Chechnya Undermines Confidence In Economy

Only months ago, Western analysts were confident that Russia had seen the worst of its economic slump and was gearing up for a period of sustained growth in 1995. But no longer. The war in Chechnya has changed all that.

"Russia is set for the best year of economic performance since reforms began," the December edition of the Economist's Business Central Europe magazine wrote in an upbeat forecast for the economy in 1995. It was an opinion shared by most analysts of the Russian economy and markets.

But war in the tiny North Caucasus republic of Chechnya has created massive new expenditures for an already overstretched 1995 budget. More significantly, it has strengthened the hand of a nationalist current in the country's leadership, a development that is causing renewed unease among foreign investors.

"It's a period of greater than usual uncertainty," said a top Western economist. "We don't know how the forces pushing in different directions will work out, but we're hopeful that the reform process will reinvigorate itself."

Intervention in Chechnya has cost President Boris Yeltsin the support of his formerly loyal liberal allies and has forced him to rely increasingly on a small circle of military and security officials who are wary of Western investment in Russia's economy.

And although reformists claimed a victory Thursday when the government ordered the lifting of oil export quotas, without imposing widely anticipated compulsory domestic sales, conservatives are still perceived to be threatening economic policy and disagreements clearly run deep within the cabinet.

The most tangible expression of this so far has been comments by the new privatization minister, Vladimir Polevanov, last week that he would seek the renationalization of key industries and that this position was supported by other members of the government and presidential administration.

"Even if nothing happens as a result, it should make foreign investors think twice before making either portfolio or direct investment here," said a senior Western official.

Coming just a day after the government approved draft legislation that would give foreign investors selected tax breaks and exemptions, Polevanov -- who is also a deputy prime minister -- sent unacceptably confusing signals to foreign business, he said.

"That worries me a lot," said one Western investment fund manager, who declined to be named. "I take a position on some shares and he says he'll renationalize the companies -- what do I do now? It's very scary."

Thomas Reed, an analyst with AIOC Capital, said Polevanov's comments were of particular concern because they focused on aluminum and energy -- most trading activity last year took place in the oil, gas and nonferrous metals industries.

"He's shaking people's confidence in Russia," said Reed. "And when investors come back from vacation to their desks in late January, they're going to act on it."

The Polevanov factor was also having a detrimental effect on the ruble, he said, which fell 52 points in heavy trading Thursday to 3,623 per dollar. (See Page 10)***

"We are hoping to see ruble stabilization," he said. "It would help the GKO (treasury bond) market tremendously. There are high expectations for this year, but it largely depends on the government."

Enlarging the market for treasury bonds is crucial to the government's plans to bridge a budget deficit of 7.7 percent of GDP. It hopes to sell 16 trillion rubles ($4.4 billion) worth of treasury bonds to private investors.

The budget itself, however, has yet to be approved by parliament beyond the first quarter and also assumes that nearly $13 billion will be provided by international financial institutions.

But these credits have not yet been granted and are heavily contingent on the government's ability to convince the International Monetary Fund and World Bank that it can maintain a tight budget this year.

Policy apart, the very cost of war in Chechnya --which initial estimates put at some 3 trillion rubles ($830 million), but which is clearly escalating along with the conflict itself -- is threatening to blow the government's budgetary plans out of the water.

And despite government assurances that monthly inflation would be brought under control in December, it hit an 11-month high of 16.4 percent, fuelled by state credits issued in the summer of last year.

All this does little to improve the already poor image Russia enjoys among foreign investors, who say the country lacks a clear legal, tax and law enforcement system. As a result, the big money has turned instead to the markets of China, Asia and Latin America.

The Economist Intelligence Unit currently awards Russia its second highest credit risk rating in the world, beaten only by Iraq in terms of its perceived instability. Direct foreign investment in Russia, from 1989 to June 1994, accounted for a mere $3.6 billion, or $24 per head, a similar per capita sum to that of Albania, according to a recent report from the United Nations.

And while Russia has received substantial commitments for direct investment in its energy sector, which could amount to as much as $60 billion, most investors are still waiting for more secure fiscal and legal frameworks.

The government claims that some $500 million is flowing into Russian securities each month, but analysts say the real level could be as much as 10 times lower since major hedge funds pulled out in October.

Nevertheless, analysts say the size of potential returns from securities still make investments worthwhile.

"For the moment there is still a lot of room for people who want to make a quick buck before the giants arrive," said the Western fund manager. "But it's very risky."