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May 7, 2012 | 07:59 GMT

19 mins read

Russia 2000 Part 1: The Economy, Russia Turns Back

ALEXEI NIKOLSKY/AFP/Getty Images

Editor's Note: This piece originally published Oct. 10, 1999.

After years of decline, Russia's flirtation with capitalism has now reached a critical juncture. The experiment with Western-style capitalism has collapsed. And the invention of Russia's peculiar - and wild - brand of capitalism has ended in outrageous scandal and popular discontent. A decade worth of foreign aid and investment has left Russia a pauper nation. Burned by its post-Cold War experience, Russia is now poised to turn back the economic clock and to narrow its economic relations with the West. Russian politics increasingly point to a return of centralized, state-directed planning which can direct Western investment, minimize corruption and begin to satisfy everyday Russians. Most major presidential candidates, for example, come from backgrounds of strong state planning.

A decade ago, such planning was known as perestroika. For the West, it was the beginning of Russia's financial opening. But for Russia, perestroika was an altogether different endeavor. It was a calculated effort by the government's security apparatus to close the technology gap with the West through foreign investment, while still maintaining the Communist Party's stronghold. In the coming 12 to 18 months, the new perestroika will attempt to rebuild highly centralized control, while keeping the door cracked for Western capital.

The economy is in such critical condition that a return to some form of centralized planning now presents itself as the only viable option. Though Russian statistics do a poor job of measuring the true state of the economy, they generally portray a situation that cannot continue. Productivity is half of what it was a decade ago. Real disposable incomes have also fallen by half. Up to $500 billion in capital has fled for havens abroad. Foreign investors are expected to pump just $1 billion into the country by the end of this year, down from $2.2 billion last year.

Whether the new perestroika succeeds or not, Russia's relations with the West will change dramatically. The economic situation is so dire failure to control it will likely plunge the country into political crisis and force a break with the West. Even if the return to centralized planning succeeds, relations with the West will narrow sharply. The economy's wide open, free-for-all will grind to a halt as Western investors wait on bureaucrats to put them into constrictive joint ventures, as now exist in China. Hunting for large returns on investment, the government will have little interest in either small, entrepreneurial investors or portfolio investment.

Either way, Russia is now poised to return to its past.

The Truth About Perestroika

There has been a fundamental flaw in the West's approach to Russia since the end of the Cold War: no one has noticed that there has been no revolution.

The West's initial elation at the collapse of the Soviet Union ignored the fact that the old regime's politicians, bureaucracy and attitudes remained intact. Intact alongside them in the late 1980s and early 1990s was Russia's history of centralized control. Russia had never had an industrial revolution, history of free markets, democracy or rule of law.

Even President Boris Yeltsin inherited a Russia that lacked only the political superstructure of the Soviet empire. Apart from a handful of eager reformers zealously encouraged by the West, Russia's "new" economy has rested on the same institutions as the old. The Soviet legal system remained in place, as did its socio-economic structures. Even the post-USSR reformist initiative was a legacy of Soviet planning.

The troubles of Russia at the end of the 1990s can be traced directly to the early 1980s, when the ponderous, centralized control of the Soviet Union began a subtle shift in the desperate hope of competing with the more advanced economies of the West. Indeed, Yuri Andropov, former KGB chairman and short-lived general secretary of the Communist Party (CPSU), not only laid the groundwork for perestroika and the collapse of the Soviet Union - but also hopelessly handicapped the reformist effort that has followed.

In the early 1980s, the KGB became aware that the West was rapidly outstripping the Soviet Union in civilian and military high technology. The KGB warned that the Soviets would lose the Cold War. And so, plans were laid to restructure economic relations with the West, through perestroika, and politically, through glasnost. In this way, Russia could capture foreign direct investment and the willing transfer of technology - all while maintaining the Communist Party's grip on power.

As early as 1984, a select group of Politburo members and KGB First Chief Directorate officers began planning to set perestroika in motion. By 1986, KGB officers and Komsomol officials were building the new economic infrastructure - banks, trading companies, stock and currency exchanges, and corporate shells - that were to attract and exploit Western investment. The KGB and trusted party members in trade ministries were also tasked with generating hard currency from the export of raw materials, which was to be laundered through offshore financial institutions and eventually return disguised as "Western" capital investment.

While the West overlooked it, the KGB in fact permeated the entire perestroika economy. Its officers took executive positions in all the new firms to guide and contain the process. Soviet perestroika law required all foreign investors to have Russian partners. According to officers who took part, the KGB's Fifth Chief Directorate formed most of the 1989-1990 joint ventures, while the Central Committee of the Communist Party was responsible for the rest. In 1992, an estimated 80 percent of joint ventures included KGB officers. Western businessmen even sought out KGB men as business partners, since they had a reputation for getting things done.

But the fundamental flaw of perestroika quickly became apparent: once the door was open, the Communist Party couldn't keep control of the economy. On orders from senior officials anxious to safeguard the Party's assets, the KGB began the first great wave of Russian capital flight since the overthrow of Czar Nicholas II. The KGB used its own foreign residencies, as well as institutions established under perestroika, to hide billions of dollars of Party and state resources abroad. The scale of the KGB project was impressive. From 1989 to 1991, the KGB first chief directorate funneled at least 60 metric tons of gold, 150 metric tons of silver, 8 metric tons of platinum, and from $15 to $50 billion in hard currency abroad, according to Russian investigators.

To conceal and protect the Party's fortune, officials formed some 100 banks and other commercial enterprises in Moscow between 1990 and 1991, with 600 more in the regions and still more outside the Soviet Union. One of these, founded in late November 1990 by Eurobank, the Paris based arm of the Soviet Central Bank, was the Jersey based Financial Management Company Ltd. - FIMACO. In 1990, then-Politburo member Primakov negotiated a $1 billion loan from Arab gulf states, which reportedly vanished into FIMACO. FIMACO would later serve the same purpose for the erstwhile reformist Russian government.

Russia Today: The Men of Perestroika Return

Ten years later, the truth about perestroika resonates more loudly than ever - though largely unheard in the West. The entire generation of key politicians and businessmen who are now vying for control of the country were intimately involved in perestroika and the export of party assets.

For example, in 1992, Yevgeny Primakov, then head of the Russian Foreign Intelligence Service (SVR), the successor to the KGB's First Chief Directorate, stifled a parliamentary investigation of Soviet Communist Party capital flight.

Primakov was reportedly one of five senior officials, including Soviet Central Bank Chairman Viktor Gerashchenko, to be briefed by KGB Col. Leonid Veselovsky on the methods available for hiding Communist Party funds overseas. Primakov is not the only senior Russian official with these ties. Some evidence suggests that Prime Minister Vladimir Putin, then a KGB officer in Germany, took part in Soviet capital flight in the late 1980s.

Several Russian oligarchs, now deep in the country's economic scandals, got their start during this period. Some traded Russian resources under perestroika, purchasing them at cheap, state-subsidized prices and selling abroad at higher, world market prices. Others established and headed banks on behalf of the Communist Party.

All benefited wildly from Russia's opening to the West. These banks scored huge profits when then-Russian Central Bank chief Viktor Gerashchenko issued them extremely cheap credits. In 1992, with inflation at 2,500 percent, the Central Bank lent the equivalent of 32 percent of Russia's entire Gross Domestic Product (GDP) at 10 to 25 percent of annual interest rates. A few privileged banks have also handled the accounts of Russian government ministries and agencies, the president's office, the parliament and regional governments.

The West, in turn, has fundamentally miscalculated, enthusiastically supporting a small group of reformers who administered unpopular shock therapy to the economy in a short-lived program of privatization, liberalization and tight monetary policy. The Russian public has seen its buying power plummet and savings evaporate in hyperinflation, marking the beginning of the Russian public's disillusionment with reform. Today, real disposable income is down more than 50 percent since 1991. Nearly 40 percent of Russians earn incomes below the official subsistence level of 787 rubles, or $31, per month.

As they rose in prominence in the early 1990s, reformers came up against both the entrenched Soviet-era managers and the proto-oligarchs. In the early stages of privatization, the reformers handed control of inefficient old Soviet factories to Soviet-era managers - who balked at reform, downsizing and restructuring.

The main clash occurred in early 1992 and effectively marked the end of reform, though Russia has wrestled with it ever since. At the time, Yeltsin, at the urging of his economic advisor, Yegor Gaidar, attempted to undermine the looting of subsidized commodities by liberalizing commodity prices and exports. Russian oil sold domestically at 1 percent of world prices, and those who traded this abroad made $24 billion on the difference in that year alone - the peak of the scheme. The lost revenues amounted to about 30 percent of Russia's GDP.

Backed by the communists, Viktor Chernomyrdin and others in the state energy apparatus who benefited from the looting challenged Gaidar, arguing the rationalization of prices would destroy Russian industry. Chernomyrdin won, becoming energy minister and later replacing Gaidar as prime minister. The rejection of Gaidar's reforms both highlighted the pervasiveness of the pre-Soviet apparatus and effectively marked the end of reform. From that moment forward, reformists like Anatoly Chubais, Moscow's privatization chief, have waged a series of losing battles against the old Soviet apparatchiks and have been forced into shortsighted tactical compromises.

The reformists' losing rear-guard battle has effectively laid the foundation for today's scandals. Reformists sought to counter the apparatchiks by building up power and influence of a few bankers - soon to be full-blown oligarchs. The oligarchs emerged with the most power and as a result have done the most looting.

In December 1995, Anatoly Chubais, then-first deputy prime minister, struck the first of these Faustian bargains. Reformists have struck them ever since, steadily losing power. In what became known as the loans-for-shares scheme, Chubais convinced a small group of bankers - the rising oligarchs - to issue loans to the government against the collateral of shares in some of the country's largest and most lucrative firms, including the oil companies Yukos, Sibneft and Sidanko. As expected, the Russian government could not repay its loans at the end of the one-year term, and the oligarchs organized rigged auctions to divide the spoils.

Chubais' second bargain again enlisted the rising oligarchs, in a desperate attempt to keep Yeltsin in power when his prospects looked grim in the run-up to the 1996 presidential election. Most Russians blamed Yeltsin's erratic economic reform program for the substantial declines in their standard of living and the communists and presidential candidate Gennady Zyuganov capitalized. Chubais called on the oligarchs to finance Yeltsin's re-election. Having sold the economy to the oligarchs in order to defeat the apparatchiks, Chubais then effectively sold the government to the oligarchs to defeat the Communists at the polls.

The oligarchs fronted the election and Yeltsin prevailed, but not before his personal bodyguard Alexander Korzhakov exposed the financing scheme after catching two of Chubais' campaign staff slipping out of the Kremlin after dark with a satchel full of cash. Korzhakov paid for blowing the whistle with his job, while Chubais and oligarchs Boris Berezovsky and Vladimir Potanin were given jobs in the government.

The resulting unholy alliance of government and full-fledged oligarchs completely eliminated all hopes of reform. Together, the seven oligarchs who backed Yeltsin together controlled 50 percent of the Russian economy. Considering that 40 percent of Russia's GDP was produced by businesses run by organized crime, according to a 1995 multi-department Russian committee report, the Kremlin had few targets to reform or tax.

The pressure to increase tax revenue in the face of evasion by politically connected oligarchs and big business has caused the tax agencies to bleed small and medium businesses dry. It has also led the tax agencies to promulgate a host of tax regulations and petty fees that have made it difficult for foreign investors to do business. Today, only the politically protected or criminal empires thrive.

With the oligarchs inside the Kremlin walls, Russia has settled into a state of unbridled kleptocracy. Exemplary of this, Berezovsky gradually took control of the state-run airline Aeroflot beginning in 1997, and allegedly proceeded to embezzle most of its profits, stashing hundreds of millions of dollars in his Swiss bank accounts.

But as the economy has increasingly dwindled there is less left to steal and the alliances of recent years are becoming uncommon. The auction of the telecommunications holding company Svyazinvest in July 1997 marked the end of cooperation between the oligarchs and set off the Bankers War. Svyazinvest was "promised" to MOST Group chairman Vladimir Gusinsky, but Oneximbank chief Vladimir Potanin, backed by George Soros, outbid him at the last moment.

But the ensuing war of accusations and counteraccusations was waged on the front pages and TV screens of the media empires controlled by the competing oligarchs. To this day, the battle irrevocably factionalized the oligarchs as they aired their dirty laundry in front of the public. Yeltsin called them together to urge them to put national interest first, but it was too late. The oligarchs, their scandal exposed to the public, have long since sown the seeds of their eventual destruction.

Perstroika Revisited

With a nearly dead economy and the oligarchs' corrupt empire exposed, Yeltsin has made his own Faustian bargains. Increasingly, these bargains point to a return to some form of centralized planning. After all, the economies of both the reformists and the oligarchs have now proven to be utter failures.

Yeltsin's selection of Primakov for prime minister in 1998 was the first of these deals that increasingly point the way to Russia's future. Initially, Primakov was merely an effort to appease the Communist-dominated Duma. But long after Primakov was dismissed, the old Soviet perestroika men have taken the opportunity to gain ground they had lost to the oligarchs.

More significant than Primakov's brief tenure were the Communist Party loyalists who returned at other levels of government to reign in the oligarchs and reassert central control. Primakov appointed several classic Soviet apparatchiks to the upper ranks of government. He brought in First Deputy Prime Minister Yuri Maslyukov, a Communist and the last chairman of Gosplan, the USSR's State Planning Committee, and put him in charge of economic policy. He also appointed Gennady Kulik, one of many early post-Soviet profiteers, as deputy prime minister in charge of agriculture.

The rise of the apparatchiks has also meant a crackdown on the oligarchs. Prosecutor General Yuri Skuratov was given free rein to investigate and expose their economic crimes. Skuratov managed to expose the FIMACO, Aeroflot and Mabetex scandals and to issue arrest warrants against Berezovsky and Smolensky before Yeltsin struck him down. These scandals broke in early 1999.

The emerging dominance of Soviet-era influences can also be seen in foreign policy. Russia has turned against the West over Kosovo, arms sales to Iraq and Syria, assistance to Iran on nuclear and missile programs, and the START II and ABM treaties. Meanwhile, the Yeltsin administration launched its own series of tactical moves aimed at consolidating its hold over the lucrative remnants of state-controlled industry, specifically arms exports and the oil and gas industries.

In a last gasp, Yeltsin fired Primakov and appointed Sergei Stepashin in his place. Stepashin stalled investigations and wooed the IMF for another loan, but he had little room to maneuver. The cat was out of the bag regarding the scandals and Russian security services were leaking information directly to the Western media and investigators. The reactionary forces quickly regrouped. Primakov found a power base in Fatherland-All Russia (OVR), which the Kremlin feared Stepashin couldn't or wouldn't assail. So, Yeltsin sacked Stepashin on Aug. 9 and appointed Federal Security Services Director Vladimir Putin, an ex-KGB operative, to the post.

The rise of Putin marks the final step back to the days of perestroika. Whether Yeltsin's decision was shortsighted and voluntary or forced on him is unclear. Yeltsin hopes that Putin can draw on his KGB resources to win the election for Yeltsin allies. Putin, however, reflects complete continuity of background, outlook, and behavior from Primakov and the perestroika faction.

Russia 2000?

So Russia has been left looted and dispirited, with an aging physical plant, some heavy industry, a little investment, and a trusty stock of raw materials. Perestroika failed to build a Russian Silicon Valley. Reformists failed to modernize and Westernize the economy. Oligarchs have been caught stealing everything that was not nailed down.

Now the perestroikists will have another turn, their second chance to centralize Russia's economy, while keeping the country open to foreign investment. As a model, the perestroikist candidates will look to China, where the ruling party thus far has managed to maintain order and control - while accepting hundreds of billions of dollars in Western investment. Primakov, Putin, Lebed or their proteges will attempt to put the system in order, first turning against the oligarchs, trying them for economic crimes, and at least temporarily nationalizing their assets. The oligarchs are convenient scapegoats and their elimination will win approval from the Russian people.

Russia, in fact, appears to be headed for a serious economic crisis and capital shortage in the year 2000. The real challenge for the next regime will be convincing international lending organizations - specifically the International Monetary Fund (IMF) - to prop up the economy. Burned by Russia's scandals, the IMF is reluctant to continue pouring money into Russia. It will be even less inclined to do so if Yeltsin's successor boosts spending on military and security, social safety nets, and subsidies to regional governments.

Attempting to re-establish the power and authority of the central government, the perestroikists simply cannot afford to meet the IMF's demands. Putin has already warned that Russia will gladly implement the IMF's austerity measures - so long as they do not conflict with Russia's national interests. For Putin and others, Russia's international position and domestic political pressures take precedence over appeasing the IMF, despite the desperate need for funds. The prime minister scarcely pretended to defend the IMF-approved budget, opening it immediately to negotiation. In addition to the changes at the hands of Communist deputies, the budget is destined for three major revisions by Putin, none of which will appeal to the IMF.

Putin intends to finance the war in Chechnya and subsequent arms purchases in the new budget. He plans to buy the support of the regional governors by attuning the budget more to their desires - more federal subsidies dispensed to the regions, fewer taxes collected from the regions. Additional funds will be earmarked to pay overdue wages, also with the intent of winning votes.

The IMF is likely to disburse at least two more tranches of its last loan package to Russia pending investigation of the scandals. The first will come before the Duma election; no matter how badly they have been burned, Western leaders are unwilling to risk throwing Russia into economic turmoil immediately before an election - and thus hand victory to extremists. For the same reason, another tranche is likely before next year's presidential election.

But after that, Russia will be hard pressed to bum a cigarette from IMF managing director Michel Camdessus. If the IMF in turn ceases to loan money, Russia will default on its foreign debt - expected to top $166 billion by the beginning of next year. Technically, as new IMF loans are only servicing Russia's debt to the IMF, Russia has already defaulted. The IMF is only hiding the fact to prevent panic and the complete abandonment and ensuing economic collapse of Russia. Presented with the inevitability of Russian default, the IMF may choose to accept Russia's appeal for forgiveness of at least the $100 billion debt it inherited from the Soviet Union.

There is a small chance that Russia could repatriate up to $500 billion estimated to have been hidden abroad over the past decade by everyone from the Communist Party and the KGB to the oligarchs and organized criminals. This would depend on the cooperation of Western banks and investigators and the next regime will not push the issue until the national debt issue is resolved - it won't want the lost capital to go straight into the IMF's coffers. Still, a Putin or a Primakov could be quite a national savior with that kind of slush fund.

Without those funds, Russia's next president will find his options sharply narrowed. The politicians poised to take Russia's helm are those who were left hanging by the sudden collapse of perestroika.

Russia has now come full circle. It has exited the political and economic cul-de-sac of the Yeltsin years and the perestroikists stand ready to resume their work. Left unanswered is the question why, having once experienced perestroika disintegrate, they feel they can make it work this time.

Next: The extensive espionage career of Russia's prime minister and what it means for the future.

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