Comparing Transitions of Russia and China (Part II)

(Editor’s Note: This is the second part of a two-part essay. The first part was published on the April issue of Perspectives.)

Section 2: The Similarities

It is much more popular nowadays to talk about the contrast between Russia and China. The similarities between the two countries, however, are neglected, and this negligence leads to too much optimism for China’s reforms and too much pessimism for Russian’s reforms. Although communist practices in the two countries were quite different in both style and level, they do share some structural similarities. The most apparent similarities are: in addition to being planned economies, as described in section I, they both possessed highly centralized power structures, which created an enormous obstacles to liberalization and democratization, be they in the forms of ideological conservatism or of economic rent-seeking (it seems that the latter is more pervasive). In this section, I will focus on how the similar inherited power structures have distorted the reform processes in both states.

  1. The Russia Case

Given the poor performance of Russian economy, it has been said that democratization alone should account for the fall of Russia. Is this true? A closer examination tells us that the rise of both economic inefficiencies and inequality in Russia can be attributed partly to the lack of democracy rather than democratization itself. Both totalitarianism, a legacy of the Soviet era, and the new authoritarianism, shaped by Yeltsin, are elements of the centralized power structure.

It is unnecessary to elaborate on Russia’s infamous totalitarianism legacy inherited from the Soviet era. As for contemporary authoritarianism in Russia, many scholars observe that Russia’s failure in its reforms lies in its adherence to its authoritative past. At the national level, power has been concentrated in the hands of the President. This is why the bombing of the Winter Palace and the dissolution of the Parliament in 1993 have become such scandals in Russian politics as symbolic challenges to presidential authority. At the regional level, representatives of the old, Soviet-era elites, or nomenklatura, were placed in a majority of the elected offices at the regional elections in March 1990 and 1994. These old, local elites have been a conservative force behind the blocking of economic reform measures that include liberalization, stabilization, privatization and internationalization. Even at the workplace level, the manager class in Russia has mostly been kept intact. [28] In a word, the centralized power structure and the official or unofficial patron-client networks at national, regional, and workplace levels have all survived to different extent during reforms. A very rough estimate of the size of the nomenklatura inherited from Russia’s Soviet past comes close to about one million, or 0.7% of the population. [29] The sheer size of the nomenklatura has allowed nomenklaturshchiki to dominate politics.

Here I do not argue that there exists no difference between totalitarian leaders and democratically elected leaders, but time is needed for democracy to be transformed from an ideal to reality. When most old elites retain their positions during the process, it is possible for them to transfer resources geared towards past interpersonal networks to lobbying in legislature, and call this transfer an exercise in “democracy”. In fact, Russian-style lobbying is on the rise. Nevertheless, the lack of democracy in Russia, is mostly embodied in the close relationship between government and all kinds of interest groups (actually, elite groups). Let us have a look at how the conspiracy between the state and the nomenklatura has eroded both economic efficiency and equality in Russia.

  1. Economic Inequality

Economic inequality could have stemmed from either of two origins: the monopoly of power or differentiation caused by market forces. If we can demonstrate that it is market processes that have created the huge gap between the rich and the poor, then we can blame liberalization as the cause of inequality; otherwise the culprit would be the unfair power structure, in which power is monopolized by a few, as market liberalization provides additional opportunities for corruption.

The existing power structure had played a crucial role in the process of reform even in the first stage of privatization, known as “voucher privatization”. Most existing managements were able to retain commands because of their rights to buy equity from other staff, thereby securing their positions within the local nomenklatura. However, “The success of privatization will be short-lived if the process is conducted in a non-transparent way and if the process is managed as an opportunity for enrichment amongst a bureaucratic elite. In most post-communist countries, a number of joint stock companies of closed type have been created, the structure of which prevents shareholders from selling their shares and provides scope for directors of enterprises to exercise effective full control and sometimes to allocate themselves large, artificially created dividends.” [30]

The collusion between nomenklatura and the state became more prevalent at the second stage of privatization after “voucher privatization”, giving rise to the “oligarchs”. These “oligarchs” had been part of the old, privileged classes who have been protected and privileged by a quasi-democratic government, not new, self-made capitalists that emerged from full competition in a market economy. [31] That is to say, what they possess can be better characterized by “capital of power” rather than “power of capital”. [32] In this sense, it is not liberalization itself, but the combination of liberalization and centralized power structure that led to the huge economic disparities in Russia.

Evidence proves that the rise of the oligarchs has been due to the “choice” of the “government” instead of the “market”. In 1994, Yeltsin announced that 1994 should be “the year of financial-industrial groupings”, and successively approved a dozen of bills to demonstrate his support. Consequently, the oligarchs rose into economic prominence. The number of financial-industrial groups surged from 1 in 1993 to 7 in 1994, 21 in 1995, 37 in 1996, and 60 in 1997, while the system of the “seven oligarchs” was established by consolidating the strongest among the strong. [33]

The concrete ways in which the government supported the “financial-industrial oligarchs” include:

  1. The Entrusted Banking System. State central bank entrusts its money to certain privileged corporations at low rates, allowing them to loan this money at higher rates to the national and international securities and banking markets. In other words, these “entrusted” banks and corporations have been able to get a large amount of virtually “free” money and manage the funds at zero risk, thus generating high profits. It is said that 90% of the operating capital of the oligarch-controlled banks came from the government’s budget. In 1996 alone, the entrusted banks obtained loans of US $5 billion from the government.
  2. Loans-for-shares program. Oligarch-controlled banks have given loans to
    the government to lower their deficits, while the government has presented a majority of the shares in state-owned enterprises to banks as collateral; if government pays the money back in three years, these shares can be retained by the government, otherwise these state-owned enterprises will be controlled by the banks permanently. Most Russian oligarchs have gained prominence through these transactions, since any of these “insider transaction” would typically exclude competition from foreign and social funds, and since these mortgaged enterprises have often been undervalued.
  3. Commission “insiders” to run state-owned assets. Mortgaged state-owned assets are required to be run by ‘insiders’ appointed by the government, though these appointments often took the form of contract. When mortgaged state-owned assets are confiscated, these “insiders” would come into control and become oligarchs themselves.

The emergence of the oligarchs through government initiatives indicates that voucher privatization, as employed in the “Shock Therapy” program, did not by itself contribute to the huge income gap. Although there has been a tendency for dispersed stocks to be centralized after voucher privatization, the “financial-industrial oligarch” did not gain from amassing these dispersed stocks. Neither did the 600 or so investment funds in Russia benefit from voucher privatization; in fact, they began to dissipate as the oligarchs rose into power through other means. In other words, mass privatization, even though it has failed to stimulate the economy, is not responsible for the rise of the oligarchs. The ascent of the oligarchs was instead due to bilateral transactions between the government and the privileged class, from which the masses have largely been excluded. Radical reform (according to neo-classical economics) requires limitation of interferences from the government, but what happened in Russia has been abnormal: the government, through its monopoly power, has provided substantial patronage for “financial-industrial groups”. Therefore, it is quite far-fetched to attribute the huge economic inequalities to radical reforms. The true reason behind the income gap and the unfair power structures is the weakness of the country’s democracy. In other words, it is the lack of democracy, not the excessive privatization, that has contributed to the emergence of the oligarchs.

  1. Economic Inefficiencies

The biggest trouble encountered by the Russian economy is the dramatic decline of the level of gross fixed investment over the past decade. [34] In fact, Stiglitz also pointed out that, because most of the Russian oligarchs’ wealth is ill-gotten (not through fair competition, but through the government’s patronage), these oligarchs might have “take[n] at least a significant part of their wealth out of the country to a safe haven,” [35] while the government’s support for the opening of capital accounts facilitated this process. Such capital outflow is part of the reasons for low investment levels in Russia. [36] According to Stiglitz, “hopes that privatization would lead to restructuring ‘by the market’ have been widely disappointed.” Part of the blame should be assigned to privatization methods that created little incentive for restructuring as opposed to ‘tunneling’ value out of firms”. [37] Michael Kaser summarized the pervasive influence that is inhibiting domestic or foreign investors with two words-nomenklatura and mafia. Neither term applies universally, but both express the empowerment of politicians and of criminals with the government’s help during the period of privatization. In other words, it is incomplete marketization due to the power structure, rather than marketization itself, that hampered foreign investments, thus preventing economic recovery.

How the centralized power structure eroded the efficiency of the market could be seen from the notorious “loans-for-shares” program launched after 1995. The government allowed private entrepreneurs to create banks, which were permitted to lend these private parties money with which to buy state-owned enterprises. Whoever got the banking license got a license to print money, and the license to print money is a license to acquire government enterprises. This created opportunities for corruption, and indeed, this illegitimate process has been called “robber baron” privatization. As a result of this patronage-oriented process, as opposed to a competition-oriented process, the “robber baron” privatization has failed to train competent managers. Why should the oligarchs invest money to create new enterprises anyway if they could extract more wealth from stripping assets rather than redeploying assets for the purpose of creating new wealth? Without entrepreneurship and enterprises under corrupted power structures, a meaningful market economy cannot be established.

Russia’s mode of privatization has widened economic disparities and produced market inefficiencies. However, the transition from a communist to a capitalist system through reform is inevitably costly, even if the costs involved in Russia’s liberalization could have been greatly reduced. Converting stakeholders from opponents to supporters of reform often requires the creation of rents by the government. [39] An obvious paradox arises, although the goal of reforms is to reduce rents and rent-seeking; such measures would undermine a fiscally poor government whose main leverage is its ability to create rents through enacting legal and regulatory restrictions. The government has to choose between two strategies with regards to the stakeholders: either that of expropriation or co-optation. Evidence shows that Russia government has been using the strategy of co-optation in its privatization, macroeconomic stabilization, and tax reform programs, in order to dampen resistance to reform. Since costs resulting from reforms are inevitable, the only choice left for a transitional government is to minimize such costs. Therefore, even though the Russian government might have known that co-optation would yield sub-optimal results, it was forced to use the strategy of “insider privatization” to co-opt the major stakeholders, so that these managers and workers would in turn support the broad strokes of reform. Similarly, during the period of macroeconomic stabilization, the Russian government sought to co-opt stakeholders such as enterprises, collective farms and the banking sector through subsidization. To stabilize the currency, the government had to lure major commercial banks away from channeling inflationary credits and speculating on the falling ruble to trading government bonds, which generates less of an inflationary effect. However, in order to provide incentives for these banks, the government had to issue treasury bills with extremely high yields while it maintained these high yields by limiting access to the banking market. In other words, the government has exchanged one rent-seeking activity for another to persuade major stakeholders to support reforms.

2. China’s case

Many of Russia’s problems haunt China as well. Arrears of salary, unemployment, and large-scale corruption are even more rampant in China than in Russia. It may appear that China has experienced a smoother transition with lower unemployment rates and expanding social welfare programs. However, such data may be misleading, since the official unemployment rates do not account for the unemployment of peasants and China, unlike Russia, never had a meaningful social security network to start with. According to the Gene index in 1994, which is the most important index measuring the extent of inequality, Russia’s was at 0.400-0.405, compared to China’s 0.409-0.445. [40] Also, according to a survey on corruption in 1995, China ranked 2nd among 41 states. [41]

China’s sizable corruption problems stemmed from pervasive “state opportunism”. The benefited classes in China are reluctant to transform society to constitutional system, since political privileges have conferred on them many economic privileges. The monopoly of market opportunities through the monopoly of power is the main source of corruption. In this sense, the problems inherent in China’s transition and those of Russia are twins born by the same “mother”-an unchecked power system.

On the one hand, the state tries its best to preserve the dominant status of state-owned enterprises. Some of these actions include forbidding private enterprises from competing in designated sectors, limiting competition in other fields, and establishing “licensing” institutions that impose stringent standards. As the state wields its power to preserve the privileges of these state-owned enterprises, opportunities for corruption arise. Another form of state predation in the reform era was simply “revenue grabbing”. Governments of different levels have imposed various kinds of taxes and fees in order to expropriate as much of the observable revenues within their jurisdictions as possible. Meanwhile, the government continues to inject funds into these state-owned enterprises, from which the money is often siphoned off to elsewhere. It is not surprising that such practices have severely undermined the financial health of both state-owned enterprises and banks. In fact, over 70% of all bank loans in China are distributed to state-owned enterprises since reform, contributing to the insolvency of many state-owned enterprises and creating huge management risk for the banking system.

On the other hand, China is reforming its state-owned enterprises by instituting the “stock-sharing” system. However, evidence suggests that this policy has not only failed to improve the performance of these enterprises, but also provides another chance for corruption. China has privatized many enterprises, especially medium-scale and small-scale ones during its “stock-sharing” program, but this process of “spontaneous privatization” has in fact led to large-scale asset stripping conducted by the state, according to some scholars. Indeed, asset stripping has been as serious a problem in China as in Russia, although, in Russia, this process has been organized by the government and has happened swiftly, while in China, this process has occurred incrementally, spontaneously and on the backstage. Until 1996, the disappearing of state-owned assets had been estimated at an annual rate of RMB 50 billion, translating to RMB 0.13 billion per day. [42]

Asset stripping in China is similar to that in Russia. In China, enterprises try their best to build up “insider management” by “internalizing” the stocks. These state-owned enterprises would then set up “collective enterprises” and allow them to own state assets free of charge, while the “insider” managers intentionally purchase raw materials from these “collective enterprises” at high prices and sell products to these same enterprises at low prices, profiting from the rents generated through this process. Besides rent-generation, the most effective way of asset stripping has been enabled by soft budget constraints-state-owned enterprises absorb incessant rounds of loans from the state without utilizing the loans effectively. In this process, although nobody destroys state assets intentionally, nobody benefits-perhaps this should be called “ideological asset-stripping”.

State-opportunism in China has brought many troubles and potential problems for further reform. Some scholars argue that, China’s experience proves again that market liberalization needs to be combined with constitutional order and rule of law to engineer a successful economic development program, where individuals’ rights are protected and where there are effective checks and balances of government power.

Section 3: The prospects

Although it is a “power sport” nowadays to applaud China’s “miracle” and ridicule Russia’s “failure”, the reality is not that simple. The transition, in both countries, has just begun.

First, Russia’s predicament is not as miserable as perceived. The system has been transformed, although the costs have been huge. Most price controls were removed in 1992, while both domestic and foreign trade were liberalized. By 1996, monthly inflation had been brought down from the peak of 245 percent in 1992 to close to 0 percent. Exports rose from about U.S. $54 billion in 1992 to about U.S. $87 billion in 1997, as Russia ran a $20 billion trade surplus that year. Markets for corporate shares and government bonds were created from scratch. The proportion of the work force employed in non state-owned firms grew from 13 percent in 1991 to more than 60 percent by the end of 1994. As of 1997, only 9 percent of registered enterprises were entirely state-owned. Although a financial crisis occurred in 1998, which was mainly caused by the slump of international oil prices and the financial contagion from Southeast Asia, Russia’s economy has resumed its vigor after these disruptions to its economic recovery. In 1999, Russia achieved fiscal balance for the first time in this decade; GDP increased 2 to 3 percent and income international trade was US$24.5billion (it was US$8.4 billion in 1998). Experts estimate the GDP growth rate of Russia would reach 7% in 2000. However, Russia’s economic achievement may not have been fully taken into account-frantic tax evasions have concealed a significant part of Russia’s economy, or the “gray economy”, from official economic statistics. In addition, Russia is replacing its ideological concerns with the rules of market when handling trade relations in the global economy, which should spur further trade activities and economic growth.

For Russia, the collapse of a gigantic imperial state without large-scale social turmoil and civil war is itself a huge success. Although Russia’s brand of democracy has not evolved into an effective mechanism through which the public could supervise the government efficiently, it is obvious that basic political and civil rights have been respected through presidential and parliamentary elections, in which strong and legitimate opposition parties also participate. The political balancing acts between the president and the parliament have become less unusual. For example, the Parliament’s veto of the President’s prime minister nominee indicates that there is no longer an omnipotent power in Russia. Furthermore, social survey indicates that there appears to be a trend towards “neutralization” within Russia’s political culture, instead of “polarization”. Extreme right- and left-wing parties have been losing appeals in Russia’s political arena. [43]

Second, China’s situation is not as rosy as propaganda paints it to be. China’s official statistics tends to overstate real growth rates. Lardy shows that official data overstate growth rates by at least 1 to 2 percent. [44] According to some Chinese scholars, such as Luo Shao, official data overstate growth rates by 2 to 3 percent. [45] Also, Lardy provides evidence that the Chinese government purposefully downplays information about bad loans of state banks and the financial state of state-owned enterprises. Therefore, pessimism is not ungrounded, especially when we notice that all groups within society have not evenly shared the economic growth.

More glaring than the severe economic disparities is the phenomenon where, under the political monopoly of the government, economic development has been compromised by state opportunism. Although the dual-track approach to economic transition may generate very high, long-term costs of constitutional transition that might well outweigh the short-term benefits of buying out vested interests, state-opportunism has muted potential crises in every field of society, including state-owned enterprises, private enterprises, agriculture, social solidarity that may well erupt and generate more significant costs. According to Sachs, when the room for imitating both the Western industrialization and the export-oriented strategies has been exhausted, China’s hybrid economic system may stop working. What remains to be seen is how long China’s economic transition can sustain itself in the absence of a constitutional reform.

(The author is a Ph.D. candidate in political science at Columbia University.)

Endnotes:

  1. The situation contrasts with, for example, the far-reaching personnel changes among directors of state enterprises in Poland in the period 1990-1991.
    29. The same as footnote 13
    30. Peter Young and Paul Reynolds, The Amnesia of Reform: A Review of Post-Communist Privatization (London: Adam Smith Institute, 1994), p.7
    31. Actually, if “radical reform” necessarily produces oligarchs, why in some other countries taking “radical reforms” such as Poland and Czech didn’t oligarchs turn up?
    32. See the same as 7th footnote
    33. See the same as above
    34. Stiglitz. 2
    35. Stiglitz 5
    36. On the contrary, although much of wealth of Chinese capitalists is also ill-begotten, the closed capital accounts in China not only enable the financial system to provide a major source of income for the government, but also limit the incentives and scope for asset stripping, and increase the investment.
    37. Stiglitz 15
    38. p182 the same as footnote 13
    39. Andrei Shleifer and Daniel Treisman Without a Map (The MIT Press, 2000) p.9
    40. see the same as the 7th footnote
    41. see the same as the 5th footnote
    42. He, Qinglian The Trap of Modernizations Industrial and Commercial Press 1997 (China)
    43. the same as the 7th footnote
    44. Lardy, Nicholas, (1998). China’s Unfinished Economic Revolution, The Brookings Institution.
    45. Economic Highlights, May 15, 1999, p. 1
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