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#15 - JRL 7213
OPINION: Capitalizing on good fortune
Contributed by Peter Westin, Senior Economist, Aton Capital

MOSCOW, June 6 /Prime-TASS/ -- Its a well-trodden path, how well Russia has been doing over the last three to four years. But its often easy to forget how just bad things were before 2000, and how dramatically theyve improved since. In truth, a lot of luck has been involved in Russias economic turnaround; yet equally importantly, the country has not squandered its good fortune. Instead, it has sought to make the most of it and insulate itself from any future shocks.

Russia's post-1998 economic performance has been remarkable: GDP has grown more than 25% in four years and the budget and current account surpluses have averaged 2.2% and 13% of GDP for the last three years.

At the same time Russias stock market has been one of the worlds best performing. For example, a $1,000 investment on the RTS in October 1998 would today net about $12,000; and more incredibly, a $1,000 investment in Yukos in December 1998 would today be worth almost $1 million.

Russia has been blessed with enormous good fortune, but more importantly it has sought to capitalize on its luck.

First came the devaluation on August 17, 1998. When saying the crisis was good fortune, one has to add that it was also a disaster: it ruined the countrys nascent middle-class as many banks froze accounts and the value of money tumbled, for the third time in less than a decade. The financial elite meanwhile stripped the good assets in the banking system, leaving only the bad ones in place. And investors in state securities saw their money disappear as the government defaulted on its obligations.

However, the devaluation also breathed new life into Russias productive assets, as an almost immediate halving of imports opened the way for import substitution, and Russian entrepreneurs were quick to capitalize on the new opportunities. To give just one example, the textile industry, virtually destroyed by the previously over-valued ruble and the imports that came with it, suddenly sprang to life. The same trend was observed in other sectors like food processing, light industry and machinery and equipment. As a result, and in combination with Russias banking system having no intermediation role, the economy swung back to growth less than a year after the crisis, an amazing turn of events.

The second and critical piece of good fortune was OPECs decision to limit output in spring 1999, triggering an immediate increase in the world oil price. As a result, Russias large oil companies saw their revenues surge and the governments coffers swell. The oil price has since remained at an exceptionally high level, with Ural Med averaging $24.9/bbl since 2000, and currently standing at $26/bbl. The capital inflow from petro-dollars also generated funding for investment. Domestic investment has increased more than 35% over the last three years, allowing for the replacement of depleted capital stocks, mainly in the natural resource sectors, but also in the machinery and equipment sector.

The third piece of good fortune came, perversely, from an increasingly pessimistic international outlook. As a result, the price of foreign credit has dropped and there has been a significant increase in foreign borrowing. The market for corporate bonds is set to double this year, while foreign loans by Russian companies have risen from $800mn in 2001 to more than $8 billion last year, and are set to reach at least $10 billion this year. Finally, with global markets reeling, Russia looks increasingly attractive from an investment point of view, triggering an increased foreign interest in both portfolio and direct investments.

Meanwhile, many companies have significantly improved their corporate governance and become far more transparent. As a result, today one can use modern financial tools to evaluate Russian companies, a huge advance on the 1996-97 stock market boom when investors had little idea what they were buying.

Finally, Russia has received with another piece of good fortune, albeit in a roundabout way. The high oil price had led to a real strengthening of the ruble, resulting in Russian companies costs rising, competitiveness falling and from last year, a general slowdown. The blessing came when the dollar started to weaken against the euro as the ruble appreciated against the dollar. With about 40% of Russias imports originating from euroland, a stronger euro means imports are again becoming more expensive, providing domestic producers with additional breathing space.

A fascinating statistic is that in the first four months of this year imports were 18.7% higher than last year; yet in the same period the $/eur exchange rate was 22% higher. Given Russian trade statistics are reported in dollars, half of this years import growth can therefore be attributed to the exchange rate. Furthermore, other European currencies have moved in a similar direction against the dollar, meaning the situation applies to an even larger share of Russias imports. Hence, although an increased cost base and falling price competitiveness for Russian manufacturers are inevitable, in the medium term the stronger euro gives Russian manufacturers further breathing space (certainly more than anyone ever expected).

The stronger euro also means increased cost for debt servicing. However, again, the net effect on the budget from the stronger euro is positive. First, the rubles nominal appreciation against the dollar this year means fewer rubles per dollar, thus cutting debt-servicing cost on dollar denominated obligations. Second, most import tariffs are set either in euros or as a percentage of value, and a stronger euro means more rubles to the budget. We estimate the net-fiscal benefit to be around $150mn-$200mn for a 10% change in the dollar/euro exchange rate.

One cannot ignore these fortunate events impact on Russias economic recovery. However, Russia has also capitalized on its luck by conducting a sound economic and reform policy, and this also refers to structural and institutional reforms. The countrys fiscal house is in order and non-payments and barter have been replaced by cash transactions. As a result, demand for rubles has increased, and the population is regaining trust in the domestic currency, which has also played a part in capital flight reduction. In fact, in the first quarter this year the net-capital inflow of the non-financial private sector was positive $500mn (for the first time ever), and countries like Cyprus, Gibraltar and Luxemburg are now major investors in Russia the bulk of which is believed to be flight capital returning. This is possibly the best indicator of Russias success: Russians are starting to trust their own country.

On the legislative front, more laws have been passed under President Vladimir Putin than under President Boris Yeltsin. Although the process of passing laws with a compliant parliament is naturally easier, there are also signs of improving implementation. For example, recent legislation to reduce red tape for small businesses has had an impact, especially when it comes to laws limiting inspections and reducing licenses. There are also signs that small businesses are on the rise, a vital component for the creation of a more diversified economy and the generation of sustainable growth.

Continued economic success is dependent on Russia continuing to capitalize on the fortune that has come its way. However, in the event Russias luck takes a turn for the worse, the country has built up a strong cushion to insulate itself from, say, a dramatic drop in the oil price. Nevertheless, it is vital that the government continue its efforts and push ahead with structural and institutional reforms, especially restructuring of the natural monopolies and the banking sector, as sustainable growth is never built purely on luck, as luck has to run out some time.

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