RUSSIA’S INDUSTRIAL CAPACITY

Russia's key industries

 Steel, 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.

 With 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’S MILITARY CAPACITY

 Russian 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–experts on the subject from both Russia and the
West–consider 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.
 For 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–
and will continue to be–decisive in shaping Russian military
capacity.
RUSSIA’S 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 –
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 – fearing massive unemployment and social unrest – 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
“gastronomes,” 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
Russia. The governor of the region, Mikhail Prusak, was just re-elected with over
90% of the vote.

But Novgorod is an island of performance in an ocean of decline. The

reforms necessary to break out of the current downward spiral will require huge
and painstaking political efforts. Advanced democracies have taken decades to
achieve good economic policy, both at the macroeconomic and sectoral
levels. Russia can benefit from the hard lessons learned there, but Russia has yet
to develop an effective political class to craft and implement a reform program.
This may be Russia's biggest challenge.

The path that Russia will take is uncertain, but the implications for the
West are crystal clear. By focusing primarily on high-level macroeconomic policy,
the IMF, the U.S. government, and most economists have completely
misunderstood the peculiar realities of the Russian economy. The right
framework could all be in place, but national and local government interference
in individual industries is so pervasive today it will undermine even the best
macro policies. No more Western taxpayers' money should be put at risk through
loans to the Russian government when the Russian governments own
interventions in the microeconomy are undermining the very stability the loans
are meant to achieve in the first place.

RUSSIA’S MILITARY CAPACITY

Russian 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–experts on the
subject from both Russia and the West–consider 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.

For 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–and will continue to
be–decisive in shaping Russian military capacity.

Russia, on the other hand, lacks the extensive and expensive networks of
bases and intelligence-deployment capabilities to actually be true to its word of
going after bases "regardless of what region they are located in," according to
Yury Baluevsky, Russia's chief of the general staff. Since the end of the Cold War,
Russia's external military capabilities have been greatly curtailed, resulting in
recalling its personnel and even closing some bases in many parts of the world.
While Russian intelligence may be capable of intercepting and deciphering
communication traffic between suspected militants and their bases, this effort
has not been followed up by quick military action necessary to destroy the threat.
The country did have limited success in preemptive strikes against the Chechen
leadership in the first Chechen War of 1994-1996; indeed, Russia's missile strike
killed the leader and inspiration of Chechen resistance, General Djohar Dudaev,
after intercepting his cellular phone conversation. But such successes have been
few, as Russia is trying to adjust to the geopolitical reality of the new threat posed
by the largely international terrorist efforts.

At present, Russia has a growing network of bases in its near-abroad, in

Central Asian and Caucasus countries on its southern borders. Its military
presence in Kyrgyzstan, Tajikistan and Armenia, as well as Georgia, allows it to
launch potential strikes at a number of countries that may have terrorist bases on
their territories. Such capability will augment Central Asia's fight against its own
terrorist formations, such as the Islamic Movement of Uzbekistan.

But Russia has limited military reach beyond its southern rim, and
military strikes against other states may invite unwelcome political stalemates.
This took place recently with the Republic of Georgia's public stand against the
Russian Federation on the question of Georgia's Pankisi Gorge, located to the
south of Chechnya. The Russian government was convinced that Chechen rebels
and terrorists who supported them were hiding out in the gorge, and repeatedly
pressured Georgia to allow Russian forces to invade.

The Georgian government rejected such proposals, instead relying on its

U.S.-trained troops to conduct a sweep of the area in question. The sweep
revealed no threatening presence of guerrillas, and the Russian government
accused Georgia of wasting time and allowing the suspected fighters to escape. At
question in this scenario was the violation of Georgia's territorial integrity and
the potential military conflict that might have resulted between the two countries.

Nor is Russia capable of containing the situation in Chechnya to the

levels where military action alone should be enough to limit the rebel activity.
The deadly attack on Ingushetian and Russian forces by the Chechen guerrillas
this summer underscored Russian forces' inability to identify and interdict the
potential threats before they materialize a crucial factor in conducting preemptive
operations. Recent attacks in Beslan once again drove home Russia's need for
more capability amongst its various security forces to properly meet the new
threats before they occur.

This weakness, according to Russian military experts, stems from the

unprepared ness of Russian security forces to combat new threats. Russia's
Special Forces are still using the modus operandi of the Cold War, when they
were created for counter-terrorist operations. However, the terrorist threat itself
has changed drastically since that time, and the new crop of hostage-takers do
not ask for financial compensation, or the ability to escape unarmed to a neutral
territory.

Throughout the Cold War, the U.S.S.R.'s Special Forces were trained to
act after its government would undertake a major negotiation effort. At present,
such conditions no longer apply. As the situation in Beslan showed, fast,
coordinated, well-rehearsed action -- the opposite of what actually took place --
by the security forces was necessary to prevent the tragedy.