#8 - JRL 7020
January 14, 2003
Chasing Portugal or Following Venezuela?
By Pyotr Aven and Christopher Weafer
Pyotr Aven, president of Alfa Bank, and Christopher Weafer, chief strategist of Alfa Bank, contributed this comment to The Moscow Times.
This year will be one of the most decisive years in Russia's relatively short and turbulent economic history. If the government's objectives are achieved, then at the end of the next 12 months the economy will finally start to develop away from crisis recovery and toward sustainable growth.
Superficially, 2003 looks set to be a relatively uneventful year for the economy, with modest macroeconomic targets written into the budget that should be achieved even with wide fluctuations in the oil price. However, 2003 is much more important, and therefore potentially much more hazardous, than these modest budget targets suggest: This year should be the last year of transition from the old economic structure to a new one that will see increased foreign direct investment, faster sustainable growth and diversification of the economy away from its dependence on commodities. If, by the end of 2003, we do not see a basic financial infrastructure in place, then the investment case for Russia will be thrown into serious doubt, if not lost.
When the current government took office in May 2000, it set two main economic objectives, one medium-term and the other long-term. The medium-term objective was to reduce the economy's exposure to world oil prices and to use the period of resulting relative stability to push through changes seen as a necessary precondition for sustainable high rates of growth.
This reduction in exposure was achieved by encouraging oil companies to increase production and exports, so that while the federal budget's dependence on oil revenues persists, a much lower average oil price is needed to balance the budget than was the case in 1998. In 1998, an average price of $26.50 per barrel (Urals) would have been necessary to balance the budget -- instead it was a little more than $11 per barrel. In 2003, the key macroeconomic targets will be achieved as long as the average oil price remains at or above $16 per barrel.
Many changes have occurred in the past three years, and attitudes now are certainly much more positive vis-a-vis future growth. Yet, much of the relative prosperity that has been achieved can be linked, directly or indirectly, to the flow of petrodollars into the economy. Even in the gray economy, which accounts for a significant share of GDP, much of the money can be traced back to oil.
For the economy to grow at 6 percent plus per year -- the target set by President Vladimir Putin in his state of the nation address last April -- and to achieve greater diversification, Russia will have to attract significantly larger capital inflows, either in the form of repatriated Russian capital or FDI. This is the government's long-term economic objective, and if it is not realized by 2004, rather than catching up with Portugal, Russia will be keeping company with Venezuela and Nigeria, experiencing boom-and-bust oil cycles.
Achieving this long-term objective will require putting into place the financial infrastructure for facilitating capital inflows and enabling their deployment in the economy. Despite a significantly improved image, Russia is still struggling with the same issues of credibility that have dogged it for the past decade. Investors are still convinced that one of the biggest risks they face in Russia is the expropriation of their assets by business partners or government agencies. To overcome this, the government will have to push ahead with structural reforms. Put simply, investors will have to be convinced that they can make money in Russia and that their investments are safe from expropriation.
In particular, this means that by the end of 2003 or beginning of 2004 we will have to see the following reforms:
Bank reform. This is essential to building the financial infrastructure. There should be fewer, but better regulated and capitalized banks in order to help build confidence in the system. The proposed deposit insurance scheme, put forward by the government, will have to be passed by the State Duma and signed into law.
Pension reform. This is necessary in order to make a domestic source of investment capital available, which is important for stable investment growth. We will need to see all the relevant legislation in place, including regulations governing the award of management mandates and supervision of the industry.
Judicial reform. Investors will have to see improvement in legal protection and a transparent system for handling commercial disputes. What constitutes adequate protection is difficult to define precisely. At this stage, it is important that we see progress on new shareholder protection legislation and an end to the abuse of minority shareholders.
Other reforms. Natural monopoly reforms, etc. will continue through 2003, but the main efforts to conclude these will not come until after the election period is over, i.e. after March 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 negotiating WTO entry and tackling Russia's vast bureaucracy -- makes it all the more important that 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 and perhaps even lost.
While these basic reforms are a precondition for FDI flows into sectors apart from energy and commodities, the other important trends to watch for this year are:
Monetary policy. The ruble exchange rate needs to remain virtually unchanged in real terms or see a real depreciation. The strong ruble in 2001 and 2002 has gone some way toward reversing the economic benefits of the 1998 devaluation and is hurting the development of the manufacturing sector. This means that by the end of 2003 the exchange rate should be between 35 and 36 rubles to the dollar (although the manufacturing sector would probably prefer to see it closer to 40 rubles to the dollar).
Inflation. The real cost of doing business in Russia is higher than even the high inflation figures show. In 2002, real wage growth was more than 15 percent, and combined with other cost increases this represents a considerable narrowing of margins and loss of competitiveness.
Trade balance. The current year trade balance has remained positive only because of the recovery of the oil price and growth in export volumes. Imports, particularly of consumer and manufactured goods, are rising fast. Imported consumer goods are again taking market share away from domestic producers, when the trend clearly should be the other way around.
Industrial growth. Without growth outside of the energy and commodities sectors, the economy will remain particularly exposed to the world oil market.
Consumers. This year, we are looking for evidence of the breadth and depth of consumption in Russia. There is plenty of visible evidence of consumption in 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 byproduct of circulating commodity cash. This year, analysts will need to scrutinize all consumer-related numbers to find evidence one way or the other.
2003 can be regarded as a "safe" year in terms of budget objectives (all else being equal vis-a-vis external factors), and we can be reasonably certain of an "adequate" return on debt instruments and equities over the next 12 months. However, the really crucial issue is preparation for the inward investment flows that are a necessary pre-condition for high rates of growth. This involves ensuring that financial infrastructure reforms are in place and that the 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 critical transition year for Russia after more than 70 years of communism and a decade of restructuring and confusion. While this coming year may look somewhat bland, the objectives that need to be achieved over the next 12 months are absolutely critical for Russia's investment case in 2004 and beyond.