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03/18/2014

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RUSSIA\u2019S INDUSTRIAL CAPACITY
Russia's key industries
\ue000Steel, cement, construction, dairy, confectionery, oil, retailing, hotels and

software. The Russian economy shares many of the features of a thriving economy, it is burdened with a unique and peculiar brand of government manipulation at the level of individual industries and companies that guarantees decline and decay.

\ue000With bountiful and diverse minerals, Russia, the world's largest country in land

area, occupying 75% of the former Soviet Union, had a significant percentage of the world's mineral resources and produced 14% of the world's total mineral extraction. Mining was the country's leading industry in 2002, and Russia was the largest producer of palladium and nickel (20% of world output), and ranked second in the production of aluminum and platinum-group metals (PGMs), third in potash, sixth in gold, and seventh in mine copper. Russia also produced a large percentage of the CIS's bauxite, coal, cobalt, diamond, lead, mica, natural gas, oil, tin, zinc, and many other metals, industrial minerals, and mineral fuels. Enterprises considered part of the mineral and raw-material complex contributed 70% of the budget revenues derived from exports; petroleum, petroleum products, and natural gas were Russia's leading export commodities in 2002; metals and chemicals also were leading export commodities.

RUSSIA\u2019S MILITARY CAPACITY
\ue000Russian military capacity remains a major consideration for global

security even in the post-Soviet era. This book assesses today's Russian military and analyzes its possible future direction. The contributors\u2013experts on the subject from both Russia and the West\u2013consider not only how Russia has built its military capacity but also the policies and doctrines that have shaped Russia's defense posture. They discuss such topics as the downsizing of the Russian military, Russia's use of military power in regional conflicts, and the management of Russia's nuclear weapons.

\ue000For more than a decade, Russian leaders have struggled to

formulate security and defense policies that protect Russia's borders and project Russia's influence. The contributors to The Russian Military find that the choices Russian leaders have made have been significantly influenced by the military reforms Russia has attempted to implement since the collapse of the Soviet Union. The protracted and intense debate over military reform has been\u2013 and will continue to be\u2013decisive in shaping Russian military capacity.

RUSSIA\u2019S INDUSTRIAL CAPACITY

The demise of the Soviet Union a decade ago astounded the world. The subsequent demise of Russia's economy is astounding too. State-owned businesses have been privatized, prices are deregulated, and competition abounds. Yet unlike Poland, which has seen per capita gross domestic product rise 20% since 1989, Russia's per capita GDP has plummeted more than 30% since 1989. Productivity is less than 20% of the U.S. level and stagnating.

To paraphrase Tolstoy, healthy economies are all basically alike. Unhealthy economies are each unhealthy in their own way. The McKinsey Global Institute has recently completed a year-long study of the Russian economy that looked in depth at the performance of many of Russia's key industries \u2013 steel, cement, construction, dairy, confectionery, oil, retailing, hotels and software. Our work shows that although the Russian economy shares many of the features of a thriving economy, it is burdened with a unique and peculiar brand of government manipulation at the level of individual industries and companies that guarantees decline and decay.

In healthy economies the most productive companies are the most profitable. In Russia today, this logic is flipped on its head. The most productive companies not only can't make a buck, but are being driven out of business by government-subsidized productivity laggards.

Yes, some of Russia's poor performance can be traced to macroeconomic factors like hyperinflation and exchange rate volatility. Yet even here the underlying culprit is governmental micro-meddling. Subsidies and tax forgiveness have contributed substantially to the government deficits and oversupply of money that have triggered financial crises.

Nowhere is governmental interference clearer than in the steel industry. About a quarter of Russia's steelworkers are employed in antiquated open-hearth plants, which are only 10% as productive as U.S. mills. These mills are out of cash and cannot pay their energy bills, but continue to operate only because local governments \u2013 fearing massive unemployment and social unrest \u2013 prevent energy companies from cutting off their power. This subsidy through low cost or free energy is rife throughout Russian heavy manufacturing. Yet in the vast majority of cases the government's fears are unfounded. The natural evolution of most of these local economies would create more than enough jobs in the service sector to redeploy workers shed in closing these uneconomic steel plants.

Absent government intervention, a good source of new high-productivity service-sector jobs would be food retailing. Roughly one-third of Russian food sales now go through new types of food retailing enterprises that did not exist in Soviet times. Yet these new businesses are only about 25% as productive as first-

class supermarkets, and little better than the famously inefficient Soviet \u201cgastronomes,\u201d which required a customer to go to a counter three times for each item purchased: once to identify the specific item to buy, once to pay for the item, and once to pick-up the item. All told, only 0.2% of Russian food sales are in supermarkets. In Poland and Brazil, which have similar levels of GDP per capita, the figure is 18% and 36%, respectively.

The Russian tax system is explicitly biased against supermarkets, which have to pay taxes equal to 8% of their sales compared with less than 1% for small food vendors. Without the prospects of profits because their competitors are effectively subsidized by the government, no multinational food retailer will ever bring best-practice food retailing methods to Russia. Multinational food retailers are more than able to overcome the problems associated with bureaucratic red tape, corruption of public officials, and even physical threats from organized crime. But they cannot overcome not making money. Total foreign direct investment in general retailing amounts to $2.1 billion in Poland, in contrast to $100 million in larger Russia.

Whether the Russian economy can be turned around is an open question. On the positive side, the potential for rapid productivity growth and thus overall economic growth in Russia is extraordinarily high. Surprisingly, only about 25% of Russia's industrial capacity is so technologically obsolete that it should be shut down. The remaining 75%, if well managed and improved with modest investments, would rapidly reach 60% to 70% of U.S. productivity. Moreover, Russia can rely on skilled and inexpensive labor, and larger proven oil and gas reserves than any other country, even Saudi Arabia.

The recent history of Poland shows that fear of unemployment, which is the underlying reason for much of government intervention, is largely unfounded. As the economy grows and modernizes, jobs will be shed, but new jobs will be created. A further economic benefit of removing micro-meddling by the government will be a reduction of corruption, since much corruption in Russia is closely tied to the intricacies of government support programs. Remove the programs and the potential for self-dealing and conflicts of interest falls accordingly. Russia also contains two tiny examples of healthy economic activity where the government does not interfere. Software project services, although employing only 6,000 people, achieve 72% of U.S. productivity levels. This sector is completely unregulated, and since it did not exist in Soviet times there are no legacy jobs for the government to try to protect. In addition, the Novgorod region, located 300 miles northwest of Moscow, has far less government interference than the rest of Russia. Its elected officials have seen good economic policy as the key to the economic performance that would get them reelected. As a result, Novgorod has increased its GDP per capita by 3.8% per year from 1995 to 1998, while the rest of Russia declined by 2.7% annually. Novgorod, with a population of only one million, attracts five times as much foreign direct investment per capita as the rest of Russia. With foreign companies bringing in global best practices, Novgorod's performance will continue to outpace the rest of

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