Well-Placed to Weather an Economic Storm

Next week's annual meeting of the World Economic Forum in Davos will open under more than just the usual degree of uncertainty about the direction of world affairs. The U.S. economy is teetering on the brink of a recession whose global reach is unknown. Political factors further complicate making an assessment of how the world will cope with what is likely to be a challenging 2008. Can Russia detach itself from the spreading gloom?

At last year's meeting, the Russian delegation was headed by First Deputy Prime Minister Dmitry Medvedev. At the time, many commentators in Russia and abroad viewed his high-profile participation as his debut on the world stage. In his main speech, as well as in numerous side meetings, Medvedev sketched out an image of a modern Russia engaged with its international partners in pursuit of decidedly liberal economic and political goals.

Assuming that Medvedev meant what he said, would he and his government team -- presumably headed by President Vladimir Putin -- be able to implement a program of modernization and reform to ensure a more diverse economy and sustainable, high rates of economic growth?

Clearly, the economic context will not be as benign as in recent years. For example, the forum's Global Risks 2008 report assessed risks in a wide range of economic, geopolitical, natural, social and technological areas. It singled out the liquidity crisis in financial markets, the soaring prices of basic foodstuffs, vulnerabilities in cross-border energy supply chains, tensions in Iran and Afghanistan and the ongoing Iraqi conflict as the most serious immediate areas of concern. It could well have added Pakistan and a lame-duck U.S. president.

A year ago, all major regions of the world, even Africa, were growing briskly with global growth at about 5 percent, and the U.S. economy along with the BRICs -- Brazil, Russia, India and China -- were the locomotives. At last year's Davos meeting, Laura Tyson, a professor of economics at the University of California, Berkeley, noted that emerging economies for the first time accounted for more than 50 percent of the global economy. So, in her view, despite a possible U.S. slowdown, the rest of the world was in a "significant growth mode," underscoring something of a decoupling, with the world no longer dependent on a single locomotive.

But the decoupling of the rest of the world from the tremors that are starting to be felt in the U.S. economy is based on the assumption that the United States would experience a "soft landing" or a so-called growth recession. All the bets are off, however, if the United States were to experience something much worse. For instance, the German and Japanese experiences have shown that persistent problems in financial transmission channels can cause long economic downturns. Today, the really important question is not whether the United States can avoid a sharp downturn. It probably cannot. Far more important is the question of how long such a downturn or recession would last. An optimistic scenario would be a short and shallow downturn. A second-best scenario would be for a sharp, but still short, recession. A really awful scenario would be a long recession that spreads its effects to trading and financial partners.

As we proceed further into the new year, investment banks and international institutions are almost tripping over each other to pronounce that they were first to see that a global economic downturn was inevitable. As the United States -- to be followed by Europe, some of Asia, and Latin America -- starts to sink, what are Russia's prospects?

In terms of the business cycle, Russia is relatively immune and in an especially strong starting position. External reserves of $474 billion at the end of 2007 were the third highest in the world. The government's stabilization fund amounted to $157 billion, or almost 13 percent of gross domestic product. Both of these numbers are a sign of the country's strong fundamental macroeconomic position. It also shows that the rise in oil prices has allowed the government -- at least on the fiscal side -- to limit the impact of increased spending on the budget surplus.

Thus, Russia's fiscal position remains very strong, with a surplus of 6.5 percent of GDP estimated for the federal budget in 2007 compared with 7.4 percent a year earlier. The reserve buildup in 2007, unlike in the past, was mainly driven by high net private capital inflows, which are estimated at $90 billion for the year. With imports catching up with exports, which are not increasing much in volume terms, the current account surplus could rapidly deflate to about $35 billion in 2008 and disappear altogether in 2009. In itself, this is a more normal position for a rapidly growing country like Russia that should tap the world's savings to build its diversified economic base.

The immediate weakness is related to inflation, which rose to 11.9 percent last year to December, rising 1.1 percent on the month. While the global food-price shock has clearly been at work, the more important underlying reason has been the particularly loose monetary policy, which if anything has loosened again since last summer. With capital inflow clearly having picked up strongly in the last quarter of 2007, the M2 money-supply growth has reaccelerated and stood at 52 percent in the year to November. Such a rate of money growth is not consistent with the goal of reducing inflation back into single digits. More likely, inflation will continue to increase.

So in financial terms, although inflation represents a serious but manageable policy problem, Russia is well insulated from the coming economic turmoil. In fact, with domestic demand booming, there is good reason to believe that the economy will continue to register high growth rates even if international markets start to falter.

Over the medium term, however, there is no room for complacency, and Russia's new president will no doubt envy some of the temporary factors that have facilitated easy growth in recent years. For instance, the economy will not enjoy large productivity increases derived from better use of underutilized capital or from a highly competitive exchange rate. And structural reforms, synonymous with Putin's first term but since on hold, will need to be reinvigorated. Moreover, the greedy grab for corporate assets, under the guise of a supposed policy of state control, will need to be unwound.

In addition, while the consensus view is that peak oil prices are determined by growing demand and limited supply, there is the possibility that international oil prices might decline significantly on a cyclical basis from today's high levels in the event of a global economic slowdown.

Faced with this gloomy global outlook, Russia is well placed to weather the storm. In fact, not only is the Russian economy likely to decouple largely from a sagging United States and even Europe, but its continuing boom -- mostly but not solely fueled by high energy revenues -- is sucking in both consumer and investment goods, and so acting as a motor of world growth. And the planned $1 trillion public investment program over the next decade should ensure that the country remains decoupled for years to come.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.