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Moscow Times
January 25, 2005
Slowdown Is Not the Product of Politics
By Laza Kekic
Laza Kekic is director for Central and Eastern Europe at the Economist Intelligence Unit. He contributed this comment to The Moscow Times.

The Russian economy slowed considerably in the second half of 2004. Although this in itself was not a surprise, if only because of base period effects, the deceleration was stronger than had generally been anticipated. According to the latest available official data, year-on-year real GDP growth slowed to 6.4 percent in the third quarter of 2004 from 7.4 percent in the first half of the year.

State Statistics Service data for 2004 as a whole is as yet unavailable. Estimates differ of the magnitude of the slowdown in the second half of 2004 and in the year as whole. According to real GDP estimates compiled by Moscow Narodny Bank based on their surveys of confidence in the manufacturing and services sectors, growth declined to 4.5 percent in the fourth quarter of 2004, the weakest result since late 2002. The estimated year-on-year growth rate in December of 3.9 percent was the lowest since April 1999.

Other estimates point to a gentler slowdown and, in some cases, to renewed vigor toward the end of the year after the trough in September-October. The State Statistics Service's estimate of growth in output of the economy's five basic sectors showed year-on-year growth of 6.6 percent for January-November.

Growth in November picked up strongly to 6.8 percent after sinking to 2.8 percent in September, although this was partly due to a higher number of working days than in the same period in 2003. According to Economic Development and Trade Ministry estimates, real GDP growth accelerated to 7.1 percent in November from 5 percent in October and 4.3 percent in September. January-November growth was estimated at 6.9 percent.

More significant than the precise extent of the second-half or full-year growth slowdown has been the degree of underperformance relative to what could have been expected on the basis of very high average oil prices. The second important issue is what current trends may portend for future performance.

Empirical estimates show that almost the entire year-to-year variation in real GDP growth between 1992 and 2003 can be explained by movements in four variables: oil prices, the real effective exchange rate or REER, an index of political risk -- a proxy for other elements of the business climate as well -- and the inflation rate.

Applying this model to 2004 data for international oil prices, REER and inflation, the predicted real GDP growth rate at 2003 levels of political risk is 8.4 percent, compared with an estimated actual rate of 6.7 percent. Had the REER in 2004 remained unchanged vs. 2003, the predicted growth rises to 9.2 percent. In other words, the considerable average real effective appreciation of the ruble in 2004 knocked nearly a percentage point off potential growth.

The other implication is that political risk and associated factors that led to the deterioration of the overall business climate cost the economy 1.7 percentage points in growth in 2004, or the difference between the 8.4 percent projection and 6.7 percent estimated actual rate. This is not a dramatic amount, but neither is it negligible, as it amounts to an estimated $10 billion in lost production.

Furthermore, if the negative trends seen in 2004 persist -- in the context of an eventual drop in average oil prices and ongoing real effective appreciation of the ruble -- the effect on GDP could become more significant.

A number of factors appear to be behind the underperformance of the Russian economy in 2004. In addition to the uncertainty caused by recent policy trends and the impact of real ruble appreciation, the banking "mini-crisis" of mid-2004 caused some damage.

Other developments also affected confidence, including new social legislation and the continued risk of terrorism. However, capital flight actually abated in 2004. Based on the balance of payments residual method, it is estimated to have declined to $11.5 billion in 2004 from an average of $15 billion in 2002-03.

Higher taxes on windfall oil profits, which are still far below rates in some other oil-producing countries, do not seem to have had much of an impact. Nor did pipeline constraints play a role. Despite the Yukos affair and an easing of oil production growth in the final quarter of the year, Russia's oil sector performed well in 2004, as other companies made up for Yukos production shortfalls. Crude oil output in January-November averaged 8.9 million barrels per day, a year-on-year increase of 8.9 percent. Contrary to widespread fears, no transport bottlenecks emerged. Indeed, pipeline monopoly Transneft reported that it actually had excess capacity in 2004.

Many observers blame the campaign against Yukos and stalled reforms for the slowdown. The longer-term consequences of Yukos remain uncertain, and the attempt to challenge the December auction of Yukos' main asset in Western courts could yet pose a serious hindrance for business. For the moment, however, the consequences are often greatly exaggerated, even if one assumes that there was some negative impact on the growth of fixed investment.

This conclusion is based on the oil-production data, capital flight figures and the uptick in foreign capital inflows into Russia, as well as a flurry of foreign direct investment deals, although Central Bank estimates for 2004 show that actual foreign direct investment inflows, at $6.6 billion, fell below some expectations. In addition, there is a surfeit of other plausible explanations for the 2004 growth slowdown.

Skepticism also applies to the supposed negative impact of lagging reforms on growth, in particular stalled utilities reforms. For one, there were some significant reforms in 2004 -- in the banking sector, public administration and the social security system. Any short-term impact of utilities sector reform, had it progressed, would most likely have been negative.

For sustainable long-term growth, Russia undoubtedly needs more efficient and transparent institutions. It also needs structural economic reforms in some areas. However, many observers have made inflated assumptions about the returns on structural reforms, especially in the short term. Institutional change operates with very long lags and has little or no positive impact in the short term; its effect can even be temporarily negative.

The fact is that Russian growth will slow irrespective of reforms -- given the country's high energy dependency and the likelihood of lower international oil prices in coming years. Russia is also beset by negative trends such as poor demographics and infrastructure and a deteriorating human capital base, or in other words, declining skills and health.

There has been a lot of commotion in the Russian press about the inability to fulfil President Vladimir Putin's goal of doubling real GDP within a decade, which requires average growth of at least 7 percent per year, depending on the initial year for the calculation. In fact, if Russia managed to sustain growth in per-capita GDP of 4-5 percent per year for a prolonged period, that would be no mean achievement by historical standards, especially for a resource-dependent economy.