BUSINESSWEEK ONLINE : OCTOBER 16, 2000 ISSUE
INTERNATIONAL ECONOMICS

Russia's Middle Class
It has emerged from the rubble of 1998. But can it grow and prosper?

Irina Lyakhnovskaya is a go-getter. Her hometown of Samara in central Russia straddles the Volga River and is surrounded by miles of fertile grassland and the Zhigulevskiye Mountains. In 1996, she started a tourist company, with seed capital supplied by herself and three friends, that specializes in arranging hunting and fishing trips for visitors from Finland and Norway. She drives a Russian-made Lada that she purchased new, for $3,500, two years ago, and she spends weekends at a country dacha that has an apple orchard she harvests to make her own wine. Last year she took vacations in Hungary and Romania, and this year she plans to get to Britain. In a country where the average factory worker is lucky to make $150 a month, she makes as much as $500.

Lyakhnovskaya, 38, embodies a major shift in Russia's economic landscape. Boosted by a resurgent national economy and by its own bootstraps, a middle class is taking root in the former land of the proletariat. They're concentrated in the big western metropolises of Moscow and St. Petersburg. But millions of others, like Lyakhnovskaya, are sprinkled across Russia in provincial cities from Samara and Nizhny Novgorod on the Volga River, to Perm and Yekaterinburg in the Ural Mountains, to Vladivostok in the Far East. By profession, most are entrepreneurs who own their shops, restaurants, hotels, bakeries, and computer software companies. Many are accountants and lawyers. Others are managers at big Russian and multinational companies such as Coca-Cola Co. ( KO) and gas monopoly Gazprom ( OGZPF). Analysts estimate 12 million to 30 million Russians, some 8% to 20% of the nation's 145 million population, qualify as middle class.

What does it mean to be middle class in Russia? Forget the house and mortgage, the golden retriever, and the sports-utility vehicles so common in the U.S. They're not saddled with mortgage payments because most live in apartments they got for free during privatization. They don't put their savings in the bank because they don't trust the banks or the oft-devalued ruble.

FRAGILE. But like their counterparts in the West, they're a stabilizing force in Russia's economy. Many are plowing their savings into their own businesses, creating jobs in the process. Russia's middle class now produces some 30% of the country's gross domestic product of $220 billion, calculates the Russian business magazine Expert.

In Moscow, a typical family of three ought to be able to make it into the middle-class with a combined monthly intake of $800, according to estimates developed by BUSINESS WEEK. In Samara, the same family could make it on $300. Members of the upper strata earn as much as $7,000 a month. Families in the center of the new class enjoy what most citizens can only regard as a dream lifestyle. They can afford to own a foreign car, as opposed to a more breakdown-prone Lada. They can escape to a country dacha that, unlike the makeshift shacks typically kept by poorer people, has indoor plumbing and heating. They can afford private medical care in an emergency, whereas those below are confined to the abysmal care meted out by public clinics. Such an existence breeds what analysts view as a distinguishing psychological feature of the sturdiest members of the new middle class--a sense of empowerment.

But their newfound status is fragile. Members of this group quake in fear that a grasping government will snatch away their hard-won savings. They uneasily sense that their neighbors envy their relatively high stations. Many are eager to start new businesses, but hardly any can find a bank to lend them money. And they are haunted by the prospect of a fresh national economic calamity. ''One new crisis, everything I have will be wiped out,'' says Lyakhnovskaya.

It's happened before. A fledgling middle class got its start during the chaotic rein of Boris N. Yeltsin, but many saw their fortunes wiped out by the economic crisis of August, 1998. Now, a buoyant economy is lifting them back up--and bringing new people with it. Aided by soaring oil prices and a devalued ruble, Russia's economy is projected to grow 5.5% this year, after expanding 3.2% in 1999. The 1998 devaluation helped boost a new set of entrepreneurs by creating an opportunity to fill a niche once supplied by now- too expensive imports. ''In the wake of the 1998 crisis, a lot of people have managed to survive and even improve their situation,'' says Harley Balzer, a Russia expert at Georgetown University.

BEST HOPE. Their ranks will grow if President Vladimir V. Putin can push through his initiatives to allow private ownership of land and to create a national banking system that can extend mortgages to prospective homeowners and credits to small businesses.

There can be no better news for Russia than the emergence of a middle class. Such a cadre of stakeholders is this troubled country's best hope for building a stable, civilized, prosperous society. Above them, in income if not manners, are Russia's notorious oligarchs, who have plundered the nation. Below them are Russia's working poor. Although these lower-income citizens are extremely resourceful, they are in no position to assert their interests against an overweening state or to create the sturdy civic institutions that Russia so badly needs. If such a thrust is going to come at all, it will likely be spearheaded by the new middle class. And despite the best efforts of the old Soviet regime to annihilate the very idea of a middle class, the dream of attaining just such a status is the central animating vision for its legions of strugglers. ''Everyone wants to be middle-class,'' says Leokadia Drobizheva, director of the Institute of Sociology at the Russian Academy of Sciences in Moscow.

Samara is an example of the depth and resilience of Russia's new sredni klass, as the Russians call the middle strata. A city of 1.2 million on the Volga River in southeastern Russia, its economy has been lifted by the progressive, probusiness policies of Governor Konstantin Titov. It is home to Russia's largest auto company, Avtovaz, which makes the Lada. Foreign investors such as Coca-Cola and Nestle ( NSRGY) operate there. Noting its improved economic performance, Standard & Poor's Corp. recently raised its long-term credit rating on Samara region bonds to B- from CCC.

Samara is, as Americans would say, a nice place to raise a family. In the heart of the city is a mile-long beach and riverfront promenade graced by ashberry trees, ice cream stands, and outdoor cafes. Pensioners in bathing suits bat around a volleyball on the beach. Young men and women in business dress stroll the walkway alongside mothers with baby carriages. Up the road is the town's new entertainment center, a mall featuring a Dolby-sound multiplex cinema, a billiards hall, a video arcade, and a children's play area.

Seeking a grasp on the sensibilities of Russia's new middle class, BUSINESS WEEK recently gathered together a crew of seven in Samara. The participants, ages 23 to 50, four women and three men, included an engineer turned crayfish farmer, a lawyer, and a trio of business consultants. For two hours on a Thursday evening, they sipped beer (Heinekens, preferred to Russian-made Balticas), snacked on salami sandwiches and potato chips, and talked about how they were doing.

Sure, things are tough. But they're getting better. The economy is adding jobs--and business opportunities. As bad as the 1998 economic crisis was, these folks weathered it, and they have acquired an unpaternalistic attitude, unusual in Russia, toward risk. Capitalism, at least, offers flexibility.

CAREER CHANGERS. Most of these folks have already changed careers at least once. Lyakhnovskaya, an environmental engineer at a defense plant in the Soviet era, founded an insurance business in 1992. But the enterprise struggled, and four years later she abandoned insurance to launch the tourist agency. The tourist company itself nearly died during the 1998 financial turmoil. For three months, no money came in at all. Vitali Kozhevatkin, 43, a Soviet-trained sea transport engineer, turned to crayfish farming after his precrisis venture installing car alarms went belly-up. Volatility, he said philosophically, is an inescapable part of business life in Russia.

Also starting such businesses are a growing number of ex-military men. ''Many officers are just afraid to change their lives. It's a hassle, but I am glad I did,'' says Sergei Tolmachev, 39, a former major in the military's engineering corps who now runs a Samara consulting firm that helps businesses lease commercial real estate. Tolmachev, who sold his Lada to raise funds for his enterprise, estimates that from 15% to 20% of small-business operators in Samara hail from the military or the security services. ''The skills you get in the Army help you to be more flexible, to understand a situation immediately, to make decisions,'' he says.

The revival of a small-business-dominated bourgeoisie in Russia harks back to the twilight of czarist times, when Moscow, St. Petersburg, and leading provincial towns had a nascent middle class that also consisted principally of merchants and small firms. In the greater Samara area, a new generation of such proprietors have established some 150 to 200 enterprises within the last two years alone to supply equipment such as tables and shelves to a growing number of shops, street kiosks, restaurants, and bars. There are now some 400 independent bakeries in the region and approximately 80 independent gas stations. There are also a number of furniture makers and companies that make computer software. With the benefit of a cheaper ruble, small firms producing dairy products have increased their share of the regional market from 10% before the crisis to 40% now.

No doubt, many of the entrepreneurs underreport income to evade taxes--something of a national pastime in Russia. Nevertheless, in sharp contrast to the oligarchs, who specialize not just in tax evasion but also in asset-stripping and offshore banking accounts, these folks typically are plowing profits back into their ventures, thus helping to create jobs and a sustainable economic base. And they're looking to get more locally involved, not less. ''I'd feel safer if I had my own solid property,'' says Lyakhnovskaya.

It's not just small-business operators, of course, that are supplying Russia's new middle class. Also feeding the ranks are managers at big Russian and multinational firms. Foreign companies, which generally pay higher salaries, are turning increasingly to Russians to fill management jobs once held by expats. In Samara, for example, the new general manager of Coca-Cola Bottlers is a Russian, replacing a British national. Many expats left the city after the 1998 crisis, and the available pool of qualified Russian managers is getting deeper each year.

The other big segment of the new middle class consists of white-collar professionals providing services to businesses and wealthy and other middle-class individuals. These include lawyers, accountants, and, especially in Moscow, a growing cadre of folks at advertising, marketing, and public-relations firms.

Meanwhile, the new middle class is beginning to create civic institutions to promote a healthy business environment. A growing force is the Chamber of Commerce of the Samara Region, based in the center of town in an elegant mansion built by a wealthy 19th century merchant and used as a hotel by the Communist Party brass during the Soviet period. There are 900 members, 700 of them small businesses. Considerable energy is devoted to lobbying the regional political administration and legislature, based in Samara. The chamber recently managed to stave off an energy tax proposal that member independent gas stations feared would hurt their efforts to compete with the retail outlets affiliated with locally based Yukos Oil Co., a big vertically integrated oil company. ''We are provided with all draft [regional] laws,'' says chamber Vice-President Alexander V. Andriyanov.

Samara's businesswomen, meanwhile, have formed their own club, headed by the owner of a local art gallery. Its 20-odd members meet there twice a month and helped elect one of the crew, Alla Dyomina, a health-care administrator, to the regional parliament. Dyomina keeps the club abreast of the local legislative scene, and members have a direct channel into the Samara regional administration: The husband of the gallery owner works for Governor Titov. In Russia as a whole, some 40% of 890,000 registered businesses are owned by women, according to the Moscow-based Federation of Russian Business Owners.

SIMPLIFIED TAXES. That's not surprising, given that women were the first to be let go when Russia's economy collapsed in the 1990s. Most of the women in the federation are in their forties and fifties; half are supporting their entire families; virtually all are making solid middle-class incomes of at least $1,500 per month. ''Women are more flexible in changing conditions. They adapt more easily,'' says Ludmila Davydenko, 44, a mathematician who runs a consulting company in Vladivostok that provides information and marketing services to construction contractors.

The real question is whether the truly down-and-out places in Russia can get on a Samara track. The development of a middle class is too large a task for local initiative alone. That's why there is ultimately no substitute for action by the Kremlin to create the basic conditions in which a middle class can have at least a chance to establish itself in such hardscrabble soil. But the idea that the Kremlin seems to be targeting the middle class as a group in need of help triggers a visceral qualm. ''Historically, whatever Moscow authorities pay attention to immediately goes wrong,'' says Elena Tsykalo, a Samara consultant who helps fledgling entrepreneurs get off the ground.

So far, Putin's regime has a mixed record. It improved matters by enacting a tax-reform bill that both simplified the tax code and slashed rates. Under the new law, all individuals will pay a flat tax of 13% on income. Payroll taxes that are paid by employers, including small businesses, are cut. Also helpful is the Putin team's liberal views in favor of open markets, which has spurred an increase in foreign investment.

Legislative enactment of a measure supported by Putin to permit ownership of land could enfranchise a potentially vast class of new property owners. Now, entrepreneurs can buy a building, but they can't buy the land underneath it.

No less important is Putin's initiative to create a credible national banking system to which small businesses and consumers have easy access. There is at present no system of deposit insurance for savers; there is almost no market in mortgages for residential housing; and very few small-business owners are able to get a loan from a bank. Bank deposits, which typically comprise half of gross domestic product in Western countries, make up only 4% of GDP in Russia.

Russia remains a laggard among post-Soviet empire nations in building a middle class. But it can't be forgotten that Russia was ground zero for the Bolshevik Revolution, for the doomed project of building a classless society. Lenin, the lawyer who led that cause, was a man of bourgeois origins, a native, in fact, of the Samara region who came to despise his own roots. He still lies entombed in a mausoleum on Red Square, but an emptier symbol is hard to imagine. For all around him, Russians have resumed their quest, frozen in time, for a middle-class society. And slowly, with no doubt more stumbles to come, they are getting there.

By Paul Starobin in Samara, with Olga Kravchenko in Moscow

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