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. Last Updated: 07/27/2016

The Year Russia Got Real About Reforms

For Russia, 2001 may be remembered, economically speaking, as the year of living realistically.

Although growth outpaced most of the world for the second year running, at current levels, to use the Kremlin's favorite comparison, it will take Russia some 20 years to equal the per-capita income of Portugal, the poorest nation in the European Union.

Spurred by that grim reminder, the government launched an unprecedented series of structural reforms -- beginning the year with a 13 percent flat tax on incomes and ending the year by passing new Labor and Land Codes and approving long-awaited plans to restructure the pension and banking systems.

Along the way it dampened inflation, raised the minimum wage, recorded a budget surplus, swelled its foreign currency reserves, moved closer to joining the World Trade Organization, emerged as a viable alternative to the OPEC oil cartel and endeared itself politically to the West.

But for all of its accomplishments in 2001, it remains to be seen whether the government, under President Vladimir Putin's unofficial motto of "patience, persistence and professionalism," will be able to convert the dizzying reform effort into tangible improvements for the average Russian in the years ahead.

As the World Bank's top expert on Russia, Christof Ruehl, put it: "This year was the year of reforms. Next year will be the year of implementation."

The government says economic growth this year will be 5.6 percent, which, although a third lower than last year's, remains robust.

"This is the level we always dreamed of," Finance Minister Alexei Kudrin said this month.

While last year's record 8.3 percent expansion was due mainly to unusually high oil prices, this year's performance, though more modest, was based on improved fundamentals, according to the International Monetary Fund.

"Growth has been mainly driven by domestic demand -- both consumption and investments -- as the external sector has actually been a drag on growth," said Paul Thomsen, head of the IMF's Moscow office.

"The strong increase in domestic demand has partly been due to the improvements in the investment climate, reflecting both the broad-based acceleration of structural reforms and the perception of increased political stability," Thomsen said.

Those improvements were applauded by investors and reflected in the performance of the stock market, with the benchmark RTS Index growing 67 percent in dollar terms over the course of the year to nearly 250.

In fact, with the exception of the sharp drop in the price of oil, which accounts for about 40 percent of the nation's hard-currency reserves, nearly every major indicator of economic health indicates that Russia is on the right track.

This year's 18 percent inflation rate was higher than original government forecasts of 12 percent to 14 percent, but it was still lower than last year's 20.2 percent.

The ruble was stable against the dollar throughout the year, although it fluctuated wildly in the last month of the year over oil worries and traditional end-of-the-year weakness.

The Central Bank increased its reserves by some $10 billion, before spending $2.5 billion near the end of the year defending the ruble and paying foreign debts. Those debts declined from 60.6 percent of GDP in 2000 to 47.1 percent this year.

In all, Russia made debt payments worth $13.1 billion in 2001, two of which were of historic interest: a $1.1 billion payment that redeemed, in full and on time, Russia's first sovereign Eurobond; and a $1 billion payment to the International Monetary Fund, Russia's first made ahead of schedule.

According to Putin's top economic adviser, Andrei Illarionov, industrial output grew 5.2 percent, overall investments 8 percent, exports hit a record $108 billion on 3 percent growth and imports jumped 21 percent.

Apples and Oranges

Contrary to Russia's economic performance, the EU is expected to post growth of just 1 percent for the year, while the world's largest economy, the United States', actually began to shrink in March.

The World Bank's Ruehl said that while Russia is also outpacing nearly every country in Central Europe, some fellow nations in the Commonwealth of Independent States, such as Kazakhstan and Ukraine, are doing even better, with 10 percent and 7 percent GDP growth expected, respectively.

The main reason for the disparity, Ruehl said, is "either a very low starting position or that some countries have taken advantage of a longer period of political stability than Russia."

"Some countries have also been successful in pushing forward more reforms than Russia has so far," he added.

Illarionov named falling oil prices, higher natural monopoly tariffs, inefficient investments and increased government spending as the "main factors that contributed to the slowing down of the Russian economy compared with 2000."

GDP growth rates, however, don't paint the whole picture. Another major indicator of the overall health of the economy is per capita income, Ruehl said.

"If we compare Russia to Portugal, with 5 percent and 3 percent annual growth, respectively, it will take Russia 18 years more to achieve the same income per person," Ruehl said.

"If the growth rate in Russia is 3 percent, it will take twice as long -- 36 years," he said.

In 2001, GDP is expected to reach $316 billion, which is $2,195 per person, compared to more than $10,000 in Portugal and $30,000 in the United States.

Setting the Stage

To have any hope of achieving that kind of wealth, however, Russia has to prepare the legal framework to create an entirely new system of commerce, which it has been doing at a frenetic pace.

Lawmakers passed so many laws this year that government officials sometimes found it hard to remember which laws had already been passed and which had not.

"One year ago, we thought that what happened in 2000 was a mirage and Putin wouldn't be able to consolidate his position and continue reforms," said Roland Nash, head of research with the Renaissance Capital investment house.

Nash said that perhaps the most unexpected victory was the passage of the Land Code, which allows for private land ownership in metropolitan areas for the first time in nearly a century.

"There were a lot of vested interests against it, and most people thought that it wouldn't pass through," Nash said. "This was a huge success."

"The Russian government was very successful in translating many reform ideas into a legal framework this year," Ruehl said. "Certainly the rate of approved reforms in Russia was higher than in any country in the Organization for Economic Cooperation and Development, but now everything depends on how they will be implemented."

Among the most important reforms, economists named deregulation of the economy, including liberalization of registration and licensing for businesses; tax reform; land reform; and the first stages of judicial reform.

Likewise, the main obstacles to implementing these reforms are complacency, the concentration of capital in several large industrial groups, resistance from vested interests and institutionalized corruption.

Furthermore, difficult technical reforms, such as restructuring natural monopolies, the backbone of the economy, lie ahead.

Even so, investors are bullish.

"Investors' sentiment toward Russia is now much better than a year ago," said Andrew Somers, president of the American Chamber of Commerce in Russia. "The performance of the Russian government in 2001 far exceeded all expectations, even of those who hoped most."

International ratings agency Moody's Investor Services acknowledged Russia's success by upgrading its sovereign rating in early December by two notches at once to a level it last enjoyed in the pre-crisis spring of 1998. And Standard and Poor's followed shortly after with an upgrade of its own.

The agencies cited "rapid economic growth, combined with fiscal consolidation and prudent monetary policy," as well as "political stability, a determined approach to structural reforms and an improved commitment to debt servicing."

S&P said the upgrade reflects almost one year of improvement in Russia's policy environment, which has strengthened the country's economic structure and bolstered economic prospects and policy flexibility.

"Finally we see some investors' recognition that reforms are going through, as RTS is moving toward 250, as compared with 150 in the beginning of the year," Nash said.

"But the real shift took place in the last three months, since Putin made his efforts to bring Russia closer to the West."

These efforts helped make the RTS the best-performing dollar-denominated index in the world.

Main Economic Indicators

20002001 (expected)
GDP, % change8.35.6
Industrial production, % change11.95.4
Trade balance, $ bln60.853.0
Inflation, %20.017.5
Rub/$ rate average28.229.3
Central Bank reserves27.937.5
Foreign debt, $ bln152145
RTS Index, Dec. 20173247
Source: Troika Dialog

It's All About Oil

The year would have been even brighter if not for the sharp fall in oil prices, which followed the terrorist attacks in the United States and the subsequent war in Afghanistan.

The fact that Russia has been heavily involved in heated negotiations with the Organization of Petroleum Exporting Countries over oil cuts demonstrates the growing importance of the country as an energy exporter -- and also shows the importance of oil to the Russian economy, which is 80 percent dependent on raw materials exports.

"The main uncertainty at present is with regard to the external environment, notably oil prices and the length and duration of recession in the major industrialized countries," the IMF's Thomsen said.

Most analysts see little chance that Russian oil companies will fulfill their promises to cut production, increasing the likelihood of another clash between OPEC and non-OPEC countries like the one that destabilized the global oil market during the final quarter of 2001.

"We believe that Russia could cope with a small further reduction in oil prices from current levels without major changes to the stance of fiscal, monetary and exchange rate policies," Thomsen said.

At the same time, "given Russia's dependence on oil prices, a very sharp and prolonged drop could, of course, require more fundamental changes in policies," he said.

However, according to Renaissance Capital's Nash, "The fears over the price of oil are overdone, and the impact of a lower oil price on economic fundamentals is reasonably limited."

Troika Dialog investment company wrote in a recent report that "rather than backing into a position of becoming just another 'boom and bust' oil economy, Russia's growing position as a global energy supplier should translate into a better balanced economy with a much lower risk perception than exists today."

A Cloudy Horizon

While the price of oil on world markets remains a key concern for 2002, the government has repeatedly stressed that it expects the macroeconomic situation to remain stable and has rejigged the federal budget to prepare for the worst.

The 2002 draft budget, which is the first post-Soviet budget with a surplus, is based on a minimum price of $18.50 per barrel of benchmark Urals crude.

The draft budget, already passed by the Duma, envisions revenues of 2.13 trillion rubles ($67.6 billion at the predicted average ruble rate for the year of 31.5 to the dollar) and spending of 1.95 trillion rubles, leaving a surplus of 1.63 percent of GDP.

It also foresees an annual inflation rate of 12 percent and GDP at 10.95 trillion rubles ($365 billion).

Economic growth in Russia will likely take a step back during 2002 but should still manage a reasonably brisk pace, the IMF said in its latest review of global economic prospects.

The IMF forecasts that Russia's economy will expand by a "reasonably healthy" 3.6 percent next year.

"While Russia remains vulnerable to lower oil prices, the impact is expected to be manageable unless the decline proves to be significantly deeper and more prolonged than currently anticipated," the IMF said.

"As history shows, prolonged periods of high growth rates of above 5 percent are an exception rather than the rule," said Ruehl of the World Bank.

Indeed, only in Germany, Japan and Italy after World War II and Southeast Asia in the 1980s and '90s have national economies grown more than 5 percent a year for close to a decade.

"Both times, growth was supported by the availability of financing for huge investment needs," Ruehl said.

The economy will be in great shape next year if oil averages $18.50 per barrel, which is "ideal" for Russia, according to Troika Dialog.

"This would allow for planned industry development and the ruble to depreciate closer to the inflation rate and provide the stable budget revenue base required to achieve the objectives of [Economic Development and Trade Ministry German] Gref's economic development plan without a risk of 'overheating' because of excessive liquidity," Troika said.

Renaissance expects the central theme for 2002 to be restructuring, "particularly among Russia's natural monopoly behemoths, such as Gazprom, Unified Energy Systems, the Railways Ministry and Sberbank," following the impressive reform plan laid out by the government.