Kaliningrad Breaks Out

Authors:

Paul Abelsky

 

Russia Profile. Special Economic Privileges Help Define the Exclave

In late December, the State Duma approved federal legislation amending the guidelines governing the Kaliningrad Region Special Economic Zone (SEZ). Signed into law by President Vladimir Putin on Jan. 17, the newly introduced measure modifies an arrangement that has been in place since 1996, when the area was granted a number of special economic concessions, centered on taxation privileges and lower tariffs.

 

While the existing customs regime is extended for 10 years, the latest plan launches several new initiatives. It grants full corporate income tax relief during the first six years of operations for companies investing at least 150 million rubles (around $5.2 million) over a period of three years; during the subsequent five years of production, corporate income tax is reduced by 50 percent. Several segments of the economy are excluded, including financial services, alcohol and tobacco production, and the oil and natural gas sector. As part of the agreement, a large portion of the value added component has to occur in the Kaliningrad region itself, while eligible companies are mandated to employ 50 percent of their workforce from among the local residents.

 

For 10 years, Kaliningrad has been the presumed ground zero of Russian economic innovation. The new legislation once again confirms and recognizes the area’s exceptional status as the westernmost and the only noncontiguous region in the Russian Federation. But the new plan hardly advances the kind of fundamental restructuring needed to normalize Kaliningrad’s place in Europe while fostering its economic ties with the rest of Russia.

 

The shifting sands of post-Soviet history have produced startling patterns on the geopolitical and economic landscape, and the exclave of Kaliningrad and the surrounding region may be the most unusual permutation. Few other areas in Russia have summoned so much hope and elicited so much disappointment. Yet the inbuilt economic potential of the region, now fully submerged in the territory of the European Union, continues to encourage imaginative economic experiments, conjuring up visions of a thriving free trade zone that could serve as a vital east-west interface between Europe and the Russian Federation.

 

Kaliningrad is the smallest territorial subject of the Russian Federation, with a densely settled population numbering nearly 1 million. As the former capital of East Prussia it was known as Koenigsberg, but the territory was conquered, taken by the Red Army in the waning months of World War II and integrated into the Soviet Union. To the long-lasting chagrin of the Lithuanians, Soviet leader Joseph Stalin assigned the region to the Russian Republic of the Soviet Union, sealing the area’s peculiar fate.

 

This historical background unavoidably accompanies all present considerations of Kaliningrad’s future. “The region still brings back the memory of World War II, Yalta and so on, like no other region in Central Europe,” said Bartosz Cichocki, an analyst at Warsaw’s Center for Eastern Studies and a specialist on Kaliningrad. “That’s why I doubt that the attitude of the Europeans to Kaliningrad will someday become completely free of fear and prejudice.”

 

After 60 years of Soviet and Russian domination, the city faces issues familiar to the rest of the country. Problems range from developing viable transport and trade infrastructure to attracting investment and converting past industrial facilities for modern uses. Spruced up last year for the celebration of the city’s 750th anniversary, Kaliningrad’s local government has launched a slew of construction projects that are transforming the grim face of the city’s Soviet heritage.

 

Even before the rest of Russia, Kaliningrad had to come to terms with Europe’s changing political jigsaw and the economic challenges posed by EU integration. Indeed, the region’s post-Soviet experience is a microcosm of Russia’s tortuous drive to endure political tremors, cope with economic breakdown and develop an effective strategy of recovery.

 

If Kaliningrad’s story is not overly encouraging, that is partly because its circumstances are unique even by European, if not world, standards. While hopeful parallels exist with such enclaves as Gibraltar or perhaps city-states like Singapore, Kaliningrad is encircled by countries that subscribe to sharply differing, and better-coordinated, economic principles. The region’s living standards are below those of its immediate neighbors – Poland and Lithuania – not to mention the nearby Germany and the Scandinavian states. Higher transit expenses create an added cost for the whole market of goods. An insular outlook that does not engage with this geographic reality would be tantamount to inevitable collapse. The outcome has brought predictable tensions, but also a kind of far-sighted pragmatism in confronting the region’s problems of economic development.

 

“The issue partly consists of a rather modern Russia coming in touch and having a region that is more post-modern than modern,” said Pertti Joenniemi, senior research fellow at the European Department of the Danish Institute for International Studies in Copenhagen. “What makes Kaliningrad special is that Russia has little experience with a part of Russia that is geographically at a distance and not an integral part of the motherland. From this perspective, Kaliningrad invites and mandates Russia to view itself in increasingly post-modern terms with a piece of it being simultaneously linked to the EU.”

 

With regard to the SEZ, the new version is expected to come into effect on April 1 and last for 25 years. It will require changes in more than 30 existing legislative acts, including the federal taxation and customs codes. Conceived under the auspices of former Kaliningrad Governor Vladimir Yegorov, the measure at last came to fruition after the new governor, Georgy Boos, previously a deputy speaker of the State Duma, assumed the post last September. The final legislative push was accompanied by extensive haggling in the Duma, concluding a strenuous effort to amend the current regulations.

 

Great expectations

 

The SEZ is an attempt to tap into the region’s striking economic potential. The area features Russia’s only ice-free port on the Baltic, and includes mineral deposits, a well-educated workforce and an advantageous location at the crossroads of Northern Europe. According to local officials, discussions of Kaliningrad’s economic future became a critical issue as early as 1989, when the independence movement began to sweep the Soviet Baltics, threatening to isolate Kaliningrad from the rest of the country. The earliest SEZ legislation was initiated in September 1991, before the Soviet Union officially came apart. The government of the Russian Republic established the so-called “Yantar” (“Amber”) zone within the region’s borders, whose status was further defined in 1995 and made law in January 1996.

 

The optimistic scenario of Kaliningrad’s prospects was dampened soon after the Soviet collapse by an abrupt fall of about 80 percent in the region’s economic output, a rate much sharper than that suffered by the rest of Russia. For all the complexities and costs of transit, the presence of Russia’s Baltic Fleet, which is stationed in the Kaliningrad region, created a set of nearly insurmountable tensions with the neighboring states. Lithuania and Poland, naturally, were not inclined to allow the transport of military equipment and supplies through their territory, obliging Russia to resort to air and sea passage.

 

By lowering tariffs and setting up tax havens inside the area, the authorities aimed to stimulate investment in the local economy and gradually integrate it into the Baltic regional system of trade. While the early form of the SEZ may have instigated a measure of economic activity, it placed Kaliningrad outside the customs and tax regime that governed the rest of Russia. That had the effect of fueling lucrative but shadowy trade ventures, focused on reimporting to mainland Russia those goods that were bought at much lower tariffs in Kaliningrad. Instead of benefiting from Kaliningrad’s proximity to the EU, the zone had the reverse effect of funneling cheap imports to Russia while eroding the region’s tax revenues.

 

The original function of the SEZ was to serve as a stabilizing mechanism, explained Feliks Lapin, the region’s economics minister, at an early February conference in Kaliningrad devoted to the 10th anniversary of the SEZ. “Initially, the purpose was to steady the regional economy,” he said. “It was created to compensate for the area’s location and offset the consequences of the region’s severed ties within the Soviet system.”

 

Pros and cons

 

But the SEZ has had adverse side effects that continue to strain the area’s economy. Although economic growth has hovered around 10 percent in the past several years, surpassing Russia’s overall rate, the volume of imports has exceeded the gross regional product by three to four times. The ballooning trade deficit negated the modest development of the local industrial base, while the expected flurry of foreign investment has mostly failed to materialize.

 

The notable exceptions include BMW, the German car maker, which runs an assembly factory in Kaliningrad. There are also hundreds of smaller joint ventures with entrepreneurs from Lithuania and Poland, the two countries that have been the most active in setting up partnerships with businesses in Kaliningrad. Significant Lithuanian capital was invested in one of the two major meat-processing factories in the region, for example.

 

At the same time, the regional administration has been deprived of steady tax proceeds, something the new governor has often complained about. Last December, before the Duma vote on the revised SEZ legislation, Boos told a meeting of the Association of Foreign Investors that the regional authorities were unable to carry out their functions with such a stunted revenue base, which is funded mostly by income taxes. In effect, the SEZ regime has been subsidized by the federal center. At the expense of structural improvements, the region has seen a bloated trade deficit, constraints on the development of a viable service sector, and, like in the rest of Russia, insufficient growth in the small and medium-sized business sector.

 

“The present economic model, to the extent that a coherent model exists, emerged in a makeshift manner as a transitional system, a strategy for survival,” said Georgy Dykhanov, the general director of Business-Expert consulting center in Kaliningrad. “It’s highly vulnerable and ineffective because it still depends on subsidies and lacks a vision for sustained economic growth. What is not clear is Kaliningrad’s place and function in the division of labor both in the Russian and European context.”

 

Natalia Smorodinskaya, an authority on special economic zones at the Institute of Economics of the Russian Academy of Sciences in Moscow, has been one of the most vocal critics of the current SEZ regime. She has argued that, instead of opening the region to free trade and integrating it into a wider European system of imports and exports, the SEZ has insulated Kaliningrad from competitive market conditions, According to Smorodinskaya, the new law merely preserves the existing defects. “Even if the arrangement has, to some degree, proved beneficial and played a positive role, from a strategic point of view it critically impedes the development of the Kaliningrad region,” she said.

 

The new measures also create a system of two overlapping SEZ regimes, injecting administrative complexity when a simpler and more transparent mode of governance is called for. By setting a threshold of 150 million rubles for potential investors, it privileges large companies and, possibly, further undercuts the development of small businesses. With foreign corporations already wary of instability and the intricacies of local bureaucracy, most new investors are expected to come from Russia itself.

 

“The new law advocates regional development, but only through massive investments for which there is no place or incentive here,” Dykhanov said. “Foreign investors are least concerned about tax privileges, which are already quite high in Russia compared to the rest of Europe. What matters most to them are problems of risk and administrative barriers, none of which are addressed in the most recent legislation. It is really aimed at large Russian investors, who are in fact interested in tax benefits and are more immune to risks and corruption. But if Russian companies arrive here, they will not bring innovative managerial techniques or new technologies.”

 

But even in this scenario, Russian firms and investors entering the Kaliningrad market are likely to embrace a set of business practices more in line with European standards. “In the long run, the new SEZ will make Kaliningrad more interdependent economically with the EU,” said Cichocki. “Now Russian companies investing in Kaliningrad will have to adapt to EU norms and they will – consciously or not – disseminate these norms, customs and culture through their subsidiaries in Russia. And I don’t mean only technical norms for products. It’s also about relations between the workers and management. It’s about the attitude to work as such. It’s about free market orientation. It is a long-term process, but it seems promising.”

 

The region has been exhibiting positive economic trends, with a share of exports in 2005 increasing at a rate 55 percent higher than during the same period in the previous year. The new challenge is the pace of European integration, which brought Kaliningrad’s immediate neighbors – Poland and Lithuania – into the EU fold in 2004. This emerging political context threatens to isolate the region further from the surrounding economies and imperil its competitiveness, unless the region is able to take full advantage of the potential of the SEZ.

 

But the challenge of EU expansion also creates an opportunity for more intense dialogue between Russia and the EU, with Kaliningrad at last assuming its long-expected place as a pilot region for cooperation. Christian Wellmann, deputy director of Schleswig-Holstein Institute for Peace Research in Kiel, Germany, points out the asymmetries that might saddle a program of mutual assistance. These would need to be resolved to make future interchange possible.

 

“The basic problem is a strong asymmetry between Russia and the EU regarding Kaliningrad’s respective significance for them,” he said. “If more empathy is developed on both sides concerning the question of what Kaliningrad means to the other, balancing the existing asymmetries, Kaliningrad could have a positive impact on the overall relations between Russia and the EU.”