price of oil forecast was improved as well: it will stand at 57 dollars per barrel for 2009, and grow by a dollar a year between 2010 and 2012. This provides a pretty good boost to the budget. It is clear that its revenues will exceed the now-planned 6.6 trillion rubles. According to some expert assessments, this “bonus” could reach 220 — 250 billion rubles.

… but strains persist.

Nevertheless, the economic situation remains unstable. The recession, it appears, is coming to an end and the free-fall in the world economy has been arrested, but the crisis lingers on. Most analysts believe that its end will be marked in the second quarter of 2010. At the same time, the Russian economy will only enter the stable development trajectory (in which the annual GDP grows by at least 5 percent) at the turn of 2014 – 2015.
Whether these forecasts come true depends, as a rule, on many factors. In my opinion, there are at least three main ones. The first is linked to the global economic recovery and the price dynamic of basic raw materials. The second factor involves the dynamic of private investments, which are stimulated by low inflations. And, finally, the third – the effectiveness of the state’s anti-crisis policy.

It is obvious that the current revival primarily owes itself to the effects of first factor. The past two months’ growth was spontaneous in nature, in many ways independent of what the Russian regulators did. Experts, however, note that except for the banking sector, the anti-crisis program (which was adopted in its final version on June 19, 2009) has not yet had the time to make an impact on the state of the economy. On the other hand, the considerable risks of financial over-stimulation are ascertaining themselves, as well: the budget spent an average of 700 billion rubles a month between January and July. In the time that remains through the end of the year, in order to fulfill the budgetary assignments, monthly expenditures have to rise to 1.1 trillion rubles.
The danger of our dependence on external factors (behavior of the commodities markets and the “window of opportunity” available on capital markets) is compounded by the serious risks that the world economy will be burdened with in the autumn – winter of 2009/2010. Fed chief Ben Bernanke believes that: “Strains persist in many financial markets across the globe, financial institutions face additional significant losses.” These risks are even higher since a considerable part of the anti-crisis package has still not entered the U.S. economy. This makes it all the more important of when exactly the Fed-developed “exit strategy” is going to go into effect, as well as what it contains.

The “exit” dilemma was fairly graphically defined by New York University Professor Nuriel Roubini. In his opinion, the optimal U-shaped world economic recovery scenario will take two years. However, there are still risks of a W-shaped development of events. If we see higher taxes, spending cutback and a rapid liquidation of excess liquidity, then this is a direct path to stagflation (a simultaneous recession and deflation).

So if financial interventions continue, then this could lead to stagflation. Higher inflation expectations, greater yields on long-term treasury bonds and the like will, in this case, spur on the speculative growth in the price of oil, electricity and food.

To one extent or another, this junction confronts all nations that are now implementing large-scale anti-crisis programs. Russia is in these ranks – and in no case the exclusion. So it is a fair opinion to say that a confident rebound from the “bottom” can only be discussed when there is also a simultaneous growth in production, earnings, demand and credit. I would like to note that when looked at from this angle, our “post-battle landscape” looks blurry indeed.

In July, the real income of the population collapsed by an entire 5.4 percent, while retail trade and paid service volumes fell by nearly 8 percent. Public consumption shrank to its lowest point in the past 12 year (68 percent of the disposable incomes in July, against 73 percent a year earlier). A fifth of all incomes are spent on repaying credits, compulsory payments and contributions. The rest goes to savings – over seven months, the amount of deposits grew by 12 percent.

But at the same, our inflation since the start of the year stands at 8.2 percent (it was 9.7 percent in 2008). The decline is apparent. The last week of August was even marked by deflation (minus 0.1 percent). It may not be excluded that, in annual terms, the rise in consumer prices may come to 10.5 percent. And still, this is too high for a normal economic recovery and the buildup of private investments. Sustainable development is guaranteed at prices that rise by no more than 5 percent a year. And this is an axiom that was derived from decades of global experience.

High inflation strips the economy of its prospects: interest rate arbitrage, the inflow of speculative capital and the procession of business to the ends of the earth in search of cheap money are overriding the chances of Russia creating truly broad credit and debt markets that are based on domestic savings. In other words, if we keep to the status quo, we will never have the required resources for modernization – in other words, the simultaneous update and humanization of all spheres of Russian life.

On the other hand, there is a chance that we can do away with high inflation. And we will have to start things off with the budgetary policy. To begin with, we will have to turn on the “red light” to a buildup in the state’s financing of the economy. Practice showed that the first signs of a revival appeared at its current level. “Pouring” even more in means seriously risking the consequences of additional emissions – in other words, a warm-up in the inflationary background and a worsening of the credit squeeze. It is equally important to prevent the additional revenues for 2010 from gradually overflowing into new spending. And if we are talking about their stimulatory effects, then we must follow words with a real redistribution in favor of those very state investments, but this time made jointly with private business into infrastructure projects. At times when it is not entirely clear whether the crisis will be long or short, it is better to “re-mortgage” yourself for the worst-case scenario and to conduct a conservative budgetary and monetary policy, one that guarantees the maintenance of macroeconomic stability. It is always useful to leave yourself room to maneuver and win yourself the time to develop mechanisms that adequately respond to changes in the situation.

We missed it coming. Why?

It has been well-known for a long time that the length of any crisis is directly dependent on the actual model of state regulation. According to the expert opinion of the Institute of Contemporary Development, the prevalence of so-called manual management techniques broadly increases the likelihood of crisis processes continuing for a much longer time than they would have had we depended on universal mechanisms, ones in which the economic role of the state could be implemented more effectively. Hedging all your bets on budgetary stimulation alone is clearly not enough. Especially since our agenda is now filled with its substantial correction – in other words, the prospects of adapting to a period of low state revenues.

But still largely untapped is the solid reserve of regulator steps that rely on “universalism,” which consists of shrinking the state sector while at the same time improving its efficiency, developing private-public partnerships that focus on targeted programs and individual projects, improving competition, reforming the natural monopolies, adjusting the tax system so that it encourages economic growth and non-technological production, as well as measures aimed at consolidating and modernizing the banking system, and supporting innovation and energy savings.

A “stagnation of the quality” of state regulations keeps the relatively-high risk of financial instability in place. To overcome this risk, we will require new solutions that should first and foremost be sought in our arsenal of structural reforms. The time for positioning Russia’s post-crisis economy in the global one has already passed.
I think that economists missed the onset of the crisis by virtue of their own dogmatism. However, with its help, one can be equally wrong in recognizing the signals coming in from the current state of economic affairs. There is a double danger here: one can fail to see the “green shoots” and continue putting out the fire with money, or one can slip into euphoria, perceiving the long-awaited spurt as the start of a stable recovery. The consequences of this are similar – the adoption of regulatory mechanisms that “miss” the content of ongoing economic processes.

The current agenda’s content must focus on strengthening and developing market institutions. Why is that the case? First of all, because globalization implies competition between these very institutions, and their quality is the primary condition of national competitiveness. Second of all, today’s economic structure is no longer composed of industries and sectors, but again – these very same institutions of market-based economies, ones that are capable of generating the incentives and motivations for the “game’s participants” to adapt to the variable challenges that lie ahead. And third of all, reliable – in other words, efficient and effective – institutions provide both a kind of insurance against the inevitable mistakes that will be made in economic policy, and the potential to correct their consequences.

Up – by four steps

So what is the “technical minimum” of our top-priority course of action? In addition to everything said above, I would highlight four of their interdependent series of steps.

The first step – in addition to providing banking sector support, we must involve measures aimed at reorienting the real sector of the economy. This, first and foremost, implies encouraging cost savings, enterprise restructuring, and mergers and acquisitions. We should overcome our false fear of bankruptcy and of replacing ineffective owners and managers. In addition, a vital factor of success involves forcing enterprises to face real-time, stiff competition. Beforehand (and through legislation), this stage must be cleared of any “difficulties” – ones in which antimonopoly controls turn (“from our best intentions,” of course) into direct price regulations.
The second step involves stepping on the throat of our own self-complacency about sufficient banking liquidity. The self-complacency also applied to the essentially “resolvable” issue of recapitalization, and the supposedly non-critical size of credit indebtedness and other “bad” loans. Recently, Standard & Poor’s very conservatively estimated the size of our banks’ recapitalization requirements for the coming three years at 40 billion dollars. In the meantime, their sources of recapitalization are nowhere in sight. Another impediment – which accounts for the lion’s share of new credits – concerns borrowing costs. We know, however, that experts estimate that the average ratio of the banking system’s “solvent” and “insolvent” borrowers now stands at one to two. In other words, the current potential of having your rolled-over credits returned is no higher than a third of their entire volume.

According to model calculations performed by the Center of Macroeconomic Analysis and Short-Term Forecasts, by the end of 2009, the share of bad and uncollectible loans will make up at least 14 percent of banks’ credit portfolios. By the middle of 2010, it could rise to 18 – 21 percent (it had reached 17.3 percent in 1998). According to analysts, this signifies the threat of a systemic banking crisis. It is abundantly clear that we have already passed the “point of no return” of concealing this problem. It requires our monetary authorities’ urgent (or, at the very least, conceptually publicized) solution.

The third step involves a consistent lowering of the expectations of another devaluation (for which, I would note, there are no fundamental prerequisites). This may be achieved by accustoming economic agents to the already de-facto (or, at the very least, in effect for the past three months) floating ruble exchange rate. In my opinion, the delicacy of the current situation – and, consequently, the acuteness of the debate about reasonable movements in the ruble exchange rate – are primarily linked to the fact that most market participants are poorly prepared (both mentally and technologically) for dealing with a heightened volatility in the ruble exchange rate. In the meantime, this is only the flip side of our transition to targeted inflation rates. And within this transition’s frameworks, weekly 5 – 10 percent fluctuations in the ruble exchange rate are a quite likely prospect.

Economic agents’ and the population’s adaptation to this new reality have already turned into a serious problem. Besides personnel, the development of our market’s infrastructure (which involves institutionally “bundling” the functions of currency risk and arbitrage insurance and the like) will also require a massive information and clarification campaign – a sort of “currency literacy” project.

Finally, the fourth step. While discussing future stability in the budget, we cannot lose sight of a potential rise in revenues from a new state privatization. That our state has already accumulated a substantial volume of surplus assets is a “medical” fact. And the fact that these must be unloaded as we make our was out of the recession is just as obvious. The preservation of a status-quo will mean us slipping into an acute economic crisis whose causes lie in a contraction of the area in which competition is practiced in the economy, and a degradation of relations between private property owners. There is no doubt that a new privatization must be carefully prepared in order to avoid the situation we had in the 1990s. But this must be done now, laying the 2010 budget’s foundation not with a pro forma and non-committal bureaucratic pledge of a 7-billion-ruble reduction in state property, but with a substantially greater amount. I believe that this would provide a positive signal to the fact that we recognize private business and competition as the main driving forces behind new economic growth.

No alternatives

The Russian economy’s medium-term trajectory promises to be a fairly complicated one. We will require not only courage – which the government excellently displayed at the end of August – but also a sequence of responsible and systemic actions that aim to overcome the “Russian disease” – a combination of a reliance on oil and has, the chronic deficit of “long money,” and the weakness of our market institutions.

What we need is not only a set of anti-crisis measures – which, by the way, are gradually turning into “anti-protest” ones – but a though-through scenario of how we can “break away from the bottom.” This would be worth having by December 2009 – in other words, by the expected adoption date of our 2010 budget. By refusing to adopt such an “action schedule,” we can only multiply the likelihood of us delivering ill-timed responses to our impending challenges.

A “reset” of our regulatory measures, which is a prerequisite of us ensuring the structural modernization of the Russian economy, is an extremely intricate task, but one that has no alternatives: we will continue to have a solid deficit of technologies (including political ones) and achievements if we fail to clear up our goals.

Russia’s modernization is the order of business not only for President Dmitry Medvedev, but the Russian government as a whole. Both his election program and “Strategy 2020” are laced with ideas about the country’s modernization. His “Four ‘I’s” and competitive growth are euphemisms for modernization. For objective and partially subjective reason, this agenda’s implementation slowed down in the second half of 2008. The financial and economic crisis and the (quite natural) slowdown in strategic planning it provoked, the “five day war” in the Caucasus, the live threats in “our own” North Caucasus, and a complication in relations with our key partners – everyone from the European Union to Ukraine – these problems all complicated the setting of proper modernization process targets.

But these difficulties do not eliminate the very goals of modernization. Instead, they only make them more topical.

We will hazard a guess that the crisis and the other complications may, in the long run, be nothing but a “blessing in disguise” – or, as they say in Russian, if it were not for bad luck, we would have no luck at all.
Standing united instead of against

The crisis has forced the Russian political and economic elite to take a more realistic look at itself and its place in the surrounding world, and to grasp the scale of the problems facing the country. All the world’s successful modernizations were achieved not by admiring your own grandeur, but by recognizing dangers – whether they follow a heavy defeat, or in view of the unavoidable threat of such a defeat occurring if the country fails to respond to its challenges in time.

When the question is raised in this manner, we deprive all meaning from the schisms and standoffs affecting the Russian elite, and about which so much is being said and written – often out of opportunistic or speculative considerations. All of these are nothing but secondary details against the backdrop of our common threats and the collapse of our modernization efforts.
So let us assume that we never introduced modernization. And we continue to produce relatively cheap metal, oil and gas. The first danger is that these commodities, together with other countries’ modernization, will stop being as important. A technological update will replace these with other materials. We will remain a raw materials appendage for what are now the underdeveloped countries, since these too have moved on to energy substitution, to replacing their timber with plastics and so on. And we are already moving into the category of being an appendage for the developing nations, ones that in exchange give us money and third-rate technologies – and not the first-class ones that we now get from the developed nations. In so doing, we are settling into the category of what is at first a medium-developed nation, and then – even further, even lower, if we do nothing now. Since we make up an entire continent, some of us will never accept this fate. A part of those in whom the genes of Tolstoy, Dostoevsky and Tchaikovsky remain strong, will still be striving for improvements. This means a splintering of the country between those who are ready, for “soup,” to turn into a raw materials appendage for the developing nations, and those who will strive for the high standards of Europe, the Unites States and other leading nations. This may tear the country apart. And this is the greatest danger of all.
All of this means that modernization serves the strategic interests of all Russian elites and society as a whole. And since this is the case, then we may raise the issue of forming a “grand coalition” that favors modernization, one that is headed by the president and the prime minister. However, the contradictions between its potential members are objective, and, for now, are complicating the modernization project’s launch.

Only the government (read – the “tandem” of our country’s leaders) has the political will to induce their cooperation.

Modernization’s success depends on the extent to which the Russian government manages to handle two functions at once. That of the “strategic reformer,” who sets the goals, determines the priorities, mobilizes the resources, protects against foreign threats, and manages domestic imbalances. And that of the “arbiter” of disputes between the various political and economic interests. It is this difficulty of our socioeconomic relations that requires our transition from “manual management” to a system of multiple institutions. The restriction of competition in politics and the economy, which has been characteristic of Russia in recent years, was dictated not by ill will but by an awareness of the limits of the means available to “manual management.” Yet modernization will inevitably engender new interests and new conflicts. However, to at least start building the institutions for managing these conflicts is our categorical imperative. The difficulty of this path lies in us having to take unpopular steps.

To strip powers from those who have “overstay their welcome” there. To deprive certain groups that control old assets, these assets’ bases, influences and strengths. But this must be done nonetheless because otherwise, we will ossify in the old, never catching up to the new times.

I will provide one more example.

The raw materials monopolies have accumulated more debts than the rest of the private sector combined. Gazprom alone, I think, already owes 120 billion dollars, not to mention the dire straits facing Rosneft and others. They need budget money. And they will continue to pester Finance Minister Alexei Kudrin: “Give! Give!” And he will give – but there will still not be enough for all. And there will certainly not be any money left for new technologies. And without these, there is no modernization. In the proper understanding of this process.
By the way, we have to clearly establish this, too. In my opinion and probably in that of some of my colleagues, modernization is the introduction in our lives of better standards and examples that have been reaped throughout the world. Modernization, from the standpoint of some of our conservative strata, is simply a strengthening in a number of positions in which Russia – in their opinion – is currently strong and must grow stronger in order to prevent, God forbid, becoming dependent on the West. This is our military-industrial complex, as well as the fuel and energy and agricultural ones. They have mottos such as “food and drug security.” No developed country on earth produces sufficient quantities of its own food, drugs and other items. After all, they depend on us for their energy! And they seem to just shrug this off.

They build their theory of modernization on the very best theories and examples, on the diffusion of the most advanced items the world has. And here, people say that we have to dig in against the others. I believe that this is the wrong type of modernization. Let us gain strength together with the others.

Modernization’s success depends on the extent to which the Russian government manages to handle two functions at once: that of “strategic reformer” and “arbiter.”

These comments were published in Rossiyskaya Gazeta on September 8.