Economic conditions seemed to improve somewhat in Q3, after GDP shrank at the sharpest rate in a

decade in Q2. In Q3, economic activity fell at a much softer pace than Q2’s average, supported by a
gradual recovery in the vital industrial sector, as manufacturing firms continued to ramp up capacity,
which partly offset sliding mining output. Moreover, the easing of restrictions should have boosted
household spending: The drop in retail sales softened considerably in Q3, which, coupled with an
uptick in consumer confidence, points to returning consumer demand. That said, a weaker ruble and
rising unemployment rate likely tempered the rebound. Externally, conditions were more downbeat:
Merchandise exports continued to slide in July–August amid constrained domestic oil output and
depressed global crude prices. Turning to Q4, worsening private sector conditions and surging new
Covid-19 cases threaten to derail the fragile recovery.

Russia Economic Growth

GDP is set to contract at the sharpest pace in over a decade this year, as exports, investment
activity and consumer demand all plunge due to Covid-19. Next year, the economy should rebound
as the pandemic is expected to subside, with fiscal and monetary stimulus further supporting the
recovery. Geopolitical risks and the uncertainty over the pandemic cloud the outlook, however.
FocusEconomics panelists project GDP to rebound and grow 3.1% in 2021, which is down 0.2
percentage points from last month’s forecast. In 2022, growth is seen slowing to 2.3%.

Russia Economy Data

2015 2016 2017 2018 2019

Population (million) 147 147 147 147 147

GDP per capita (USD) 9,289 8,699 10,718 11,371 11,583

GDP (USD bn) 1,361 1,277 1,574 1,669 1,700

Economic Growth (GDP, annual variation in %) -2.0 0.2 1.8 2.5 1.3

Consumption (annual variation in %) -9.5 -2.6 3.7 3.3 2.5

Investment (annual variation in %) -10.6 1.3 4.7 0.1 1.5

Industrial Production (annual variation in %) 0.2 1.7 3.8 3.5 2.3

Retail Sales (annual variation in %) -9.8 -4.8 1.2 2.8 1.6

Unemployment Rate 5.6 5.5 5.2 4.8 4.6

 2015 2016 2017 2018 2019

Fiscal Balance (% of GDP) -2.4 -3.5 -1.4 2.6 1.8

Public Debt (% of GDP) 13.5 13.2 14.6 14.9 15.3

Money (annual variation in %) 11.3 9.2 10.5 11.0 9.7

Inflation Rate (CPI, annual variation in %, eop) 12.9 5.4 2.5 4.3 3.0

Inflation Rate (CPI, annual variation in %) 15.5 7.1 3.7 2.9 4.5

Inflation (PPI, annual variation in %) -   -   -   -   -  

Policy Interest Rate (%) 11.00 10.00 7.75 7.75 6.25

Stock Market (annual variation in %) 26.1 26.8 -5.5 11.8 29.1

Exchange Rate (vs USD) 72.88 60.27 57.63 68.88 61.91

Exchange Rate (vs USD, aop) 61.06 67.05 58.33 62.68 64.75

Current Account (% of GDP) 5.0 1.9 2.1 6.8 3.8

Current Account Balance (USD bn) 67.8 24.5 32.4 114 64.7

Trade Balance (USD billion) 148 90.2 115 194 163

Exports (USD billion) 341 282 353 443 418

Imports (USD billion) 193 191 238 249 255

Exports (annual variation in %) -31.3 -17.5 25.3 25.5 -5.7

Imports (annual variation in %) -37.3 -0.8 24.5 4.3 2.5

 2015 2016 2017 2018 2019

International Reserves (USD) 368 378 433 468 554

External Debt (% of GDP) 38.1 40.1 32.9 27.3 28.9

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Russia Economy Overview

Economic Overview of Russia

Following the collapse of the Soviet Union, the first decade of transition from a centrally-planned
economy to market economy was disastrous for Russia: nominal gross domestic product (GDP) fell
from USD 516 billion in 1990 to USD 196 billion in 1999, which represented a plunge of over 60%. In
an attempt to address the economic turmoil and follow the recommendations from the IMF, the
Soviet government began to privatize many Russian industries during the 1990s. Important
exceptions were, however the energy and defense sectors.

The devaluation of the Russian ruble in 1998—after the financial crisis known as the ruble crisis—
together with the uninterrupted upward trend that oil prices experienced in the period from1999 to
2008 propelled the Russian economy—heavily reliant on its energy sector exports—to grow at an
annual average rate of 7%. Russia was among the hardest-hit economies by the 2008-2009 global
economic crisis: the economy plunged 7.8% in 2009 as oil prices plummeted and foreign credit dried
up. The economic contraction was the sharpest since 1994, but no long-term damage was caused
due to the government and Central Bank’s proactive and timely response to ring fence key sectors of
the economy, in particular the banking sector, from the effects of the crisis. As a result, Russia’s
economy began to grow again and increased 4.5%, 4.3% and 3.4% in 2010, 2011 and 2012,
respectively, before slowing to 1.3% in 2013 and 0.6% in 2014.

The Russian economy experienced two major shocks in 2014, narrowly avoiding recession with
moderate growth of 0.6%. The first shock was the sharp decline in oil prices during the third and
fourth quarter of 2014, exposing Russia’s extreme dependence on global commodity cycles. After
fluctuating within a tight band near USD 105 per barrel from 2011-2013, crude oil prices ended 2014
at less than USD 60 per barrel. The second shock was the economic sanctions resulting from
geopolitical tensions, which negatively affected investor appetite for Russian investments. Capital
flights and high inflation compound Russia’s economic woes as the economy registered the steepest
contraction since 2009 contracting 3.7% in the full year 2015. Forecasts are pointing to an end to the
recession coming soon in 2017.

Inflation has been falling rapidly since August 2015, when it reached a peak of 15.8%. Along with the
fall in inflation, Central Bank lending rates have been reduced. Russian bonds and equities are
performing well against those of other emerging markets and a modest recovery in oil prices has
bolstered economic sentiment.
Considering that the price for Urals oil will average USD 38 per barrel in 2016, the Central Bank
expects the economy to contract between 0.3% and 0.7% this year, which is less than the Bank’s
previous estimate that saw the economy contracting between 1.3% and 1.5%. The Bank expects the
economy to expand at a rate of between 1.1% and 1.4% in 2017, assuming that Urals oil prices
average USD 40 per barrel. Previously, the Bank had expected the price for Urals oil to average
USD 35 per barrel and had projected economic growth rising to within a range of minus 0.5% and
plus 0.5% in 2017.

Following the economy’s collapse in 2015, analysts surveyed by FocusEconomics expect the
Russian economy to continue contracting in 2016, although at a more moderate pace.
FocusEconomics Consensus Forecast panelists project that Russia’s GDP will fall 0.7% in 2016,
which is up 0.1 percentage points from last month’s forecast. Panelists expect the economy to
expand 1.3% in 2017.

Russia’s Balance of Payments

Russia’s current account records regular trade surpluses largely due to exports of commodities such
as crude oil and natural gas. From 2010 to 2014, Russia’s average current account surplus was
USD 66.8 billion, reaching a peak in 2011 at USD 98.8 billion.

Russia’s balance of payments suffered a significant terms-of-trade shock in the fourth quarter of
2014 as a result of falling oil prices, which were, in part, offset by a drop in imports. Simultaneously,
geopolitical uncertainties and related sanctions in 2014 resulted in large capital outflows, further
deteriorating Russia’s BoP. Private sector capital outflows increased from USD 60.7 billion in 2013
to USD 130.5 billion in 2014. During the same period, capital and financial accounts of the Russian
Federation fell from a deficit of USD 45.4 billion to a deficit of USD 146 billion (2.2% and 7.8% of
GDP, respectively).

Russia’s economy registered the steepest contraction since 2009 last year as a combination of
external factors—such as a plunge in oil prices and international sanctions—coupled with structural
weaknesses took a heavy toll on growth. The economy contracted 3.7% in the full year 2015, which
contrasted the meagre growth registered in the previous year. However, the contraction in the
Russian economy in the second quarter of 20167 was the slowest since the recession began in late
2014. Comprehensive data showed that GDP contracted 0.6% annually in Q2, which came in above
the 1.2% decrease recorded in Q1. Although industrial production shrank in September, falling at the
fastest pace seen in 8 months, it is expected to expand slightly in 2016 after suffering the worst
contraction in six years in 2015.

Russia’s trade structure

Crude oil, petroleum products and natural gas comprise roughly 58% of total exports, iron and steel
represent 4% and other mining sector related exports including gems and precious metals account
for about 2.5%. Sales to Europe represent over 60% of total exports while Asia has an export share
of roughly 30%. Russian exports to the United States, Africa and Latin America combined represent
less than 5% of total shipments.

Russia’s main imports are food and ground transports, which represent 13% and 12% of total
imports, respectively. Other significant imports include pharmaceuticals, textile and footwear,
plastics and optical instruments. Exports peaked in 2012 reaching USD 527 billion; imports peaked
in 2013 reaching USD 341 billion.

In August of 2015, Russian exports amounted to USD 25.0 billion, which marked a 39.7%
contraction in annual terms. This marked the 10th consecutive contraction at a double-digit rate.
Imports totaled USD 16.5 billion, which marked a 34.7% year-on-year contraction.

Russia’s trade surplus is narrowing rapidly. Russia’s trade surplus narrowed to USD 4.4 billion in
August of this year, which came in dramatically below the USD 8.8 billion registered in the same
month last year and the USD 16.2 billion the prior year. August’s result prompted the 12-month
rolling surplus to decrease to USD 99.5 billion, the smallest accumulated surplus in over a decade.
The fall in the trade surplus continues to reflect the free fall that Russian exports have registered
over the last few years.

Following a period of heightened volatility, oil prices have recently stabilized especially since the
extraordinary meeting of the OPEC Conference in Algiers in the last week of September, which
concluded with a commitment to freeze oil production at between 32.5 and 33.0 million barrels a
day. Analysts expect the commitment to be honored by most members at OPEC’s official meeting in
November where non-OPEC oil exporters are also encouraged to sign on the dotted line. The re-
establishment of OPEC’s price leadership prompted global oil prices to spike, including for Urals oil.
On 30 September, the price for Urals oil settled at USD 46.3 per barrel, which was 4.6% higher than
at the end of August. Urals oil has also recovered from the lows registered earlier this year and was
31.8% on a year-to-date basis.

Russia’s Monetary Policy

The Central Bank of Russia (Bank Rossii), founded in 1990, has several responsibilities in
compliance with the Russian Constitution and Russian Federal Law: maintaining the value and
stability of the ruble, overseeing Russian financial institutions (including acting as a lender of last
resort), managing Russia’s foreign reserves and foreign exchange, and setting short-term interest
rates, which is one of the main instruments of the bank’s monetary policy implementation.

Low oil prices and sanctions shocks to the Russian economy resulted in the ruble losing 46% of its
value against the U.S. dollar in 2014, prompting policies from the Bank Rossii aimed at stabilizing
the financial system. Bank Rossii raised its key interest rate in December 2014 by 650 basis points
to a lofty 17% to curb runaway inflation caused by the weakened ruble (core inflation reached 11.2%
in December 2014, year-on-year). Bank Rossii spent USD 27.2 billion in October 2014 and USD
11.9 billion in December of the same year on interventions to support the ruble.

Russia’s Central Bank gradually reduced interest rates over the course of 2015, starting the year at
17.00% and reduced to 11.00% by July. Interest rates were kept steady for nearly a year until June
2016 when they were cut by 50 basis points to 10.50%. In making the decision to cut interest rates,
the Central Bank indicated that authorities were more confident about the evolution of inflation and
noted the positive results of a drop in inflation expectations and decreased inflation risks against a
backdrop of their slowly but surely recovering economy.

Since then there has been a noticeable drop in inflation, which drove the Bank to cut rates in
September 2016 from 10.50% to 10.00%. Authorities did however state that in order to cement a
sustainable fall in inflation, “the current value of the key rate needs to be maintained till end-2016
with its further possible cuts in 2017 Q1-Q2.” Considering its decision, the Bank remains confident
that with a still relatively-tight monetary policy, inflation will fall to 4.5% in Q3 2017 and decrease
further toward its 4.0% target at the end of 2017. The bank also indicated that it will hold off from
further monetary easing until the first or second quarters of 2017.

Russia’s Exchange Rate Policy

On 10 November 2014, Bank Rossii un-pegged the ruble from a dual-currency (U.S. dollar and euro)
basket band, ending two decades of exchange rate controls and moving Russia to a free-float
exchange rate system. The Central Bank also ended the regular interventions with the ruble, but
signaled that it remained committed to intervening in support of the Russian currency in case there
were risks to financial stability. As the ruble continued to slide against the greenback because of
falling oil prices and higher uncertainty among investors, the Central Bank decided to continue
intervening in the foreign exchange market, costing the Central Bank hundreds of millions per day.

The value of the ruble first began to fall in early 2014 after several years of an exchange rate of
roughly 30 RUB per USD, as the country was acutely affected by weak economic growth, high
geopolitical risks following the annexation of Crimea and the outbreak of war in Ukraine. However, it
was with the collapse of oil prices at the end of 2014 when the ruble’s value could not defy gravity
and thus began its free fall against the U.S. dollar, with the currency bottoming out at 68.5 RUB per
USD on 16 December. Throughout 2015, the Russian ruble has been on a roller coaster. High
volatility and strong fluctuations in oil prices have weighed heavily on the country’s currency. The
beginning of 2015 saw strong volatility in the foreign exchange market, but the Russian currency
stabilized within a corridor of 50 to 60 RUB per USD at the end of the first half of the year. There was
another episode of strong volatility at the outset of second half of the year and, on 24 August, the
Russian currency closed the trading day at 70.9 RUB per USD, which was even lower than the
aforementioned low point of the December 2014 ruble crash and represented a new all-time low.
The sharp drop in August was primarily a response to falling oil prices and rising fears regarding the
effects that the shockwave caused by China’s stock-market crash could have on the global
economy. The ruble closed 2015 at 72.9 RUB per USD—a 30% loss in value compared to the end of
2014.

Fluctuations of the Russian ruble are largely driven by the price of oil, which along with gas, is
Russia’s main commodity export. The currency took a dramatic fall to an all-time low of 82.4 RUB
per USD on 21 January 2016, as oil prices fell to lows not seen in over a decade. It has gradually
stabilized between 60 and 70 RUB per USD as the economy has improved and oil prices have crept
back up since January 2016.

Russia’s Fiscal Policy

Since the country’s 1998 debt crisis, a nearly decade-long environment of favorable commodities
prices (particular in the energy sector), a relatively weak ruble and tight fiscal policy allowed Russia
to run budget surpluses from 2001 to 2008 until the global financial crisis hit.

Russia depends heavily on its energy exports. In fiscal year 2008, oil and gas revenues reached a
peak, accounting for half of the Russian federal budget. However, since the global financial crisis hit
the country in 2009, the Russian economy began to run fiscal deficits. In 2012, 2013 and 2014
Russia ran budget deficits representing -0.02%, -0.7% and -0.6% of GDP, respectively. The
exception was the year 2011, when the Russian budget incurred a 0.8% of GDP surplus.

Low oil prices and a collapse in domestic demand and imports as the economy fell into recession
decimated fiscal revenues in 2015. In fact, the impact of low oil prices on Russia’s fiscal revenues
raised questions about the country’s long-term economic prospects as well as fiscal sustainability.
With the decline of energy prices and the Russian government's dependence on energy revenues to
fund its budget—revenues from oil and natural gas represented around 52% of the Russian budget
—forced the Russian government to rethink its fiscal policy. The Finance Ministry announced in early
September 2015 that it had decided to suspend the fiscal rule—a law designed to limit government
spending.

The fiscal rule went into effect in 2013 to prevent the government from wasting windfall oil revenues
and instead divert them into rainy-day funds. The rule also aimed to limit government expenditure to
projected non-oil revenues, oil revenues calculated using long-term historical oil prices, and a fiscal
deficit of at no more than 1.0% of GDP. At the time the rule was created, Russian authorities were
concerned that the income generated from rising oil prices would encourage pro-cyclical spending.
However, within the context of weak economic growth and oil prices at just half the level observed in
2014, Russia faced the opposite problem.

Because the budget rule limits government spending to long-term historical oil prices, if the law were
to continue into 2016, it would have implied a reference price higher than the one that was forecast
for 2016—which was an average USD 50 per barrel.

Officially, the fiscal rule was suspended temporarily. Some advisors, among them former-Finance
Minister Alexei Kudrin, voiced support for suspending the rule, at least for a year. Moreover, in
addition to the suspension of the fiscal rule, the government also announced a transition from a
three-year budget plan to one-year budgeting. The three-year budget plan was designed to force the
government to take a medium-term approach and avoid making unsustainable pledges. All in all, the
changes to the budget process paved the way for a more accommodative fiscal stance in an effort to
mitigate the low oil prices and weaker economic growth.

Some analysts suggest that, with sizeable reserves and low public debt, Russia can afford to run a
modest fiscal deficit without imperiling fiscal sustainability. The fiscal deficit ended at 2.8% in 2015.

Russia has two fiscal buffers, the Reserve Fund and the National Welfare Fund (NWF), both of
which have been under pressure as a result of deteriorating economic conditions. The Ministry of
Finance indicated that the budget deficit projected for 2015 (RUB 2.7 trillion, equivalent to 3.8% of
GDP) would be covered by the country’s Reserve Fund, rather than by raising debt. Unfortunately,
the government was unable to sustain that deficit due to the inability to fund it. Due to international
sanctions, the government has been unable to borrow from abroad. The government allowed for
increased discretionary use of NWF resources in December of 2014 in order to help stabilize the
financial system. The Russian government had no choice but to continue to draw down on the NWF.

ust as leaders of the Soviet Union had to create their own command socialist systems, leaders of
the economies making the transition to market capitalist economies must find their own paths to
new economic systems. It is a task without historical precedent.

In this section we will examine two countries and the strategies they have chosen for the
transition. China was the first socialist nation to begin the process, and in many ways it has been
the most successful. Russia was the dominant republic in the old Soviet Union; whether its
transition is successful will be crucially important. Before turning to the transition process in
these two countries, we will consider some general problems common to all countries seeking to
establish market capitalism in the wake of command socialism.

Problems in Transition
Establishing a system of market capitalism in a command socialist economy is a
daunting task. The nations making the attempt must invent the process as they go
along. Each of them, though, faces similar problems. Former command socialist
economies must establish systems of property rights, establish banking systems,
deal with the problem of inflation, and work through a long tradition of ideological
antipathy toward the basic nature of a capitalist system.

Property Rights
A market system requires property rights before it can function. A property right
details what one can and cannot do with a particular asset. A market system
requires laws that specify the actions that are permitted and those that are
proscribed, and it also requires institutions for the enforcement of agreements
dealing with property rights. These include a court system and lawyers trained in
property law and contract law. For the system to work effectively, there must be
widespread understanding of the basic nature of private property and of the
transactions through which it is allocated.

Command socialist economies possess virtually none of these prerequisites for

market capitalism. When the state owned virtually all capital and natural resources,
there was little need to develop a legal system that would spell out individual
property rights. Governments were largely free to do as they wished.

Countries seeking a transition from command socialism to market capitalism must

develop a legal system comparable to those that have evolved in market capitalist
countries over centuries. The problem of creating a system of property rights and
the institutions necessary to support it is a large hurdle for economies making the
transition to a market economy.

One manifestation of the difficulties inherent in establishing clear and widely

recognized property rights in formerly socialist countries is widespread criminal
activity. Newly established private firms must contend with racketeers who offer
protection at a price. Firms that refuse to pay the price may find their property
destroyed or some of their managers killed. Criminal activity has been rampant in
economies struggling toward a market capitalist system.

Banking
Banks in command socialist countries were operated by the state. There was no
tradition of banking practices as they are understood in market capitalist countries.

In a market capitalist economy, a privately owned bank accepts deposits from

customers and lends these deposits to borrowers. These borrowers are typically
firms or consumers. Banks in command socialist economies generally accepted
saving deposits, but checking accounts for private individuals were virtually
unknown. Decisions to advance money to firms were made through the economic
planning process, not by individual banks. Banks did not have an opportunity to
assess the profitability of individual enterprises; such considerations were
irrelevant in the old command socialist systems. Bankers in these economies were
thus unaccustomed to the roles that would be required of them in a market
capitalist system.

Inflation
One particularly vexing problem facing transitional economies is inflation. Under
command socialist systems, the government set prices; it could abolish inflation by
decree. But such systems were characterized by chronic shortages of consumer
goods. Consumers, unable to find the goods they wanted to buy, simply
accumulated money. As command socialist economies began their transitions,
there was typically a very large quantity of money available for consumers to
spend. A first step in transitions was the freeing of prices. Because the old state-
determined prices were generally below equilibrium levels, prices typically surged
in the early stages of transition. Prices in Poland, for example, shot up 400% within
a few months of price decontrol. Prices in Russia went up tenfold within six
months.

One dilemma facing transitional economies has been the plight of bankrupt state
enterprises. In a market capitalist economy, firms unable to generate revenues that
exceed their costs go out of business. In command socialist economies, the central
bank simply wrote checks to cover their deficits. As these economies have begun
the transition toward market capitalism, they have generally declared their
intention to end these bailouts and to let failing firms fail. But the phenomenon of
state firms earning negative profits is so pervasive that allowing all of them to fail
at once could cause massive disruption.

The practical alternative to allowing firms to fail has been continued bailouts. But
in transitional economies, that has meant issuing money to failed firms. This
practice increases the money supply and contributes to continuing inflation. Most
transition economies experienced high inflation in the initial transition years, but
were subsequently able to reduce it.

Ideology
Soviet citizens, and their counterparts in other command socialist economies, were
told for decades that market capitalism is an evil institution, that it fosters greed
and human misery. They were told that some people become rich in the system,
but that they do so only at the expense of others who become poorer.

In the context of a competitive market, this view of market processes as a zero-sum

game—one in which the gains for one person come only as a result of losses for
another—is wrong. In market transactions, one person gains only by making others
better off. But the zero-sum view runs deep, and it is a source of lingering hostility
toward market forces.

Countries seeking to transform their economies from command socialist to more

market-oriented systems face daunting challenges. Given these challenges, it is
remarkable that they have persisted in the effort. There are a thousand reasons for
economic reform to fail, but the reform effort has, in general, continued to move
forward.

China: A Gradual Transition

China is a giant by virtually any standard. Larger than the continental United
States, it is home to more than 1.3 billion people—more than one-fifth of the
earth’s population. Although China is poor, its economy has been among the
fastest growing in the world since 1980. That rapid growth is the result of a gradual
shift toward a market capitalist economy. The Chinese have pursued their
transition in a manner quite different from the paths taken by former Soviet bloc
nations.

Recent History
China was invaded by Japan during World War II. After Japan’s defeat, civil war
broke out between Chinese communists, led by Mao Zedong, and nationalists. The
communists prevailed, and the People’s Republic of China was proclaimed in
1949.

Mao set about immediately to create a socialist state in China. He nationalized

many firms and redistributed land to peasants. Many of those who had owned land
under the old regime were executed. China’s entry into the Korean War in 1950 led
to much closer ties to the Soviet Union, which helped China to establish a
command socialist economy.
China’s first five-year plan, launched in 1953, followed the tradition of Soviet
economic development. It stressed capital-intensive production and the
development of heavy industry. But China had far less capital and a great many
more people than did the Soviet Union. Capital-intensive development made little
sense. In 1958, Mao declared a uniquely Chinese approach to development, which
he dubbed the Great Leap Forward. It focused on labor-intensive development and
the organization of small productive units to quickly turn China into an
industrialized country. Indeed, households were encouraged to form their own
productive units under the slogan “An iron and steel foundry in every backyard.”
The Great Leap repudiated the bonuses and other material incentives stressed by
the Soviets; motivation was to come from revolutionary zeal, not self-interest.

In agriculture, the new plan placed greater emphasis on collectivization. Farmers

were organized into communes containing several thousand households each.
Small private plots of land, which had been permitted earlier, were abolished.
China’s adoption of the plan was a victory for radical leaders in the government.

The Great Leap was an economic disaster. Output plunged and a large-scale
famine ensued. Moderate leaders then took over, and the economy got back to its
1957 level of output by the mid-1960s.

Then, again in the mid-1960s, power shifted back towards the radicals with the
launching of the Great Proletarian Cultural Revolution. During that time, students
formed groups called “red guards” and were encouraged to expose “capitalist
roaders.” A group dubbed the “Gang of Four,” led by Mao’s wife Jiang Qing, tried
to steer Chinese society towards an ever more revolutionary course until Mao’s
death in 1976.

China’s Reforms
Following Mao’s death, pragmatists within the Communist Party, led by Deng
Xiaoping, embarked on a course of reform that promoted a more market-oriented
economy coupled with retention of political power by the Communists. This policy
combination was challenged in 1989 by a large demonstration in Beijing’s
Tiananmen Square. The authorities ordered the military to remove the
demonstrators, resulting in the deaths of several hundred civilians. A period of
retrenchment in the reform process followed and lasted for several years. Then, in
1992, Deng ushered in a period of reinvigorated economic reform in a highly
publicized trip to southern China, where reforms had progressed farther. Through
several leadership changes since then, the path of economic reform, managed by
the Communist Party, has continued. The result has been a decades-long period of
phenomenal economic growth.

What were some of the major elements of the economic reform? Beginning in
1979, many Chinese provincial leaders instituted a system called bao gan dao hu
—“contracting all decisions to the household.” Under the system, provincial
officials contracted the responsibility for operating collectively owned farmland to
individual households. Government officials gave households production quotas
they were required to meet and purchased that output at prices set by central
planners. But farmers were free to sell any additional output they could produce at
whatever prices they could get in the marketplace and to keep the profits for
themselves.

By 1984, 93% of China’s agricultural land had been contracted to individual

households and the rate of growth in agricultural output had soared.

At the industrial level, state-owned enterprises (SOEs) were told to meet their
quotas and then were free to engage in additional production for sale in free
markets. Over time, even those production directives were discontinued. More
importantly, manufacturing boomed with the development of township and village
enterprises, as well as various types of private endeavors, with much participation
from foreign firms. Most price controls were abolished. The entry of China into the
World Trade Organization in 2001 symbolized a commitment towards moving
even further down the road of economic reform.

In effect, China’s economy is increasingly directed by market forces. Even though

five-year plans are still announced, they are largely advisory rather than
commanding in nature. Recognizing the incomplete nature of the reforms, Chinese
authorities continue to work on making the SOEs more competitive, as well as
privatizing them, creating a social security system in which social benefits are not
tied to a worker’s place of employment, and reforming the banking sector.

How well has the gradual approach to transition worked? Between 1980 and 2006,
China had one of the fastest-growing economies in the world. Its per capita output,
measured in dollars of constant purchasing power, more than quadrupled. The
country, which as late as 1997 was one of the poorest of the 59 low-income-
countries in the world, is now situated comfortably among the more prosperous
lower-middle-income countries, according to the World Bank. Figure 34.6
“Soaring Output in China” compares growth rates in China to those achieved by
Japan and the United States and to the average annual growth rate of all world
economies between 1985 and 2006.
 Figure 34.6 Soaring Output in China

China’s growth in per capita output from 1985 to 2006 greatly exceeded rates recorded for Japan, the United States, or the
average of all nations.
Source: World Bank, World Development Reports, 1997, 1998, 2004, 2005, 2006 Table 1.

Where will China’s reforms lead? While the Chinese leadership has continued to
be repressive politically, it has generally supported the reform process. The result
has been continued expansion of the free economy and a relative shrinking of the
state-run sector. Given the rapid progress China has achieved with its gradual
approach to reform, it is hard to imagine that the country would reverse course.
Given the course it is on, China seems likely to become a market capitalist
economy—and a prosperous one—within a few decades.

Russia: An Uncertain Path to Reform

Russia dominated the former Soviet Union. It contained more than half the Soviet
people and more than three-fourths of the nation’s land area. Russia’s capital,
Moscow, was the capital and center of power for the entire country.

Today, Russia retains control over the bulk of the military power that had been
accumulated by the former Soviet Union. While it is now an ally of the United
States, Russia still possesses the nuclear capability to destroy life on earth. Its
success in making the transition to market capitalism and joining as a full partner
in the world community thus has special significance for peace.

Recent History
Russia’s shift toward market capitalism has its roots in a reform process initiated
during the final years of the existence of the Soviet Union. That effort presaged
many of the difficulties that have continued to plague Russia.

The Soviet Union, as we have already seen, had a well-established system of

command socialism. Leading Soviet economists, however, began arguing as early
as the 1970s that the old system could never deliver living standards comparable to
those achieved in market capitalist economies. The first political leader to embrace
the idea of radical reform was Mikhail Gorbachev, who became General Secretary
of the Communist party—the highest leadership post in the Soviet Union—in
1985.

Mr. Gorbachev instituted political reforms that allowed Soviet citizens to speak
out, and even to demonstrate, against their government. This policy was
dubbed glasnost, or “openness.” Economically, he called for much greater
autonomy for state enterprises and a system in which workers’ wages would be
tied to productivity. The new policy, dubbed perestroika, or “restructuring,”
appeared to be an effort to move the system toward a mixed economy.

But Mr. Gorbachev’s economic advisers wanted to go much further. A small group
of economists, which included his top economic adviser, met in August 1990 to
draft a radical plan to transform the economy to a market capitalist system—and to
do it in 500 days. Stanislav Shatalin, a Soviet economist, led the group. Mr.
Gorbachev endorsed the Shatalin plan the following month, and it appeared that
the Soviet Union was on its way to a new system. The new plan, however,
threatened the Soviet power elite. It called for sharply reduced funding for the
military and for the Soviet Union’s secret police force, the KGB. It would have
stripped central planners, who were very powerful, of their authority. The new plan
called for nothing less than the destruction of the old system—and the elimination
of the power base of most government officials.

Top Soviet bureaucrats and military leaders reacted to the Shatalin plan with
predictable rage. They delivered an ultimatum to Mr. Gorbachev: dump the
Shatalin plan or be kicked out.

Caught between advisers who had persuaded him of the necessity for radical
reform and Communist party leaders who would have none of it, Mr. Gorbachev
chose to leave the command system in place and to seek modest reforms. He
announced a new plan that retained control over most prices and he left in place the
state’s ownership of enterprises. In an effort to deal with shortages of other goods,
he ordered sharp price increases early in 1991.
These measures, however, accomplished little. Black market prices for basic
consumer goods were typically 10 to 20 times the level of state prices. Those
prices, which respond to demand and supply, may be taken as a rough gauge of
equilibrium prices. People were willing to pay the higher black market prices
because they simply could not find goods at the state-decreed prices. Mr.
Gorbachev’s order to double and even triple some state prices narrowed the gap
between official and equilibrium prices, but did not close it. Table 34.1 “Official
Versus Black Market Prices in the Soviet Union, 1991” shows some of the price
changes imposed and compares them to black market prices.
Table 34.1 Official Versus Black Market Prices in the Soviet Union, 1991

Item Old price New price Black market price

Children’s
2–10 rubles 10–50 rubles 50–300 rubles
shoes

Toilet paper 32–40 kopeks 60–75 kopeks 2–3 rubles

Compact car 7,000 rubles 35,000 rubles 70,000–100,000 rubles

Bottle of vodka 10.5 rubles 10.5 rubles 30–35 rubles

Mikhail Gorbachev ordered sharp increases in the prices of most consumer goods early in 1991 in an
effort to eliminate shortages. As the table shows, however, a large gap remained between official and
black market prices.
Source: Komsomolskaya pravda

Perhaps the most important problem for Mr. Gorbachev’s price hikes was that
there was no reason for state-owned firms to respond to them by increasing their
output. The managers and workers in these firms, after all, were government
employees receiving government-determined salaries. There was no mechanism
through which they would gain from higher prices. A private firm could be
expected to increase its quantity supplied in response to a higher price. State-
owned firms did not.

The Soviet people faced the worst of economic worlds in 1991. Soviet output
plunged sharply, prices were up dramatically, and there was no relief from severe
shortages. A small group of government officials opposed to economic reform
staged a coup in the fall of 1991, putting Mr. Gorbachev under house arrest. The
coup produced massive protests throughout the country and failed within a few
days. Chaos within the central government created an opportunity for the republics
of the Soviet Union to declare their independence, and they did. These defections
resulted in the collapse of the Soviet Union late in 1991, with Russia as one of 15
countries that emerged.

The Reform Effort

Boris Yeltsin, the first elected president of Russia, had been a leading proponent of
market capitalism even before the Soviet Union collapsed. He had supported the
Shatalin plan and had been sharply critical of Mr. Gorbachev’s failure to
implement it. Once Russia became an independent republic, Mr. Yeltsin sought a
rapid transition to market capitalism.

Mr. Yeltsin’s reform efforts, however, were slowed by Russian legislators, most of
them former Communist officials who were appointed to their posts under the old
regime. They fought reform and repeatedly sought to impeach Mr. Yeltsin. Citing
health reasons, he abruptly resigned from the presidency in 1999, and appointed
Vladimir Putin, who had only recently been appointed as Yeltsin’s prime minister,
as acting president. Mr. Putin has since been elected and re-elected, though many
observers have questioned the fairness of those elections as well as Mr. Putin’s
commitment to democracy. Barred constitutionally from re-election in 2008, Putin
became prime minister. Dimitry Medvedev, Putin’s close ally, became president.

Despite the hurdles, Russian reformers have accomplished a great deal. Prices of
most goods have been freed from state controls. Most state-owned firms have been
privatized, and most of Russia’s output of goods and services is now produced by
the private sector.

To privatize state firms, Russian citizens were issued vouchers that could be used
to purchase state enterprises. Under this plan, state enterprises were auctioned off.
Individuals, or groups of individuals, could use their vouchers to bid on them. By
1995 most state enterprises in Russia had been privatized.
While Russia has taken major steps toward transforming itself into a market
economy, it has not been able to institute its reforms in a coherent manner. For
example, despite privatization, restructuring of Russian firms to increase efficiency
has been slow. Establishment and enforcement of rules and laws that undergird
modern, market-based systems have been lacking in Russia. Corruption has
become endemic.

While the quality of the data is suspect, there is no doubt that output and the
standard of living fell through the first half of the 1990s. Despite a financial crisis
in 1998, when the Russian government defaulted on its debt, output recovered
through the last half of the 1990s and Russia has seen substantial growth in the
early years of the twenty-first century. In addition, government finances have
improved following a major tax reform and inflation has come down from near
hyperinflation levels. Despite these gains, there is uneasiness about the long-term
sustainability of this progress because of the over-importance of oil and high oil
prices in the recovery. Mr. Putin’s fight, whether justified or not, with several of
Russia’s so-called oligarchs, a small group of people who were able to amass large
fortunes during the early years of privatization, creates unease for domestic and
foreign investors.

To be fair, overcoming the legacy of the Soviet Union would have been difficult at
best. Overall, though, most would argue that Russian transition policies have made
a difficult situation worse. Why has the transition in Russia been so difficult? One
reason may be that Russians lived with command socialism longer than did any
other country. In addition, Russia had no historical experience with market
capitalism. In countries that did have it, such as the Czech Republic, the switch
back to capitalism has gone far more smoothly and has met with far more success.
Try It!
Table 34.1 “Official Versus Black Market Prices in the Soviet Union, 1991” shows three
prices for various goods in the Soviet Union in 1991. Illustrate the market for compact cars
using a demand and supply diagram. On your diagram, show the old price, the new price,
and the black market price.

Case in Point: Eastern Germany’s Surprisingly Difficult Transition Experience

Figure 34.7
Gavin Stewart – The fall of the Berlin Wall – CC BY 2.0.

The transition of eastern Germany was supposed to be the easiest of them all. Quickly
merged with western Germany, given its new “Big Brother’s” deep pockets, the ease with
which it could simply adopt the rules and laws and policies of western Germany, and its
automatic entry into the European Union, how could it not do well? And yet, eastern
Germany seems to be languishing while some other central European countries that had also
been part of the Soviet bloc are doing much better. Specifically, growth in real GDP in
eastern Germany was 6% to 8% in the early 1990s, but since then has mostly been around
1%, with three years of negative growth in the early 2000s. In the early 1990s, the Polish
economy grew at less than half east Germany’s rate, but since then has averaged more than
4% per year. Why the reversal of fortunes?

Most observers point to the quick rise of wages to western German levels, despite the low
productivity in the east. Initially, Germans from both east and west supported the move. East
Germans obviously liked the idea of huge wage increases while west German workers
thought that prolonged low wages in the eastern part of the country would cause companies
to relocate there and saw the higher east German wages as protecting their own jobs. While
the German government offered subsidies and tax breaks to firms that would move to the
east despite the high wages, companies were by and large still reluctant to move their
factories there. Instead they chose to relocate in other central European countries, such as the
Czech Republic, Slovakia, and Poland. As a result, unemployment in eastern Germany has
remained stubbornly high at about 15% and transfer payments to east Germans have totaled
$1.65 trillion with no end in sight. “East Germany had the wrong prices: Labor was too
expensive, and capital was too cheap,” commented Klaus Deutsch, an economist at Deutsche
Bank.
While the flow of labor has primarily been from Poland to Germany since the break-up of
the Soviet bloc, with mostly senior managers moving from Germany to Poland, there are
some less-skilled, unemployed east Germans who are starting to look for jobs in Poland.
Tassilo Schlicht is an east German who repaired bicycles and washing machines at a Soviet-
era factory and lost his job in 1990. He then worked for a short time at a gas station in his
town for no pay with the hope that the experience would be helpful, but he was never hired.
He undertook some government-sponsored retraining but still could not find a job. Finally,
he was hired at a gas station across the border in Poland. The pay is far less than what
employed Germans make for doing similar jobs but it is twice what he had been receiving in
unemployment benefits. “These days, a job is a job, wherever it is.”
Sources: Marcus Walker and Matthew Karnitschnig, “Eastern Europe Eclipses Eastern
Germany,” Wall Street Journal, November 9, 2004, p. A16; Keven J. O’Brien, “For Jobs,
Some Germans Look to Poland,” New York Times, January 8, 2004, p. W1; Doug Saunders,
“What’s the Matter with Eastern Germany?” The Globe and Mail (Canada), November 27,
2007, p. F3.
Try It!
There is a shortage of cars at both the old price of 7,000 rubles and at the new price of
35,000, although the shortage is less at the new price. Equilibrium price is assumed to be
70,000 rubles.
Figure 34.8
Political and economic context
Russia’s interventions in Ukraine and illegal annexation of Crimea in
2014, the chemical attack in Salisbury in 2018, and the use of a
chemical weapon on Russian territory in 2020, pose a challenging
backdrop for British businesses operating in Russia. There are
limitations on pursuing some activities in Russia but legitimate business
can continue and UK exports remain robust in both goods and services.

The Department for International Trade (DIT) (formerly known as UK

Trade & Investment) continues to support British companies in the
market with a range of services including targeted events, sector-specific
advice, market introductions and trade missions.
Russia is the world’s 11th largest economy by GDP according to the IMF
´s estimates for 2020. The economy declined by a relatively modest
3.1% in 2020 thanks in part to lighter-touch COVID-19 restrictions.
However, the outlook remains subdued due to sanctions and structural
constraints. Macroeconomic policy continues to prioritise stability;
government debt remains low, even after the pandemic, and inflation is
low and stable. The IMF predicts growth to be 3.0% in 2021 and return
to pre-crisis levels by 2022. A $400bn government spending programme,
the ‘National Projects’, could push growth higher and presents
opportunities for businesses in areas like infrastructure, financial
services, healthcare and education.

Although Russia has the smallest population of the BRIC economies, it

is the wealthiest in per capita terms by a considerable margin. This
means that it has a relatively large middle class, though recent low
growth has suppressed their real incomes. Consumers nonetheless seek
quality and innovation within a growing retail sector.

Russia’s domestic supply of consumer goods and services is still

underdeveloped – so there are opportunities to develop new business
e.g. e-commerce. Growth is currently sector-specific e.g. mining,
hydrocarbons and agriculture.

Heightened political tensions and the Russian government’s focus on

import substitution have made some companies more wary of buying
foreign goods and services. However, Russians understand that British
exports provide some of the highest quality, most innovative goods and
services available. Significant opportunities remain in, for example,
consumer goods, luxury, education and machine tools.

Russia’s investment climate is mixed. It reached 28th position in

the World Bank’s Doing Business rating in 2020; it currently ranks higher
than China, India and Brazil. However, there are concerns about the rule
of law, transparency and access to credit. These concerns pose
challenges for domestic and international investment but major Western
companies continue to have a large presence in Russia in a range of
sectors including energy, finance, business services, consumer goods,
automobile and engineering. Despite the sanctions and the economic
downturn, a number of companies are continuing to invest.
In 2011, Russia, Kazakhstan and Belarus entered into a Customs Union.
In 2015 the union evolved into the Eurasian Economic Union, which
consists of a Customs Union and a Single Economic Space. Armenia
and Kyrgyzstan has since joined the Union. The organisation is still
developing, but regulation of various different sectors and technical
regulations are now being set centrally by the Eurasian Economic
Commission. The Eurasian Economic Union’s ultimate ambition is for
free movement of goods, services, capital and labour

EU sanctions
The UK government and our international partners, including the EU,
have introduced sanctions against Russia’s interventions in Ukraine and
the illegal annexation of Crimea. These sanctions mean that trade and
investment with Russia in specific targeted areas and/or with specific
entities/individuals is illegal.

We are working hard to secure full implementation of the Minsk

Agreements and work with our international partners to ensure future
stability and prosperity in the region. To achieve these objectives we will
use the full range of our diplomatic channels and keep our overall
engagement with Russia under constant review.

Information about the restrictive measures that have been implemented

can be found on the GOV.UK site. If in doubt, businesses should consult
the Business Support helplines. UK businesses should be mindful of the
potential risks and challenges of working in a sanctions environment.
Business should continue to pay close attention to the Russia sections of
the DIT and FCDO.
Companies may also need to be aware of sanctions regimes imposed by
other countries, for example, the US.
The EU’s restrictive measures are targeted, so legitimate business may
continue where sanctions do not apply. Companies should consult the
information about sanctions on the GOV.UK site and if in doubt
contact DIT Russia who can share contact details for Moscow based law
firms familiar with the sanctions regime.

It is important that companies research sanctions thoroughly and take

advantage of the advice offered by DIT. We expect UK companies to
stay strictly within the law.

Human rights
Russia is a country of concern for human rights issues. See the FCDO
Annual Human Rights Report on Russia for more details.

Bribery and corruption

Bribery is illegal. It is an offence for British nationals or someone who is
ordinarily resident in the UK, a body incorporated in the UK or a Scottish
partnership, to bribe anywhere in the world. In addition, a commercial
organisation carrying on a business in the UK can be liable for the
conduct of a person who is neither a UK national or resident in the UK or
a body incorporated or formed in the UK. In this case it does not matter
whether the acts or omissions which form part of the offence take place
in the UK or elsewhere.

Corruption is endemic in Russia and is a major concern for businesses

operating there.The Russian government continues to state its
commitment to reducing corruption and other damaging informal
practices but they remain a challenge in practice. Russia fell
in Transparency International’s Corruption Perceptions Index in 2018 to
138 out of 180 countries.
Visit the Business Anti-Corruption portal which provides advice and
guidance about corruption in Russia.
Read the information provided on our Bribery and corruption page.
Terrorism threat
There is a high threat from terrorism. Although there is no indication that
British nationals or interests have been specific targets, attacks could be
indiscriminate, including in places frequented by foreigners. You should
remain vigilant in all public places, including tourist sites and crowded
places, particularly where access is not controlled (eg open-air events
and markets) and in major transport hubs.

Previous attacks have targeted transport infrastructure, including

airports, buses, trains and metro systems. Further attacks are likely, and
could take place anywhere in Russia.

See the FCDO travel advice.

Read the information provided on our terrorism threat page.
6. Protective security advice
There are protective security issues attached to doing business in
Russia; business people need to be conscious of the following activities
of the local security service (FSB):

 IT attack against office computers, laptops, PDAs and other

electronic devices
 physical, audio and video surveillance
 approaches to staff
 interception of telephone calls (landline and mobile), texts,
emails, fax and post
 searches of offices, homes, vehicles and (especially) hotel
rooms (including safes)
For specific advice email MoscowBusinessSecurity@fcdo.gov.uk
Read the information provided on our protective security advice page.
Intellectual property
IP rights are territorial, that is they only give protection in the countries
where they are granted or registered. If you are thinking about trading
internationally, then you should consider registering your IP rights in your
export markets.

Read the information provided on our Intellectual Property page.

Organised crime
Read the information provided on our organised crime page.

Department for International Trade

contact
Contact us on tradeinvestmentmoscow@fcdo.gov.uk