Natalya Orlova of Alfa Bank -
In 2000-2007, Russia's improved macroeconomic management led to economic stability. However, high dependence on oil and the small share of small and medium-sized enterprises (SMEs) still need to be addressed to improve the quality of GDP growth. Taming inflation, which is necessary to stimulate local savings, will be difficult without revisiting the reform agenda.
Better macro-management is the main achievement of 2000-2007: Russia's stabilization fund is equal to 12% of GDP - the third-largest reserves in the world - and its state debt is only 3.6% of GDP. These are the most impressive results of this decade's economic policy. Better macro-management helped Russia attain an investment grade rating, with $81.5bn in net capital inflows and $32bn from IPOs and secondary offerings in 2007.
Consumption-focused model fuelled 42% on year imports growth in the first quarter: The 140% increase in real disposable income over the last seven years and access to retail loans, which did not exist in 2000, helped Russia increase its ratio of private consumption to GDP. In fixed prices, consumption increased from 46% of GDP in 2000 to 62% of GDP in 2007. The positive side of this increase is higher living standards; the negative, however, is the strong 42% import growth.
In May 2003, we launched the Alfa Bank Investor Confidence Index to reflect fluctuations in private, foreign and market confidence. The index has been flat since 2006, while the RTS went up more than 40% from January 2006 to January 2008. Although other Alfa research suggests a substantial upside to the market, in isolation, this indicator suggests that the fundamentals of the Russian economy need to be improved in order to support continuing asset-price increases in future.
While playing only a modest role in the growth indicator, the fuel sector accounts for an increasing share of all financial flows. As a share of exports, fuel increased from 50% in 2000 to 69% in the first quarter, and it represented around 50% of total federal budget revenues last year. Meanwhile, last year's import growth was equivalent to a $20 per barrel drop in oil prices.
Inflation control is crucial, but will be difficult without revisiting the reform agenda. We anticipate that the central bank will soon respond to inflationary pressure with an increase in rates. Controlling the monetary component of inflation, however, is not enough to compensate for inflation resulting from tariff hikes, import inflation and lack of a qualified labour force. We have just raised our 2008 CPI growth target to 11.5%. Carrying out reforms focused on economic diversification is the only way to address structural inflation.
Reforms agenda still in focus
Starting in 2000, the Russian government focused on a very ambitious reform plan, which had been prepared in the immediate aftermath of the economic crisis of 1998. This plan included very ambitious financial infrastructure reforms, industrial development plans, and a focus on state governance. The anticipation of these reforms laid the foundations for the success of the Russian financial market in recent years.
Looking back, only the first block of financial infrastructure reforms have turned out to be a significant success for the economic policy. In 2001-2005, the government launched an aggressive tax cut, expecting to increase tax collection with the low tax rate. The tax reform was also supposed to harmonize local regulation with global principles; for instance, the profit tax in 1999 in Russia was double the OECD level and 40% above transition countries. Following the tax reform, tax collection improved significantly, particularly for personal income tax. A larger share of salaries is now paid officially.
Furthermore, a very important change to the local system was the creation of the stabilization fund. At end-2007, Russia had accumulated $158bn in its stabilization fund or around 12% of GDP. The stabilization fund covers 85% of Russia's public debt, which was 14.5% of GDP as of year-end 2007. The unintended consequence of the creation of the stabilization fund was the tough fiscal stance adopted by the Russian government in recent years. It was also an efficient tool for sterilizing the excess monetary supply that came from the positive current and capital accounts.
The restructuring of the banking sector gave mixed, but still rather positive results. The creation of the deposits insurance was implemented in 2004-2005 and seems to have helped to re-establish confidence from private and also corporate clients. As of end-2007, retail deposits had risen to equal 17% of GDP. In the meantime, the number of banks in Russia is still 1,089 and more than 900 of them have entered the deposit insurance system. However, the central bank has always preferred to have 500-600 banks operating in Russia. Foreign banks' penetration into Russia does not exceed 12% of total assets, and the state banks are still dominating the landscape.
The pension reform was clearly a fiasco. With 38.3m pensioners (27% of the population), Russia has failed to create a properly functioning, well-defined contribution system. The State Pension Fund manages $15bn in pension savings, while only $350m is managed by private funds. The average pension in Russia equals only 26% of the average salary, while in 1998 the figure was close to 40%.
Slow progress was observed in industrial development. While the communal housing tariffs continued to increase at a speed of 10-20% a year, the quality of services is still modest. This sector is still waiting for major restructuring, as the absence of a concession law is preventing de-monopolization of this market.
Even though the four deregulation reform laws were approved and implemented, they have failed to increase the role of SMEs in the Russian economy. They are still estimated to account for only 17% of GDP, contributing only 2% of exports. The costs of running a small business are still significant.
The three state monopolies - Railways, Gazprom and RAO UES - focused more on ambitious capex plans than on internal restructuring. The railways and electricity monopoly UES were the main contributors to the 21% investment increase in 2007. This investment boom was financed mainly by the sale of assets, but also by an increase in local tariffs. Pushing monopolies to cut costs still appears to be a good idea.
Unfortunately, better macroeconomic management in itself cannot guarantee sustainable growth if it's not supported by changes to the business environment and the structural improvement of the economy. Improved macroeconomic management was an important part of the accelerated growth trends in 2000-2007. However, the latter could soon face trouble generated by the unresolved industrial policy problems and inefficient state governance. The 2000 reform list should be revisited to address Russia's long-term challenges.
Non-oil FDI is virtually flat at 1% of GDP
Together with portfolio capital inflows, Russia continues to benefit from a continuing inflow of foreign direct investment. In 2007, total FDI inflow to the country was $27.8bn, up from $13.7bn in 2006. In relative terms, this corresponded to an increase in FDI from 1.4% GDP to 2.2% GDP. The accumulated FDI reached $103bn, or 8.0% GDP, increasing 1.1 percentage points from the 6.9% seen in 2006.
It is interesting that Russia's FDI inflow is still highly dependent on the commodity extraction sector. In 2004-2007, FDI in commodity extraction was $26.4bn, or 40% of the entire FDI inflow to Russia. Its share increased significantly to 50% in 2007, and was the key reason behind the acceleration of FDI. Excluding these flows, FDI amounted to only 1.0% of GDP last year, making it virtually unchanged from the 2004 level.
Another important point is that FDI inflows into Russia are dominated by two countries - the Netherlands and Cyprus, which in reality reflects the repatriation of Russian capital. These two countries are still contributing around 60-70% of annual inflows to Russia, suggesting that the investment climate should become even friendlier to foreign investments. In the meantime, a positive aspect of this FDI structure is that it means that FDI inflows are not particularly sensitive to global economic trends.
Dependence on oil increasing
Addressing the social issue should be seen as an important task for the Russian state, mainly because the Russian economy remains poorly diversified and a substantial share of the population still relies on the state. The increased dependence of the Russian economy on the commodity extraction sector is probably one of the most serious problems that was not resolved in the past.
The crucial question is clearly the role of the fuel sector in GDP production. The official statistics indicate that the role of the commodity extraction sector, after being stable in 2000-2004 at around 7.0% of GDP, declined to 5.8% by 2007. This seems to be a reflection of the unfavourable tax regime, which prevents oil companies from investing in new fields.
The increase in commodity prices is a key factor behind the increasing role of fuel in Russian exports. While in 2000-2004 the share of fuel exports remained around 50-54% of total export revenues, from 2005 its importance went up substantially along with an increase in oil prices. In the first quarter, the share of fuel export was as high as 69%, making the trade balance very dependent on this factor.
The Russian budget is also significantly dependent on oil revenues. The share of fuel revenues in the federal budget receipts went up to 50-60% in 2006- 2007, after stagnating at 30% in 2000-2003. Oil companies paid around 12% of GDP in tax revenues in 2007.
All in all, it seems that while the production of GDP is less dependent on the fuel sector, it is still a cash-cow, providing the Russian economy with a money inflow. Russia's ability to attract capital inflows seems to be directly correlated to oil price dynamics. This suggests that if there is a drop in the current account, Russia will be very unlikely to benefit from continuing capital inflows.
Natalya Orlova is chief economist of Alfa Bank in Moscow
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