Where did Russia’s post-communism economic reforms go wrong?

Since the early 1990s, both Russia and China have reformed their economies – but the paths taken have been very different. In Russia, the speed of privatisation, alongside inadequate laws and institutions, led to economic collapse and ultimately the rise of Putin.

In 1989, Russia’s population was nearly one billion smaller than China’s – but its economy was 17% bigger. Now the Chinese economy is ten times the size of the Russian economy.

From Deng Xiaoping’s famous 1978 speech into the 1980s and early 1990s, China had been gradually moving away from having a command economy – an economic system controlled and largely owned by a central authority – towards an economy where prices are set by market forces. During the perestroika (reform) era from 1985 to 1991, Russia had been on a similar path.

In 1989, the means of production in both countries were largely in the hands of state-owned enterprises (SOEs) and there was a widespread view that such enterprises consumed more inputs than they produced in outputs. The inefficiencies inherent in SOEs came from having a multiplicity of conflicting goals, weak managerial incentive structures and a soft budget constraint. Soft budget constraints meant that SOE managers spent more than their enterprise earned in the knowledge that the government would make good the shortfall (Kornai, 1986).

Because of these inefficiencies, at the beginning of the 1990s, China and Russia began the process of privatising their SOEs. But they did so in completely different ways, with long-lasting and far-reaching consequences that echo to the present.

Russia’s ‘big bang’

Where did Russia go for advice on how to change from a command economy to a market-based one? It turned to the United States and some of the brightest minds of their generation. The US State Department’s Agency for International Development contracted the now-defunct Harvard Institute for International Development to advise the Russian government on privatisation and the creation of capital markets.

The policy advice given and implemented was to go for a ‘big bang’ approach by engaging in a rapid mass privatisation programme. This started in 1992, and by 1994, 14,000 medium and large state enterprises – or 70% of Russian industry – had been transformed into joint-stock companies (Hoff and Stiglitz, 2004).

Ownership in these newly minted companies was distributed on the cheap to managers and employees. The remaining shares could be bought by Russian citizens using vouchers issued by the government.

Did privatising all these enterprises unleash robust economic growth thanks to removing inefficiencies? Did firm productivity improve thanks to the managerial incentives created by private ownership and the removal of soft budget constraints? As Figure 1 shows, Russia’s GDP plummeted during and after the implementation of the programme. What went wrong?

The architects of the programme had pressed ahead without creating the necessary laws and institutions to protect private property and to prevent self-dealing by managers. They believed that privatisation would result in the emergence of private property owners who would then lobby the government to create laws and enforcement institutions that would protect them from expropriation (Hay et al, 1996; Shleifer and Vishny, 1998).

Crucially, this did not happen. Instead, company managers and other kleptocrats lobbied to oppose the strengthening of laws and institutions that would protect shareholders (Black et al, 2000).

The typical privatisation in Russia resulted in managers and employees owning 60-65%, investors owning 20% and the state holding the remainder (Black et al, 2000). Managers engaged in self-dealing to increase their ownership stake and wealth. Self-dealing is where those who control a company use their position to divert wealth away from other shareholders towards themselves (Djankov et al, 2008).

Managers increased their initially modest stakes in three ways:

First, they forced employees to sell their shares cheaply.
Second, they used company funds to buy the privatisation vouchers – which were tradable – to allow them to buy more shares in the company.
Third, they used dubious tactics to reduce demand for their company’s shares when they were auctioned. For example, auctions were held in a remote location or mafia henchmen were used to exclude bidders. This allowed managers to acquire more company shares per voucher than they had obtained using company funds.

The largest enterprises, mainly those in oil and metals, were not part of the voucher privatisation scheme. Instead, they were auctioned off in a highly rigged manner – and at very low prices – to a small number of well-connected men who had made their wealth by expropriating funds and assets from the government (Black et al, 2000).

These men, dubbed kleptocrats by the Russian press and oligarchs by Western media, came to control Russia’s largest corporations. They also controlled its major media outlets and, through those, they could manipulate elections.

The rapid and corrupt privatisation process meant that companies were now under the control of their managers or, in the case of the largest ones, under the control of the oligarchs. Those managers and oligarchs had two choices: run their companies efficiently and profitably; or tunnel value out of their company.

They typically chose the latter option because even their property rights were insecure – assets and profits were stripped out of firms and the proceeds invested in Western democracies. It is estimated that between 1995 and 2001, capital flight from Russia averaged 5% of GDP per annum (Hoff and Stiglitz, 2004). The economic collapse of Russia borne out in Figure 1 ultimately resulted in a currency and financial crisis in 1998.

Reforms under Putin

Vladimir Putin’s rise to power in 2000 brought the days of the oligarchs, asset stripping and the erosion of Russia’s wealth to an end. The oligarchs were expected to cooperate with the state’s economic and political objectives or else face exile or worse (Vanteeva, 2016). For example, Boris Berezovsky was exiled to London, while Roman Abramovich chose to cooperate with the new regime.

The pillars of Putin’s administration were the siloviki – veterans of the country’s secret service, the KGB, and other law enforcement agencies. The siloviki were placed on company boards to enforce Putin’s policies and safeguard company assets. Even though Russia returned to its long-standing tradition of authoritarian rule, the Putin regime did not renationalise companies or revert to a command economy (Vanteeva, 2016).

Instead, the government became a partner with private business. Putin’s version of state capitalism ensured that in the absence of secure property rights, managers and owners would not engage in asset stripping at the expense of the country or self-dealing at the expense of minority shareholders.

Figure 1: Real GDP in Russia and China, 1989-2020

Source: World Bank
Notes: Index = 100 in 1989 for both countries.

As Figure 1 shows, Putin’s new regime reversed a decade of dismal economic performance. But growth has slowed over the past decade and some fear that Putin’s state capitalism has evolved into something more akin to crony capitalism, whereby political connections and collusion determine business success (Åslund, 2014). Furthermore, Russia’s ill-fated privatisation scheme of the 1990s means that its citizens are sceptical of any attempts to move from the model of state capitalism and all its associated problems.

China’s gradualism

Could Russia have gone about its privatisation in a different way? Parallels have been drawn with the successful privatisation in other transition economies such as Poland (Sachs, 1994). Poland’s privatisation scheme was staged, in that small businesses were privatised first and major businesses were only privatised once capital market regulation and self-dealing laws were in place. But China may offer a better comparison and perhaps even a counterfactual.

As with Russia, China did not have laws and institutions to protect private property rights and investors from self-dealing behaviour by managers. In contrast to Russia, China privatised slowly. In the words of Deng Xiaoping’s famous speech, China privatised its industries by ‘crossing the river one stone at a time’.

In the 1990s, the Chinese Communist Party gradually retreated from the control of SOEs that operated in highly competitive markets, but it retained complete control of SOEs in banking, mining and utilities. The majority of large SOEs were converted into companies that issued shares to their own employees or to other SOEs, with the government and other SOEs maintaining a large percentage of ownership (Tenev and Zhang, 2002).

Following the establishment of the Shanghai and Shenzhen Stock Exchanges in 1990 and 1991 respectively, these former SOEs began to issue shares to the public (Wong, 2006). The Chinese government kept control of these privatised SOEs via large ownership stakes. Ownership by the state, particularly local government, played a major role in protecting minority shareholders from self-dealing by managers (Zhan and Turner, 2012).

China’s gradualism resulted in an orderly privatisation process. Figure 1 highlights a stark contrast between Chinese and Russian economic growth since 1989. By 2020, China’s economy was ten times the size of Russia’s.

China may not offer a good counterfactual because initial conditions were much better in China than in Russia. Further, China in 1989 was a peasant economy, whereas Russia had already industrialised. Nevertheless, it is noteworthy that after its disastrous privatisation scheme, Russia adopted a version of the state capitalism model employed by China.

Were economists to blame?

One of the lessons of economic history is that the wrong economic policies can have devastating consequences (Grossman, 2013). The poor advice from economists in terms of both the speed and nature of Russia’s privatisation process is an example of free market ideology trumping pragmatism. It is also an example of why transplanting economic ideas from other economies needs to take proper account of the political and institutional setting in the host country.

Finally, it raised serious issues about integrity within the economics profession. The head of the Harvard Institute for International Development’s Russian privatisation scheme broke conflict-of-interest rules by investing in the securities of Russian businesses that were being privatised (Warsh, 2018).

The wrong policy advice on Russia’s privatisation contributed to the rise of Vladimir Putin and the siloviki. Putin brought the oligarchs to heel and reversed the erosion of Russia’s wealth. This made him popular with the people. It also turned Russia away from its brief experience of democracy and back towards an authoritarian regime. This is the regime that has invaded Ukraine.

Where can I find out more?

How Harvard lost Russia: Institutional Investor magazine on the role of Harvard economists in Russia’s economic reforms.
Judge finds against Shleifer, Hay and Harvard: David Marsh on Harvard’s ill-fated Russia project.
Russia’s failure to reform: Jeffrey Sachs contrasts Russia with other transition economies.
What I did in Russia: Jeffrey Sachs defends his work in Russia.
Distinguishing post-communist privatizations from the Big Bang: Branko Milanovic on the need to differentiate between the speed and way in which privatisations were carried out.
The arduous transition to a market economy: Anders Åslund on Russia’s transition to a market economy.
Inside Putin’s circle – The real Russian elite: Anatol Lieven on the siloviki.
Myth 13: Liberal market reform in the 1990s was bad for Russia: Chatham House on myths about Russia.
The makers and the takers: The Economist’s crony-capitalism index and Russian oligarchs.