The Russian economy underwent tremendous stress 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 decline and steep (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.
Russia, however, appears to have weathered the crisis relatively well. The following year real GDP increased by the highest percentage since the fall of the Soviet Union, the ruble stabilized, inflation was moderate, and investment began to increase again. Russia is making progress in meeting its foreign debts obligations. During 2000-01, Russia not only met its external debt services but also made large advance repayments of principal on IMF loans but also built up Central Bank reserves with government budget, trade, and current account surpluses. Russia remains current on its foreign debt. Service of the official foreign debt service amounted to about $14 billion in 2002. Large current account surpluses have brought a rapid appreciation of the ruble over the past several years. The appreciation affect has been reduced by channeling some of this money into a government stabilization fund which will help cushion Russia from price shocks should energy prices remain low for an extended period. The ruble appreciation of the past several years has given back much of the terms-of-trade advantage that Russia gained when the ruble fell by 60% during the debt crisis. Oil and gas dominate Russian exports, so Russia remains highly dependent upon the price of energy. Loan and deposit rates at or below the inflation rate inhibit the growth of the banking system and make the allocation of capital and risk much less efficient than it would be otherwise.
In 2003, the debt will rise to $19 billion due to higher Ministry of Finance and Eurobond payments. However, $1 billion of this has been prepaid, and some of the private sector debt may already have been repurchased. Russia continues to explore debt swap/exchange opportunities.
At the June 2002 G8 Summit, leaders of the eight nations signed a statement agreeing to explore cancellation of some of Russia's old Soviet debt to use the savings for safeguarding materials in Russia that could be used by terrorists. Under the proposed deal, $10 billion would come from the United States and $10 billion from other G-8 countries over 10 years.
Gross Domestic Product
Russia's GDP, estimated at $287.9 billion at 2002 exchange rates, increased by 4.3% in 2002 compared to 2001. High oil prices, relatively low inflation (15.1%), and strict government budget led to the growth, while real ruble appreciation slowed it. During 2002, the unemployment rate fell from 9.0% to 7.1%. Combined unemployment and underemployment may exceed those figures. Industrial output in 2002 grew by 3.7% compared to 2001.
The exchange rate stabilized in 1999; after falling from 6.5 rubles/dollar in August 1998 to about 25 rubles/dollar by April 1999, one year later it had further depreciated only to about 28.5 rubles/dollar. As of January 2003, the exchange rate was 31.9 rubles/dollar, down from 29.2 rubles/dollar the year before. After some large spikes in inflation following the August 1998 economic crisis, inflation has declined steadily. The consumer price index (CPI) rose 15.1% during 2002, slightly below the 18.6% inflation rate of the previous year but above the inflation target of 12% set in the 2002 budget. The Central Bank's accumulation of foreign reserves drove inflation higher, and that trend is expected to continue.
Central and local government expenditures are about equal. Combined they come to about 38% of GDP. Fiscal policy has been very disciplined since the 1998 debt crisis. The overall budget surplus for 2002 was 2.3% of GDP. Much of this growth, which exceeded most expectations for the third consecutive year, was driven by revenue from higher oil prices. Analysts remain skeptical that high rates of economic growth will continue, particularly since Russia's planned budgets through 2005 assume that oil prices will steadily increase. Low oil prices would mean that the Russian economy would not achieve its projected growth. However, high oil prices also would have negative economic effects, as they would cause the ruble to continue to appreciate and make Russian exports less competitive.
Russia's population is falling. Lower birth rates and higher death rates reduced Russia's population at a 0.5% annual rate during the 1990s. By comparison, although in many developed countries birth rates have dropped below the long-term population replacement rate, in only a few countries is the population actually declining. Population decline is particularly drastic in Russia, with higher death rates, especially among working-age males due to poverty, abuse of alcohol and other substances, disease, stress, and other afflictions. Russians generally disapprove of permanent or temporary immigration of workers from countries other than the Russian-speaking former Soviet states that might help solve economic problems brought on by its declining population.
Russia and Ukraine are said to have the highest growth rates of HIV infection in the world. In Russia HIV seems to be transmitted mostly by intravenous drug users sharing needles, although data is very uncertain. Data from the Federal AIDS Center shows that the number of registered cases is doubling every 12 months and by November 2002 had reached 220,000 persons. When this number is adjusted to include people who have not been tested for the disease, estimates of the actual number of infected persons vary from 1-2 million. The high growth rate of AIDS cases will have negative economic consequences. Investment will suffer from the diversion of private and government funds to AIDS treatment. The problems of population aging will be magnified, especially since about 60% of infected individuals in Russia are between 20 and 30 years of age.
Lack of legislation and, where there is legislation, lack of effective law enforcement, in many areas of economic activity is a pressing issue. During 2000 and 2001, changes in government administration increased the power of the central government to compel localities to enforce laws. Progress has been made on pension reform and reform of the electricity sector. Nonetheless, taxation and business regulations are not very predictable, and legal enforcement of private business agreements, especially outside of Moscow and St. Petersburg, is weak. Attitudes left over from the Soviet period will take many years to overcome. Local officials in some areas interfere in business. Government decisions affecting business have often been arbitrary and inconsistent, and corruption remains a serious problem. Crime has increased costs for both local and foreign businesses. On the positive side, Russian businesses are increasingly turning to the courts to resolve disputes. The passage of an improved bankruptcy code in January 1998 was one of the first steps. In 2001, the Duma passed legislation for positive changes within the business and investment sector; the most critical legislation was a deregulation package. A new flat tax boosted income tax collections considerably. This trend in legislation continued through 2002 when the new corporate tax code went into effect.
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 climactically unfavorable areas that are difficult to develop and far from Russian ports. Oil and gas exports continue to be the main source of hard currency, but declining energy prices have hit Russia hard. Russia is a leading producer and exporter of minerals, gold, and all major fuels. The Russian fishing industry is the world's fourth largest, behind Japan, the United States, and China. Russia accounts for one-quarter of the world's production of fresh and frozen fish and about one-third of world output of canned fish. 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 machinery. Russia inherited most of the defense industrial base of the Soviet Union, so armaments are the single-largest manufactured goods export category for Russia. Efforts have been made with varying success over the past few years to convert defense industries to civilian use.
Russia comprises roughly three-quarters of the territory of the former Soviet Union but has relatively little area suited for agriculture because of its arid climate and inconsistent rainfall. Northern areas concentrate mainly on livestock, and the southern parts and western Siberia produce grain. Restructuring of former state farms has been an extremely slow process. The new land code passed by the Duma in 2002, which makes it easier for Russians to buy and sell farmland, should speed restructuring and attract new domestic investment to Russian agriculture. Foreigners are not allowed to own farmland in Russia. Private farms and garden plots of individuals account for over one-half of all agricultural production.
During 2002, cumulative foreign investment increased by 20%. This was mostly due to increases in loans and trade credits since the "other" category accounted for $15.3b out of $19.8b in new 2002 foreign investment in Russia. Russia does poorly in the international competition for foreign investment. Russian investment in their own country also is low. Indeed, $15-$20 billion of Russian capital leaves Russia every year for want to attractive investment opportunities at home. Over the medium to long term, Russian companies that do not invest to increase their competitiveness will find it harder either to expand exports or protect their recent domestic market gains from higher quality imports.
Foreign direct investment, which includes contributions to starting capital and credits extended by foreign co-owners of enterprises, rose slightly in 1999 and 2000, but decreased in 2001 by about 10%. FDI rose during 2002 by 20% to a total of $20.4 billion. Foreign portfolio investment, which includes shares and securities, decreased dramatically in 1999, but has experienced significant growth since then. During 2002 , foreign portfolio investment grew by 20% to reach $1.47 billion in January 2003. Capital flight seems to have slowed, although very large trade surpluses owing to high energy prices are pushing it up again. Inward investment from Cyprus and Gibraltar, two important channels for capital flight from Russia in recent years, suggest that some Russian money is returning home.
A significant drawback for investment is the banking sector, which lacks the resources, the capability, and the trust of the population that it would need to attract substantial savings and direct it toward productive investments. Russia's banks contribute only about 3% of overall investment in Russia. While ruble lending has increased since the October 1998 financial crisis, loans are still only 45% of total bank assets. The Central Bank of Russia reduced its refinancing rate five times in 2000, from 55% to 25%, signaling its interest in lower lending rates. Interest on deposits and loans are often below the inflation rate providing little incentive for depositors. Many Russians prefer to keep their money outside the banking sector. The poorly developed banking system makes it difficult for entrepreneurs to raise capital as well as to permit capital transfer from a capital-rich sector such as energy to capital-poor sectors such as agriculture and manufacturing and to diversify risk. Banks still perceive commercial lending as risky, and some banks are inexperienced with assessing credit risk.
Money on deposit with Russian banks represents only 7% of GDP. Sberbank receives preferential treatment from the state and holds 73% of all bank deposits. It also is the only Russian bank that has a federal deposit insurance guarantee. Sergei Ignatiev recently replaced Viktor Gerashchenko as Chairman of the Russian Central Bank. Under his leadership, necessary banking reforms, including stricter accounting procedures and federal deposit insurance, are likely to be implemented although the switch to International Accounting Standards was recently pushed back from 2004 to 2007.
During 2002, Russian goods exports rose 5% to $107b while imports grew 12% to $60.9b. World prices continue to have a major effect on export performance, since commodities, particularly oil, natural gas, metals, and timber comprise 80% of Russian exports. Russian GDP growth and the surplus/deficit in the Russian Federation state budget are closely linked to world oil prices.
The combination of import duties, a 20% value-added tax and excise taxes on imported goods (especially automobiles, alcoholic beverages, and aircraft) and an import licensing regime for alcohol still restrain demand for imports. Frequent and unpredictable changes in customs regulations and great variations in enforcement practices from one customs terminal to another also have created problems for foreign and domestic traders and investors. Uncertainty over Russian veterinary regulations cut U.S. poultry exports to Russia by 40% during 2002. Quotas to be introduced for poultry, pork, and beef in spring 2003 will likely keep U.S. poultry exports below their 2001 peak.