Ruchir Sharma on Russia

While economic growth in most emerging markets has returned to levels that prevailed during the boom years of 2003 to 2007, Russia is struggling to shrug off the "new normal" ball and chain. Two years after the global financial crisis, it is one of the few developing countries where growth forecasts are still being downgraded.

The country suffered one of the worst declines, with the economy contracting more than 10 percent on a peak-to-trough basis. Of all the major emerging markets, Russia will likely be the last to recoup its lost output; the economy is set to return to its pre-crisis peak only by the end of 2011.

So why has Russia lost its mojo? After all, in the last decade it grew at the same pace as the average emerging market, off the back of the global liquidity glut and soaring commodity prices. Those factors are once again propelling peers like Brazil, but Russia has yet to partake in the current boom.

It seems Russia's economic model is in need of a major recast for the country to move to the next stage of economic development. At the end of the 1990s Russia's economy was in complete chaos, and its per capita income was a poor $1,500. It needed strong political leadership to stabilize the system, and it got that from Vladimir Putin, who took over as president in 2000. Russia was subsequently able to participate in the wider emerging-market renaissance that followed.

But a decade later, with a per capita income of more than $10,000, the rules of the game have changed. Success carried too far can become a country's weakness. A heavy-handed, centralized form of government (the state's share in the economy is now a massive 50 percent) is thwarting Russia's further economic progress.

An old rule of development economics is that a rich nation produces rich goods. For Russia to become a fully industrialized country, it needs to move beyond natural resources and into more innovative and tech-savvy industries. To do that, it must dramatically improve the investment climate by clipping the government's tentacles at every level.

South Korea and Taiwan were able to grow at 6 percent even after their per capita income crossed $10,000 because these nations created an environment in which small and midsize businesses could prosper. Russia, by contrast, has a smaller percentage of small and medium enterprises (SMEs) as a share of overall business than any of the world's major economies. World Bank surveys rank Russia 120th out of 183 countries for the ease of doing business. Budding entrepreneurs cite the maze of bureaucracy, poor contract enforcement, and the lack of access to easy credit as major impediments to growth. Thanks to an underdeveloped banking system, Russian SMEs pay interest rates of 15 to 20 percent, and the mortgage market is virtually nonexistent. Russia's loan-penetration ratios are similar to those of countries such as Egypt that have a far lower per capita income.

Indeed, the Russians ran into serious trouble during the 2008 global financial crisis because many corporates borrowed heavily from overseas between 2003 and 2007, resulting in a panic in the domestic marketplace when that source of funding dried up. Steps to improve the banking system will go a long way toward increasing Russia's domestic savings and investment ratios. With the share of investment in the economy at a low 20 percent, the cracks in infrastructure are only too visible—witness the jammed roads of Moscow and an archaic rail network that connects the capital city to the hinterland.

It's incredible that even with oil at $80 a barrel, Russia's government requires help from the private sector and foreign investors to build out its infrastructure. Nearly two thirds of government expenditure goes toward social spending, and the country's budget deficit is currently 4 percent of GDP. Fortunately, the penny is beginning to drop among some policy-makers that Russia needs a sea change in its economic direction. One marquee project designed to move the country up the high-tech ladder is the new science center Skolkovo, under construction near Moscow, and billed as the country's answer to Silicon Valley. Russia certainly has the human capital to succeed in scientific and medical areas.

However, it is imperative for the authorities to understand that a richer Russia requires less top-down management and more individual enterprise. When Russia was a poor country, abundant in natural resources, it required a strong government. A decade later, a more developed Russia needs a new model.