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#13 - JRL 7240
www.gateway2russia.com
June 25, 2003
Natural Habitat
Tatyana Gurova, Alexander Privalov, and Valeri Fadeyev

Russians continue to discuss the economic goal announced by the president of doubling the GDP in ten years. Mainly they cant imagine how it would be possible. We, however, cant imagine just what kind of economic logic allows them not to see the obvious, that notable acceleration of economic growth is completely realistic. The country has all the necessary prerequisites for this acceleration to happen and all we need is to make a few strong economic decisions.

The government, naturally, was not able to respond to Putins challenge. In the very first week after the address, Mikhail Kasyanov in an interview on the Vesti news program announced several points where the government was taking a new approach. Of these, only two seemed truly new: reducing the tax burden to 1.7% of the GDP and supporting a wider spectrum of Russian exports.

The cabinets though process, to be blunt, is far from overwhelming. First of all, the government intends to increase investment in Russia by increasing company funds by $6 billion (the rest, the prime minister hopes, will come from foreign investors inspired by the dramatic increase in the profitability of Russia companies). Secondly, the government continues to believe in an export-oriented economy, only, taking into account the unanimous criticism of solely exporting raw materials, now it plans to support processed goods export as well.

Alas for the government, the turn that the economy needs to take is far more radical. Not only in our opinion, but in the opinion of many representatives of the business community, we need both an unambiguous emphasis on domestic market development and a significant expansion of the economys capital base. Only in this case will a big country like Russia be able realistically to become economically independent and to achieve high growth rates, an independent financial market, and a strong national currency.

Where we stand

We plan to prove that the Russian economy is ready to grow. Our decade of development began around 1995. That was when the Russian GDP reached its lowest point, and when companies, having either successfully passed through the stage when state property was privatized or found their niche without touching state spoils, began to consciously build their business. Eight years have since passed, and this is the first sign of how close the start of our decade of growth lies.

The efficiency of capital investments in many industries new to Russia is very high. This can be demonstrated by comparing profitability on analogous markets in Europe, American, and now even China, as well as by the simple fact that our progressive companies can afford to borrow expensive money. The average profitability for the Russian economy is meaningless here. Growth will depend on these new companies and on those companies that interact with them. This is the second, very important sign that the Russian economy is on the threshold of growth. However, we dont need occasional bursts of investment activity; we need an investment boom.

What about investments

Today there is a huge gap between the level of current investment in the economy and the level that it absolutely needs. Today, investment in the Russian economy is estimated at $60-70 billion dollars. The GDP ranges from $350 (official figure) to $450 billion (an estimate including monetary transactions not considered by the State Statistics Committee). Thus, the investment standard for our economy today is 13-20%. If we compare this with todays figures for developed countries, then this is a completely respectable number. However, we must focus on the investment levels for countries in periods of rapid economic growth. Judging from the experience in post-war Germany and Japan, energetic economic growth occurs when investment reaches 30-40%. This means that todays $60-70 billion should be two to three times greater: $110-180 billion.

The gap between what we have and what we need becomes even wider if we look at the reproduction and expansion of fix assets. Many business people today see that their current investments will not allow them to increase their basic capital, or even reproduce it.

In terms of determining required investment levels, today the efficiency of investment in Russia is at an extremely high level, and we shouldnt expect it to go any higher. This means that now is the time to make it easy to invest. To do this, we need to do two things. First, we need to define our long-term economic development reference points at least in very general terms for at least the next decade. Second, we need to flood our financial system with capital, not with random excess liquidity but with real long-term money.

Room to grow

It is completely incomprehensible why Russians seem so convinced that money and power are the fundamental raisons detre for the economy. In truth, they are simply components. All of the greatest achievements in material culture were based on another component. High-powered entrepreneurs and high-powered nations sought a higher spiritual reason for their economic expansion.

What is the historical reason for Russias existence? Is Russias point on this planet to inundate the entire world with oil, natural gas, and other natural resources? No. This suggestion is, to put it mildly, bizarre. Raw materials are only resources that give us the chance not to sink into an extremely deep national crisis. The entire history of Russia is connected with dominating the huge swath of land that touches three great oceans. That is its function or, if you prefer, its mission, subconsciously recognized as vitally important even today at a wide variety of levels. The worlds leading diplomats consider Russias size and central position the defining factors in its foreign policy. Russia entrepreneurs who refused to think about leaving after the 1998 crisis expressed a similar notion: I decided that Russia is a huge land that someone would take over eventually. Why not me?

Taking over and taking good care of our own country could be our most important goal for the next decade. This line of thought already seems natural for Russian business. Interregional expansion has been one of the biggest growth trends in our economy in recent years.

In this sense, the emphasis on export diversification, even in terms of hi-tech products, seems mistaken and old-fashioned. The majority of entrepreneurs have clearly grasped that our main competitive edge as a country is our huge market, a market with more potential than any other in the world. This potential needs to be taken advantage of. The expansion of Russian material culture abroad is a task for the future. It also has its place in Russias destiny, but it is pointless to emphasize it now. In order to expand abroad, companies producing world-quality innovations must be economically strong. To become strong, they need to gain experience and financial resources and test demand for their innovations in a real economy. All this can only be done with a fast growing domestic market.

Where to get investment money

Lets return to the gap between the investment we have ($60-70 billion) and the investment we need ($110-180 billion). How can we move from one level of investment activity to another? The answer is simple: we need to look for money in places we are not looking now.

Liberal economists believe that the basic source of investment is individual investors and argue about how to get people to take their money out from under the mattress, put it in the bank, and leave it there. Today, individual savings in banks totals around $40 billion dollars, or around $300 per capita. If we add mattress money, $40-60 billion, we end up with at least $400 per capita. Now, if you had $700 saved up, would you invest it for the long term? Thus, individual citizens money can only become a source of investment after they get rich, or in other words after the economy expands. This means that today Russians savings are not a source of growth.

You might ask, What about pension funds? Arent they the main long-term assets in Western financial systems? Pension funds became what they are today after the rapid economic growth of the 1960s. This is supported by current Russian forecasts for pension funds. Even the most optimistic of them estimate that pension funds will not have more than $5 billion in the next three to five years.

Another liberal favorite is foreign investment. And it is wonderful that liberals are trying to improve Russias investment climate in order to attract it. However, it seems strange that they are literally deaf to several important comments from potential investors, who say: We could multiply our investment by several times only if you are also start investing. They then add, No country has ever pulled itself up with someone elses money. There you have it. We are still going to have to get a little more self-reliant.

Turning wealth into capital

When we discuss potential investment sources, we always use the term long-term money. Perhaps this is leading us astray. Capital growth is not based on money but on wealth transformed into capital.

The total capital of active market agents (the capitalization of listed companies and bank capital) does not exceed $250 billion, even if we make all sorts of allowances. With a lot of effort, all owners of land and real estate could probably scrape together about that much. There is no other liquid, meaning capitalized, wealth in Russia. All of our capital equals just a bit more than one GDP. In this situation, dreaming of growth is truly difficult.

But we do have potential sources for capital. This is land, first and foremost. According to some estimates, in Moscow alone the cost of land equals $150 billion. Then theres real estate. If we look at the market price for all real estate in Russia, we get an estimated $800 billion. There are natural resources owned by the state. However, for the most part, this wealth is not liquid, as we have a limited domestic financial market.

Thanks to three years of lucky oil prices, Russia has extensive currency reserves, a good amount of steadiness in its trade balance, and a harmless level of foreign debt. For these reasons, the government is completely able to invest its resources and even issue rubles and bonds in order to expand the financial market.

No one, naturally, wants the state to start pumping the missing trillions of dollars into the economy immediately. But business people and financiers can easily point out some instruments the government could use to start expanding the financial market. The first is to refinance banks, which the Central Bank currently does not do. The second is to reduce the reserve rate. Apparently, in some cases, the reserve rate for long-term loans is 100%, which means that banks do not make a penny from reserves. Third is issuing federal bonds. Finally, the forth and perhaps the most outrageous is for the state to get over its fear of involvement in a major mortgage program. The mortgage issue is a good example of both the incredible psychological barriers preventing the government from expanding the capital base, and of the powerful cumulative effect the entire economy feels when the state decides to go for it.

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