A decade ago, the demise of the Soviet Union astounded the world. The collapse of Russia’s economy since then has been, in its own way, equally astounding. State-owned businesses have been privatized, prices are deregulated, and competition abounds. Yet unlike Poland, whose per capita gross domestic product has shot up by 20 percent since 1989, Russia has seen its per capita GDP—now at a paltry 15 percent of US levels—fall by more than 30 percent in the same period (Exhibit 1). Meanwhile, the country’s stagnating productivity stands at less than 20 percent of the US level (Exhibit 2).

How could such a collapse occur? To paraphrase Tolstoy, healthy economies are all basically alike; each unhealthy economy is unhealthy in its own way. The McKinsey Global Institute’s recently completed year-long study of the Russian economy explored the performance of many of its most important industries: cement, confectionery, dairy, food retailing, general merchandising, hotels, petroleum, residential construction, software, and steel.¹ Our findings confirm the severity of Russia’s predicament. These ten industries average only 19 percent of US productivity levels, with software leading the group at 38 percent and cement in last place at 7 percent (Exhibit 3).

The old and the new

In today’s Russian economy, old and new facilities alike perform dismally. Labor productivity in Soviet legacy assets, which operated at roughly 30 percent of US productivity levels in 1992, has dropped by half, which indicates that those assets haven’t reduced their labor forces despite a sharp fall in demand from once captive consumers who now have access to products from around the world. For example, oil production—buffeted by a decline in domestic demand and in exports to the countries of the former communist bloc—has fallen by half since its 1988 peak, but employment in the industry still stands at roughly Soviet-era levels. Similarly, employment in the cement and steel industries remains at 1990 levels, while production has dropped by 60 percent.

Performance is bleak even in industries, for instance, residential construction, that have not been affected directly by foreign competition. The government finances more than half of all such construction in Russia. Although officially submitted to open bids, the contracts are almost invariably awarded to ex-Soviet companies closely affiliated with local authorities, which give these enterprises contracts in return for promises not to lay off workers. As a result, the contractors have no incentive to raise their low productivity, although a big increase would be easy to achieve.

New assets are hardly better. Those added since communism fell should have spurred productivity; in reality, they are a disappointment. Almost no new capacity is being added in economic sectors, such as the consumer goods and the oil industries, that could improve their performance most quickly. Compounding the problem is the tendency of local governments to prop up inefficient competitors through tax breaks in an effort to protect jobs.

So the consumer industries as a whole are small—Russia lacks the modern retail sector needed to distribute and market products economically—and individual companies are well below efficient scale. As for the petroleum industry, growth is virtually impossible because of export restrictions, unfair tax laws, and government programs that force companies to sell their oil at below-market prices to failing domestic concerns. The drilling of new wells has therefore fallen by two-thirds since 1990, despite Russia’s 127 billion barrels of estimated oil reserves, which could be extracted, in many cases, for as little as $6 a barrel. Moreover, new assets are well below efficient scale.

The software industry, one of the prime creators of jobs and value in healthy modern economies, employs a mere 8,000 workers in Russia, compared with 640,000 in the United States. Why is this important industry so small? For starters, 89 percent of all packaged software in Russia is produced illegally (Exhibit 4). Russian packaged-software firms therefore can’t produce sufficient returns to justify investing in new products or in research and development to improve existing ones. In addition, the software-consuming sectors, whose demand drives the emergence and growth of software firms, are both smaller and less interested in productivity-enhancing software tools than are their Western counterparts (Exhibit 5). In modern economies, for example, supermarkets—with their complex inventory management systems—are big consumers of software, but Russia has few of them. Similarly, modern banks use software to keep costs low and customer service high, but in Russia, where success in banking depends on relationships with the authorities, the demand for banking software is nearly nonexistent relative to demand in the United States.

Government meddling

The roots of Russia’s decline reach into the government. Russian markets have of course been deregulated and broadly privatized; to that extent, the country’s economy displays many of the features of a thriving one. But Russia is burdened with a peculiar kind of government manipulation—at the level of individual industries and companies—that guarantees decline and decay.

In healthy economies, businesses compete, and the most productive businesses are the most profitable. In Russia today, this logic is flipped on its head: competition is vigorous because of deregulation, but government-subsidized laggards drive the most productive companies out of business. In the confectionery industry, for instance, regional and municipal governments use the threat of hundreds of unnecessary fire, health, safety, and other inspections to prevent best-practice companies from laying off excess labor and reaping the productivity benefit of their investments. These governments prop up incumbent companies and the local jobs they represent by waiving or subsidizing their taxes.

To be sure, some of Russia’s poor performance results from macroeconomic factors like hyperinflation and volatile exchange rates. Yet government meddling through subsidies and tax forgiveness has itself contributed substantially to budget deficits and to the oversupply of money, and these problems have in turn prompted financial crises.

Nowhere is government interference more obvious than in the steel industry. About a quarter of Russia’s steelworkers labor in antiquated open-hearth plants that are only one-tenth as productive as US mills. Since these completely uneconomic Russian facilities lack cash, they are unable to pay their energy bills and continue to operate only because local governments—fearing massive unemployment and social unrest—prevent energy companies from cutting off their power. Indeed, subsidies through low-cost or free energy proliferate throughout Russian heavy manufacturing.

Without government intervention, food retailing would be a good source of high-productivity service sector jobs. Roughly one-third of Russian food sales now pass through novel kinds of food retailers, such as kiosks and container markets, that didn’t exist in Soviet times. Yet these new businesses are only about 25 percent as productive as first-class supermarkets abroad; in fact, they are hardly better than the famously inefficient Soviet "gastronoms," which required customers to go to counters three times for each item purchased. All told, only 0.2 percent of food sales in Russia take place in supermarkets, as compared with 18 percent in Poland and 36 percent in Brazil—both of which have comparable per capita GDPs.

Why don’t supermarkets dominate? For one thing, the Russian tax system is explicitly biased against them. They have to pay taxes amounting to 8 percent of sales, versus less than 1 percent for small food vendors. Since the government in effect subsidizes the competitors of supermarkets, multinational food retailers, seeing no chance for profits, stay out of Russia and thus don’t expose the country to best practices. Such multinational retailers can overcome bureaucratic red tape, find legal ways to deal with corrupt public officials, and even cope with physical threats from organized crime, but they can’t overcome an inability to make money. Total foreign direct investment in general retailing amounts to only $100 million in Russia, compared with $2.1 billion in Poland.

Still, the potential for supermarkets is huge. In Obninsk, in central Russia, they gained a 15 to 20 percent market share after the local government forced all competitors to abide by the same land allocation, tax, tariff, and counterfeiting policies. Supermarkets and hypermarkets in Poland, which started out in 1989 with a mixture of retailing formats similar to the one prevailing at that time in Russia, gained an 18 percent market share in less than five years after the government implemented equal tax policies and made land available.

For richer or for poorer

Can the Russian economy be turned around? It is an open question. On the positive side, the country’s potential for rapid productivity growth, and thus overall economic expansion, is extraordinarily high. Surprisingly, only about 25 percent of Russia’s industrial capacity is subscale or obsolete. Although this ought to be shut down, the remaining 75 percent could rapidly operate at 60 to 70 percent of US productivity levels if it were managed well and improved with only modest investments (Exhibit 6). Moreover, Russia can rely on a skilled and inexpensive labor force and on larger proven oil and gas reserves than exist in any other country, including Saudi Arabia.

Moreover, Poland’s recent history shows that fear of unemployment—the "official" underlying reason for much government intervention—is largely unfounded. As the economy grows and modernizes, jobs will be shed but new ones will be created. A further economic benefit of less government micromeddling would be a lower level of corruption, since in Russia much of it is closely tied to government support programs. Remove them, and the potential for self-dealing and conflicts of interest falls accordingly.

Russia does offer two tiny examples—one sectoral, the other geographic—of healthy economic activity that isn’t constrained by government interference. Software project services, though employing only 6,000 people, achieve 72 percent of the US productivity level. This sector is completely unregulated: since it didn’t exist in Soviet times, there are no legacy jobs for the government to protect. And the Novgorod region, 380 miles northwest of Moscow, endures far less interference than do other parts of the country. Novgorod thus increased its per capita GDP by 3.8 percent a year from 1995 to 1998, while the GDP of the rest of Russia fell by 2.7 percent a year, and the region attracts five times as much foreign direct investment per capita as the rest of Russia (Exhibit 7). Since foreign companies bring in global best practices, Novgorod likely will continue to have a buoyant economy. This, however, is an island of performance in an ocean of decline.

The reforms needed to reverse the current downward spiral will require a huge and painstaking political effort. Advanced democracies have taken decades to develop effective economic policies, both at the macroeconomic and the sector levels. Russia can benefit from the hard lessons learned there, but leading a democratic process to overcome the obstacles will be difficult. On the economic side, however, we have found no fundamental constraints that would prevent Russia from quickly joining the ranks of the advanced economies.