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RUSSIA - ECONOMY
The Russian economy underwent tremendous stress in the 1990s as it moved from a centrally planned economy to a free market system. Difficulties in implementing fiscal reforms aimed at raising government revenues and a dependence on short-term borrowing to finance budget deficits led to a serious financial crisis in 1998. Lower prices for Russia's major export earners (oil and minerals) and a loss of investor confidence due to the Asian financial crisis exacerbated financial problems. The result was a rapid and steep decline (60%) in the value of the ruble, flight of foreign investment, delayed payments on sovereign and private debts, a breakdown of commercial transactions through the banking system, and the threat of runaway inflation.
The Russian economy bounced back quickly from the 1998 crisis and enjoyed over nine years of sustained growth averaging about 7% due to a devalued ruble, implementation of key economic reforms (tax, banking, labor and land codes), tight fiscal policy, and favorable commodities prices. Household consumption and fixed capital investments both grew by about 10% per year during this period and replaced net exports as the main drivers of demand. Inflation and exchange rates stabilized due to a prudent fiscal policy (Russia ran a budget surplus from 2001-2008). Foreign exchange reserves grew to close to $600 billion by mid-2008, the third-largest in the world, of which more than $200 billion were classified as stabilization funds designed to shelter the budget from commodity price shocks. The balance of payments experienced twin surpluses until mid-2008 in the current and capital accounts, which accounted for the phenomenal growth of reserves. As of July 1, 2006, the ruble became convertible for both current and capital transactions. Russia prepaid its entire Soviet-era Paris Club debt of $22 billion in late 2006, but by October 2008 foreign external debt totaled $540 billion, of which $500 billion was short-term debt owed by private sector banks and corporations.
The global economic crisis hit Russia hard, starting with heavy capital flight in September 2008, which caused a crisis in its stock market. Several high-profile business disputes earlier in 2008 such as TNK-BP and Mechel, as well as the Georgian war helped drive capital out of Russia. By mid-September, Russia’s stock market had collapsed, as businesses sold shares to raise collateral for margin calls required by international lending institutions. As the global financial crisis gathered steam in the fall of 2008, the accompanying steep fall in global demand, commodity prices, and tightening of credit served to almost grind Russia’s economic growth to a halt in the fourth quarter of 2008, to 1.1% down from 9.5% during the same period in 2007. The Central Bank of Russia responded by pumping liquidity into Russian banks, which helped avert a banking crisis. At the same time, the government attempted a managed devaluation, which successfully avoided a run on the ruble and bank deposits but at the cost of a steep decline in foreign exchange reserves to $387 billion by mid-February 2009. This in turn prompted S&P and Fitch rating agencies to downgrade Russia’s sovereign debt to the lowest investment-grade. With the exchange rate in line with global oil prices by end-January 2009, according to preliminary data from the Central Bank, the balance of payments stabilized, with a current account surplus of $11.1 billion in the first quarter of 2009. Capital outflows slowed to $38.8 billion from $130.5 billion in the fourth quarter of 2008.
Gross Domestic Product
Tighter credit, collapsing global demand, global uncertainty, and rising unemployment have hurt investment and consumption in Russia (which have been the main drivers of GDP growth in recent years). GDP growth and industrial production for 2008 were 5.6% and 2.1%, respectively, compared to 8.1% and 6.3% in 2007, according to the World Bank. However, GDP growth in the first seven months of 2008 was 7.7% on average before collapsing in the fourth quarter. GDP in the first quarter of 2009 contracted by over 7% and growth estimates for the year range from the Russian Government’s -2.2 % to the IMF’s -6%. GDP growth is currently derived from non-tradable sectors, but investment remains concentrated in tradables (oil and gas). Over the course of 2008, tradables, including manufacturing, showed lower growth rates than non-tradables, such as retail and construction. Manufacturing was hit severely in the last two months of 2008, contracting by 10.3% in November and 24.1% in January 2009, compared to the prior year, due to tight credit and free fall of demand. By January 2009, construction experienced an 18% year-on-year decline. Real disposable incomes, which grew by 10.4% in 2007, dropped 6.7% in January 2009, which led to negative 2.4% retail trade growth in February.
For most of the past decade, Russia experienced persistent inflation, gradually declining from 85% in late 1998 to 9% by end-2006. However, a combination of surging international food and energy prices and looser monetary and fiscal policy pushed the Consumer Price Index (CPI) to 11.9% by the end of 2007, and up to 15% in early 2008. The Central Bank of Russia (CBR) monetary policy tended to be limited to managing the ruble’s exchange rate against a bi-currency basket of dollars and euros. The CBR intervened to keep the ruble stable during times of volatile international commodity prices and to manage inflation. In years of record high oil prices, the Central Bank typically purchased dollars to prevent real appreciation of the ruble. These interventions initially had limited effect on inflation, as they were mostly sterilized by budget surpluses and demand for rubles grew in a robust era of economic growth. By 2007, fiscal policy and the balance of payments were the actual drivers of monetary policy, particularly as large capital inflows due to increased borrowing by Russian banks and corporations caused the money supply to swell and added to inflationary pressures. Inflationary pressures eased in late 2008 as energy and commodity prices collapsed and international credit flows virtually stopped, causing money supply growth to halt. Estimates for inflation in 2009 according to the World Bank are 11%-13%, with rising import prices and loose fiscal policy expected to contribute to inflationary pressures, while lower demand, a continuing credit crunch, and large capital outflows will likely moderate it.
The Russian federal budget ran growing surpluses from 2001-2007, as the government taxed and saved much of the rapidly increasing oil revenues. The government overhauled its tax system for both corporations and individuals in 2000-2001, introducing a 13% flat tax for individuals and a unified tax for corporations, which improved overall collection. Responding to demands from the oil sector, the government reduced the tax burden on oil production and exports, but only marginally. Tax enforcement of disputes continues to be uneven and unpredictable. In 2007 the federal budget surplus was 5.5% of GDP, and in 2008 the government ended the year with a surplus of 4.1% of GDP. However, the 2009 budget was revised with an oil price assumption of $41 per barrel Urals, and the government expects a 7.5% deficit, which will be financed from the Reserve Fund, the larger of the government’s two stabilization funds. The government’s anti-crisis package in 2008 and 2009 are worth about 6.7% of GDP, according to World Bank estimates. Measures focus on supporting the financial sector and enterprises, through liquidity injections to banks and tax cuts/fiscal support to enterprises, entities that were hit first by the crisis, with modest support for households, small and medium enterprises (SMEs), and increased unemployment benefits. More expenditures will be likely if the crisis deepens or is prolonged.
Russia's population was 141.91 million as of January 2009, a very slight decrease from the previous year according to the government statistics service and the Ministry of Public Health. The birth rate in 2008 was the highest recorded in the last 15 years. The improvements may in part be attributed to the implementation of a National Priority Health Project and financial incentives to mothers having two or more children. Life expectancy remains low compared to developed countries, but rose to 61.4 years for men and 73.9 for women in 2007. Cardiovascular diseases, cancer, traffic accidents, and violence continue to be major causes of death among working age men. Many premature deaths are attributed to excessive alcohol consumption and smoking. A truly healthy Russia will require serious improvements in the health sector and some major changes in current cultural norms. To combat the looming demographic crisis, in October 2007 then-President Putin approved the concept of demographic policy for the years 2008-2025. The program aims to increase life expectancy, reduce mortality, increase the birth rate, improve the population's health, and develop a sound migration policy. The government instituted the National Priority Health Project and "mother's capital" in order to slow the population decline. These programs had short-term success; Russia's population declined by 0.25% in 2008, compared to 0.4% in 2007. It is unknown if such programs offer a long-term solution. In April 2008, the government approved joining the World Health Organization's Framework Convention on Tobacco Control, which is expected eventually to reduce extremely high smoking rates, and the government put significant amounts of money into prevention of smoking and alcohol abuse in the 2009-2011 budget. The economic crisis, however, raises doubts about the future of such spending.
As of the end of 2008, there were 461,754 HIV cases officially registered in Russia, though experts believe the actual number may be as many as 1 million HIV cases. According to the chief medical officer of Russia, 50,670 new HIV cases were registered in 2008, an increase of 18.9% compared to 2007. Prevalence of HIV cases was 300 per 100,000 people in 2008, higher than the 2007 indicator of 270.1 per 100,000. The chief form of transmission continued to be intravenous drug use, which accounted for 65% of new HIV cases in 2008. More than 44% of new HIV cases are identified in females, and transmission through heterosexual sex has grown rapidly. The Government of Russia implements HIV treatment and prevention programs through its National Priority Health Project, Federal Targeted Program, and Global Fund Grants. The government currently spends over $250 million per year on HIV/AIDS treatment programs and has allocated over $42 million for the period of 2007-2010 to support HIV/AIDS vaccine research. Approximately 52,000 patients are receiving antiretroviral therapy, with the government paying for 41,000 patients and 11,000 through the Global Fund grants. At the September 2003 Camp David Summit, and again at the Bratislava meeting in February 2005, then-Presidents Bush and Putin pledged to deepen ongoing cooperation between the two countries to fight HIV/AIDS.
Russia has a body of conflicting, overlapping and rapidly changing laws, decrees and regulations, which has resulted in an ad hoc and unpredictable approach to doing business. In this environment, negotiations and contracts from commercial transactions are complex and protracted. Uneven implementation of laws creates further complications. Regional and local courts are often subject to political pressure, and corruption is widespread. However, more and more small and medium businesses in recent years have reported fewer difficulties in this regard, especially in the Moscow region. In addition, Russian businesses are increasingly turning to the courts to resolve disputes. Russia's World Trade Organization (WTO) accession process is also helping to bring the country's legal and regulatory regime in line with internationally accepted practices.
The mineral-packed Ural Mountains and the vast oil, gas, coal, and timber reserves of Siberia and the Russian Far East make Russia rich in natural resources. However, most such resources are located in remote and climatically unfavorable areas that are difficult to develop and far from Russian ports. Nevertheless, Russia is a leading producer and exporter of minerals, gold, and all major fuels. Natural resources, especially energy, dominate Russian exports. Ninety percent of Russian exports to the United States are minerals or other raw materials.
Russia is one of the most industrialized of the former Soviet republics. However, years of very low investment have left much of Russian industry antiquated and highly inefficient. Besides its resource-based industries, it has developed large manufacturing capacities, notably in metals, food products, and transport equipment. Russia is now the world's third-largest exporter of steel and primary aluminum. Russia inherited most of the defense industrial base of the Soviet Union, so armaments remain an important export category for Russia. Efforts have been made with varying success over the past few years to convert defense industries to civilian use, and the Russian Government is engaged in an ongoing process to privatize many of the state-owned enterprises.
Russia has relatively little area for agriculture, but given its massive expanses, the country still accounts for about 9% of the world's arable land. Grain production for export is concentrated in the south of European Russia, with additional grain for domestic consumption grown throughout the rest of non-Arctic Russia west of the Urals as well as western Siberia. Livestock production was in decline from 1990 to 2006, when new government support policies were instituted to stimulate cattle and hog raising. Poultry production has rebounded and is rising at 17% per year. Small plots averaging one acre in size, urban and suburban gardens, and gardening cooperatives produce over half of Russia's food output. Former state and collective farms have been largely privatized, but management quality is uneven and profitability is highly dependent on proximity to major urban markets. Foreigners are not allowed to own farmland, although long-term leases are permitted.
Russia attracted $58.7 billion in foreign direct investment (FDI) in 2008 (4.1% of GDP), up from $47.1 billion in FDI in 2007. Although much of the FDI in recent years was Russian capital “returning home,” from havens like Cyprus and Gibraltar, these flows have now reversed in the wake of the economic crisis. Moreover, although the annual flow of FDI into Russia was in line with those of China, India, and Brazil, Russia's per capita cumulative FDI lagged far behind such countries as Hungary, Poland, and the Czech Republic. Investment in manufacturing sectors accounted for 22% of the total. Real estate, extraction of raw materials, and trade were also high FDI growth sectors, accounting for 18%, 17%, and 15% of the new FDI, respectively. With the weakening global investment climate, Russian political risk (challenging business climate, lack of transparency, and weak rule of law/corruption) is now a significant consideration for investors’ allocation of scarce capital, even though the country’s markets remain largely untapped.
Although still small by international standards, the Russian banking sector before the crisis was growing fast and becoming a larger source of investment funds. To meet a growing demand for loans, which they were unable to cover with domestic deposits, Russian banks borrowed heavily abroad in 2007-2008, accounting for 57% of the private-sector capital inflows in 2007. Ruble lending has increased since the October 1998 financial crisis, and in 2007 loans were 66% of total bank assets, with consumer loans posting the fastest growth at 57% that same year. In 2004, Russia enacted a deposit insurance law to protect deposits up to 100,000 rubles (about $3,700) per depositor. Amendments to the law in the fall of 2008 increased the Deposit Insurance Agency's 100%-coverage for deposits up to 700,000 rubles. The vast majority of Russians keep their money in the banking sector. The combination of liberalized capital controls and ruble appreciation against the dollar in 2005-2008 persuaded many Russians to keep their money in ruble- or other currency-denominated bank deposits. In 2007, total retail deposits grew by 35%, with foreign currency deposits accounting for 13% of the total. In 2008, despite the onset of the crisis, deposits rose more than 14%, with foreign currency deposits exceeding 26% of the total.
Despite the banking sector’s recent growth, financial intermediation in the overall economy remains underdeveloped. Contradictory regulations across the banking and securities markets have hindered efforts to transfer resources from capital-rich sectors, such as energy, to capital-poor sectors, such as agriculture and manufacturing. The sector is dominated by large state banks, and concentrated geographically in Moscow and the Moscow region. Thus financial service providers face little competition for resources and charge relatively high interest rates for favored, large corporate borrowers.
This state of affairs makes it difficult for entrepreneurs to raise capital, and banks generally perceive small and medium commercial lending as risky. Most of the country’s financial institutions are inexperienced with assessing credit risk, though the situation is improving. The low level of trust, both between the general public and banks as well as among banks, makes the system highly susceptible to crises. As of early 2009, the sector had not emerged from its current crisis and the outcome was uncertain. Although the banking sector was not exposed to excessive leverage and structured products like in the West, a potentially serious problem of non-performing loans could cause future bank failures, especially those banks with concentrated lending to one adversely affected sector/client. Banks had repaid much of their short-term foreign debt obligations as of end-March 2009.
The U.S. exported $9.3 billion in goods to Russia in 2008, a 25% increase from the previous year. Corresponding U.S. imports from Russia were $26.7 billion, up a significant 38% (in 2007 imports were down by 2%). Russia is currently the 28th-largest export market for U.S. goods. Russian exports to the U.S. were fuel oil, inorganic chemicals, aluminum, and precious stones. U.S. exports to Russia were machinery, vehicles, meat (mostly poultry), aircraft, electrical equipment, and high-tech products.
Russia's overall trade surplus in 2008 was approximately $180 billion, a significant rise from a $129 billion surplus in 2007. However, the overvalued exchange rate and collapse in global demand in the last quarter of 2008 quickly turned the trade surplus into deficit. Given a readjustment of the exchange rate, the outlook for 2009 is better with a projected surplus of $80 billion, given slower growth in exports and severe contraction of imports. World prices continue to have a major effect on export performance, since commodities--particularly oil, natural gas, metals, and timber--comprise nearly 90% of Russian exports. Russian GDP growth and the surplus/deficit in the Russian Federation state budget are closely linked to world oil prices.
Russia is in the process of negotiating terms of accession to the World Trade Organization (WTO). The U.S. and Russia concluded a bilateral WTO accession agreement in late 2006, and negotiations continue on meeting WTO requirements for accession. Russia reports that it has yet to conclude a bilateral agreement with Georgia.
According to the 2008 U.S. Trade Representative's National Trade Estimate, Russia continues to maintain a number of barriers with respect to imports, including tariffs and tariff-rate quotas; discriminatory and prohibitive charges and fees; and discriminatory licensing, registration, and certification regimes. Discussions continue within the context of Russia's WTO accession to eliminate these measures or modify them to be consistent with internationally accepted trade policy practices. Non-tariff barriers are frequently used to restrict foreign access to the market and are also a significant topic in Russia's WTO negotiations. In addition, large losses to U.S. audiovisual and other companies in Russia owing to poor enforcement of intellectual property rights in Russia are an ongoing irritant in U.S.-Russia trade relations. Russia continues to work to bring its technical regulations, including those related to product and food safety, into conformity with international standards.
Russia's efforts to transform its Soviet-legacy military into a smaller, lighter, and more mobile force continue to be hampered by an ossified military leadership, discipline problems and human rights violations, limited funding, and demographics. Recent steps by the Government of Russia suggest a desire to reform, and the August 2008 conflict with Georgia further highlighted the need for Russia to modernize its armed forces. There has been an increased emphasis on practical training, and the government is introducing bills to improve the organization of the military.
Despite recent increases in the budget, however, defense spending is still unable to sustain Russia's oversized military. Current troop strength, estimated at 1.1 million, is large in comparison to Russia's GDP and military budget, which continues to make the process of transformation to a professional army difficult. This is the result of the Soviet legacy and military thinking that has changed little since the Cold War. Senior Russian leaders continue to emphasize a reliance on a large strategic nuclear force capable of deterring a massive nuclear attack.
Russian military salaries are low. Theoretically, the army provides all necessities, but housing and food shortages continue to plague the armed forces. Problems with both discipline and brutal hazing are common as well. Such conditions continue to encourage draft evasion and efforts to delay military service. Moreover, military officials complain that new recruit cohorts are plagued by increasing incidences of poor education, communicable diseases, and criminality. HIV infection rates in the Russian army are estimated to be between two and five times higher than in the general population, and tuberculosis is a persistent problem.
The Russian Government has stated a desire to convert to a professional army, but implementation has been progressing slowly. In an effort to make military service more attractive, the tour of duty for conscripts was reduced to one year (from 18 months) beginning in 2008, and the military is offering increased pay and benefits to raise the number of professional servicemen. Current plans envision a transition to a mixed force, in which professional soldiers fill approximately 70%, including in select units, and conscription fills 30%. There is also an effort to develop a non-commissioned officer (NCO) corps, but the military faces difficulties recruiting NCOs, and has done little to develop the mechanisms and capability to sustain such a force.
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