12.07.2006
The Russian Economy Today and Tomorrow
№3 2006 July/September

Russia’s economic development in the first five years of the
21st century has revived hopes that the country will regain its
leading positions in the world, which it lost during its transition
from a centralized and planned governance system to market-economy
methods of regulation. From 2000 to 2005, Russia’s Gross Domestic
Product increased 50 percent, while the government’s rigid
financial policy eliminated the need for foreign loans. This has
given Russia the opportunity to beef up its budgetary and hard
currency reserves against possible financial crises.

One of the major contributing factors to the success of Russia’s
economic policy was the upbeat economic situation on international
markets. Before 2004, no one expected such a rapid growth in energy
prices on the global markets. At the same time, few could have
predicted that the U.S. Federal Reserve System would maintain
record low interest rates to restore high economic growth. For
Russia, the combination of these factors meant a radical
improvement in its balance of payment, as well as the availability
of a large amount of liquid assets for investment.

Before 2004, Russia’s economic development was driven by the
export-oriented resource sector, which ensured high growth rates,
the rapid growth of budget revenues, and the accumulation of hard
currency reserves for the Bank of Russia. This growth largely came
from the extensive development of relatively new oil fields. At the
same time, in 2003-2004, new sources of economic growth were found
in less risky investment projects in the non-resource sectors.

The events involving YUKOS, Russia’s largest oil company in the
early 2000s, marked the beginning of stricter tax regulations. It
also had a major impact on the development of the Russian economy
in 2005. Apart from the obvious positive effect the new legislation
meant for the collection of taxes, this move created additional
risks for companies in view of the mass tax law violations in
previous years.

THE CONTRASTS OF 2005

The fifth year of the new century came as a period of striking
contrasts for the Russian economy. The most important were the
sharp changes in the structure of economic growth, the failure to
fulfill official plans for reducing inflation (despite the
inclusion of huge amounts of liquid assets in the Stabilization
Fund), and the slowdown in the growth of industries oriented to the
domestic market amidst an increase in domestic demand, supported by
consumer crediting.

In 2004, the GDP increased 7.2 percent, primarily due to growth
in the extraction of raw materials, whereas in 2005, when the GDP
grew 6.4 percent, resource extraction increased slightly more than
one percent. Thus, we can see that contributions from the
non-resource sectors to the national economy essentially increased.
The main factors behind the slowdown in the growth in the resource
sector were as following: a decline in oil output by the major oil
companies (YUKOS and Sibneft) after they changed hands and
exhausted their resources through the extensive development of
their oil fields; uncertainty over plans for developing the
transport infrastructure; and the excessive growth of the tax
burden amidst rapid growth in global resource prices.

The oil industry was replaced as the motor of economic growth by
other sectors, above all, in the construction, communications and
trade sectors.

Throughout a greater part of the year, these industries saw
100-percent growth rates, the improvement of product quality and
services, and the introduction of new technologies. This was the
main trend of the Russian economy in 2005. Other factors included a
considerable increase in the scale of consumer crediting, and the
development of network operation by real estate companies, cellular
operators, and large retail holding companies.

Last year graphically demonstrated that the Russian economy is
capable of growing at a high rate even without a rapid expansion of
its resource sector. At the same time, it became evident that a
long-term slack in the extraction and processing of raw materials
can put a drag on Russia’s further economic development, and this
factor sets special requirements for the future structure of GDP
growth.

The next three years will be a critical period for
providing answers to the challenges now confronting the Russian
economy

During the year, consumer prices rose 10.9 percent – slightly less
than the 11.7 percent reached in 2004, and much more than the
officially declared target of 8.5 percent. The government and the
Bank of Russia blamed this excessive growth on public utilities and
passenger transport fees. Blame also fell on the growth in meat
prices, sparked by customs quotas and gasoline prices connected to
the rapid growth in oil product prices on the global markets.
Another obvious factor in the inflationary pressure was accelerated
growth in producer’s prices throughout 2004 and 2005.

One explanation for the rapid growth in consumer prices is the
overestimation of the influence of the accumulation of money in the
Stabilization Fund as a factor for restraining growth in money
supply. Although the Fund received more than 700 billion rubles
(over 40 percent of the increase in the Bank of Russia’s hard
currency reserves), the money supply increased by almost 40
percent. This figure is higher than that in 2004 and much higher
than the target set in the Guidelines for the Monetary and Credit
Policy for 2005.

In this situation, the inflation rate could be reduced to 8.5
percent only if the money velocity was reduced by more than 15
percent, which is higher than the figure in 2003 and 2004. However,
the year 2005 witnessed a substantial slowdown in the growth of
real demand for money (without taking into account the GDP growth).
On the whole, demand grew almost five percent over the year, and
was unchanged throughout the second half of the year.

The level of mistrust that many feel toward the government’s
financial policy goes far at explaining this situation. In
addition, expansion in the private sector was rather slow amidst
the growing uncertainty over tax policy: the primary emphasis was
made on projects that provided relatively short-term return of
investment. Disregard for these factors may have a long-term
negative effect on the quality of the government’s financial
policy.

Enduring high inflation resulted in the slow decrease in the
poverty level and real interest rates – factors that do not allow
one to speak of the overcoming of the tendency for reproducing
technological backwardness of the Russian economy and its
structural imbalance. These factors also indicate that currently
the country has small opportunities for fast formation of a broad
middle class necessary for stable social development. 

On the domestic market, the persistent decrease in the
competitiveness of Russian goods, compared to imports, was the most
worrisome trend in 2005. While domestic demand grew by more than 50
percent, imports accounted for over half of this increase. An
important factor here was the expansion of consumer credit created
to ensure reliable demand for durable goods – products in which
imports obviously prevail (cars, household goods, furniture).

“HOMEWORK”

The next three years will be a critical period for providing
answers to the challenges now confronting the Russian economy. This
refers to legitimizing private property, reducing the rate of
inflation, as well as poverty levels, and creating a competitive
environment for economic growth, especially in light of Russia’s
imminent accession to the World Trade Organization.

The large-scale expansion of investment activities by the owners
of Russian companies is being thwarted by a lack of protection of
ownership rights, together with the elimination of competition by
means of “administrative resources.” The institution of private
property, essential for a market economy, will strengthen with the
modernization of corporate legislation, the improvement of law
enforcement practices (above all, within the framework of the
judicial system) and the development of the idea that private
property is a legitimate phenomenon. Well-known instances of tax
violations and general corruption, as well as the non-transparent
atmosphere of privatization deals impede the latter goal.

The main ways to legitimize property, now being considered or
already used, include: buying out private companies at market
prices by government-controlled organizations; selling shares to
well-known foreign organizations; making additional tax payments in
agreed amounts, and granting amnesty to companies that formerly
violated tax or other laws (a bill proposing the latter option has
not yet been made into law). The first option is the least
attractive from the point of view of economic effectiveness, yet
most often resorted to due to its simplicity. The second option is
checked by the stalled negotiations on Russia’s accession to the
WTO, as well as the fact that Moscow has not yet formalized its
position on the sale of its “strategic” assets. The third option
may well imply selective application, while the fourth one may
prove ineffective due to the previously mentioned public mistrust
of the government’s actions.

So, in the near future the government will have to choose more
effective ways of legitimizing private property in Russia, which
will require a dialog with the business community and other
institutions of civil society. The success of these efforts will
lay the foundation for the significant expansion of investment
activity and economic growth in the country.

However, the existence of private companies per se is not a
sufficient condition for the effective operation of the market –
equally important is the presence of a competitive environment. The
unwarranted interference of state bodies in companies’ activities
and inter-company relations is the main cause for competitive
weakness. This interference is “facilitated” by high administrative
barriers where a company’s operations, as well as the
implementation of its investment plans, is made dependent on the
position of particular government officials, who may have interests
with the company’s rivals. Similar problems may arise in regard to
procedures for purchasing goods and services for state and
municipal needs. The general atmosphere of corruption inflicts
serious damage to the investment climate and social relations as a
whole.

Russia’s anti-monopoly legislation and its enforcement do not
yet meet the requirements of its economic situation. On the one
hand, little is done to stop the use of the “administrative
resource” for gaining competitive advantages; on the other hand,
anti-monopoly measures are increasingly invoked in those markets
where the concentration of business is expedient. Meanwhile,
efforts to protect competition should focus on countering the use
of one’s dominant positions to the detriment of the rights of
consumers of goods and services.

The government does not fully take into account the advantages
and disadvantages that would derive from access of Russia’s markets
by foreign producers. Given the desire of foreign companies to
invest in the modernization of Russia’s strategic industries,
shareholders could reach agreements and assume mutual obligations
with regard to investment in the latest technologies and R&D in
the country.

In the nearest future, the government must focus its efforts on
winning more trust in its financial policy, while increasing the
efficiency of budget spending – above all, at ending stagnant
poverty and reducing inflation to the minimum.

RUSSIA’S BIG TEST

While the problems that Russia must solve in the next three
years are quite serious, the long-term challenges are much more
fundamental. These challenges include the reduction of the Russian
population; the decline in the skill level of manpower resources;
the aging of the infrastructure; and the need for sufficient
competitive niches in the global division of labor (considering the
scope of the Russian economy).

At the end of the 20th century, Russia entered a long period of
population decline. Between 1992 and 2004, the difference between
the number of births and the number of deaths in the country
reached 10.4 million people. However, thanks to the growth of
immigration, the country’s overall population decreased by only 4.9
million people. Birth rates in Russia remain low despite some
growth in recent years: in 2004, there was an average of 1.34-1.35
children per woman (the aggregate birth rate). This figure is 1.6
times less than required for the simple reproduction of the
population (in developed European nations, the average number of
children per woman stands at 1.6-1.8).

At the same time, the lifespan of the Russian population is
extremely low: compared with the world’s ten most developed
nations, it is 15 to 19 years less for men and 7 to 12 years less
for women. The average number of deaths per year between 2001 and
2004 stood at 2.3 million, with the death rate being particularly
high among the able-bodied population. During the same years,
immigration rates decreased five times in comparison with
1995-2000, reaching a mere 0.03 percent of the Russian population
in 2004. Should the present birth and death rates persist, and
immigration growth stuck at zero, the Russian population will
decrease from 143.5 million as of early 2005 to 123 million by
early 2025.

Measures taken by the Russian government in pursuance of its
Concept for the Demographic Development of Russia have failed to
improve the situation, because they did not correspond to the set
objectives. For example, efforts to raise the birth rate did not
focus on the birth of a second and third child, but rather on
social aid to families where the first child is born without this
aid. Russia’s migration policy offers another example: changes made
to the citizenship law were intended not to attract new citizens
into the country, but to cut the inflow of migrants and complicate
procedures for receiving Russian citizenship.

The government must take measures to stimulate higher birth
rates, immigration and better health services, which would help
stabilize the Russian population at 140 to 142 million by the year
2015. In the longer term, population growth could be sustained by
increasing the overall birth rate by 20 to 30 percent, reducing –
at least by half – infant mortality, bringing the population’s life
expectancy to 70 years, and increasing the inflow of permanent
immigrants by not less than 10 percent a year.

To raise birth rates in the country, the government must, first
of all, encourage the birth of two to three children per family –
and support such families. In particular, the government could
introduce housing and tax benefits for families with children;
introduce more allowances for mothers and families; take measures
to improve the reproductive health of the population; build a
positive image of families with several children; enhance the
prestige of motherhood and fatherhood; and consolidate the
institution of family.

Improving the population’s health and reducing death rates
requires a set of measures to protect the well-being of children
and adolescents. These measures include preventing child
traumatism; enhancing the physical activity of the population;
popularizing a healthy lifestyle, including efforts to prevent
alcohol and tobacco abuse; reducing mortality rates on the nation’s
highways while making roads safer; improving the quality of
nutrition; improving working conditions and increasing labor
safety; reducing poverty and minimizing poverty-related threats to
people’s health.

To achieve its migration policy objectives, the government must
take measures to attract representatives of those people who
traditionally populate Russia from abroad (primarily from the
former Soviet republics); attract foreign labor migrants who can
help boost the Russian economy; stimulate ethno-cultural and
language adaptation, together with the integration of legal
immigrants into the Russian society; stop illegal migration to
Russia; regulate internal migration processes to stimulate the
settlement of the population in the country’s eastern regions; and
reduce emigration from Russia.

Other important “big test questions” for Russia, answers to
which require special study, include modernizing the Russian
educational system; integrating it into the world educational space
and establishing close ties with scientific and innovation systems;
overcoming the growing shortage of high-quality production
infrastructure; and ensuring the permanent self-rejuvenation of the
Russian economy in order to find adequate answers to the challenges
of the globalization.

FINAL NEWS RELEASE ON DECEMBER 31, 2008

On December 31, 2008, what will the news reports say about the
results of the development of the Russian economy?

Most probably, the news channels will say that between 2006 and
2008 the Russian economy has grown by an average of six percent
(which is not enough for fulfilling the declared task of doubling
the GDP over ten years); that the inflation rate has decreased to 7
percent (rather than four to five percent, as planned by the
government and the Bank of Russia); that dozens of major industrial
enterprises are planned to be put into operation within the next
year, thus inspiring hope for the future; that the standards of
living are growing, while poverty is decreasing; and that new
initiatives by the Russian president will create the necessary
prerequisites for the country’s stable development in the near
future.

For a majority of present observers, this scenario may seem
overly optimistic. However, its implementation (and even
overfulfillment of the aforementioned targets) is quite feasible if
the majority of the Russian population stops being passive
observers and unite into a harmonious creative team that is capable
of coping with the difficult tasks facing the Russian economy and
society as a whole. To this end, we must commence an intensive
dialog and implement specific decisions.