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RUSSIA’S INDUSTRIAL CAPACITY Russia's key industries  Steel, cement, construction, dairy, confectionery, oil, retailing, hotels and software. The Russian economy shares many of the features of a thriving economy, it is burdened with a unique and peculiar brand of government manipulation at the level of individual industries and companies that guarantees decline and decay.  With bountiful and diverse minerals, Russia, the world's largest country in land area, occupying 75% of the former Soviet Union, had a significant percentage of the world's mineral resources and produced 14% of the world's total mineral extraction. Mining was the country's leading industry in 2002, and Russia was the largest producer of palladium and nickel (20% of world output), and ranked second in the production of aluminum and platinum-group metals (PGMs), third in potash, sixth in gold, and seventh in mine copper. Russia also produced a large percentage of the CIS's bauxite, coal, cobalt, diamond, lead, mica, natural gas, oil, tin, zinc, and many other metals, industrial minerals, and mineral fuels. Enterprises considered part of the mineral and raw-material complex contributed 70% of the budget revenues derived from exports; petroleum, petroleum products, and natural gas were Russia's leading export commodities in 2002; metals and chemicals also were leading export commodities. RUSSIA’S MILITARY CAPACITY  Russian military capacity remains a major consideration for global security even in the post-Soviet era. This book assesses today's Russian military and analyzes its possible future direction. The contributors–experts on the subject from both Russia and the West–consider not only how Russia has built its military capacity but also the policies and doctrines that have shaped Russia's defense posture. They discuss such topics as the downsizing of the Russian military, Russia's use of military power in regional conflicts, and the management of Russia's nuclear weapons.  For more than a decade, Russian leaders have struggled to formulate security and defense policies that protect Russia's borders and project Russia's influence. The contributors to The Russian Military find that the choices Russian leaders have made have been significantly influenced by the military reforms Russia has attempted to implement since the collapse of the Soviet Union. The protracted and intense debate over military reform has been– and will continue to be–decisive in shaping Russian military capacity.

RUSSIA’S INDUSTRIAL CAPACITY The demise of the Soviet Union a decade ago astounded the world. The subsequent demise of Russia's economy is astounding too. State-owned businesses have been privatized, prices are deregulated, and competition abounds. Yet unlike Poland, which has seen per capita gross domestic product rise 20% since 1989, Russia's per capita GDP has plummeted more than 30% since 1989. Productivity is less than 20% of the U.S. level and stagnating. To paraphrase Tolstoy, healthy economies are all basically alike. Unhealthy economies are each unhealthy in their own way. The McKinsey Global Institute has recently completed a year-long study of the Russian economy that looked in depth at the performance of many of Russia's key industries – steel, cement, construction, dairy, confectionery, oil, retailing, hotels and software. Our work shows that although the Russian economy shares many of the features of a thriving economy, it is burdened with a unique and peculiar brand of government manipulation at the level of individual industries and companies that guarantees decline and decay. In healthy economies the most productive companies are the most profitable. In Russia today, this logic is flipped on its head. The most productive companies not only can't make a buck, but are being driven out of business by government-subsidized productivity laggards. Yes, some of Russia's poor performance can be traced to macroeconomic factors like hyperinflation and exchange rate volatility. Yet even here the underlying culprit is governmental micro-meddling. Subsidies and tax forgiveness have contributed substantially to the government deficits and oversupply of money that have triggered financial crises. Nowhere is governmental interference clearer than in the steel industry. About a quarter of Russia's steelworkers are employed in antiquated open-hearth plants, which are only 10% as productive as U.S. mills. These mills are out of cash and cannot pay their energy bills, but continue to operate only because local governments – fearing massive unemployment and social unrest – prevent energy companies from cutting off their power. This subsidy through low cost or free energy is rife throughout Russian heavy manufacturing. Yet in the vast majority of cases the government's fears are unfounded. The natural evolution of most of these local economies would create more than enough jobs in the service sector to redeploy workers shed in closing these uneconomic steel plants. Absent government intervention, a good source of new high-productivity service-sector jobs would be food retailing. Roughly one-third of Russian food sales now go through new types of food retailing enterprises that did not exist in Soviet times. Yet these new businesses are only about 25% as productive as first-

class supermarkets, and little better than the famously inefficient Soviet “gastronomes,” which required a customer to go to a counter three times for each item purchased: once to identify the specific item to buy, once to pay for the item, and once to pick-up the item. All told, only 0.2% of Russian food sales are in supermarkets. In Poland and Brazil, which have similar levels of GDP per capita, the figure is 18% and 36%, respectively. The Russian tax system is explicitly biased against supermarkets, which have to pay taxes equal to 8% of their sales compared with less than 1% for small food vendors. Without the prospects of profits because their competitors are effectively subsidized by the government, no multinational food retailer will ever bring best-practice food retailing methods to Russia. Multinational food retailers are more than able to overcome the problems associated with bureaucratic red tape, corruption of public officials, and even physical threats from organized crime. But they cannot overcome not making money. Total foreign direct investment in general retailing amounts to $2.1 billion in Poland, in contrast to $100 million in larger Russia. Whether the Russian economy can be turned around is an open question. On the positive side, the potential for rapid productivity growth and thus overall economic growth in Russia is extraordinarily high. Surprisingly, only about 25% of Russia's industrial capacity is so technologically obsolete that it should be shut down. The remaining 75%, if well managed and improved with modest investments, would rapidly reach 60% to 70% of U.S. productivity. Moreover, Russia can rely on skilled and inexpensive labor, and larger proven oil and gas reserves than any other country, even Saudi Arabia. The recent history of Poland shows that fear of unemployment, which is the underlying reason for much of government intervention, is largely unfounded. As the economy grows and modernizes, jobs will be shed, but new jobs will be created. A further economic benefit of removing micro-meddling by the government will be a reduction of corruption, since much corruption in Russia is closely tied to the intricacies of government support programs. Remove the programs and the potential for self-dealing and conflicts of interest falls accordingly. Russia also contains two tiny examples of healthy economic activity where the government does not interfere. Software project services, although employing only 6,000 people, achieve 72% of U.S. productivity levels. This sector is completely unregulated, and since it did not exist in Soviet times there are no legacy jobs for the government to try to protect. In addition, the Novgorod region, located 300 miles northwest of Moscow, has far less government interference than the rest of Russia. Its elected officials have seen good economic policy as the key to the economic performance that would get them reelected. As a result, Novgorod has increased its GDP per capita by 3.8% per year from 1995 to 1998, while the rest of Russia declined by 2.7% annually. Novgorod, with a population of only one million, attracts five times as much foreign direct investment per capita as the rest of Russia. With foreign companies bringing in global best practices, Novgorod's performance will continue to outpace the rest of

Russia. The governor of the region, Mikhail Prusak, was just re-elected with over 90% of the vote. But Novgorod is an island of performance in an ocean of decline. The reforms necessary to break out of the current downward spiral will require huge and painstaking political efforts. Advanced democracies have taken decades to achieve good economic policy, both at the macroeconomic and sectoral levels. Russia can benefit from the hard lessons learned there, but Russia has yet to develop an effective political class to craft and implement a reform program. This may be Russia's biggest challenge. The path that Russia will take is uncertain, but the implications for the West are crystal clear. By focusing primarily on high-level macroeconomic policy, the IMF, the U.S. government, and most economists have completely misunderstood the peculiar realities of the Russian economy. The right framework could all be in place, but national and local government interference in individual industries is so pervasive today it will undermine even the best macro policies. No more Western taxpayers' money should be put at risk through loans to the Russian government when the Russian governments own interventions in the microeconomy are undermining the very stability the loans are meant to achieve in the first place.

RUSSIA’S MILITARY CAPACITY Russian military capacity remains a major consideration for global security even in the post-Soviet era. This book assesses today's Russian military and analyzes its possible future direction. The contributors–experts on the subject from both Russia and the West–consider not only how Russia has built its military capacity but also the policies and doctrines that have shaped Russia's defense posture. They discuss such topics as the downsizing of the Russian military, Russia's use of military power in regional conflicts, and the management of Russia's nuclear weapons. For more than a decade, Russian leaders have struggled to formulate security and defense policies that protect Russia's borders and project Russia's influence. The contributors to The Russian Military find that the choices Russian leaders have made have been significantly influenced by the military reforms Russia has attempted to implement since the collapse of the Soviet Union. The protracted and intense debate over military reform has been–and will continue to be–decisive in shaping Russian military capacity. Russia, on the other hand, lacks the extensive and expensive networks of bases and intelligence-deployment capabilities to actually be true to its word of going after bases "regardless of what region they are located in," according to

Yury Baluevsky, Russia's chief of the general staff. Since the end of the Cold War, Russia's external military capabilities have been greatly curtailed, resulting in recalling its personnel and even closing some bases in many parts of the world. While Russian intelligence may be capable of intercepting and deciphering communication traffic between suspected militants and their bases, this effort has not been followed up by quick military action necessary to destroy the threat. The country did have limited success in preemptive strikes against the Chechen leadership in the first Chechen War of 1994-1996; indeed, Russia's missile strike killed the leader and inspiration of Chechen resistance, General Djohar Dudaev, after intercepting his cellular phone conversation. But such successes have been few, as Russia is trying to adjust to the geopolitical reality of the new threat posed by the largely international terrorist efforts. At present, Russia has a growing network of bases in its near-abroad, in Central Asian and Caucasus countries on its southern borders. Its military presence in Kyrgyzstan, Tajikistan and Armenia, as well as Georgia, allows it to launch potential strikes at a number of countries that may have terrorist bases on their territories. Such capability will augment Central Asia's fight against its own terrorist formations, such as the Islamic Movement of Uzbekistan. But Russia has limited military reach beyond its southern rim, and military strikes against other states may invite unwelcome political stalemates. This took place recently with the Republic of Georgia's public stand against the Russian Federation on the question of Georgia's Pankisi Gorge, located to the south of Chechnya. The Russian government was convinced that Chechen rebels and terrorists who supported them were hiding out in the gorge, and repeatedly pressured Georgia to allow Russian forces to invade. The Georgian government rejected such proposals, instead relying on its U.S.-trained troops to conduct a sweep of the area in question. The sweep revealed no threatening presence of guerrillas, and the Russian government accused Georgia of wasting time and allowing the suspected fighters to escape. At question in this scenario was the violation of Georgia's territorial integrity and the potential military conflict that might have resulted between the two countries. Nor is Russia capable of containing the situation in Chechnya to the levels where military action alone should be enough to limit the rebel activity. The deadly attack on Ingushetian and Russian forces by the Chechen guerrillas this summer underscored Russian forces' inability to identify and interdict the potential threats before they materialize a crucial factor in conducting preemptive operations. Recent attacks in Beslan once again drove home Russia's need for more capability amongst its various security forces to properly meet the new threats before they occur. This weakness, according to Russian military experts, stems from the unprepared ness of Russian security forces to combat new threats. Russia's Special Forces are still using the modus operandi of the Cold War, when they

were created for counter-terrorist operations. However, the terrorist threat itself has changed drastically since that time, and the new crop of hostage-takers do not ask for financial compensation, or the ability to escape unarmed to a neutral territory. Throughout the Cold War, the U.S.S.R.'s Special Forces were trained to act after its government would undertake a major negotiation effort. At present, such conditions no longer apply. As the situation in Beslan showed, fast, coordinated, well-rehearsed action -- the opposite of what actually took place -by the security forces was necessary to prevent the tragedy.