02.03.2008
The Change in the External Factors of Russia’s Development
№1 2008 January/March

The Russian
election campaign and related political events have distracted the
public’s attention from the fact that the country has found itself
in new circumstances. Luck, which has helped Moscow to greatly
consolidate its positions over the past few years, is giving way to
increasingly growing problems. The general situation may be far
less favorable in the new political cycle.

WORSENING GLOBAL
ECONOMIC TRENDS

Food prices shot
up in Russia at the end of 2007.

A combination of
fundamental and short-term factors fueled the global growth in food
prices. The European Union abolished subsidies for milk and dairy
products, and there was an epizootic situation in China.

Climate change
also contributed to the growth in food prices. There was a
large-scale drought and a poor corn harvest, which means that
global wheat reserves in 2008 will be at their lowest in the past
28 years, while the reserves of the world’s five leading exporters
(Argentina, Australia, the EU, Canada and the United States) will
be at a 34-year record low. Other factors include increased food
consumption by developing countries, first of all China, and the
growing popularity of biofuels.

However, there is
at least one fundamental reason behind the increase in food prices
that is not given enough attention – the migration of global
speculative capital (“hot money”) into new markets. After the
painful adjustment of the American stock market in April 2000 and
the collapse of the “new economy,” money was put into
exchange-traded mineral resources – oil and metals. Now these two
speculative resources are giving way to food, which is no less
important for human development than oil and demand for which is
not very elastic in price.

The growth in
food prices will deliver a terrible blow to poor countries that
import food. If the present trend continues, these countries will
be hit by famine, and if they do not learn to produce food for
themselves to meet their requirements, the population of those
countries will gradually die out. Moreover, even a modest step
toward self-sufficiency in food supply would require serious
efforts from these countries to improve the quality of state
governance and introduce modern agricultural technologies on a
large scale (which often requires a modern educational system and
developed infrastructure). In order to develop their own
agriculture amid the current global competition, poorer countries
will need moderate protectionism; that is, at least a partial
revision of the economic policy based on liberal ideology, meaning
they should reject the dogmas of the Washington Consensus. For
underdeveloped countries, rejecting these dogmas would mean a deep,
systemic conflict with the West, since Western food producers would
receive less profit. Strictly speaking, these countries cannot
afford such a conflict politically – unless they enlist the support
of China.

Russian imports
of foodstuffs exceeded food exports by 290 percent in
January-August 2007 and totaled $17 billion compared to $4.4
billion. The growth in food prices means that the foreign trade
surplus is dropping more rapidly. Global speculative capital forced
up the prices of Russian exports in previous years, whereas the
pendulum has now started swinging in the opposite direction –
speculative capital is beginning to push up the prices of Russian
imports.

Since Russia is
highly dependent on farm produce imports (it imports half of the
milk it consumes, about half of the pork, and almost three-quarters
of the beef), the worldwide growth in food prices has an automatic
impact on the domestic market, boosting inflation. The price hikes
hit, first of all, the poorest groups of society, who spend most of
their income on food.

It is important
that Russia has not yet reached even the average consumption level
it had in Soviet times. Meat consumption in Russia was estimated at
73 kg per capita a year in 1989, while the norm was about 80 kg.
However, meat consumption was a mere 55 kg in 2006. The same is
true for the consumption of milk and dairy products: at present,
Russians consume 235 kg per capita, compared with an average of 392
kg in the Soviet Union. Fish consumption stood at 12 kg per capita
in 2006, compared to 20 kg in 1989.
The drop in food consumption by Russians due to price hikes might
bring about serious social and political
destabilization.

INFLATION GETTING
OUT OF CONTROL

The above-said
would not be frightening for a healthy economy with a sensible
government. But Russian inflation is expected to grow to at least
11 percent in 2007 from last year’s 9 percent. Moreover, these are
official figures, which are often set too low. Some specialists
estimate the real growth in inflation at no less than 150 percent
in 2007.

Inflation is not
likely to slow in 2008: budget spending in the fourth quarter of
2007 increased by 1.07 trillion rubles (not only for the election
campaign or due to corrupt sentiments, but also in order to support
bank liquidity), exceeding the planned figure by 130 percent and
accounting for 46 percent of all expenditures in 2007. This growth
will bring back monetary inflation for the first time since
Russia’s financial default of 1998. The growth rate for the
domestic wholesale price for natural gas will almost double to 25
percent – in addition to a growth for electricity tariffs and
utility rates.

Food prices are
growing as well – not only for global, but also for purely domestic
reasons.

The immediate
cause of increased prices on the domestic market was the rapid
growth of grain exports: in January-August 2007 they doubled to
almost $1.5 billion and kept growing afterwards (Russia exported
2.4 million tons of grain in September and grain exports reached
3.1 million tons in October). Export duties are unable to hold back
these sales, while commodity interventions are insufficient, too
late and only play into the hands of re-wholesalers rather than
producers.

The price was
high for the government’s incapacity in the sphere of market
regulation. Bread prices soared 20 percent in January-September,
compared with 7.6 percent in the same period of 2006; macaroni
prices increased by 13.8 percent (compared to 3.8 percent), and
groat prices went up by 15.9 percent (11 percent).
Wholesale prices for new harvest sunflower seeds almost doubled,
and even the price of sunflower oil from old harvest seeds
increased by 17.2 percent, although it fell 1.2 percent in the
first nine months of 2006.

The inflation
wave is even hitting new sectors of the economy that saw stable
prices in the first nine months of the year.

For example,
retail gasoline prices grew by a mere 2.3 percent in
January-September 2007, compared with a 12.2-percent increase in
the same period of 2006 – primarily because the price growth
potential was exhausted (similar things happened on the sugar
market).

However, in the
second half of October, wholesale gasoline prices soared to a point
where the profitability of independent refuellers fell to a
critical level. The reason was not only a growth in world oil
prices, which stimulated the export of oil products, but also a
drop in production due to repairs at oil refineries and the
inefficient distribution of oil to refineries that were recently
placed under Rosneft control.

The recent
freezing of prices for six ‘socially significant’ product groups
will only have a temporary and limited effect, even if the state
ensures their universal availability for sale. First, because the
price freeze is voluntary and non-participating monopolists can
raise prices. In addition, even those who have pledged to freeze
prices can engage in cross-subsidization, thus offsetting their
profit shortfall with price hikes on “socially insignificant”
goods. And after the price freeze agreement expires on February 1
or April 1, monopolists can drastically raise prices. So the price
freeze is simply a measure to win time, which the government will
not be able to make use of since an effective antimonopoly policy
is in conflict with business interests and the dogmas of liberal
fundamentalism.

The government
has not fully understood that an underdeveloped agricultural sector
and a servile dependence on external markets is behind the surge in
inflation. Measures to comprehensively develop agriculture, which
would combine reasonable protectionism (at least at the level of
developed countries), the development of agricultural
infrastructure and the lifting of artificial barriers on domestic
markets, remain beyond the government’s consciousness. The most
that the government can do is to take pinpoint protectionist
measures to support lobbyists, not the economy.
For example, the government added fuel to the price fire by almost
doubling the import duty on sugar on December 1 – as if this
measure could help increase the amount of the already harvested
sugar beets in Russia.

The government’s
activity has caused panic buying of long-term staple goods, whose
prices are regulated (in anticipation that prices will increase
once the regulation period expires), and long-term storage
substitute goods (primarily canned food).

The main cause of
the price increases was not the price jump on global markets and
not the weakness of agriculture, but the monopoly in trade. This
was already evident during the undoubtedly man-made food crisis in
the Kaliningrad region. Similar crises had been arranged in the
past, as well – to condense the market and oust small companies
from it (e.g. the ‘wine crisis’ in early 2007, caused by the
introduction of the Unified State Automated Information System), or
simply for the sake of a clearance sale (the salt crisis and
several small sugar crises).

This time food
prices jumped before imported goods purchased at higher prices or
liable to higher duties entered the market, and before the
government raised pensions. On the whole, prices rose not because
of increased demand or costs, but merely on news about expected
increases. This means that inflation was caused by a total abuses
of monopoly. Fighting such abuses is not only technologically and
legally difficult (Russian laws still require evidence of direct
collusion, which may not take place at all), but also politically
dangerous. Indeed, putting an end to monopoly overpricing would
deprive businesses of funds for bribing the corrupt bureaucracy,
who would thus lose this money.

CHANGES IN
CAPITAL MOVEMENT

The mortgage
crisis in the United States, which has also hit the UK and shaken
the global financial system, was not accidental. It reflects the
end of the economic recovery stage in developed countries achieved
by easing financial policy. Now the time has come to toughen this
policy, appreciate the national currency, raise the cost of
borrowing, and return capital from risky markets (including Russia)
to developed ones.

It is important
that the mortgage crisis only acted as a catalyst and accelerated
the reduction of capital inflow into Russia, which began long
before the subprime lending crunch. The inflow of private capital
into Russia began to grow in March 2007 when its net volume reached
$17.4 billion. The growth continued to $18.8 billion in April and
accelerated to $29.1 billion in May. But the net inflow of private
capital dropped to only $4.8 billion already in June (before
businesses went on holiday).

The massive
inflow of private capital into Russia ended in the second quarter,
although statistically it hit a record high, giving rise to new yet
unfounded hopes. Private capital outflow again exceeded inflow in
the third quarter by $9.4 billion – a record for the entire Putin
presidency.

The changes in
capital movement are even more evident if we analyze the gross
inflow and outflow by month (we do not consider here the movement
of ‘shadow capital’ which is totally illegal and invisible to the
state – see Table 1). Capital outflow and inflow were a respective
$3.5 billion and $3.7 billion in January 2007. Capital outflow grew
to $11.1 billion in February and stabilized at that level for three
months ($10.8 billion in March and $11.3 billion in April). At the
same time, gross capital inflow during the same months grew
rapidly: to $13.4 billion in February, $27.1 billion in March and
$28.1 billion in April. May was a record month for capital inflow
when gross capital outflow fell by half to $6.4 billion, while
capital inflow jumped to $38 billion. However, the trend reversed
in June as capital outflow grew to $14.3 billion, while inflow fell
to $15.2 billion.

CAPITALIZATION –
THE END OF THE “LAST FREEBIE”

The practice is
widespread among Russian businesses to adjust accounting reports by
reporting expenditures as investment. This measure inflates profits
and hides losses, while increasing capitalization and improving a
business’s image. This, in turn, helps the business to borrow more
money (or place shares) in order to cover reliably concealed
running losses.

Worsening global
financial trends caused by the mortgage crunch in the U.S. and
higher food prices are putting an end to this business
practice.

The flow of money
from the West has almost stopped and the scale of ruble borrowings
has shrunk dramatically. The average interest rate on loans given
to mid-sized and large businesses has increased from 10 to 13-14
percent, which is a disaster for businesses that used to cover
their growing losses by borrowing money against capitalization
growth.

The situation is
aggravated further by a possible crisis in private foreign debt,
which has been growing quickly since 2002. Whereas private debt
grew by 7.5 percent (from $29.2 billion to $31.4 billion) in 2000
and by 10.6 percent in 2001, it increased by 36.4 percent in 2002,
by 66.7 percent in 2003, by 35 percent in 2004, by 62.1 percent in
2005 and by 49.1 percent in 2006. Private foreign debt grew by 31.4
percent to $343 billion in the first half of 2007. The share of
private debt in Russia’s overall foreign debt jumped from 20.9 to
89.1 percent.

A large part of
private borrowings abroad – at least since 2005 – is used to
service and renew loans. Loan allocations peak in the fourth
quarter of a year, causing an accelerated growth in private foreign
debt at that time of the year. For example, foreign debt in
Russia’s private sector grew by 20.2 percent in the fourth quarter
of 2005, while the growth for the whole year was 62.1 percent. The
growth was even more impressive in the fourth quarter of 2006,
making almost half of the yearly figure – 21.4 and 49.1 percent
respectively.

Businesses were
no longer able to refinance and increase their foreign debt for
free in 2007. Therefore, the most natural way to go is through the
practice already underway of taking insolvent debtors into the
ownership of creditors. However, banks do not want to recognize the
loans they have provided as hopeless (this would hurt their
reputation and financial standing). Their silence will ensure that
there will be no scandals, yet it will not solve the problem, but
only postpone it: banks will not be able to improve the management
of companies that come under their control and ensure their
financial recovery. Russian businesses are built to exist if the
cost of borrowing is about 10 percent, and most of them will not
survive a growth of this cost.

Shifting the
burden of corporations that hide their losses onto their creditors
will only postpone a general crisis and increase its dimensions,
and bring the banking system into it. At the same time, the number
of Russian businesses bought with foreign capital has fallen to a
point where there will be no shock-absorbing effects.

THE PROSPECTS OF
THE BANK LIQUIDITY CRISIS

A falling foreign
trade surplus, coupled with a drop in capital inflow, sharply cuts
the inflow of hard currency, which forces the government to
spasmodically toughen its financial policy – precisely at a time
when the economy begins to badly need easier policies. This will
hit the banking system first of all.

In particular,
the government made a decision which testified to the depth of the
liquidity problem – a decision on an unscheduled allotment from the
2007 budget of 180 billion rubles “for development,” but it was
actually used to provide liquidity to Russia’s three largest banks
(two of them – Sberbank and VTB – recently raised considerable
resources in IPOs).

Correspondent
accounts at Moscow banks fell to a record low in late October
compared to the past nine months of 247.7 billion rubles, while
interbank rates rose again (to 8-8.5 percent for first-tier banks
and 8.5-9 percent for second-tier banks). Russian banks continue to
experience a shortage of ruble liquidity as they build up their
accounts at foreign banks. Their funds at foreign banks rose by
37.8 billion rubles in September, while loans and deposits for
non-resident banks increased by 210 billion rubles. At the same
time, banks had reduced their funds at correspondent accounts in
other banks by 30 percent to 80.5 billion rubles by the end of
September. Several banks reduced blank limits and many banks got
rid of them entirely.

Banks withdrew
320 billion rubles from securities in September. According to
expert estimates, Russian banks had built a pyramid scheme on the
bond market by buying bonds, investing them in repos and obtaining
funds for purchasing new bonds. Now, this pyramid is falling to
pieces.

Debts to banks
increased by 644 billion rubles to 12.9 trillion rubles in
September, as banks gave more loans to businesses and other banks.
This partially reflects the general desire to reduce investment
risks, giving preference to loans (as opposed to
securities).

THE END OF
STABILITY?

Russians have
unfounded social expectations in a situation like this that are not
related to the actual state of the economy.

According to the
Levada analytical center, 58 percent of Russians believe that
President Vladimir Putin does have a plan, highly publicized by the
United Russia party, that would “make Russia a strong, rich and
prosperous country” (although only 6 percent think that they know
what this plan is) and expect that it will be successfully
implemented, rather than face upcoming difficulties.
The key question for the present stage in Russia’s economic
development is whether the government can close the gap in the
financial balance of businesses and gradually cool down the
overheated economy, reorganizing it and improving the quality of
corporate governance.

The national
budget and the Central Bank have accumulated enough funds to solve
this problem, yet the government will not cope with it due to the
following factors:

  • shortsightedness
    (the government is not even aware of and has not set such a
    task);
  • a lack of
    specialists;
  • bureaucratic
    disunity (the Finance Ministry had to replenish the liquidity of
    state banks from the national budget, probably because the Bank of
    Russia refused to violate its corporate policy for the sake of the
    common cause).

The government
will keep the general situation “within the bounds of decency”
until the presidential election and it will keep promptly
addressing individual problems as they become more acute. At the
same time, the government will not be aware that these problems are
manifestations of a gradually escalating general structural crisis
of the economy. Therefore, it will not so much solve these problems
as only make them less acute, thus postponing their manifestations
on a larger scale for later.

Due to general
irresponsibility, poor coordination and management, and fear of
opening oneself up to attacks from hostile political clans,
decisions will be delayed with unjustified material
costs.

The policy of
ineffective and delayed neutralization of individual manifestations
of the general structural crisis will continue until the
presidential election, after which there will be a new government
and Central Bank management. However, due to the nature of the
present corruption-oriented state, their effectiveness will not
improve.

After the
election, since everyone will be absorbed in political problems and
the start of summer vacation, the government will manage to
maintain stability until the end of July 2008 (when market
participants will see dangers and take the lead), but later the
danger that the structural crisis may evolve into an open crisis
for the Russian economy will become real. This danger will manifest
itself in:

  • some companies
    will stop servicing debt;
  • a divestiture of
    assets (above all, non-core assets), which will fuel a drop on the
    stock market and push down property prices;
  • a serious crisis
    in bank liquidity.

Inflation will
step up as the state tries to ease these problems by allocating
poorly controlled funds and the ruble could weaken.
But this will happen after the next president is appointed (under
the guise of presidential elections).