Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 1 - Evidence - March 13, 2001
OTTAWA, Tuesday, March 13, 2001
The Standing Senate Committee on Foreign Affairs met this day at 6:00 p.m. to examine and report on emerging political, social, economic and security developments in Russia and Ukraine; Canada's policy and interests in the region; and other related matters.
Senator Peter A. Stollery (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, I want to deal with one agenda item before we hear from our witness, Professor Vladimir Popov. The steering committee has discussed our need to hold some full-day meetings on Mondays. You will get notices, but I wanted to bring this to your attention. We are looking at Monday, April 30. This is because of the same problem that we faced today and our need to get going on this study. I am giving committee members plenty of notice and everyone will be informed. We will take a full day and try to pick up the speed.
Professor Popov has been very patient. He has been waiting for more than an hour.
Professor, this is the first meeting of this committee in this session and on this very important subject. We will be spending some months on it.
Professor Vladimir Popov, Institute of European and Russian Studies, Carleton University: Honourable senators, I would like to use my time to give you a general picture and then, if you have questions about any details, I will do my best to answer them.
I want to make sure you understand that my area of expertise is basically in economics. I am watching economies in transition, the Russian economy included. However, I would be prepared to answer any other questions if I can.
The general picture is such that there was a dramatic decline in output. There was something called a "transformational recession" in the 1990s, which was a nearly decade-long decline in output. That decline is unprecedented. There is no other case in economic history of such a dramatic decline in output, except in the face of extreme or unusual circumstances, such as war or earthquakes. In peacetime history, there has never been such a decline in output. The decline was greater than that of the Great Depression in the 1930s.
Basically, output fell in Russia until 1998. I have provided a graph which shows that in the last two years output was growing, but at the lowest point, output was only 55 per cent of what it used to be before the recession began in 1989, before the reforms were carried out.
In Ukraine, the situation is even worse. At the lowest point, Ukraine output fell to 35 per cent of what it used to be before the recession.
Of course, the magic question is why were these countries doing so poorly? Why was economic performance so bad? In recent years, there has been some improvement and some economic growth in both countries, but that growth was very insignificant compared to the decline that occurred.
Conventional wisdom held that the reason for the poor economic performance was associated with the degree of liberalization. Conventional wisdom held that if countries liberalize and are fast reformers, then they are supposed to perform better than others. The basic example, of course, was of Eastern European countries and especially Central European countries versus former Soviet republics and especially countries of the CIS, the Commonwealth of Independent States.
Conventional wisdom said that East European countries proceeded with radical reforms, or shock therapy treatment, and that they were doing better than virtually all former Soviet republics.
Currently, conventional wisdom is changing because quite a number of examples no longer fit into that scheme. China does not fit into the scheme. The degree of liberalization in China is about the same as in Russia. Different indices were developed to measure the extent to which economic life was liberalized during reforms. Vietnam also does not fit the scheme.
Speaking about the post-Soviet space, I have provided a comparison between Central European countries and others. Out of the 15 former Soviet republics that are now independent states, which republics have done better than the others? The number-one performer is Uzbekistan. The number two performer is Belarus; the third line is for Belarus. The number three performer is Estonia. They are pretty much at the same level. Number four is Turkmenistan.
Turkmenistan, Belarus and Uzbekistan are famous for being authoritarian and for being poor reformers. They are not reforming rapidly. They are procrastinators, but they are showing very good results that are either better or as good as Estonian results.
To summarize the new conventional wisdom, then, it is moving in a direction called post-Washington consensus, instead of the Washington consensus which existed previously. Conventional wisdom is shifting toward stressing the importance of factors other than the speed of reform. The pace of liberalization was not the major factor in performance after all. To put it in very strong terms, it was something like 5 per cent of the story or 5 per cent of the factors that influenced performance, whether an economy liberalized quickly or slowly.
There were at least three more-important factors. The first one was initial conditions: To what extent was the economy distorted? To what extent was the military sector larger than in other countries? Those resources have to be converted to non-defence production. To what extent was industry in the country over- industrialized? Did the country's industry have a high share in GDP? Was the service sector small, thus requiring a reallocation of resources from the industrial sector to services? To what extent was trade distorted? All these things are measurable.
What part of trade was with former Soviet republics? Pricing in former Soviet republics had nothing to do with international prices. Once trade was switched to international prices, of course, trade pools were reshaped, and that switch became a reason for reduction of output.
That is the first reason for reduction of output -- initial conditions. One can explain quite a lot by looking at the initial conditions.
Another reason for reduction of output is associated with the strength of the institutions. The strength of the institutions, being state institutions, is defined as the ability of the state to enforce rules and regulations. No matter whether the rules and regulations are good or bad -- such as the state being able to collect taxes, for example, in a shared economy -- an indicator of the strength of the state would be if the state is able to enforce the rules and regulations. The state must be able to enforce the rules and regulations that it makes.
The ability of the states to enforce their rules and regulations was very different. In China and in Central European countries, that ability was pretty strong. What about former Soviet countries? Belarus has an authoritarian regime. In Uzbekistan and Turkmenistan, the strength of institutions is at a pretty high level, as measured by the shadow economy, by the share of the shadow economy and how it increased; as measured by the crime rate; as measured by various indicators. For example, the share of government spending in GDP did not decrease as much as it did in other former Soviet Union countries like Estonia and Central European countries.
That is the alternative explanation of the Estonian success. Not only was Estonia a fast liberalizer, but Estonia was also one of two countries in the former Soviet Union where the share of government spending in GDP did not go down. That is not to say that countries should have a high or low share of government spending in GDP. The argument is different. The argument is that if in the course of five years the share of government spending goes from 50 per cent to, say, 30 per cent of GDP and if GDP fell by 50 per cent, the state administration will virtually collapse.That did not happen.
Comparisons of countries like Belarus, Ukraine and Russia reveal that distortions were pretty high in Belarus and Ukraine but not so high in Russia. Why? Because Russia has resources.
Russia has commodities that can be exported and sold in the world market. Belarus and Ukraine do not have such resources. However, if one measures institutional capacities, then the comparison would show that Belarus had greater institutional capacity. If one looks at the share of the shared economy, in Belarus it is much lower than in either Ukraine or Russia.
Ukraine had poor institutions as well as Russia, but Russia had some resources; Ukraine did not. As a result, the Ukraine economy did worse than any other economy in the former Soviet Union not engaged in military conflict. All the countries that did worse than Ukraine were engaged in military conflicts, such as Moldova, Georgia and Armenia. Azerbaijan, which was also engaged in a military conflict with Armenia, did better than Ukraine. This is a general picture.
I will describe for you the recent events in Russia. By "recent," I mean when President Putin came to power. He became President on March 26, but he had been Acting President since March 26 of last year. Soon it will be a year that he has been in power. Before that, he was Prime Minister. Basically, he has been in power for one and one-half years.
In that time, the economy has done surprisingly well. If you remember, there was a big currency crisis in Russia in August 1998 and the ruble collapsed. Previously, the exchange rate was six rubles to one dollar. It went to 25, nearly 30 rubles to one dollar in the period of one month after the August 1998 crisis.
The big difference between the Russian crisis and the crisis in Southeast Asia, for instance, was that in East Asian countries output fell after the crisis. In Russia, it fell before the crisis. Right after the crisis, the economy started to do very well.
The crisis occurred in August. I am now pointing to September on the screen. After that point, output started to grow. Last year the GDP increased by 7.5 per cent. This was incredible growth, the fastest growth in the Russian economy since the 1950s. The year before, in 1999, the GDP increased by 3.2 per cent.
In Ukraine, the picture was pretty much the same. Output increased in 2000 by 6 per cent.
It is important to realize that output was increasing not because of government policies, but despite government policies. Why? The policy of the government and of the central bank, which is formally independent in Russia, was to keep the ruble stable as long as possible. Hence, devaluation occurred despite government efforts and became the major reason for such a dramatic increase in output.
The economic policy of the government in those years was to sit still so as not to scare away economic growth. The government should be given some credit for not destroying economic growth. As they say in Latin America, the economy grows at night when the government is asleep. Actually, the current government should be given credit for not destroying economic growth because the previous government destroyed economic growth, which was barely starting. I can go deeper into that issue if you are interested, since economics is my area.
There are two things I still wish to discuss. The first is that this slide shows economic growth; this shows industrial output. The last month here is January 2001. The thick line is seasonally adjusted industrial output. You can see that it started to increase after the crisis. Currently, this economic growth is coming to an end. Therefore, the trends of the recent two or three months are not that favourable. Inflation may be on the rise and output may have stopped growing because the period of increase in output triggered by devaluation is coming to an end. There is an increase in the real exchange rate of the ruble, which is undermining Russian exports.
Here is the real exchange rate of the ruble. It is a pretty old chart, but because the nominal exchange rate is stable, if inflation continues, the real exchange rate starts to go up, which undermines the Russian competitive advantages.
Second, Mr. Putin, the current Russian President, tried to do several things. There were no major changes in economic policy. The whole program was discussed, but basically there were no tangible measures.
There were tangible measures in other areas. There is a war in Chechnya, and Putin's popularity is based on his tough position on Chechnya. It is important to recognize that, at 62 per cent, his popularity is very high. It has decreased a little from the time he was elected President.
There has not been any progress on the war in Chechnya. Russia loses about four to five soldiers every day, which is about 20 soldiers a week or 100 soldiers a month. There are more and more reports about corruption, abuses and atrocities in Chechnya against civilians and so on. This is where Mr. Putin has not been able to make major progress, though his initial support was mostly based on his position regarding Chechnya.
Mr. Putin was also waging a war against the financial tycoons in Russia, known as the oligarchs, who allegedly had great influence during the last days and years when Mr. Yeltsin was in power. Several oligarchs were expelled from or were pushed out of the country. One of them is under house arrest and currently has moved to a jail in Spain. Another is in Paris. However, there are others who are influencing the government, although not perhaps in such an apparent way. In this area, Mr. Putin's success may be only partial.
There is another war on the regions. There is a general agreement that Russia went through a period of decentralization with respect to the regions. Russia is a federation of 89 regions, each with the same powers. Here, Mr. Putin's success is also mixed. He was able to put through Parliament laws allowing him to dismiss the governors of the regions. He can dismiss them right away, but the issue has to go through the courts. He is supposed to accuse them of violating laws. If they are breaking laws, the issue should go to the courts.
Although he has this right, Mr. Putin has never used it. The government is not sure if it can push the whole thing through the court system, since the court system is independent.
Recently, Mr. Putin reached a deal with one of the maverick governors in the far east of the country. The federal authorities opposed the governor for years but were not able to remove him from power because he had the strong support of the electorate in his province. Mr. Putin reached a deal with him, but it was a deal. It was not as if Putin removed him; the governor was given another post in the federal government. He became the head of the commission on fisheries.
Comparing the strength of the federal government versus the regions, there is apparently some strengthening of the federal government, which most people in Russia would support. However, the successes are also mixed.
The other war that Mr. Putin is waging is the war against the independent media. You may have noticed in the news details about an independent TV company owned by one of the oligarchs who is currently in Spain. It televises the only national TV program that is very critical of the government, the only one not controlled by the government. The program is still on the air. There is a financial dispute. Mr. Putin has said more than once that he will not interfere in the way the company covers the developments, that this is only a financial dispute.
The government-owned company, a gas monopoly called Gazprom, has 46 per cent of the shares of the media company, which is called Media-MOST. The controlling stake belongs to Mr. Vladimir Gusinsky, not the government. However, the government gas monopoly issued a credit to the media company, which was not returned. When this credit was issued, 90 per cent of the shares were used as collateral for the credit.
The issue is going through the courts, and one of the courts in Moscow recently ruled that these 90 per cent of the shares may be appropriated by Gazprom, but Gazprom cannot use them yet for voting. This conflict continues, and here there was no major success.
The Chairman: My question concerns the first part of your presentation. I though that the "stan" states have done better than Russia and Ukraine. Were you making the argument that the states where the authority did not break down have done better?
Mr. Popov: It is not a straightforward argument. Those states that did not go through the weakening of the institutional capacity as measured by the shared economy, by the share of government spending in GDP, or by the increase in the prime rate and indicators like that, and those states where institutions did not collapse to the same extent that institutions deteriorated in other countries, did better.
Among those states there are two groups of states. One of them is our democratic states. Estonia, in the former Soviet Union, is one of them, and that is probably the only one.
In central European countries, the share of government spending in GDP did not decline. I happen to have the chart that shows the share of government spending in GDP. This upper line is for the central European countries during the transition from 1989 to 1996. This was the only group of states in transition where the share of government spending in GDP did not decline. People usually do not realize, although not the specialists, that this was the case. In Estonia, there was no decline.
In China, for instance, in the first years of transition, there was no decline. In Russia and in the Caucasian states -- virtually in all other former Soviet republics, with the exception of Belarus and Uzbekistan -- there was a dramatic decline in the share of government spending in GDP. Belarus and Uzbekistan would be authoritarian regimes. Those authoritarian regimes managed to preserve the institutional capacity of the state in a different way. They just did not dismantle the old system. The east European countries moved from strong authoritarian regimes to strong democratic regimes. Uzbekistan moved from a strong authoritarian regime based on communist ideology to a strong authoritarian regime that is not based on communist ideology. It is pretty much like Belarus.
In Russia and Ukraine, when the Communist Party, which was the substitute for the state in those countries, collapsed and was banned for some time, we saw the collapse of the state. This led to a tremendous decrease in the institutional capacity of the state.
Was it possible to do things in a different way? Perhaps so, but that is the actual story.
The Chairman: I find that very interesting.
Senator Bolduc: What would you suggest in terms of structural reform that could help economic growth, for example, but not only economic growth? There is a registration of titles and property rules in our market economy system. We have contract law. We have a bankruptcy system. We have an independent judiciary. We have a stock exchange. In other words, we have many institutions. That system is tied together by the fact that people are familiar with and they trust the system. Most of the time people work within the system.
Speaking of Russia, we know that there is a huge problem with corruption. There is a problem of capital going elsewhere. You are an economist, but at the same time, in a political economy, we must look at the structural aspects. How do you see the future unfolding? What should Mr. Putin do?
Mr. Popov: That is the big question. I should start by saying that all of these institutions are there. Several stock exchanges were created in Russia 10 years ago. Stocks are currently traded. There are contracts. There are laws about all kinds of things that one might imagine. There are pretty much the same laws. The laws may not yet be well developed, but they are there.
Much has been done in those 10 years. There are contract laws and bankruptcy laws. One problem is that the laws are not enforced. Another problem is that regional authorities basically captured the institution of bankruptcy.
Senator Bolduc: Are the authorities not elected?
Mr. Popov: They are elected. There are elections in every one of the 89 regions of the Russian Federation. Even in Chechnya, elections were held in 1989. The government sometimes has a problem with the elected authorities a region because they do not listen to what the federal government says. They are violating federal laws and the federal government is not able to deal with that problem.
Everyone in Russia and probably in Ukraine realizes that the process of institution building must proceed. This is not an area where one can achieve great results tomorrow. This is slow work, not work that can be credited to politicians and not work for which there is an immediate outcome. This is happening in Russia.
If your question is what can one do in order to stimulate economic growth right away, I would say that one needs to proceed with measures in the area of market economic policy and industrial policy. It is important to realize that we cannot do anything about institutions immediately or tomorrow. That is slow work. Growth depends on the proportion of investment in GDP. Increasing the proportion of investment in GDP would result in increased economic growth. Investment can be increased in only two ways: stopping the flight of capital and increasing savings. Currently, savings are up in Russia. However, something like $20 billion of capital has left the country in recent years. Unlike all central European countries, Russia must keep a current account surplus. The trade surplus in Russia last year was $60 billion.
Senator Bolduc: Is that because of oil, natural gas and such things?
Mr. Popov: Previously there was also oil and natural gas, but there is no surplus because Russia keeps an undervalued exchange rate, which makes imports very unprofitable. This limits consumption. By limiting consumption, you can finance this capital flight.
Russia would prefer the status quo. The Communists, however, would suggest that Russia introduce tighter controls over the flight of capital. Those on the right would say that nothing can be done. They do not like the flight in capital, but it cannot be stopped by prohibition. The flight in capital from China is $60 billion a year, even though they shoot people who are involved in illegal currency operations, and even though the yuan is not convertible on capital accounts and on current accounts.
Basically, the measures are to boost investment and increase the share of savings. Let me give you one example. The government advertised its tax reform. The government lowered personal income tax, which was previously progressive. It was up to 35 per cent, which is not that progressive, because 35 per cent was the highest marginal tax rate. Now the government has introduced a flat tax rate. Russia is one of the few countries in the world to do this, and the rate is only 12 per cent. Whether a flat tax is good or not is another story.
The Russian story is that, previously, revenues collected from personal income tax were only 10 per cent of total revenues of the consolidated budget. The Russian system, like European systems, was heavily based on indirect taxes, value-added tax, and so on, so personal income tax is not an issue. One of the least important taxes is personal income tax. The number of people paying taxes at a rate higher than 12 per cent was so small that the proceeds from those people were something like 1 per cent of 10 per cent. A flat tax was the major measure of the Putin administration. Today, it stands as the measure that the government is most proud of with respect to reforming the tax system. There were also some minor measures, but the major hopes were pinned on this tax reform. I would argue that it is very unimportant.
What is important and what has been virtually untouched in recent years is that after the devaluation of the ruble in 1998 and after the oil prices started to increase in March 1999, the huge gap between domestic energy prices and international prices began to merge. Russian gasoline prices are something like 25 American cents a litre, and Russian oil prices are something like 20 per cent to 25 per cent of the world prices. The world prices are over $20 a barrel. Russia keeps export taxes, as Canada once did under the National Energy Program. Russia keeps quotas, or the proportion of oil that can be exported and the proportion of oil that every company should supply to the domestic market. With this energy policy, the energy intensity in the GDP was the highest in the world and was actually growing. European countries that had the same problem were gradually bringing their domestic prices in line with the international prices, and there was a decrease in the energy intensity of the GDP. In Russia, there was no decrease in the energy intensity. The energy intensity in Russia is probably two times higher than in North America, and in North America it is considerably higher than in European countries and in Japan.
The reasonable policy would be to increase those prices gradually, maybe by taxing oil companies so as to subsidize the energy consumers, replacing this by direct subsidies and gradually devaluing the ruble, because companies are facing increased costs in the form of rising oil and gas prices. Devaluing the ruble would create competitive advantages. Unfortunately, this was not the policy. I would say that this is the most important problem with respect to the immediate stimulus of economic growth.
Institution building is important, but it is not something that can yield immediate results or immediate dividends. Measures that can yield immediate dividends and can stimulate economic growth are associated with energy pricing, the exchange rate, macroeconomic policy and perhaps government investment. However, the government does not have the money for investment. You point to the example of eastern European countries saying that their government spending is very low as compared to GDP, but their government investments are very high as compared to GDP. They do not crowd out private investment on a one-to-one basis, even if they are financed through government borrowings. To trigger the process, one should increase government investment. Unfortunately, the Russian government does not have the money in its budget for that. This year will not be good for Russia in terms of economic growth.
Senator Bolduc: Immediately after the fall of the Berlin Wall, we saw a huge investment by the Germans, the Americans and others. They got burned by their investments, so their investment is actually less now. Do you see the possibility of protecting private investors in Russia?
Mr. Popov: Once again, I would like to divide the answer into two parts. The first part is to build the institutional foundations needed for that protection. The courts are instrumental in terms of guaranteeing contracts, the rights of property holders and so on. This is happening in Russia. It is slow, but it is happening. The process cannot be sped up, and everyone in Russia knows that. If you come to Russia saying that we should improve institutions, we have known that for 10 years. This work is ongoing. To have a perfect British lawn, you are supposed to cut your grass every day and do it for 200 years. This is what is happening currently in Russia. Institutions are being built.
There is a second part to the answer to your question. You say that Russia attracted a whole lot of foreign investment. Well, that is not exactly the case if you compare it to other countries. Overall, the total inflow of foreign direct investment into Russia in the 1990s was only something like $10 billion or $15 billion, which is surprising in per-capita terms. The inflow of foreign direct investment into China is about $40 billion to $60 billion annually. The total amount of foreign direct investment in Hungary is over $30 billion.
Countries such as Azerbaijan, Kazakhstan and Turkmenistan attracted considerably more foreign investment than Russia. Why? Was it because the rule of law is better in Kazakhstan, Turkmenistan or Azerbaijan? Azerbaijan was at war with Armenia for a number of years. Now there is no war, but there was war. The rule of law is no better in Azerbaijan. What is better in Azerbaijan is that there was a decision to sell resources and to proceed with major projects. This was a government decision, and it was a decision to sell those resources to foreign companies. I would argue that it was the right decision. When a country is in difficult times, it is supposed to sell resources, even though it knows that it is selling them at a discounted price. The conditions of law and order are such that where there is investment risk, foreign investors are not willing to pay as much as they would under conditions where there is little or no investment risk.
Russia, I think, has a policy failure. Russia has a resource advantage. If a country has a resource advantage, it can attract direct foreign investment, as the example of Kazakhstan shows. Law and order in Russia is not considerably better or worse than in Kazakhstan. The two regions are comparable in that respect. However, Kazakhstan made a bed for itself on top of this direct foreign investment, and it seems that Russia was not able to do the same thing, perhaps because of the problems in the Parliament and in the regions. There are conflicts between the regions and the federal government over this issue. However, a law on a production sharing agreement was discussed in the Duma for over five years -- not the law itself, actually, but a smaller document on a list of mineral deposits eligible for a production sharing agreement. This legislation was discussed for years and years, and finally eight sites that contained particular mineral deposits were included. There was a definite policy failure in attracting direct foreign investment.
Senator Di Nino: My colleague has asked many pertinent questions. I wish to ask you two direct questions. The first deals with Mr. Putin's ability to rally behind him the people who can help him deliver on the promises and on the objectives that have been set. Is there the will in Russia, not just from Mr. Putin but from others, to make provisions, not only for foreign investors and but also for domestic investors, to stop the outflow of capital? Is there a strong commitment to do that?
Mr. Popov: Again, that is a difficult question. If we divide that into two parts, the first question is this: Are there people around Putin who are willing to improve institutions? The answer is definitely yes. Everyone is willing to improve institutions to guarantee property rights. This is an important part of the government program, namely, to guarantee the rights of shareholders, and so on.
The second issue is the following: Are there people around Putin who are willing to proceed with measures of industrial policy and macroeconomic policy that would ensure growth -- which implies devaluation -- increased government investment and industrial policy?
Why do I say "industrial policy"? What is currently happening is called import substitution. There is heavy orientation toward import substitution. It is not export-led policy nor is it a policy to stimulate exports. This is questionable.
There are several groups in the government. One commentator recently described these groups by saying that there is a group of power ministers, including defence, intelligence and the police; a security council headed by Mr. Ivanoff; and a group of political technologists. This was the group that pushed for the non-confidence vote.
I do not know if you have followed the story, but tomorrow Parliament will vote on the issue of confidence in the government. The Russian Constitution states that if there are two votes of non-confidence, the President should suspend Parliament and hold elections.
The Unity Party, which is Mr. Putin's party, has a near majority in the Parliament. The issue of non-confidence was suggested by the Communist Party. Suddenly, however, the Communist Party cannot collect the majority. They have something like one third of the votes in the Duma at most, together with the other parties that support them. If the Unity Party were to support them, however, there would be a vote of non-confidence.
The deputy head of the Unity Party has said that they would support the non-confidence vote, not because they are unhappy with what the government and the President is doing, but because they are not happy with the Parliament. They want to have a parliamentary election ahead of time to ensure that Parliament is more pro-government and so that the Communist Party cannot easily push a vote of non-confidence and block particular reforms.
The second group is that of the political technologists. They know how to win both elections in the regions and national elections. They were pushing for this kind of premature parliamentary election ahead of time. The reforms that the government is carrying out do not matter that much to the political technologists. What matters is the ability to mobilize support for Mr. Putin. They think that they are skilful in that area, and they may be correct. The head of the presidential staff heads this staff of political technologists. They managed to deliver support for Mr. Putin out of virtually nothing. This party was created half a year before the election, and it almost received a majority of the votes during both the parliamentary elections in 1999 and the presidential elections in 2000.
The third group is composed of economic reformers. Economic reformers consist of the Prime Minister, the Minister of Finance and the Minister of the Economy. Mr. Chubais is the head of the energy company, which is the state monopoly that produces electric energy. This group is pushing for economic reforms, but they are not dealing with the most important issue, which is the price of energy. Energy prices are too low. Until they are brought in line with international prices, Russia will have this type of time-bomb economy. Why? Because once energy prices are brought in line with international prices, output decreases. This is called restructuring.
This difficult and painful restructuring is still supposed to happen in Russia. However, the time to follow this policy was when oil prices were high and the economy was performing nicely. There was a window of opportunity at that time to proceed with this policy of increasing domestic oil and gas prices, but the government did not do so.
The reformers are pushing for several reforms. They want tax reform. That does not mean much. Tax reform is happening, as has personal income tax reform and some reform of payments into the non-budget funds such as pension funds, and so on. A regressive tax will be used to make contributions to those funds.
The reformers are also pushing for deregulation of major Russian monopolies. One is called Gazprom, which produces all the gas in Russia. It is a state company. Another one, called the Unified Energy System of Russia, produces all the electric energy in Russia. The third is the Ministry of Railways. It is not even a company. It continues to manage the railways.
The reformers are pressing for restructuring and a partial privatization of those monopolies. I would say that this is wrong. Why? In the long term, it may be a good thing to do, but even Russian liberals are not happy with the plan to de-monopolize Gazprom. Why? Because they realize that Gazprom competes in Western Europe -- not with small energy companies but with the same monopolies in most western European countries. There are state monopolies. This is a continental European gas market. Britain, Canada and the United States would be the only countries where gas is deregulated. In Europe, it is different. Maybe it makes sense in the long term, but this is definitely not pressing reform. There are more pressing things to be done.
The reformers are also pressing for shareholders' rights and property rights. Everyone knows that this is good, but, again, we will not see immediate results.
Senator Di Nino: It sounds as if a number of stakeholders are creating conflicts. That may be part of the problem. Action is a lot slower when there are internal conflicts of that nature. This is what I was getting to when I asked the question.
Mr. Popov: Absolutely. I had not realized that you were heading in that direction. Yes, there is a political economy of reforms.
Senator Di Nino: You talked about some of the other states that have done much better. Is the size of the dragon part of the problem? Is Russia too big and the others too small? Or, have democratic reforms created different stakeholders, which in turn have created potential conflicts?
Mr. Popov: I would not say that size is an issue at all. Canada is the same size or a little smaller than the territory of Russia. The Canadian GDP is pretty much the same as the purchasing power of the Russian GDP. There are some problems with railways, however. Railways are supposed to be subsidized to promote east-west ties, such as in Canada, but this is not the most important issue.
Previously, Russia had a smaller population and was managing the territory better than it is able to do now in terms of the efficiency of state institutions and enforcing rules and regulations. In the 1950s, there was a period of significant growth. This was a central planned economy. It was inefficient as compared to a market economy, but it was growing at a rate of 10 per cent a year. Even labour productivity was growing at 6 per cent. This was the golden age of Soviet economic growth, accompanied with the space breakthrough in 1957 and with the introduction of satellites.
Size is not the issue. Whether we like it or not, democracy is not really an issue either. It is better to have democracy than not to have it. However, economic policy investors in some countries, such as China -- and this is widely known -- prefer a strong authoritarian regime to an "illiberal democracy." They are now calling those countries "illiberal democracies" -- that is, democracies without the rule of law. Hong Kong never had a democracy, not under the British or the Chinese Communist Party, but the institutions in Hong Kong are strong.
Mr. Chairman, would you say there is a rule of law in Hong Kong? Obviously there is. When there is no rule of law, like in Uzbekistan, and when a country democratizes quickly, then what you get is a liberal democracy, such as exists in some African countries and some Latin American countries. This democratization, coupled with the lack of the tradition of the rule of law, is leading to the collapse of institutions. That is the lesson.
The single most important lesson to be derived from this transformation is that when countries with a poor rule of law and with poor enforcement mechanisms democratize, they get into a territory called "illiberal democracies," which has costs in terms of increasing mortality, for instance. Increasing mortality in Russia was about 50 per cent. The mortality rate is now 1.5 per cent, which means that there are 700,000 people dying every year as compared with 1989, when mortality was at a level of 1 per cent only. Since 1995, the mortality rate has remained at 1.5 per cent. Before 1995, it was increasing. With the loss of some 700,000 people per year, it is like a big war. Over the course of 10 years that amounts to 7 million people. Thus, there are costs in terms of human lives.
Democracy is a great thing, but, as for all good things in life, we must be prepared to pay.
As a member of the Commonwealth of Independent States, the Baltic states enjoyed the low price of Russian oil. Independence was discussed in 1991, as well as in 1992, in exactly those terms. They were saying, "We realize that our living standards will decline because we will not have the right to buy Russian oil and gas at discount prices, which are the rules in the CIS, but freedom is more precious." Thus, they chose to stay out of the CIS. It was a choice. This is the sort of lesson that can be derived from quick democratization. Whether one likes it or not, it has a negative impact on institutions and on the government's ability to enforce the rule of law.
Senator Poulin: Mr. Popov, we appreciate your analysis and your identification of the many challenges President Putin is facing with the Russian people today. I would like to know your views on the key factors, the key incidents or the key events that happened after the Second World War up until today to create the situation you are talking about.
Mr. Popov: A former prime minister of Russia, who writes a great deal, is a director of the research institute. He wrote a book in which he speculated that Russia could have taken a different road -- if what you are asking about is the post-Cold War era -- during Kruschev's spring. This was when Russia was able to initiate Chinese-type reforms. At that time, the Soviet Union did not choose to do that. What emerged was an extremely inefficient closed economy. The industrial potential was very sophisticated, but it was stillborn. Why was it stillborn? Because in 1992 it was open to the whims of foreign competition and it just collapsed. It was not able to withstand the foreign competition.
Before 1975, the gap between Russian GDP per capita and GDP per capita in Western countries, such as in the United States, was closing. Before 1975, Russia was catching up. However, after 1975, it was no longer catching up. The crucial junction probably occurred in the 1960s. At that time, the growth rate started to fall. Of course, central planned economies are inefficient. We are talking about dynamics. I teach classes at Carleton about central planned economies.
What are the particular inefficiencies of the central planned economy compared with the market economy? The central planned economy in the former Soviet Union was closing the gap with the Western countries and was growing faster than the economies of Western countries. However, it then became very inefficient in terms not only of growth but in terms of static inefficiency. In the central planned economy, more capital must be invested to get one unit of GDP. Thus, capital intensity was high while capital productivity was low. These are all known things. However, the central planned economy obviously had a potential for economic growth, and it was growing successfully in a number of countries. The cost of this growth was enormous, but the rates of growth were pretty high.
At the beginning of the 1960s, it was possible to initiate market-type reforms. At this time, the industrial potential was not that distorted. Had the Soviet Union initiated market-type reforms in the 1960s, there would not have been any major recession. The recession that occurred in the 1990s, when the central planned economy was dismantled and replaced by a market economy, was due to the fact that distortions in terms of overindustrialization were high, and the equipment industries were not able to create machinery to compete in the world market.
In the 1950s and 1960s, it was possible to open up the economy, as the Chinese did, perhaps under an authoritarian regime, which is what the question is about. The secondary question is whether there would be an authoritarian or a democratic regime. I am just talking about economic development.
Distortions at that time were not that high. At the end of the 1950s and the beginning of the 1960s, Russia was where China was in 1978 when the Chinese government decided to proceed with economic reforms. Had Russia made this decision in 1960 under Kruschev, for instance, things would have been very different.
Senator Setlakwe: My question is very short and follows on Senator Bolduc's question. It has to do with foreign direct investment. To what extent is there foreign investment in relation to the gross domestic product? Apparently, it is not much.
Mr. Popov: The Russian GDP at the market exchange rate is U.S. $250 billion. The accumulated stock of foreign direct investment is something like $10 billion to $15 billion. I point out that there is a discrepancy between EBRD figures and Russian figures. The EBRD figures are based on accumulated inflows. Foreign direct investment increases not only because of the inflows into the country. If profits are reinvested, they also increase. The difference is not that substantial.
Before 1987, there was no direct foreign investment at all. It was prohibited. Overall, this accumulated amount is $10 billion. Russian GDP is $250 billion according to the market exchange rate. The ratio of total accumulated stock of foreign direct investment to the GDP would be approximately 4 per cent, at most. If I am not mistaken, the average for all the countries of the world is approximately 10 per cent, or perhaps a little more than that.
Senator Setlakwe: How high would the GDP have been had the FDI been at 10 per cent? You had a 9 per cent increase. If the FDI had been at 10 per cent rather than 4 per cent, how high would the GDP be?
Mr. Popov: This is a difficult question. There are many articles written on the issue and there is no consensus. For instance, to what extent did foreign direct investment contribute to China's economic growth? When foreign direct investment in China started to increase, China was closed. The policy of openness started right from 1978. It was proclaimed in 1979 and it continued, but foreign direct investment started only in the 1990s. Before that time, China was growing at a rate of 10 per cent a year. After that time, China grew at 10 per cent a year. Therefore, to evaluate the contribution, one must make certain assumptions about what the Chinese growth would have been without foreign direct investment.
It is widely believed that the ability to attract technology is associated with the ability to attract foreign direct investment because technology does not really travel without foreign direct investment. It does, but it is not very efficient. If patents and licences are sold, foreign direct investment should be attracted.
For instance, at 30 per cent of GDP, Hungary is the eastern European country that managed to attract the most foreign direct investment. China, because it has so many people, and Hungary have an accumulated stock of foreign direct investment of about 30 per cent of GDP on a per capita basis. It is lower in China, but in terms of the ratio of stock of foreign direct investment to GDP, the two countries are comparable. This indicator is very high. For other developing and emerging market economies, the ratio of the stock of foreign direct investment to GDP would be much lower than 30 per cent.
To evaluate the contribution of foreign direct investment to the annual growth, the FDI is usually compared to the flow of domestic investment. In Russia, the flow of domestic investment would be about $40 billion every year. For instance, when Mr. Borodin -- who is currently spending time in a New York prison -- renovated the Kremlin palace, he spent approximately $1 billion, which is equal to 2.5 per cent of the national investment fund. That is not to say that he appropriated all the money himself, but that was the price of the contract.
In the best years of macro-economic stabilization from 1995 to 1998, before the ruble collapsed, foreign direct investment was flowing at a rate of $3 billion to $5 billion. Total investments were flowing at a rate of nearly $10 billion, but this included all investments, even foreign investment in government treasury bills.However, foreign direct investment was probably $3 billion a year. That, compared to total domestic investment of $40 billion, is very substantial.
Investment can be financed by borrowing money and by selling bonds, for instance, but this is not direct investment because they do not give control. Foreign direct investment is so precious because it brings technology. The other advantage is that FDI is not taken back in times of crisis, so it is not volatile.
Senator Corbin: Professor Popov, part of our mandate is to examine Canada's policy and interests in the region. Would you be critical of the way in which Canada currently deals with Russia?
Mr. Popov: I am not sure that I can be helpful in that respect because I do not know much about Canada-Russia relations. If you were to ask what is the single most important measure Canada could implement to improve its image in Russian eyes, I would tell you to put a couple of immigration officers into the Canadian embassy. I am a Russian citizen and I know what I am talking about. I have taught in Canada for about 10 years. Every second year, I come for two terms. I get Canadian visas and work permits virtually every year, and I am sorry to say that the process is becoming more difficult, probably because of a lack of personnel. It is as simple as that. Two more immigration officers would probably deal with all the issues.
Unfortunately, there is a list of embassies in Moscow that are not doing well in terms of service: Canada is one of the three worst. The Czech Republic, which recently introduced visa requirements, is another. The third may be Germany, but that may be because there are so many people going to Germany. However, the Canadian embassy was on that list at one point.
While that matter is not exactly on point, it immediately came to mind when you asked for criticism against Canada. It is not the most important issue, of course. Speaking of trade relations and investments, I want to point out a couple of issues, again with the reservation that I am not really knowledgeable in this regard.
At one point I looked at the distribution of Canadian investment, Canadian foreign trade and Canadian assistance to former Soviet republics. With respect to Canadian foreign trade and Canadian investment, the Russia, Ukraine and Moldavia share of world GDP is much greater than the share of these countries in total Canadian trade and total Canadian investment.
Canadian trade with the Czech Republic is pretty much in line with the share of the Czech Republic in the world, and Canadian trade with Russia is very underdeveloped as compared to the share of Russia's world output. There is room. Perhaps it is associated with higher risk, but as compared to East European countries, Canadian trade and Canadian investment are skewed in favour of East European countries, not in favour of the former Soviet republics. Therefore, there is room for increasing these relations. That is the general picture.
With respect to official development assistance, it is usually distributed in a way that links it to the GDP per capita. Canadian assistance is greater on a per capita basis or as a percentage of the GDP of the recipient country, if the GDP per capita is lower. Therefore, Mongolia will get more Western assistance because it is a poorer country. Again, controlling for this factor, there is a bias toward East European countries, not in favour of former Soviet republics.
Perhaps this is politics. I do not understand much about politics, but perhaps this is how it is designed. The fact is that there is such a bias.
If you distribute foreign assistance based only on indicators of GDP per capita of how poor or wealthy the country is, there would be more assistance going to the former Soviet Union.
The Chairman: I am delighted that you made observations about the immigration problem. I have heard this from other academics who are professors in Canada and who have great difficulty at our embassies abroad, particularly in one of the Baltic States. I am delighted that you brought it up because it gives us an opportunity to ask the minister questions.
Senator Graham: Mr. Chairman, I appreciate the observation that you just made and the question asked by Senator Corbin that prompted the response given by Professor Popov.
My question goes back to foreign investment. Perhaps it is somewhat too specific. There is a company by the name of IMP, which is Nova Scotia-based. Mr. Kenneth Rowe is the principal owner. A few years ago, he invested heavily in hotels in Moscow. As I remember the case, it attracted regional and then national and international attention. I do not know whether his problem was with his Russian partners or with the state. I do not know what has happened since the time of that difficulty. I suppose that I could go to the phone tomorrow, call Mr. Row and find out. Are you familiar with that particular case, since it does relate to foreign investment? It seemed to have an adverse effect generally on Canadian investment in Russia at the time.
Mr. Popov: I do not know the IMP company, but one of the hotels in Moscow by the name of Aerostar is owned by a company that comes from New Brunswick. You mentioned that the company is from New Brunswick.
Senator Graham: Nova Scotia.
Mr. Popov: Nova Scotia, excuse me. It may be Nova Scotia. I had feeling that this was a New Brunswick company and not a Nova Scotia company.
This hotel is doing fairly well. It had problems. The managers of this hotel were part of the previous programs when the problems of foreign direct investment were discussed.
This is one of the success stories, I think. They had problems, like all foreign businesses had problems, during the currency crisis. I think that one of their managers, when taking the ATM slips of the hotel through the border, was thought to be smuggling currency. It was a misunderstanding.
However, I think that this is a success story. All of the businesses in Russia face problems.
The Aerostar Hotel is located in the city but on the way from the airport to the city. I have been in the hotel more than once. It is a nicely run hotel.
When academics organize their conferences, the Aerostar is considered to be a good hotel with reasonable rates. There are several expensive hotels.
The Chairman: We are making a note of the hotel, Senator Graham.
Senator Graham: I was not bootlegging that hotel by way of a promotion of Nova Scotia.
The Chairman: We are taking note of the name because we are interested.
Senator Bolduc: We forecasted a rate of growth next year that might be a bit lower than the 7.6 per cent you mentioned, probably around 3.5 per cent or 4 per cent. If that were to be the case, how would you handle the foreign debt of the government?
Mr. Popov: How would I evaluate the foreign debt?
Senator Bolduc: How would you manage to evaluate that with all the others?
Mr. Popov: I am sure you know that there was a story about the restructuring of the debt. It is not a very good story.
The presidential adviser, who is a liberal, said that the government is behaving like -- he used a very derogatory and offensive expression. He said it is sort of a criminal, and that it is not the way for the government to behave.
The government was blackmailing the Paris Club by not paying its debt. Technical default is defined as non-payment of the principal of the debt and of the interest for less than 90 days. After that it is not a technical default. It is a real default.
In the first month of this year, the government was in a technical default by trying to restructure the debts of the Paris Club. The total indebtedness of Russia, currently, is about $150 billion. That would be considered reasonable for countries of this size of GDP. If you compare it to the GDP at the market exchange rate, which is $250 billion, it would be a little over 60 per cent. Sixty per cent would be considered borderline. One should not exceed 60 per cent.
Overall, Russia can pay the debt. I would say that there are reasons to restructure the debt because Russia is in difficult times. It is not the appropriate time to pay the debt. The Russian economy has been growing for a number of years and moving closer to the previous level of the GDP per capita.
It would be an advantage to pay the debt, but it cannot be done unilaterally. One cannot blackmail the international community by saying that the debt will not be paid for 90 days and we will see what happens.
Economic growth depends on that also. It all depends on oil prices. The government budget for 2001 assumes that the price of oil will be $20 or $22 a barrel, which is a conservative estimate. It may be higher.
The laws that were recently passed through the Duma are such that Russia finally agreed to make all the payments it is supposed to make to service the debt to the Paris Club. The laws that were passed in the Duma state that the additional revenues will be used for paying the debt. Previously, these monies were not scheduled to pay the interest. Paying the principal of the debt was not scheduled in the budget for 2001.
The government has now said that it will pay the debt. It is estimating that there will be additional revenues, which will be enough to pay the debt.
Whether there will or will not be enough, it seems the issue will be resolved and Russia will be paying the debt. If there will not be enough, the government will reallocate expenditures. There will be another law to reallocate expenditures from other areas to pay the debt.
I do not think that there will be any problems. Russia will not be in default. It will continue to pay the debt.
However, this plan all depends on oil prices. If oil prices are relatively high, Russia will pay its debt easily. If prices are low, yes, this payment of the debt will hurt the Russian economy. From the Western point of view, it would make sense to proceed with the restructuring of the Russian debt and maybe with a cancellation of the Russian debt based on an evaluation of Russian policy.
Current Russian economic policy is not that bad. There may be conditions. For instance, there may be conditions on the side of IMF and the World Bank to increase oil prices to proceed with the structural reforms. Given that Russia meets those conditions, there would be debt restructuring. There would be a reasonable deal. Basically, Russia needs debt restructuring.
Senator Bolduc: In Canada, most federal laws are administered by the federal civil service. Provincial administrations handle the provincial laws. In Germany, for example, most of the federal laws are administered by lenders. In Russia, are all federal laws administered by the federal bureaucracy or by regional people?
Mr. Popov: There are federal laws that the federal government requires the regions to administer. It requires the public service in the regions to administer.
Even more so, there is something called the federal mandates. In recent times, the federal Parliament passed laws and regulations that required the regional governments to increase spending. Right? Sometimes they did; sometimes they did not.
Senator Bolduc: We talk about the culture having some very heavy bureaucracy. If the federal government must direct employees, it is easier to handle the situation than to give orders to people at the professional level who are elected. They may say no and refuse to do it.
Mr. Popov: I can only add that police, for example, have a double subordination. Police are subordinated to the federal authorities and also to the regional authorities. The Ministry of the Interior supervises the police in every region.
In the first half of the 1990s, decentralization was obvious. That began in 1992, probably, when Yeltsin said to the regions, "Take as much autonomy as you can digest." The regions' share of total consolidated government revenues and expenditures increased dramatically from a level 30 per cent as a unitary state. The former Soviet Union was a federation and even Russia was a federation, but in reality they were one unitary state.
Therefore, the share of the federal government decreased and, starting from the mid-1990s and especially in 1998 -- this is one of the few things that Mr. Putin managed to achieve -- Putin redistributed the revenues in favour of the federal centre. The Russian Constitution states that no less than 50 per cent of all spending should be carried out by the regions. The federal government now actually carries more than 50 per cent of spending.
The Chairman: Thank you, professor, for your patience and for this tremendously interesting beginning to our study.
Hon. Senators: Hear, hear!
The Chairman: Honourable senators, I want to introduce to you Mr. John Wright, our researcher and our expert on Russia. He will help us with our witnesses.
The committee adjourned.