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Business Week
July 21, 2003
Commentary: Sizzling Growth Could Singe Russia's Economy
By Jason Bush

Russia has a knack for defying expectations. Next month marks the fifth anniversary of one of the blackest days in Russia's post-Soviet history: the great ruble crash and debt default of Aug. 17, 1998. Yet today, Russia's economy has never looked healthier. Growth is spiking upward, inflation is falling, Russia's external trade and government finances are both in surplus, foreign debt is low, and foreign exchange reserves are mushrooming. It almost seems too good to be true.

Perhaps it is. No matter how strong Russia's economy looks on the surface, there's never been any shortage of predictions that boom will turn to bust.

Even growth can pose risks. Gross domestic product looks set to grow by 6%, while investment is rising 14% year-on-year. This has some experts fretting that the economy is growing too fast for its own good. "Russia's economy is like an amateur bodybuilder on steroids," says Roland Nash, head of research at Moscow investment bank Renaissance Capital. But he adds: "At least it is now a bodybuilder and not a corpse."

Joking aside, Nash is on to something: It's not clear how an underdeveloped Russia can keep absorbing the vast amounts of money now flooding into it. Higher prices for oil are fueling trade surpluses on the order of $30 billion annually. That in turn feeds the money supply, which is growing this year by 30% to 40%.

The wash of rubles has some positive benefits: It is feeding economic growth and finding its way into the paychecks of ordinary Russians, whose real incomes are expanding by 8% to 10% a year. But it also is feeding a boom in asset prices. The Russian equity market has risen 40% in the last three months, while the demand for Treasury bills is now so excessive that inflation-adjusted yields are negative. Moscow real estate prices have jumped about 25% over the last 12 months. "There's no way an economy can deal with negative real interest rates and the money supply growing by 30% without some sort of macro problem," says Nash.

The asset-price explosion invites worrying parallels with 1997-98, when the Russian market boomed before crashing. A bubble is definitely possible. The good news is that Russia is much better equipped to prevent a meltdown if the bubble bursts. Its '98 crash had a lot to do with an overvalued exchange rate and a huge hole in government finances. Neither of these is a big problem now. Plus, the central bank's foreign reserves -- $60 billion and rising -- means Russia can defend any attack on the ruble.

The most likely trigger for a crisis would be an oil price crash. Yet few expect prices to drop below $20 a barrel, a level more than adequate to yield healthy profits for Russian oil companies and revenues for the state.

If a drop in oil can be managed, what could unhinge the recovery? Politics. The first risk is that something happens to end the truce between the business elite and President Vladimir V. Putin, who, it was widely assumed, was keen to reassure Russian barons their assets were safe from renationalization. This implicit understanding has bolstered much of Russia's recent growth and stability. So investors got a jolt when, in early July, prosecutors launched criminal investigations of senior managers at Yukos, Russia's largest oil company and a pioneer in good corporate governance. Analysts have linked the probe to the political ambitions of Yukos Chairman Mikhail B. Khodorkovsky, who said he'd finance two opposition parties in upcoming parliamentary elections. Khodorkovsky already is backing away from politics. Still, the episode underlines the risks that investors were starting to forget. "Every time someone said, 'Now it's clear what will happen,' there came a new surprise," says Christof Ruehl, chief economist at the World Bank in Moscow.

The second risk is that Putin will delay crucial reforms until after the March presidential election. He should be toughening up regulations on banks, slashing the bureaucracy, and completing the tax and legal overhaul he launched. Putin can't delay too long: Russia needs a second act after oil. A repeat of 1998 is unlikely. But even Russia's President should beware the nasty surprises Russia can produce.

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