For more than a decade, Russia has been attempting to diversify, innovate and modernize its economy, but its efforts thus far have failed to come to fruition. Here is why.

An oil pump in the Krasnodar Region, Russia. Photo: RIA Novosti 

Way back in July 2006, when Russia was still basking in an unprecedented windfall of petrodollars, the nation’s economic strategic plan for 2020 (now known as the “2020 Concept”) was formulated. The main objective was to wean Russia off from its growing dependence on energy, and serve as a blueprint for market-oriented economic reforms, which included divestment of state-owned enterprises and incentives for private investment.

The plan’s authors also set lofty goals for sustainable economic growth through an elaborate innovation and modernization program and sustainable infrastructure development. There were even plans for turning Moscow into an international financial center like Hong Kong, Singapore or Tokyo.

That was before Russia was hit hard by the global financial crisis of 2008-2009, reversing almost a decade of robust growth that started in 1999. Ever since, the Russian economy has been expanding or shrinking with the price of oil and gas. Innovation and modernization quickly became little more than economic policy mantras for the Kremlin.

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On the heels of the “2020 Concept” came then President Dmitry Medvedev’s “Forward Russia.” The Skolkovo Innovation Center was launched, but was never quite completed, scuttled, as it were, by corruption and several fraud investigations. Every new cycle of turbulence in the oil market and the economy seems to remind public officials of the need to diversify the economy.

"It was a mistake to rely so much on oil and gas over the past 10 years as this has resulted in the ruble strengthening to the point it disrupted other industries," said Finance Minister Anton Siluanov.

The head of the Central Bank of Russia, Elvira Nabiullina, earlier this year called for “structural efforts to diversify the economy.” She made clear that, “We should not expect to see oil prices return to high levels.” And, as recently as June 2016, even Russian President Vladimir Putin reminded media executives in St. Petersburg that Russia is still committed to diversifying the economy and moving forward. Yet, despite good intentions, crisis after crisis has not jolted Russian policymakers into taking concrete steps to free the country from its “resource curse.”

Perhaps, Russia’s biggest problem is its economic growth model, experts say. Over the past decade, Russian economic growth has been heavily dependent on the natural resources and energy sectors, which are directly or indirectly controlled by the government.

The seduction of high oil prices has been difficult to resist. Proceeds from the export of natural resources still comprise up to 50 percent of state budget revenues. If, in 1999, oil and gas accounted for less than half of Russia’s export proceeds; today they account for 68 percent.

Russian experts estimate that a drop of $1 in oil price costs the Russian budget up to $2.5 billion. This means that any significant decline in commodity prices affects not only the Russian state budget, but by extension, the GDP, the state’s social programs, defense spending and the exchange rate of the ruble, the national currency.

"It's impossible to escape from economic stagnation without adopting a new growth model," says Alexei Kudrin, Russia's former finance minister, whose recent appointment to head the Center for Strategic Research (CSR) sparked a wave of optimism in economic circles.

The causes of Russian economic problems, Kudrin says, "lie in a weak market environment dominated by state-owned enterprises and quasi-state companies with perverse incentives that operate counter to conventional market logic and enjoy ‘informal’ relationships with the state."

Even as the “oil curse” weighs heavily on the economy, there is currently little indication that the Russian government is about to relax its grasp on the economy. Though the government has announced four privatization schemes this decade alone, the previous three - in 2007, 2009 and 2012 – were never implemented.

Only time will tell what becomes of the latest announcement, made in February, to privatize state firms, including Rosneft and Bashneft, shipping firm Sovkomflot, diamond miner Alrosa and state-controlled bank VTB. Leading economists have repeatedly said that the proceeds from the privatization of a number of large state-owned companies will give Russia the opportunity to diversify its economy.

“Russia could reassure investors by moving ahead with long-stalled privatization plans as well as improving the rule of law to ease pressure on businesses,” said Ivan Tchakarov, chief economist at Citigroup in Russia.

But rather than ease the pressure on businesses, the government has deftly assigned a backseat to the development of small and medium-sized enterprises (SMEs), which are very essential to economic growth and any diversification efforts.

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This tends to confirm yet another dilemma facing the Russian government: whether economic diversification should be left to private entrepreneurs or micromanaged and steered from above.

SMEs currently make up only about 22 percent of the Russian economy, contributing just 15 percent to GDP, according to Eurostat. By way of comparison, in all EU countries and in Norway, SMEs make up over 99 percent of all enterprises.

And they account for around two-thirds of total employment, ranging from 53 percent in the United Kingdom to 86 percent in Greece, contributing an average of 40 percent to member states’ GDP.

Constant drains on the private sector in Russia have included but are not limited to repeated inspections — and demands for extortion — by a host of government agencies, including health, fire and tax, according to William Pomeranz, the deputy director of the Kennan Institute.

“And with interest rates jacked up to 17 percent to defend the ruble, the small- and medium-business sector will be starved of credit for the foreseeable future,” Pomeranz said. Thanks largely to government policies, Russia’s private sector lost 300,000 jobs between 2008 and 2012, while the state added 1.1 million workers to its payroll, The Economist reported.

Economic diversification in the area of innovation and modernization has proved even more problematic. Over-reliance on energy revenues has not translated into a steady stream of investment in science, technology and innovation.

When then Deputy Prime Minister Dmitry Medvedev assumed the presidency in 2008, he spearheaded efforts to diversify the energy-dependent economy, leading to the creation of the Skolkovo high-tech innovation center, billed as the country's answer to Silicon Valley.

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Skolkovo was to act as an incubator for high-tech start-ups, providing a home to numerous domestic and foreign companies and workplaces for up to 50,000 scientists and researchers. In 2011, then Prime Minister Vladimir Putin announced the establishment of the Agency of Strategic Initiatives that he said would promote business start-ups and promote young talent. He followed this up in December 2014 with the launch of the National Technology Initiative (NTI), a state-sponsored program designed to strengthen Russia’s position in global technology markets by 2035.

Yet, despite these state-sponsored efforts, none of these initiatives have come anywhere close to challenging the pride of place enjoyed by state-owned energy giants such as Gazprom or Rosneft. Russia pumped a record 534 million tons of crude oil in 2015 even as sanctions deprived the country of the Western financing and technology it needs to streamline energy extraction.

Meanwhile, Russia’s best and brightest talents in science and technology continue to leave the country in droves. The new import substitution policy is yet to result in innovative and top-quality high-tech products at affordable prices. Calls to develop long-neglected sectors of the economy continue unheeded and policymakers continue to squander opportunities to diversify the economy.