Diversifying Russia

Simon Commander, Alexander Plekhanov, 29 January 2013

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Russia aims to diversify its economy, thereby moving away from its dependence on oil and gas. Despite much political rhetoric, our research (European Bank for Reconstruction and Development 2012) indicates that, to date, relatively little has been achieved. Oil and gas still account for nearly 70% of total merchandise exports and around a half of the federal budget. Figure 1 shows the increasing share of minerals in total exports when measured in constant prices.

Figure 1. Russia: Structure of exports in real terms (at constant prices)

Source: Rosstat and authors' calculations. Measured in constant 2007 prices.

Further, relatively few Russian firms compete in export markets and very few do so in higher value-added products. In the early 1990s, Russia had comparative advantage in only 12% of its total product lines (measured by using a four-digit SITC classification). Most were natural resources. Few of Russia’s export products were closely connected to other products, limiting the scope for enhancing its exports. Comparatively, China had comparative advantage in over three times as many product lines during the same period. By 2010, our research shows increased concentration on natural resource exports. The contraction of manufacturing has been associated with a 33% decline in the number of Russian product lines with comparative advantage, while for China there was an increase of around 7%. In sum, the Russian export basket has become even more concentrated since the mid-1990s. The ability to shift into proximate products, as well as diversify into new ones, has been very restricted. Why has this been the case?

Business environment, competition and entry

One recurrent diagnosis has been that failings in the business environment are to be blamed. The broad policy directions and options for addressing these problems are well understood. Indeed, a key challenge is in enforcement, which requires a political commitment that is largely lacking.

Our research goes beyond national-level conclusions by looking at the regional dimensions. We use a representative sample of firms in 37 regions collected in the Business Environment and Enterprise Performance Survey (BEEPS) in 2012. This shows that although corruption, access to finance and availability of skills – as well as tax rates – are the main perceived constraints for Russian businesses, not a single region matches the sheer extent of Russia’s problems. However, in the midst of this heterogeneity, some regions, such as Kaluga, stand out for the relative benevolence of their business climate and for the efficacy of some of their policies in attracting and retaining investment. Others, such as the region around Vladivostok in the far east, are testimony to mismanagement. In sum, there is significant scope for regional administrations to learn from and to compete with each other in bettering the business environment. This regional dimension may offer a partial counterweight to the fact that many federally determined policies and practices work against progress. And while diversification may be a desirable national goal, some regions might actually be expected to become more specialised.

One consequence of an adverse business environment is the weak role that the entry and exit of firms plays in driving the economy. Large firms are still dominant. Small and medium-sized enterprises’ contributions to output, investment and employment are at only half the level of those in the EU. Relatively few Russians have tried to start their own company compared with some western and eastern European countries and, in particular, the success rate of those that had was low (according to EBRD’s Life In Transition survey). In short, not only do relatively few new firms enter but the sectoral distribution of entry does not appear consistent with diversification and a shift into higher productivity activity. We also find that competition in product markets – particularly in higher value-added industries – remains relatively weak. Although an independent competition authority was created in 2004, there has again been weak enforcement.

Education and skills

Diversifying and raising productivity depends on much more than just a good business climate. Critically, it also depends on what sorts of skills and knowledge are available. Although Russia does much better than most emerging markets in terms of education and skills, the evidence indicates no improvement in education scores (Figure 2) over time as well as very large regional variations.

Figure 2. Russia, PISA scores for reading

As regards the supply of skills, businesses consistently cite this as a major constraint, including the supply of high-quality management. Evidence from surveys that we conducted confirms that firms face problems in finding workers with the appropriate skill profile. And while this may be the situation for existing firms, it seems likely that potential entrants to new, diversified activities may, if anything, face even steeper constraints. A survey of the leading recruitment firms in Russia was carried out. Not only are there widespread skill gaps, but it takes firms much longer to fill vacancies for skilled personnel. This is particularly true for what we call ‘relatively innovative activities’, such as web technology aimed at social networking. Recruiting managers or high-level professionals in the major Russian cities, including Moscow, on average takes three to five times longer for relatively innovative activity. Moreover, recruiters also reported an absence of essential skills among potential recruits. Among the consequences, many firms decided to postpone launching new products and/or modernising plant.

At the same time, among the thin layer of top talent – likely to be essential for high tech and other innovative activities – many prefer to emigrate. In contrast, Russia largely fails to attract talent from other countries, not least because of a restrictive migration regime. Although immigration levels are not trivial, the great majority (more than 80%) of legal migrants are unskilled or semi-skilled workers.

Innovation and public policy

Russian public policy has also relied on publicly funded and publicly managed entities, such as Rusnano Corporation, to lead the economy into more diversified and more productive spaces, particularly in high tech. This approach has yielded relatively meagre results: the supply of high-quality research from public sector institutions remains very limited and is unlikely to improve in the foreseeable future; little attention has been given to the critical need to link research to the market and to customer demand; and the incentives for private companies to invest in research and development remain limited, whether in terms of tax treatment or because of the business environment. The limited extent to which multinational companies have entered Russian markets has also held back the supply of innovation.

Yet the Russian government’s approach attributes lack of innovation to market failure that can best be addressed by activist public policy. Rather than emphasising provision of a facilitating environment for innovation, the cornerstone of public policy for innovation has been the provision of public funding for pre-determined sectors and technologies, such as nanotechnology. Russian government involvement in venture funding carries many of the usual risks. These include, lack of transparency, non-neutrality in allocating resources, the introduction of multiple objectives, and weak governance. A further question concerns the likely crowding-out of private-sector funding and investment. Comparative experience suggests that successful instances of government involvement with venture finance have been when governments have mainly been investing in privately managed funds. Moreover, providing venture finance needs also to be complemented by making financing and other support to entrepreneurs and inventors available at the earliest stages of the innovation cycle. The evidence indicates that funding for early stage companies or initiatives is largely absent. We suggest that small grants to researchers can also be complemented by grants to entrepreneurs. Small grants at an early stage can thus be particularly fruitful if they provide entrepreneurs with access to business support services and advice. The constraint in Russia, as in many emerging markets, remains that this support infrastructure is limited and/or skewed mainly towards the provision of physical infrastructure, as through industrial or technology parks. Rather than trying to organise through a government agency or ministry, a better solution would be to establish an independent authority with governance shared between the government (as initial funder) and private representation, both local and international.

Conclusion

Diversification and modernisation – effectively two sides of the same coin – have been the policy mantras of the recent past in Russia, and for good reason. Yet, Russia has become more narrowly specialised in natural resources, even as ownership and control of those resources has been concentrated in the hands of the state. Indeed, the tentacles of the state have extended further into other industries deemed to be strategic. Policy has relied on publicly funded and managed entities shepherding the economy into more diversified and more productive spaces. But this model has had very limited success and many drawbacks. Even the much-vaunted aim of building competitive high-technology sectors through state support has yielded disappointing results. And in export markets – the arena that provides the most compelling metric of viability – the evidence shows that relatively few Russian firms compete in international markets and very few do so in higher value-added trade. Yet, despite this balance sheet, the current Russian administration proposes more of the same policies. In so doing, they are taking a huge gamble by relying on a mix of energy prices and publicly funded industrial policy to paper over the structural weaknesses of the economy.

References

European Bank for Reconstruction and Development (2012), “Diversifying Russia: Harnessing regional diversity”, special report, 13 December.

Topics: Development
Tags: economic diversification, education, gas, oil, Russia, skills

Managing Partner, Altura Partners
Senior economist in the Office of the Chief Economist, European Bank for Reconstruction and Development

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