Russia: Five Things To Worry About

We remain essentially positive on the outlook for the Russian economy. Strong macroeconomic fundamentals will allow the authorities to confront a more difficult external environment with considerable margins of safety. Nevertheless, looking beyond the financing of the 2002 budget, the economic agenda remains full of challenges. Of particular importance are:

• The need to reduce the economy’s dependence on primary commodities.
• Improving the investment environment, particularly for foreign investors.
• Ensuring that the ruble remains competitive.
• Maintaining the momentum of structural reforms, particularly as regards the banking sector and pension reform.

The authorities must guard against complacency, mindful that their ultimate success will be judged less by how well they managed the windfalls of an oil boom in 2000-01 and more by their ability to steer the economy through an international recession.

The Things We Don’t Worry About

Not to sound alarmist, it is important to highlight that we are not concerned about the overall strength of the macroeconomic situation. As we have argued, the macroeconomic picture remains strong and we feel comfortable with the broadly held assumption in the markets that the government will have no major problems in coping with the more difficult external environment likely to prevail in 2002 (including lower oil prices).[1] A combination of cautious fiscal management, improved tax compliance, a growing economy and a much strengthened structural reform agenda are all likely to serve the authorities well in the period ahead. To this might be added, belatedly, recent changes to energy taxation, which will increase the tax burden on the oil sector. Our latest forecasts are presented in the table below.

The Things We Worry About

All that said, the authorities do nevertheless face serious challenges in the period ahead. How they confront these will have a considerable bearing on the overall macroeconomic climate and in the government’s future ability to respond to external shocks and, more generally, an uncertain global environment. We worry about five things in particular.

Worry 1: Undue Dependence On Commodities

Russia exported $106bn of goods in 2000. Although this figure is impressive (compared to Turkey’s $28bn and Argentina’s $26bn) and highlights the country’s wealth-creating potential, the balance of payments and the budget remain unduly reliant on primary commodities. Roughly 85% of total exports consist of oil, gas, ferrous and non-ferrous metals, chemicals, wood and pulp. Approximately 80% of profits and overall investment are accounted for by enterprises linked to these export sectors. Cumulative real GDP growth during the period 1999-01 is likely to top 20%, and much of this has come from the investment and modernization plans carried out by enterprises flush with cash in the aftermath of the recovery of commodity prices which began in early 1999. Reducing this dependence will involve a multi-faceted approach, one component of which could be the creation of a Norway-style stabilization fund.

This idea has been discussed within the government and in parliament during the last several months, but has fallen hostage to purely bureaucratic considerations, mainly having to do with issues of jurisdiction over “excess revenues.” While the question of who should decide how to allocate additional revenues when international commodity prices are above budget assumptions is clearly important, the government and the Duma will have to join forces to create a formal mechanism that begins to accumulate a share of revenues from export proceeds to reduce the budget’s dependence on one-off terms of trade gains.

Surely a country that has exported over $700bn during the period 1992-2001 could find a way to stash away $2-3bn per year to create a reserve for the inevitable day when weak foreign demand brings commodity prices down? Not to do so would seem an abdication of government responsibility for efficient macro management. That Russia does not have “a state oil company” will make the task of creating a stabilization fund a bit more difficult, but it should not be an excuse for inaction. This fund could be financed by a share of export duties on oil, gas and metal exports, and be launched with a share of the surplus accumulated this year.

Worry 2: An Ambivalent Attitude to FDI?

The government remains publicly committed to encouraging foreign direct investment and, at least on paper, Russia has a fairly liberal regulatory framework.[2] The authorities seem to recognize that the benefits of FDI could be potentially enormous, involving much-needed technology transfers, improved managerial skills in the enterprise sector, as well as help to reduce the dependence of the balance of payments from primary commodity prices. However, in practice the authorities sometimes betray a more ambivalent attitude toward foreign ownership that seems to reflect the (slightly anachronistic) view that there are “strategic sectors” that should largely remain under Russian control.

For example, the authorities have voiced a desire that the share of foreign ownership of the banking sector rise above the present low 7%, but it is clear that few would be willing to contemplate majority foreign ownership of the sector, as has happened, for instance, in Hungary and other transition economies in central and eastern Europe. The recent consolidation of the aluminum sector is yet another example of “strategic” thinking at work. We do not wish to overdo these concerns, but they are legitimate and are one of the reasons why FDI, which has been in the range of 6% of GDP per year in the more developed transition economies in Europe, remains well under 2% of GDP in Russia. The sooner the authorities recognize that growing FDI could help diversify the Russian economy and boost growth and employment prospects, the more likely they are to attract it and catalyse the much needed modernization of the industrial sector.

Worry 3: Is The Ruble Too Strong?

Not yet, but the ruble has lost some of the substantial “headroom” which it gained in the aftermath of the 1998 devaluation, and the authorities will have to keep its level under close review. Because Russia, unlike Turkey and Argentina, has a sizable tradeables sector, the level of the ruble does matter and is seen as having played a key role in the recovery, post-1998. The large current account surpluses in recent years have complicated exchange rate management at the central bank and put upward pressure on the ruble. The liquidity inflows associated with the strong balance of payments position have also boosted inflation pressures and forced the authorities, in the absence of adequate instruments to drain liquidity in the market, to tighten reserve requirements and, de facto, to use the budget as a monetary control mechanism.

In addition, the authorities face a strong popular constituency in favour of a strong ruble; in a dollarized economy Russians tend to measure wages and prices in dollars and, the recovery notwithstanding, these have not gone back to pre-crisis levels yet. For instance, dollar GDP  was $430bn in 1997, but is likely to reach US$304bn this year. The bottom line: the ruble remains competitive, some further real appreciation over the medium term is inevitable, but the authorities must avoid the erosion of competitiveness that was a precipitating factor in the last crisis.

Worry 4: The Banking Sector

There is a (worrying) line of thinking in Russia which argues that, because the economy has been growing in the post-1998 period, enterprises are flush with cash and there seems to be no shortage of investment opportunities, there is less need to press ahead with banking sector restructuring. This misses the point that low levels of financial intermediation and lack of access to bank lending – except for well established large enterprises – is most likely preventing the development of Russia’s small and medium-sized enterprise sector. The impressive success of the EBRD’s micro-lending programme, which provides small loans to thousands of private entrepreneurs, suggests that the lack of an adequately capitalized banking sector, operating in an acceptable prudential environment and in which there is active (and growing) foreign participation, has been and remains a costly deficiency for the Russian economy.

The government has recently signalled its support for a banking sector restructuring plan put together by the Central Bank of Russia which has a number of positive elements. The central bank has also agreed to invite a financial sector assessment programme (FSAP) mission fielded by the IMF and the World Bank to review the banking sector and issue policy recommendations. More than three years after the 1998 financial crisis, it is mildly reassuring that the authorities finally seem to be getting their act together in this key area.

Worry 5: Pension Reform

Among the dozens of pieces of legislation that the government is steering through the Duma as part of its strengthened structural reform effort, pension reform is near the top in terms of priority. Few issues are more central to the success of the authorities’ attempts to lay down a credible framework for long-term financial stability. The issues are multi-faceted and nearly all, directly or indirectly, have a bearing on the future financial viability of the pension fund and efficiency in the use of its resources. A short list of the issues to be tackled by the authorities would include: increases in the retirement age; the link between the level of pensions and increases in the cost of living and the role of the minimum pension; the need to improve the pension fund’s revenue base by streamlining/eliminating exemptions, thereby increasing the effective contribution rate; the distribution of the contribution rate between employers and employees; jurisdiction issues associated with the distribution of functions between the pension fund and other government agencies performing a social safety net role; the targeting of social benefits; and the modus operandi of a privately funded “second pillar” and the associated thorny issue of who would actually manage the contributions collected.

Owing to the complexity of the subject and the major implications that decisions will have for future resource allocation, pension reform will ultimately be tackled in at least five pieces of separate legislation. We expect that this will take at least six months of debate and dozens of hours of parliamentary deliberation. The stakes are high, the technical issues difficult, the government’s administrative capacities to formulate and implement “first best” solutions rather limited and, hence, the potential for sub-optimal decisions quite large. But, dithering further is not an option and the government will have to move this forward, availing itself of as much technical assistance from international donors as possible. Well executed, as in other countries, pension reform could provide a healthy boost to the development of Russia’s financial markets.

Conclusion

In the aftermath of the 1998 financial crisis, the authorities have built up their macroeconomic management credentials. However, welcome as this is, it is unlikely to be enough. An uncertain global environment will require concerted action on a number of fronts, including measures aimed at reducing the dependence of the economy on primary commodities, creating a more favorable environment for foreign investment, keeping an eye on the ruble, and accelerating banking sector and pension reform.

Markets are unlikely to give the authorities additional credit in the period ahead – in terms of tangible reductions in debt spreads – unless the authorities can go to the next stage and demonstrate that, in addition to running a tight budget, they are also able to tackle some of the thornier structural weaknesses afflicting the Russian economy. We are cautiously optimistic that they will rise to the challenge. As always, timing will be essential and the next 12 months will be key.

[1] For the detailed arguments see: “Russia: Well Prepared For 2002”, Global Weekly Economic Monitor, 28 September 2001.

[2] For a fuller discussion of this issue and some international comparisons, see the Emerging Europe section in this issue of the Global Weekly Economic Monitor.