Russia’s Resurgent Economy

Reforms and Their Consequences [1]

Russia launched ambitious market reforms on January 2, 1992, which aimed at abolishing the Soviet-era command-and-administer system, as Moscow embarked on simultaneous economic, political and structural changes. However, the situation deteriorated, with an all-out economic recession setting in. The country’s budgetary and monetary systems no longer functioned. Runaway inflation and a production slump were also recorded throughout the 1990s.

By the end of 1991, there were no fully-fledged institutions of state authority, that is, following the disintegration of the Soviet Union. This presented a great danger. Economic institutions were demolished, leading to an economic recession and a shortage of goods. Consequently, Russia’s first post-Communist authorities moved to reinstate elementary institutions that are vitally important for any country’s existence. This applied first of all to institutions of state authority as well as basic economic mechanisms and property relations.

Russia continued to establish basic institutions of market democracy throughout the 1990s. Efforts were made to restore macroeconomic and political stability. All these objectives were accomplished by the late 1990s, and the country’s main political institutions became stronger. The adoption of the Constitution and streamlined federative relations became a key aspect. Standard measures, such as price liberalization, budgetary and monetary stabilization, facilitated macroeconomic stabilization. An all-out privatization drive was conducive to market-style economic relations. These reforms became the first step toward dividing the state and the economy; moreover, they served as an extremely important pre-requisite of market economics.

The August 1998 default, which signaled an economic-and-financial meltdown, caused the rouble to plunge. That event highlighted the imperfect nature of Russia’s market machinery. The national GDP dwindled by 5.3% by late 1998 as compared with 1997. Nationwide inflation was 84% in 1998, with the Central Bank’s gold-and-Forex reserves shrinking by over 30%. But the Central Bank implemented a tough budgetary policy, as well as a moderate monetary-credit policy, throughout 1999. This made it possible to collect more taxes, to curb inflation and to stabilize the rouble. As a result, the Russian economy began to recover as early as the fall of 1998. The rouble was devalued, with its real-life exchange rate matching 1994 levels. An improved situation on the global raw-materials markets boosted exports and expanded the import substitution sectors. [2]

Thus the stabilization period had ended, paving the ground for resumed economic growth.

Market institutions began to develop at a breath-taking pace. Nationwide stability made it possible to establish modern economic institutions that reflect the Russian reality more adequately. The Government attached priority to such basic market-economics institutions as the Civil, Tax, Budgetary, Labor and Land Codes, as well as pension legislation. De-regulation policies were also launched, making it possible to reduce administrative barriers that hindered business activity. Relations between the federal budget, regional budgets and local self-government structures were also improved. In addition, Russia moved to overhaul its natural monopolies and launched talks on joining the World Trade Organization (WTO). The process of more profound Russia-CIS integration also set in. The Central Bank’s gold-and-Forex reserves increased rapidly, with inflation gradually subsiding. (See Table 1 and Diagram 1)

The Russian Federation’s gold-and-Forex reserves (in billions of dollars)

May 1998	January 1999	January 2000	January 2001	January 2002	January 2003	January 2004	January 2005	November 2005
14,6	12,2	12,8	28	36,7	47,8	77,1	124,6	164,7

Source: Russian Central Bank statistics.

Russia’s sovereign credit ratings were raised consistently, with the European Union and the United States recognizing its market-economy status. All this highlights the country’s successful socio-economic development. Russia’s sovereign credit rating was raised to investment grade in October 2003 by Moody’s rating agency, followed by Fitch and Standard & Poor’s in November 2004 and January 2005, respectively.

In October 2005, Moody’s raised Russia’s deposit ratings in roubles and foreign currency from the lowest investment rating Baa3 to Baa2. Fitch had raised the rating accordingly in the summer of 2005.

These changes highlight nationwide macroeconomic stability. Economic Development and Trade Ministry estimates that the country’s GDP grew by 5.6% in January-June 2005 on the same period in 2004. Industrial output was up by 4%, with fixed-capital investment volumes increasing by 9.4%. Russia’s growing Stabilization Fund (over $29 billion) and gold-and-Forex reserves (more than $150 billion) protect the country from external shocks.

Market reforms therefore facilitated Russian economic growth (See Diagram 2).

Russian Economic Development in 1999-2004

Statistical data shows that Russia’s economy developed successfully in the period following the 1998 default until 2004.

Virtually all economic sectors and industries posted dynamic growth in 1999-2004. Russia’s GDP has soared by 48% in the last six years. Household consumption went up by 48.1%, while fixed-assets investment volumes skyrocketed by 72%. Investment growth outpaced production and consumption, thereby facilitating greater business activity. This had a great impact on structural GDP changes and sector production patterns. Industrial output increased by 53.4% in 2004 on 1998 levels, with that of the agro-industrial sector going up by 26.4%. A revamped service market infrastructure emerged during economic reforms and boosted commodity production. In fact, commodity production increased by 57.5% from 1998 to 2004, with the volume of market services growing by 43.4% during the same period. As compared to 1998, the volume of telecommunications services skyrocketed by 238.7%, with retail trade going up by 49.3%.

Main macroeconomic indicators in 1999-2004 (in percentage to the previous year)

	1999	2000	2001	2002	2003	2004
GDP	106,4	110,0	105,1	104,7	107,3	107,1
Actual household consumption	97,1	107,3	109,5	108,5	107,5	111,3
Fixed-asset investment volumes	105,3	117,4	108,7	102,6	112,5	110,9
Industrial output	111,0	111,9	104,9	103,7	107,0	106,1
Agro-industrial output	104,1	107,7	107,5	101,7	101,5	101,6
Telecommunications services	133,1	113,8	119,1	115,6	127,5	127,3
Retail trade turnover	93,9	108,8	110,7	109,1	108,0	112,1
Paid services to the population	107,0	105,0	102,8	100,4	105,1	107,1
Foreign trade turnover	86,7	129,7	105,4	108,1	124,6	131,1
Real-life disposable incomes	86,4	109,1	108,5	108,8	114,5	107,8
Real-life wages	78,0	121,0	119,9	116,6	110,4	110,8
Average annual number of workers	100,5	100,6	100,6	101,0	99,2	101,8
Number of jobless, end of each year	102	77	90,0	98,0	106,0	96,4
Price indexes
Consumer price indexes	136,5	120,2	118,6	115,1	112,0	111,7
Industrial producers’ price indexes	167,3	131,6	110,7	117,1	113,1	128,3

Source: Russian State Committee for Statistics; Federal State Statistical Service.

Investment

In 2000-2004, fixed capital investment grew more quickly than Russia’s GDP and basic economic sectors. In 2004, President Putin signed a number of laws on the stock market’s development, including amendments to the federal law on Law Enforcement Proceedings, which aims to protect market players’ assets, and the federal law on Shareholding Companies making it possible to streamline shareholding companies’ investment operations by means of a cost-effective dividend policy and through financial and economic transparency. Normative and legal documents for regulating the activity of professional stock market players were adopted. They were designed to reduce various risks, promote new financial instruments for attracting foreign and domestic investors, simplify the securities registration procedure and enable investors to receive additional information from stock-and-bond issuers.

In July 2004, President Putin signed a set of amendments to the federal law on Countering Money-Laundering Operations and the Financing of Terrorism. This document makes it possible to oversee the activities of banks and institutional investors, real-estate sales and purchases, as well as other operations with currency and securities.
A federal law on Amending the Federal Law On the Insolvency of Loan Agencies was recently passed. This law aims to improve legal regulation of loan agencies’ bankruptcy-notification and bankruptcy proceedings.

Foreign Investment In the Russian Economy

Russian economic development over the last four years highlights greater foreign investment volumes as compared to GDP dynamics and domestic investors’ business activity. Foreign investment volumes increased by 36.4% last year on 2003, reaching $40.5 billion.

As has already been mentioned, international rating agencies recently raised Russia’s sovereign credit ratings. This served to improve the Russian economy’s investment climate. The country has continued to attract increasing volumes of direct investment since 2003. The direct foreign investment increment was 138.9% in 2004, and made up 23.3% of the total. The share of all other investments was 75.8%, while the share of portfolio investment plunging to 0.8%.

Foreign investment categories received by the Russian economy’s non-financial sector (in millions of dollars) *.

	2000	2001	2002	2003	2004
Grand Total	10 958	14 258	19 780	29 699	40 509
Direct	4 429	3 980	4 002	6 781	9 420
Portfolio	145	451	472	401	333
Other	6 384	9 827	15 306	22 517	30 756

* Minus monetary accommodation agencies, commercial and savings banks, including rouble investment recalculated in dollars.
Source: Transitional Economy Institute; Federal State Statistical Service.

The Russian economy attracted more foreign investment in 2003-2004 than had been channeled by Russian investors into other countries. Such foreign investment into the Russian economy exceeded Russian investment abroad by $6.74 billion last year. The similar figure for 2003 was $6.44 billion.

Basic oil-and-gas investors named Russia the most promising market after Australia in 2004, said the A.T. Kearney international consultancy.

Most direct investment is channeled into the oil-and-gas sector. However, foreign investors have started invading the processing industry more actively in the last few years. They also finance medium-size enterprises, consumer sector projects and trade networks.

The Russian processing industry is now showing signs of recovery. According to the Economic Development and Trade Ministry, the processing industry conducted more active investment operations than processing sectors in the first six months of 2005. The processing industry accounted for 28.4% of all foreign investment in January-June 2005, while mining and energy sectors received just 21.2%. This is an encouraging sign for Russia’s processing industry.

Those investing into wholesale and retail trade are attracted by sustainable Russian economic growth. Russia is now placed fifth, rather than thirteenth, in terms of direct foreign investment volumes. The domestic consumer market is also developing at a breathtaking pace. Retail trade, the public catering sector and the soft-drink industry continue to grow, as well. A.T. Kearney surveys show that Russia rose from eleventh place to third in terms of food, tobacco and clothing production in 2004.

Raw Materials Export Revenues and Their Use

The exceedingly favorable situation on the world fuel and raw materials markets has undoubtedly had a positive effect on Russian economic development over recent years.
The oil and gas sector is fundamental to Russia’s economy. It plays a leading role in contributing to the state budget and keeping the balance of trade favorable. The determining factor here is world oil prices. With more than 70% of Russia’s oil exported in crude or refined form and oil sales inside the country made at prices well below world levels, world oil prices determine the revenues and financial position of the Russian oil industry.
With the rapid pace of world economy development, and demand for raw materials particularly strong from the Asian countries, world oil prices have been rising extremely rapidly recently. In 2004, the Russian Urals blend was priced at an average of $34.45 per barrel on the world (European) market, or 27.4% up on the previous year (Table 4).

World oil prices in 1997-2004 (dollars per barrel)

	1997	1998	1999	2000	2001	2002	2003	2004
Britain’s Brent	19,12	12,72	17,97	28,50	24,44	25,02	28,83	38,21
Russia’s Urals	18,33	11,83	17,30	26,63	22,97	23,73	27,04	34,45
OPEC basket	18,68	12,28	17,47	27,60	23,12	24,34	28,13	36,05

Source: OECD, International Energy Agency, OPEC

In foreign trade terms, 2004 was the best year in Russia’s post-Soviet history: oil prices hit an all-time high, regularly exceeding $30 per barrel for most of the year and occasionally going as high as $50 dollars per barrel. The two most fundamental factors for the Russian economy are the demand for raw materials and the distribution of the revenues. With budget revenues directly depending on those of the fuel and energy sector (a dollar per barrel rise translates into a budget growth of $1-1.5 billion), the problem of how to use the Stabilization Fund money took center stage. As fuel and energy budget revenues soared, so did the Stabilization Fund, reaching 1,094.5 billion roubles ($37.9 billion, or €32.38 billion) by November 1, 2005, according to the Finance Ministry.
With the control wing gaining influence in the government, the issue of using this fund for investments in industry was predictably raised. But taking this step would mean giving up both the stabilizing role of the Fund and the policy of curtailing the public sector in the economy launched in the 1990s. Theoretically, the Fund could be used for current financing, but then its principal task would be negated — to prevent the state budget and recipients of its funds from over-dependence on foreign trade.
A compromise solution was proposed: to spend a part of the Fund on infrastructure projects and another part on repaying the country’s sovereign debt ahead of schedule. The debt is already being repaid. However, the compromise is still being questioned, and the Fund is certain to remain in the focus of political controversy. Given a source of freely available funds, the Finance Ministry is finding it very difficult to stand up to the combined pressure of ministries and lobby groups.

Further Reforms

Following the default and until 2004, economic growth was mainly restorative, i.e. it breathed life into capacities left idle by the crisis. Currently this growth is tapering off as free and available capacities are used up, as the year 2003 showed (diagram 2). The present policy should be designed to go over from the restoration phase to investment phase. And the step no longer depends on economic reforms, but on the development prospects of political and legal institutions.
The way the market is functioning in Russia is far from ideal. Some branches are monopolized, ownership rights are poorly protected, and administrative fiat is still felt in business. But it should not be forgotten that the principal market mechanisms in Russia had to be created anew, and this happened only 15 years ago. To ensure further economic development it is not enough to have sound economic laws. All norms and rules should be applied in practice, and this calls for an effective government machinery and fair justice. The Russian political and business elites are increasingly coming to realize the importance of these steps. Therefore, there is a special focus on administrative and judicial reforms.
Through administrative reform the authorities are trying to remove the main obstacle in the way of entrepreneurship — administrative barriers. The reform of state governance aims to reduce the state’s excessive interference in the economy. The reform of technical regulation seeks to create conditions for successful business practices and the harmonization of domestic and international standards. The basic law has already been passed, and work continues on subordinate legislation.
The reform of law enforcement is concerned with the protection of property rights, including those of investors and shareholders, resolution of corporate conflicts, and arbitration. The reform of the legislature is moving forward to make court proceedings more effective and the courts independent.
Taxes are being reduced. Last summer legislators amended the Tax Code, allowing taxpayers to write off 10% of capital outlays outright from January 1, 2006. Further steps, according to official representatives, will deal with improvements in tax administration, and particularly audit techniques.
Effective anti-trust legislation supporting competition is one of the conditions for protecting the rights of an economic agent. Work continues to improve prevention of abuses of market domination.
In March 2005, the president signed a federal law on amendments to Articles 17 and 18 of the Russian law on Competition and on the Restriction of Monopolies in the Commodity Markets. The law has lifted the cap on assets held by economic agents.
In order to provide investments for the economy, financial infrastructure and financial broker services continue to be reformed. In April 2005, the government and the Bank of Russia adopted a strategy for the development of banking in Russia. In December 2004, the Russian president signed a law on credit histories. The law defines ways of compiling, processing, storing and revealing information about credit repayments.
New investment mechanisms are being introduced — special economic zones and public-private partnerships. Relevant laws were signed last summer. Special economic zones and concession agreements are expected to attract private investments into specific projects and help diversify the Russian economy and its regional development.

Economic development paradigm

The Russian government’s position on economic growth is reflected in its program documents, i.e., Guidelines for the Activities of the Government of the Russian Federation for the Period Until 2008 and Medium-Term Program of Socio-Economic Development (2005-2008). Both documents are comprehensive and systemic.

The Medium-Term Program focuses on the formation of institutions ensuring the stable growth of a modern market economy at a fast pace. The priority trends of economic policy for the next few years are as follows:

– to create conditions for enhancing individuals’ ability to compete and the efficiency of the public health and education systems, the pension system, social security and the housing and utilities complex; to consistently fight poverty;
– to strengthen the state, including through implementing an administrative reform, enhancing the efficiency of the judicial and law-enforcement systems and the agencies ensuring compliance with laws;
– to develop the institutions of civil society essential for consolidating economic growth;
– to strengthen guarantees of property rights, including intellectual property, and also to continue privatization and enhancing the efficiency of state property management;
– to develop competition and reduce the non-market sector, to radically improve anti-monopoly legislation and the activity of anti-monopoly agencies, including liberalization of the terms of economic transactions (mergers), while increasing the responsibility for monopolistic actions;
– to eliminate economic problems, primarily those related to the infrastructure and technological development, including by reforming natural monopolies and enhancing the efficiency of their operation;
– to enhance the Russian companies’ ability to compete and develop small and medium-sized businesses, which is also a factor for attracting investment and modernizing the economy;
– to stimulate innovative growth of the economy, enhance the role of R&D work in the country’s economic development and increase its contribution to the effort to diversify the economy;
– to develop Russian regions, support regional strategies of socio-economic development, and also create conditions encouraging the constituent Federation members and municipal entities to mobilize the available economic growth resources; and
– to integrate the Russian economy into international economic relations and enhance its transparency, which presupposes Russia’s accession to the WTO, the development of integration ties within the Commonwealth of Independent States (CIS) and other integration associations (like the EurAsEC, the Common Economic Space and the Union State), as well as Russia’s deeper cooperation with the European Union.

The last point is especially important for Russia. In the years of the economic crisis and market reforms, the country was mainly concerned with tackling its internal economic problems. Meanwhile, new integration groups have arisen on the international scene, with the world globalization process gaining momentum.

However, now that Russia has overcome the crisis and achieved macroeconomic stability, and the task of effective economic growth is coming to the fore, the country has an opportunity to step up its activities in the international arena. President Putin has said repeatedly that many states would like to see Russia playing a more active role in international affairs. Now the conditions are ripe to promote the political dialogue with different countries, regions and integration associations and expand trade and economic cooperation and versatile contacts, including business contacts and cultural exchanges.