Subscribe to this page2003 is shaping up to be one of the most decisive years in Russia's relatively short and turbulent economic history. If government objectives are achieved, then at the end of this next twelve months the economy will finally start to develop away from crisis recovery and towards one with sustainable growth and depth. At a quick glance, 2003 looks like being a relatively uneventful year for the economy, with the budget having set modest macro targets that should be achieved even with a wide tolerance for the average oil price. However, 2003 is much more important than that, and therefore potentially much more hazardous than the modest budget targets suggest. In fact, 2003 is the last year of a transition from the old economic structure to a hoped-for new economic variant that will see increased FDI, sustainably faster growth and a broadening of the economic base away from dependency on commodities. If by the end of 2003 we do not see a basic financial infrastructure in place that allows us to forecast this required growth, then the future investment case for Russia will be thrown into serious doubt, if not lost.
When the present government took office in early 2000, it set out two main economic objectives, one medium-term and the other long-term. The medium-term objective was to reduce the economy's vulnerability to the oil price and use the period of resulting relative stability to force changes that were seen as a necessary pre-condition for future growth. This reduction in price vulnerability was achieved by encouraging oil companies to grow production and exports ? amidst a very favorable international oil price environment ? so that while the federal budget's dependency on oil revenue remains, it now needs a much lower average oil price to balance than it did in 1998. In that crisis year, the economy would have needed $26.5/bbl (Urals) to balance; instead it got just a little over $11/bbl. In 2003, the main macro targets will be achieved with an average price of $16/bbl.
Many changes have occurred over the past three years, and attitudes are certainly much different and more positive towards future growth. Yet, much of this relative prosperity can be linked either directly or indirectly to oil cash flows into the economy. Even in the grey economy, which represents a large chunk of GDP, much of these flows can be traced through to oil in one way or another. For the economy to grow at the targeted 6%+ annual rate as set out by the President in his address to the joint houses of parliament last April and do so with a broadening of dependencies (i.e. away from oil and commodities), Russia will have to attract significantly higher capital inflows, either as returning Russian capital or FDI. This is the government's long-term economic objective, and we will need to see this happening from 2004 or the economy will end up as no more than a more complex Venezuela or Nigeria with boom and bust oil cycles. If that objective is to be achieved, the basic financial infrastructure to facilitate capital inflows and allow their deployment in the economy will have to be in place. At the same time, local capital sources will also have to be created with adequate protections in place to persuade the owners of this capital that their investments are legally protected. Despite a generally positive atmosphere and significantly improved image, as a potential destination for investment Russia is still struggling with the same issues of credibility and attractiveness that have dogged it for the past decade. Indeed, to a remarkable degree, investors are still convinced that one of the biggest risks they face in Russia is the theft of their assets. Substantively, the government will have to create economic conditions that establish a future investment case for Russia beyond the one-off restructuring that we have witnessed over the past three years. Put simply, investors will have to be persuaded that they can make money in Russia and that their investments are safe from theft.
Specifically, this means that by the end of 2003 or very early 2004 we will have to see the following:
Bank reform is an essential part of that financial infrastructure. There should be fewer, but better regulated and capitalized banks in order to help build credibility in the system. The proposed deposit insurance scheme will have to be signed into law.
Pension reform is necessary in order to make available a local source of investment capital, which is important for stable investment growth. We will need to see all legislation in place, including regulations governing the award of management mandates and supervision of the industry.
Judicial. Investors will have to see improvement of their legal protections in Russia amidst a fair and transparent system for handling any disputes. What will constitute adequate protections is, right now, difficult to define precisely. At this stage it is important that we see progress on new and protective legislation and, just as importantly, no more cases of minority shareholder abuse. Other reforms, such as that of the natural monopolies, will also continue through 2003, but the main efforts to conclude these will not come until after the election period is over in 2004. The fact that the government will then be faced with several major reform issues, all of which will encounter active opposition from lobbying groups (including the process of negotiating WTO entry and tackling Russia's vast bureaucracy) makes it much more important that these financial infrastructure reforms are concluded satisfactorily by early 2004. Otherwise, the necessary investment flows will fail to materialize, and the investment case for Russia will at best be delayed, or perhaps even lost.
While these basic reforms represent a precondition for future FDI flows (i.e. outside of the oil and other commodities sectors), the other trends to watch in 2003, as part of creating the investment conditions for an acceptable return in other parts of the economy, are the following:
Monetary policy. The ruble-dollar exchange rate needs to stay virtually unchanged in real terms, if not see a small real depreciation. The strong ruble in 2001 and 2002 has gone some way to reversing the economic benefits of the 1999 devaluation and is hurting the development of manufacturing. This means that by the end of 2003 the exchange rate should be between R35—36/$.
Inflation. The real cost of business in Russia is higher than even the high inflation numbers show. In 2002 real wage growth will be over 15%, and combined with other cost increases this represents a considerable narrowing of margins and competitiveness.
Money supply. The amount of rubles in circulation will again rise substantially in 2002. This is a direct result of the CBR's policy of foreign earnings conversion, a policy that has now been reduced to 30% from January 1, 2003. We will need to see a significant slowdown in ruble printing if costs are to be brought under control.
Trade balance. The current year trade balance has remained high only because of recovery of the oil price and growth in export volumes. The fact remains that imports, particularly of consumer and manufactured goods, are rising fast. Imported consumer goods are again taking market share from domestic producers, when the trend clearly needs to be the other way around.
Industrial growth. Without growth in this sector (i.e. outside of energy and commodities), the economy will remain particularly vulnerable to oil. Consumers. In 2003 we will look for evidence of the breadth and depth of consumerism in Russia. For sure, there is plenty of visible evidence of consumption in the large cities, but a packed Ikea and a multitude of expensive stores in Moscow does not constitute a sustainable pattern of consumption. This may well be merely a by-product of circulating commodities cash. This year, analysts will need to scrutinize all consumer related numbers to find evidence either way.
Therefore, while 2003 can be regarded as a “safe” year in terms of the budget objectives (i.e. all else being equal as regards external drivers), we can be reasonably assured of an “adequate” investment return from debt instruments and equities over the next twelve months. However, the real issue concerns preparation for the inward investment flows that are a necessary precondition for future growth. This partly involves ensuring that the financial infrastructure reforms are in place and that the economic basis for future growth is not destroyed or severely delayed because of a failure to maintain the basic integrity of the economy. In many ways, this is the first real transition year for Russia after 75 years of communism and a decade of restructuring and confusion. Either way, while this coming year may now look somewhat bland, the objectives that need to be achieved over the next twelve months are absolutely critical for Russia's investment case in 2004 and beyond.
