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Russia's Underground Boom Economy

In the conventional wisdom, Boris Yeltsin's political difficulties demonstrate the failure of democracy and a free-market economy in Russia. Old cold-warriors predict the resurrection of the Evil Empire and its accompanying jolt to the American economy, defense establishment, and sense of national purpose.

Not so. Russia is becoming a success story of capitalism and market forces. Its economy and standard of living are almost twice as high as officially reported, and they have been growing since 1994. Furthermore, Russian banks' promissory notes can now be traded in the international financial market, and a growing number of United States companies have entered the Russian market by investing in it rather than exporting to it. As a result, many US policies, shaped by Russian official statistics about the poor health of the Russian economy and its wobbly financial system, should be changed to reflect reality.

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This conclusion is based on macroeconomic data; an ongoing study, beginning in 1988, of Russian citizens and business managers; expert opinion; and a recent survey of US companies operating in Russia. These diverse approaches produce a consistent picture of a vibrant and growing economy, an economy that is increasingly trusted by the world financial market and US companies. Even Russia's inflation rate has fallen to 4.1% in January and 2.8% in February. As a result, Russia will become more powerful internationally and a more inviting place for US business.

High standard of living

Specifically, my 1995 focus group in Russia reported that 40% of focus-group participants' family incomes was not reported to tax and statistics collectors. This means that the purchasing power of the focus-group participants and their families is 66.7% higher than officially reported. It is believed that these and other focus- group findings represent Russian families in general.

In addition, most of the focus-group participants said their economic situations were better than a year ago. Some said their situations stayed the same, and a few - invariably women in their 60s and 70s - said theirs were the worst they have ever experienced. Most spent about 70% of their family income on food, some bought cars ("for investment"), others remodeled their apartments, one built a second home in the country, and several took trips abroad during the past year.

To achieve this high standard of living, the participants either held well-paying jobs in the private sector, or had low-paying jobs at a state enterprise and conducted other activities that normally paid as much as, and often more than, the official job.

So, if things are so good, why are they reportedly so bad? The answer to this question lies in statistics and psychology. Of every $100 in income, only $60 is reported to the tax authorities and counted as part of Russia's gross domestic product (GDP) and per capita income (PCI). Russians believe that privately earned income need not be reported to the tax authorities, and the consensus among focus-group participants was that in Russia 90% of private-sector transactions go unreported. Russians are experiencing a classic revolution of rising expectations - the more they have, the more they want. As several participants said: "Overall, the situation is better, but it is not possible for me to buy what I want all the time. There are plenty of quality goods now, but not enough money to buy all I want."

Even more startling are my 1995 findings from many interviews with managers representing state and privately owned companies in different industries.

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Notably, 90% of all private-sector production, sales, and profits are not reported to the tax authorities. This means the private-sector companies participating in this study understate their economic activity by 90%, and it is believed that these companies reflect the practice of other private companies. And since the Russian private sector is more than half the Russian economy, this understatement of private-sector activity suggests that the true size of Russia's GDP and PCI are perhaps twice as high as officially reported.

In addition, beginning in 1994, the Russian economy began to grow again. Managers of companies in the private sector (most companies in Russia are now privately owned) reported that, typically, sales and profits have doubled in real terms each of the past two years. These managers used various tactics to underreport 90% of their sales and profits. These include cash deals, double sets of books (one showing actual activity, one for income-tax purposes), fictitious subcontracts to overstate expenses and understate profits, and bogus capital expenses to overstate production cost.

As one manager said, echoing many other managers in the private sector: "It is impossible to survive with this legal accounting.... I must play games in order to survive."

Good credit risks

Likewise, seven experts from Russian institutes and large US consulting companies whom I interviewed in 1995 said that Russia's economy has been growing since summer 1994, that Russia's banks are increasingly regarded as good credit risks, and that 60% of all economic activity in Russia is not reported. If this is true, Russia's officially reported GDP is 40% of actual GDP. "Russians," said another expert, "are filthy rich."

Finally, my survey of 87 companies doing business in Russia showed that the number of companies entering the Russian market has risen from nine in 1989 to 22 in 1993. Equally noteworthy, when 15 companies already operating in Russia changed their strategies, seven of them, or 47%, opted for wholly owned subsidiaries, indicating a decrease in perceived risk over time and an increasing commitment to Russia.

According to Alan Bickell, managing director of Hewlett Packard's worldwide operations, such a change follows a well-documented cycle in international business: After a low-risk entry strategy produces good results, it matures into higher commitments such as wholly owned subsidiaries. For example, Caterpillar Inc. changed its export strategy into a joint venture in 1992, and Ernst & Young is now replacing its joint-venture strategy with a wholly owned subsidiary. McDonald's got involved in manufacturing and real estate, even while it continued to use a joint-venture strategy.

In view of these findings, US foreign policy toward Russia is based on unrealistic data and should be modified.

*First, because Russia's economy is not weak as previously assumed, it does not need as much foreign assistance as previously thought. For example, the State Department has several programs that assist Russian scientists whose state wages are very low. Most of them, however, make good money in the private sector and do not declare it. Should the US continue to help them? Alternatively, the US could get more bang for the present aid buck.

*Second, US policy toward Russia could be made more effective by changing the mix of aid projects offered by such organizations as the Agency for International Development and the World Bank. For example, many of these projects are designed to teach business to Russians. In fact, many of these "students" are shrewd businesspeople. Indeed, several Russian recipients told me that they comply with such aid projects for the sake of goodwill that might lead to something useful.

*Third, history suggests a positive relationship between a country's economic health and its international stature. Russia's large and growing economy points to a rise in its international standing. Yesterday's military power may become an important player in global economic competition.

US foreign-policy implications

As a result, American foreign policy should begin to regard Russia as a potential economic and industrial competitor, capable of dominating many markets and creating niches in others. This calls not only for a different foreign policy, but also for a different role and process of foreign-policy information and implementation.

Such a policy must be less intrusive and more respectful of Russia. Restrictions that the US and the World Bank attach to their aid are often perceived by Russians as patronizing foreign intrusion.

Equally important, American foreign policy should respect Russia's right to craft its own brand of democracy and market economy, and should accept the probability that, sooner rather than later, Russian nationalist and Communist parties will successfully move their country toward socialism, likely in the mold of Sweden's social democracy. Poland and the Czech Republic have already taken that path, and Russia will take it even further. Such a socialist system in Russia will result in a more guarded attitude toward the US because for many years Russia perceived itself against the backdrop of the US.

Russia has demonstrated that it is possible to adjust and prosper in the post-cold-war era. The United States can adjust positively to this new era as well.

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