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Jamestown Foundation
Russia and Eurasia Review
Volume 2, Issue 2
January 21, 2003

By Jacques Sapir
Jacques Sapir is a professor of economics and director of studies at L'Ecole des Hautes Etudes en Sciences Sociales in Paris.

Since the 1998 financial crash, Russia--to the surprise of some Western observers--has seen impressive economic growth. But, after three very good years, this trend is now declining. GDP grew by barely 4 percent in 2002, down from over 8 percent in 1999. By the end of October 2002 activity in the manufacturing industry was at a standstill, even falling. This raises some important questions about Russia's economic future, just at a time when most Western observers are giving the country high marks for its reform policy over the last eighteen months.

Russia's growth spurt since 1998 has frequently been linked to the rise of oil and gas prices, making it purely a product of exogenous factors. However, hydrocarbon prices only started rising in the fall of 1999, and growth had already begun during the last months of 1998. A much more conclusive factor seems to have been the shift in the real exchange rate. The 1998 crash induced a strong devaluation that came after years of obvious ruble overvaluation induced by mistaken macroeconomic policies. The low exchange rate, combined with a fall in the relative domestic price of energy, boosted internal producers' competitiveness. Internal demand switched from imported to locally produced goods. Investment, which increased massively after summer 1999, induced labor productivity growth, enabling wages to be progressively raised without deteriorating competitiveness. Internal demand was then fuelled in a noninflationary way.

Recent Russian research about the relative contributions of different growth factors confirms this story.

By 2000, everything was in hand for the unfolding of a sustainable growth scenario. Unfortunately, the combination of strong export earnings and an over-liberal reorganization of the exchange market led to a real appreciation in the ruble exchange rate. The reform measures included a progressive liberalization of capital flow regulations, the softening of rules regarding repatriation of export earnings, and abolition of the two-sessions system of currency auctions, under which one auction is reserved for export-generated currencies with an exchange rate fixed by the Central Bank.

The real appreciation of the exchange rate after the summer of 2000 led to a progressive increase of imports, which were seen as negative, nearly minus 40 percent, in economic growth [TABLE 1]. [DJ: Not here.] This was the death knell for the sustainable growth scenario. Economic activity became much less impressive by the end of 2001, and investment growth rates declined sharply in 2002.

Investment slowed in 2002 after the introduction--under the aegis of German Gref, minister of trade and economic development--of a much vaunted liberal regulation framework, alongside the new tax code and land code. Quite obviously investors, be they Russian or foreign, were much more prone to react to actual profit variables (that is, the real exchange rate and internal energy and utilities prices) than to proclamations of commitment to liberal policies.

The economic slowdown would have been worse but for the shifts in the value of the euro against the U.S. dollar. Usually the ruble/dollar real exchange rate was used as the main index of Russian competitiveness. But the introduction of the euro in 1999 started to change the situation. Although Russia's oil and gas exports are denominated in dollars, a significant part of Russian imports came from the euro zone, at a time when the euro/dollar exchange rate was fluctuating. The value of the euro fell in 1999 and 2000, thus constraining Russian imports, but rebounded strongly from the end of 2001 to the fall of 2002. To refine the analysis, a composite real ruble exchange rate demonstrates the impact of the exchange rate on the Russian economy [TABLE 2]. [DJ: Not here.]

The very fact that investment growth declined faster than output growth is extremely disturbing. Two possible scenarios, which are to be understood as extremes in a rainbow of possible developments, are emerging for the 2003-2005 period.

The positive scenario continues the positive trends displayed in 1999 and 2000. Lowering the real exchange rate through market regulation would have a strong effect on enterprise profitability and investment. Foreign direct investors could be induced to step up their projects in Russia. More FDI would progressively lead to a labor productivity increase allowing for better wages and better household incomes without inflationary pressures. Investment and consumption would support high growth, leading to an automatic increase in tax revenues, allowing for a more active state policy in infrastructure and public services, and a wage hike for civil servants, which is the best defense against corruption.

The negative scenario assumes that the government will not react to current trends and that the euro will not continue to gain in value. The real exchange rate increase would lead to an economic standstill, which would be forecast for October/November 2003. Investment would contract, because both Russian and foreign investors would prefer to wait for more favorable conditions, and labor productivity would stagnate or even fall, inducing progressively a new contraction in GDP.

Tax revenues would then decrease, leaving the government with no other choice but to either reduce budget expenditures (increasing the downward GDP trend) or launch a new borrowing campaign. This would lead in turn to much higher interest rates, and attract Western "hot" money now unable to find good opportunities on Western markets. This would lead to a progressively overvalued real exchange rate, increasing imports fast and reducing the trade balance surplus to zero, a point reached in late 1997/early 1998. This could occur by fall 2004, at which point Russia would then find itself in the same situation as 1997, with a depressed real economy and a financial bubble quickly ballooning up until the next crash, which any brutal change on the world oil market would probably induce. The volatility of such a situation would discourage foreign industrial investors and strengthen the short-term rent-seeking bias already much too present in the Russian economy, progressively destroying the remnants of true entrepreneurship in the country.

Of course, a mixed scenario might also unfold, with the real exchange rate stabilized at the current level, after countering an overvalued exchange rate with (for example) increased import taxes. Still, it is doubtful that this would produce a development path stable enough to prevent a collapse into the negative scenario, because the investment problem will become more and more acute, with major breakdowns in the private or the public sector being highly probable. One can also hope for a reversal of policies leading to the positive scenario. After all, the 1998 crash is still fresh in most memories. Talk about some kind of state control on natural resources and strengthening the Central Bank's grip on the currency exchange market could unfold into a growth-oriented policy. (One possible change, for example, could be a return to the two-sessions system for currency auctions.)

In any event, the Russian government faces important choices, and these will be made, either by acting or by doing nothing at all.

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