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Russia - Economy (Notes)

The Russian economy underwent tremendous stress in the 1990s as it moved from a centrally planned economy to a free market system. Difficulties in implementing fiscal reforms aimed at raising government revenues and a dependence on short-term borrowing to finance budget deficits led to a serious financial crisis in 1998. Lower prices for Russia's major export earners (oil and minerals) and a loss of investor confidence due to the Asian financial crisis exacerbated financial problems. The result was a rapid and steep decline (60%) in the value of the ruble, flight of foreign investment, delayed payments on sovereign and private debts, a breakdown of commercial transactions through the banking system, and the threat of runaway inflation.

Still, Russia weathered the crisis well. In the 8 years following the financial crisis, GDP growth averaged just under 7% due to a devalued ruble, implementation of key economic reforms (tax, banking, labor and land codes), tight fiscal policy, and favorable commodities prices. Household consumption and fixed capital investments have both grown by about 10 percent per year since 1999 and have replaced net exports as the main drivers of demand growth. Inflation and exchange rates have stabilized due to a prudent fiscal policy (Russia has run a budget surplus since 2003). The government created a stabilization/rainy day fund ($127 billion in mid-2007), and has the third-largest foreign exchange reserves in the world (close to $420 billion in mid-2007) which should shelter it from commodity price shocks.

Russia's balance of payments moves from strength to strength. The current account balance grew from $58.6 billion in 2004 to $95.3 billion in 2006, almost entirely due to oil price increases. The capital account turned positive in 2006, with net inflow of $6.1 billion. In addition, net private capital flows in 2006 increased significantly to $40.9 billion, compared to an inflow of $0.1 billion in 2005 due to liberalization of the capital account in mid-2006. Foreign direct investment (FDI) flows dramatically improved in 2006 to an estimated $31 billion (inflows totaled $15.4 billion and $14.6 billion in 2004 and 2005, respectively). As of July 1, 2006, the ruble is convertible for both current and capital transactions. Russia prepaid its entire Soviet-era Paris Club debt of $22 billion in late 2006, pushing Russia's sovereign foreign debt down to $45 billion at the end of 2006, or about 5 percent of GDP. Russia's total public and private foreign debt at the end of 2006 was $310 billion, or 31 percent of GDP. Such a dramatic reversal to the macroeconomic situation is truly remarkable. Russia currently has a sovereign investment-grade rating from Standard and Poor's of BBB+.

Although the economy has begun to diversify, the government budget remains dependent on oil and gas revenues; consumption and investment are, however, contributing to an increasing share to GDP growth. While currently sheltered from external price shocks, the government realizes the need to intensify reforms that will promote new investment in aging infrastructure and continued productivity gains. The government believes it can do this by creating state-sponsored investment funds, special economic zones, and by exercising control of strategic enterprises (a draft law defining strategic sectors was submitted to the Duma in August 2007). Although investors are returning to Russia, excessive bureaucracy, corruption, insufficient and insufficiently enforced legislation, selective interpretation of laws (particularly tax laws), unclear limits and conditions on foreign investment, obsolete infrastructure, and stalled economic reforms still remain a problem. In 2005, the government announced reform programs in four priority areas (health, education, housing, and agriculture), but further work is needed on them as well as in financial regulation, civil service reform, and reform of government monopolies, such as railroads, gas, and electricity.

Gross Domestic Product
A strong expansion in domestic demand continues to drive GDP growth, despite a slowdown in manufacturing. GDP growth and industrial production for 2006 were 6.7% and 4.8%, respectively, relative to 6.4% and 5.7% in 2005. GDP growth is currently derived from non-tradable sectors, but investment remains concentrated in tradables (oil and gas). Construction was the fastest growing sector of the economy, expanding by 14% in 2006. The main private sector services--wholesale & retail trade, banking & insurance, and transportation & communications--showed strong growth of about 10%. In contrast, public sector services--education, health care, and public administration--lagged behind with only 2-4% growth in 2006. Recent productivity growth has still been strong in some parts of domestic manufacturing. Real disposable incomes grew by 10.2% in 2006, spurring considerable growth in private consumption.

Monetary Policy
Large balance of payments surpluses have complicated monetary policy for Russia. The Central Bank has followed a policy of managed appreciation to ease the impact on domestic producers and has sterilized capital inflows with its large budget surpluses. However, the Central Bank also has been buying back dollars, pumping additional ruble liquidity into the system. Given the rising demand for money, this has softened the inflationary impact, but these policy choices have complicated the government's efforts to lower inflation to the single digits. Consumer Price Index (CPI) inflation was 9% in 2006 and 10.9% in 2005, having steadily decreased from 20.2% in 2000, due primarily to prudent fiscal policy and in 2006 lower world oil prices.

Government Spending/Taxation
The Russian federal budget has run growing surpluses since 2001, as the government has taxed and saved much of the rapidly increasing oil revenues. According to preliminary figures, the 2006 budget surplus was 7.4% of GDP on a cash basis. Although there are strong pressures to relax spending ahead of elections, the government has loosened its spending gradually, as the economy is running at near capacity and there are dangers of increasing inflation and rapid exchange rate appreciation. Spending increases to date have mostly been for increased salaries of government employees and pensions, but some money is also being dedicated to special investment funds and tax breaks to develop new industries in special economic zones. The government overhauled its tax system for both corporations and individuals in 2000-01, introducing a 13% flat tax for individuals and a unified tax for corporations, which improved overall collection. Business has put pressure on the government to reduce value added taxes (VAT) on oil and gas, but the government has postponed this discussion. Tax enforcement of disputes, particularly following the Yukos case, continues to be uneven and unpredictable.

Russia's population of 142.9 million (2006) is falling. Lower birth rates and higher death rates have reduced Russia's population at a nearly 0.5% annual rate since the early 1990s. Russia is one of few countries with a declining population (although birth rates in many developed countries have dropped below the long-term population replacement). Population decline is particularly drastic in Russia due to higher death rates, especially among working-age males. Cardiovascular disease, cancer, traffic injuries, suicide, alcohol poisoning, and violence are major causes of death. In a June 2006 speech to the Russian National Security Council, President Putin declared that Russia is facing a demographic crisis and called for measures to improve birth and mortality rates and increase population through immigration, primarily the return of Russian-speaking foreigners.

Russia and Ukraine are said to have the highest growth rates of HIV infection in the world. In Russia HIV seems to be transmitted mostly by intravenous drug users sharing needles, although data is very uncertain. Data from the Federal AIDS Center shows that the number of registered cases is doubling every 12 months and is currently at 300,000 persons. When projections are made which allow for people in high-risk groups who have not been tested for the disease, estimates of the actual number of HIV-infected persons are approximately 3 million. The high growth rate of AIDS cases, if unchecked, will have negative economic consequences. Investment will suffer from the diversion of private and government funds to AIDS treatment. The effect on the labor force may be acute since about 80% of infected individuals in Russia are under 30 years of age. At the September 2003 Camp David Summit, and again at the Bratislava meeting in February 2005, Presidents Bush and Putin pledged to deepen ongoing cooperation between the two countries to fight HIV/AIDS.

Commercial Law
Russia has a body of conflicting, overlapping and rapidly changing laws, decrees and regulations, which has resulted in an ad hoc and unpredictable approach to doing business. In this environment, negotiations and contracts from commercial transactions are complex and protracted. Uneven implementation of laws creates further complications. Regional and local courts are often subject to political pressure, and corruption is widespread. However, more and more small and medium businesses in recent years have reported fewer difficulties in this regard, especially in the Moscow region. In addition, Russian businesses are increasingly turning to the courts to resolve disputes. Russia's WTO accession process is also helping to bring the country's legal and regulatory regime in line with internationally accepted practices.

Natural Resources
The mineral-packed Ural Mountains and the vast oil, gas, coal, and timber reserves of Siberia and the Russian Far East make Russia rich in natural resources. However, most such resources are located in remote and climatically unfavorable areas that are difficult to develop and far from Russian ports. Nevertheless, Russia is a leading producer and exporter of minerals, gold, and all major fuels. Natural resources, especially energy, dominate Russian exports. Ninety percent of Russian exports to the United States are minerals or other raw materials.

Russia is one of the most industrialized of the former Soviet republics. However, years of very low investment have left much of Russian industry antiquated and highly inefficient. Besides its resource-based industries, it has developed large manufacturing capacities, notably in metals, food products, and transport equipment. Russia is now the world's third-largest exporter of steel and primary aluminum. Russia inherited most of the defense industrial base of the Soviet Union, so armaments remain an important export category for Russia. Efforts have been made with varying success over the past few years to convert defense industries to civilian use, and the Russian Government is engaged in an ongoing process to privatize the remaining 9,222 state-owned enterprises, 33% of which are in the industrial manufacturing sector.

For its great size, Russia has relatively little area suited for agriculture because of its arid climate and inconsistent rainfall. Northern areas concentrate mainly on livestock, and the southern parts and western Siberia produce grain. Restructuring of former state farms has been an extremely slow process. Foreigners are not allowed to own farmland in Russia although long-term leases are permitted. Private farms and garden plots of individuals account for over one-half of all agricultural production.

Russia attracted an estimated $31 billion in FDI in 2006 (3.2% of GDP), up from $13 billion in foreign direct investment (FDI) in 2005.Russia's annual FDI figures are now in line with those of China, India, and Brazil. However, Russia's per capita cumulative FDI still lags far behind such countries as Hungary, Poland, and the Czech Republic. The paradox is that Russia's challenging business climate, lack of transparency, and weak rule of law/corruption has taken a back seat to Russia's extraordinary macroeconomic fundamentals and the consumer and retail boom, which is providing double digit returns to investors and attracting new flows. Russian domestic investment is also returning home, as the foreign investment coming into Russia from havens like Cyprus and Gibraltar, is actually returning Russian capital . As of the end of 2006, loans to the financial sector were 57.2% of total banking sector assets. Retail loans amounted to $78.4 billion at the end of 2006, up from $41 billion at the end of 2005. Retail deposits increased to $144.1 billion from $95.7 billion over the same period. Also, currently deposits are fully insured up to $4,000 and an additional $12,000 is insured at 90%.

Although still small by international standards, the Russian banking sector is growing fast and is becoming a larger source of investment funds. To meet a growing demand for loans, which they were unable to cover with domestic deposits, Russian banks borrowed heavily abroad in 2006, accounting for two-thirds of the private-sector capital inflows in that year. Ruble lending has increased since the October 1998 financial crisis, and in 2006 loans were 63% of total bank assets, with consumer loans posting the fastest growth at 74% that same year. Fewer Russians prefer to keep their money outside the banking sector, the recent appreciation of the ruble against the dollar has persuaded many Russians to keep their money in rubles or other currencies such as the euro, and retail deposits grew by 65% in 2006. Despite recent growth, the poorly developed banking system, along with contradictory regulations across banking, bond, and equity markets, still makes it difficult for entrepreneurs to raise capital as well as to permit capital transfer from a capital-rich sector such as energy to capital-poor sectors such as agriculture and manufacturing and to diversify risk. Banks still perceive small and medium commercial lending as risky, and some banks are inexperienced with assessing credit risk, though the situation is improving. In 2003, Russia enacted a deposit insurance law to protect deposits up to 100,000 rubles (about $3,700) per depositor, and a bill is currently in the Duma, which if passed will increase this coverage to 190,000 rubles (about $7,000) per depositor.

The U.S. exported $4.7 billion in goods to Russia in 2006, a 21% increase from the previous year. Corresponding U.S. imports from Russia were $19.8 billion, up 29%. Russia is currently the 33rd-largest export market for U.S. goods. Russian exports to the U.S. were fuel oil, inorganic chemicals, aluminum, and precious stones. U.S. exports to Russia were machinery, meat (mostly poultry), electrical equipment, and high-tech products.

Russia's overall trade surplus in 2006 was $139 billion, up from $118 billion in 2005. World prices continue to have a major effect on export performance, since commodities--particularly oil, natural gas, metals, and timber--comprise 80% of Russian exports. Russian GDP growth and the surplus/deficit in the Russian Federation state budget are closely linked to world oil prices.

Russia is in the process of negotiating terms of accession to the World Trade Organization (WTO). The U.S. and Russia concluded a bilateral WTO accession agreement in late 2006, and negotiations continue in 2007 on meeting WTO requirements for accession. Russia reports that it has yet to conclude bilateral agreements with Saudi Arabia and Georgia.

According to the 2005 U.S. Trade Representative's National Trade Estimate, Russia continues to maintain a number of barriers with respect to imports, including tariffs and tariff-rate quotas; discriminatory and prohibitive charges and fees; and discriminatory licensing, registration, and certification regimes. Discussions continue within the context of Russia's WTO accession to eliminate these measures or modify them to be consistent with internationally accepted trade policy practices. Non-tariff barriers are frequently used to restrict foreign access to the market and are also a significant topic in Russia's WTO negotiations. In addition, large losses to U.S. audiovisual and other companies in Russia owing to poor enforcement of intellectual property rights in Russia is an ongoing irritant in U.S.-Russia trade relations. Russia continues to work to bring its technical regulations, including those related to product and food safety, into conformity with international standards.

Facts at a Glance: Geography - People - Government - Economy - Communications - Transportation - Military - Climate - Current Time - Ranking Positions - Russian Rouble Exchange Rates
Notes and Commentary: People - Economy - Government and Political Conditions - Historical Highlights - Foreign Relations - Relations with U.S.

Facts at a Glance
Current Time
Ranking Positions
Russian Rouble Exchange Rates

Notes and Commentary
Government and Political Conditions
Historical Highlights
Foreign Relations
Relations with U.S.

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