Though weakened by crisis in 1998, Russia has staged a remarkable turnaround. Its economy now ranks amongst the world's most dynamic. Skyrocketing oil prices are certainly part of the reason. In fact, Russia is the world's second-largest exporter of black gold, and it is sitting on the eighth-largest pile of reserves.
Here we review the Russian crisishow it began, how it unfolded and how it endedas a prelude to analysing its recent economic performance. The macroeconomic picture that is coming into focus right now, driven by surging oil prices, combines strong growth, an improvement in the public finance situation, an enhanced trade balance, abundant reserves, massive debt paydown, tighter spreads and good stockmarket index performances. All of these factors argue in favour of optimism on Russia, against a backdrop of persistently high oil prices. However, a few shady areas persist: inflation is high and the flight of capital has picked up in the wake of the Yukos scandal. Under the circumstances, is it wise to consider Russia as a sure thing?
A look back at 1998
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With the break-up of the Soviet Union at the end of the Cold War, Russia found itself facing the huge challenge of making the transition from a centrally-planned to a free market economy. The failure of the first set of reforms (Perestroika) initiated by Gorbachev before 1991 offer a glimpse into the complexity of the process. Then, during the first term of Boris Yeltsin, the emergence of political groups with divergent interests made Russia's political economy incoherent, leaving Russia even more vulnerable and unstable.
In 1995, the Russian government decided to stem the rising tide of inflation by financing the public deficit not through monetary issuance but rather through debt. Treasury bonds (GKO) yielding 70% were issued. Then inflation receded and speculative forces drove the yield on GKOs down to 20%. As a result, the capital raised was only enough to pay interest to the earliest subscribers. In the run-up to elections, tax breaks multiplied and public finances got really out of hand: the deficit reached 7.6% of GDP in 1997, with a primary deficit of only 2.8%, increasingly financed by GKOs. The debt spiral was firmly in place.
In the autumn of 1997, the Russian financial system was shaken by the Asian crisis. Foreign investors began to withdraw massively from the emerging markets, a retreat that was exacerbated in Russia by domestic political troubles (the government was sent packing in March of 1998). Interest rates rose abruptly, reaching historical highs in real terms. As a result, the debt servicing charge jumped rapidly, to around 13% of government revenue in 1997. One-fifth of the total debt was short-term.
One last item, but not the least, was the nosedive in the price of oila vital raw material for the Russian economy. Per barrel, it had fallen to a low of $12 in the summer of 1998only half of what it was in early 1997. Capital fled the country. The crisis was at its height: default on internal debt, partial default on external debt, the rouble devalued (70% in effective real terms and 45% in real effective terms through the end of 1998), substantial erosion in the value of financial assets (the Russian MSCI lost 94% between October 1997 and October 1998; over the same period, the spread with US treasuries went from 458 to 6,275 points), the banking system in crisis, budgetary crisis, currency reserves exhausted, etc.
Russia rises up from its ashes: blessed oil
The consequences of the crisis were multiple, but suffice to mention the bank failures, the massive layoffs (the unemployment rate shot up to 14% in early 1999), and the substantial drop in household purchasing power. GDP shrunk by 4.9% in 1998, whilst inflation went as high as 126.5% in July of 1999 (9.6% in August 1998). The government was broke.
As of 1999, the trade balance improved thanks to the drop in imports caused by the rouble's decline. The hike in oil prices was enough to help exports recover. Yet again, Russia was bailed out by its oil. The country's economic growth has always been intimately linked to oil price trends. Today, black gold accounts for 55% of Russia's exports. Moreover, Russia picks up additional market share with each passing year: 12% of world oil production in 2004, compared with 9% in 1997.
The arrival of Putin at the Kremlin was one of the keys to putting the crisis behind Russia. Against the backdrop of renewed fighting in Chechnya, the law and order policy and the strong state on which it relies were appreciated. With a smoothly functioning economy to boot, it was that much easier to win the trust of foreign investors once again.
The Russian economy turned in its fifth year of strong GDP growth in 2004, and expects an increase of around 6% this year. Oil has once again led to an impressive improvement in Russia's external accounts. The current account surplus was equal to 10% of GDP last year (USD60bn), thanks in particular to the surge in oil exports. Growth in oil revenue, combined with tax reform - flat income tax rate at 13%, corporate tax cut, VAT cut at 18%, employer contribution rates cut to 22-23% all significantly improved tax collection in Russia - has led to budget surpluses several years in a row. Russia was able to honour its debt to the IMF three years before it fell due, and early repaid a part of its debt to the Paris Club. International reserves reached USD151.5bn in mid-2005, which is equal to eleven months of imports. As a result, the yield spread has narrowed considerably (to only 138pts in August, versus 1,172pts in January 2001). The stock market has gained 35% since January.
The picture looks excellent, then. But it hides certain realities: growing income inequality, corruption, ethnic conflict. In addition, the inflow of oil revenue has not encouraged public policymakers to get public spending under control in a context in which inflation fails to slowdown (+13%yoy). However, important investment needs are still unmet, especially the need to overhaul Russia's obsolete infrastructure: oil production has been slowing since early 2004 due to bottlenecks. The sector's investment needs are all the more important given that the growth outlook for non-energy related sectors of the economy appears limited. In addition, since the Yukos fiasco, capital has been fleeing the country even faster. Russia is not attracting enough direct investment from abroad ($1-3bn/year). 2004 will be an exception to this rule, with about $10bn coming in.
In the face of these challenges, Russia must accelerate the pace of structural reform (private ownership, retirement, bankruptcy legislation, banking), which will increase its growth potential whilst reducing its dependence on oil. Undeniably, Russia as an emerging country is better armed today to meet any future return of investors' risk aversion, an economic slowdown or further Fed tightening. But it is just as certain that public policymakers must embark on the road to structural reform if the Russian economy is to develop.
Being blessed with oil gives Russia a trump card over its emerging rivals over the medium term. However, the government spread is historically expensive. We therefore prefer equities, which show better valuation levels (PER of 8.2 x versus 10.1 for emerging Europe).
By Irina Topa-Serry, Strategist at AXA Investment Manager
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