[A-List] October 2002

["Mark Jones" <markjones011@xxxxxxxxxxxxx>]

[Excerpt.
Full text at:
http://www.state.gov/r/pa/ei/bgn/3183.htm]

US Department of State
Bureau of European and Eurasian Affairs
October 2002
Background Note: Russia

ECONOMY
The Russian economy underwent tremendous stress 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 decline 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.

Russia, however, appears to have weathered the crisis relatively well. Real
GDP increased by the highest percentage since the fall of the Soviet Union,
the ruble stabilized, inflation was moderate, and investment began to
increase again. Russia is making progress in meeting its foreign debts
obligations. During 2000-01, Russia not only met its external debt services
but also made large advance repayments of principal on IMF loans but also
built up Central Bank reserves with government budget, trade, and current
account surpluses. The FY 2002 Russian Government budget assumes payment of
roughly $14 billion in official debt service payments falling due. Large
current account surpluses have brought a rapid appreciation of the ruble
over
the past several years. This has meant that Russia has given back much of
the
terms-of-trade advantage that it gained when the ruble fell by 60% during
the
debt crisis. Oil and gas dominate Russian exports, so Russia remains highly
dependent upon the price of energy. Loan and deposit rates at or below the
inflation rate inhibit the growth of the banking system and make the
allocation of capital and risk much less efficient than it would be
otherwise.

In 2003, the debt will rise to $19 billion due to higher Ministry of Finance
and Eurobond payments. However, $1 billion of this has been prepaid, and
some
of the private sector debt may already have been repurchased. Russia
continues to explore debt swap/exchange opportunities.

In the June 2002 G8 Summit, leaders of the eight nations signed a statement
agreeing to explore cancellation of some of Russia's old Soviet debt to use
the savings for safeguarding materials in Russia that could be used by
terrorists. Under the proposed deal, $10 billion would come from the United
States and $10 billion from other G-8 countries over 10 years.

Gross Domestic Product
Russia's GDP, estimated at $287.9 billion at 2002 exchange rates, increased
by 4.9% in 2001 compared to 2000. However, this rate slowed compared to the
phenomenal 8% growth in 2000. Continued low inflation and strict government
budget led to the growth, while lower oil prices and ruble appreciation
slowed it. At the end of 2001, the unemployment rate was 9.0%, down from
10.4% at the end of 2000. Combined unemployment and underemployment may
exceed those figures. Industrial output in 2001 grew by 4.9% compared to
2000, driven by private consumption demand. The contribution of fixed
capital
investment, an important contributor to growth in 1999, lost its importance
in industrial growth.

Monetary Policy
The exchange rate stabilized in 1999; after falling from 6.5 rubles/dollar
in
August 1998 to about 25 rubles/dollar by April 1999, one year later it had
further depreciated only to about 28.5 rubles/dollar. As of June 2002, the
exchange rate was 31.4 rubles/dollar, down from 29.2 rubles/dollar the year
before. After some large spikes in inflation following the August 1998
economic crisis, inflation has declined steadily. Cumulative consumer price
inflation for 2001 was 18.6% slightly below the 20.2% inflation rate of the
previous year but above the inflation target set in the 2001 budget. The
Central Bank's accumulation of foreign reserves drove inflation higher and
that trend is expected to continue. The 2002 budget estimates an inflation
rate of 12%, but the World Bank predicts inflation will stay above 15% in
2002.

Government Spending/Taxation
Central and local government expenditures are about equal. Combined they
come
to about 38% of GDP. Fiscal policy has been very disciplined since the 1998
debt crisis. The overall budget surplus for 2001 was 2.4% of GDP, allowing
for the first time in history for the next year's budget to be calculated
with a surplus (1.63% of GDP). Much of this growth, which exceeded most
expectations for the third consecutive year, was driven by consumption
demand. Analysts remain skeptical that high rates of economic growth will
continue, particularly since Russia's planned budgets through 2005 assume
that oil prices will steadily increase. Low oil prices would mean that the
Russian economy would not achieve its projected growth. However, high oil
prices also would have negative economic effects, as they would cause the
ruble to continue to appreciate and make Russian exports less competitive.

Population Aging
Russia's population is falling. Lower birth rates and higher death rates
reduced Russia's population at a 0.5% annual rate during the 1990s. By
comparison, although in many developed countries birthrates have dropped
below the long-term population replacement rate, in only a few countries is
the population actually declining. Population decline is particularly
drastic
in Russia, with higher death rates especially among working-age males due to
poverty, abuse of alcohol and other substances, disease, stress, and other
afflictions. Russians generally disapprove of permanent or temporary
immigration of working-age males from countries other than the
Russian-speaking former Soviet states that might help solve economic
problems
brought on by its declining population.

HIV/AIDS
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 by May 1, 2002 had reached 193,400 persons. When this
number is adjusted to include people who have not been tested for the
disease, estimates of the actual number of infected persons vary from
800,000
to 1 million. The high growth rate of AIDS cases will have negative economic
consequences. Investment will suffer from the diversion of private and
government funds to AIDS treatment. The problems of population aging will be
magnified, especially since about 60% of infected individuals in Russia are
between 20 and 30 years of age.

Law
Lack of legislation and, where there is legislation, lack of effective law
enforcement, in many areas of economic activity is a pressing issue. During
2000 and 2001, changes in government administration increased the power of
the central government to compel localities to enforce laws. Progress has
been made on pension reform and reform of the electricity sector.
Nonetheless, taxation and business regulations are unpredictable, and legal
enforcement of private business agreements is weak. Attitudes left over from
the Soviet period will take many years to overcome. Government decisions
affecting business have often been arbitrary and inconsistent. Crime has
increased costs for both local and foreign businesses. On the positive side,
Russian businesses are increasingly turning to the courts to resolve
disputes. The passage of an improved bankruptcy code in January 1998 was one
of the first steps. In 2001, the Duma passed legislation for positive
changes
within the business and investment sector; the most critical legislation was
a deregulation package. This trend in legislation is continued through 2002,
with the new corporate tax code going into effect.

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
climactically unfavorable areas that are difficult to develop and far from
Russian ports. Oil and gas exports continue to be the main source of hard
currency, but declining energy prices have hit Russia hard. Russia is a
leading producer and exporter of minerals, gold, and all major fuels. The
Russian fishing industry is the world's fourth-largest, behind Japan, the
United States, and China. Russia accounts for one-quarter of the world's
production of fresh and frozen fish and about one-third of world output of
canned fish. Natural resources, especially energy, dominate Russian exports.
Ninety percent of Russian exports to the United States are minerals or other
raw materials.

Industry
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 machinery. Russia
inherited most of the defense industrial base of the Soviet Union, so
armaments are the single-largest manufactured goods export category for
Russia. Efforts have been made with varying success over the past few years
to convert defense industries to civilian use.

Agriculture
Russia comprises roughly three-quarters of the territory of the former
Soviet
Union but 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. The
new land code passed by the Duma in 2002 should speed restructuring and
attract new domestic investment to Russian agriculture. Foreigners are not
allowed to own farmland in Russia. Private farms and garden plots of
individuals account for over one-half of all agricultural production.

Investment
In 1999, investment increased by 4.5%, the first such growth since 1990.
Investment growth has continued at high rates from a very low base, with an
almost 30% increase in total foreign investments in 2001 compared to the
previous year. Higher retained earnings, increased cash transactions, the
positive outlook for sales, and political stability have contributed to
these
favorable trends. Foreign investment in Russia is very low. Cumulative
investment from U.S. sources of about $4 billion are about the same as U.S.
investment in Costa Rica. Over the medium-to-long term, Russian companies
that do not invest to increase their competitiveness will find it harder
either to expand exports or protect their recent domestic market gains from
higher quality imports.

Foreign direct investment, which includes contributions to starting capital
and credits extended by foreign co-owners of enterprises, rose slightly in
1999 and 2000, but decreased in 2001 by about 10%. Foreign portfolio
investment, which includes shares and securities, decreased dramatically in
1999, but has experienced significant growth since then. In 2001, foreign
portfolio investment was $451 million, more than twice the amount from the
previous year. Inward foreign investment during the 1990s was dwarfed by
Russian capital flight, estimated at about $15 billion annually. During the
years of recovery following the 1998 debt crisis, capital flight seems to
have slowed. Inward investment from Cyprus and Gibraltar, two important
channels for capital flight from Russia in recent years, suggest that some
Russian money is returning home.

A significant drawback for investment is the banking sector, which lacks the

resources, the capability, and the trust of the population that it would
need
to attract substantial savings and direct it toward productive investments.
Russia's banks contribute only about 3% of overall investment in Russia.
While ruble lending has increased since the October 1998 financial crisis,
loans are still only 40% of total bank assets. The Central Bank of Russia
reduced its refinancing rate five times in 2000, from 55% to 25%, signaling
its interest in lower lending rates. Interest on deposits and loans are
often
below the inflation rate. The poorly developed banking system makes it
difficult for entrepreneurs to raise capital and to diversify risk. Banks
still perceive commercial lending as risky, and some banks are inexperienced
with assessing credit risk.

Money on deposit with Russian banks represents only 7% of GDP. Sberbank
receives preferential treatment from the state and holds 73% of all bank
deposits. It also is the only Russian bank that has a federal deposit
insurance guarantee. Sergei Ignatiev recently replaced Vikto Gerashchenko as
Chairman of the Russian Central Bank. Under his leadership, necessary
banking
reforms, including stricter accounting procedures and federal deposit
insurance, are likely to be implemented.

Trade
In 1999, exports were up slightly, while imports slumped by 30.5%. As a
consequence, the trade surplus ballooned to $33.2 billion, more than double
the previous year's level. In 2001, the trend shifted, as exports declined
while imports increased. 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. Ferrous metals exports suffered
the most in 2001, declining 7.5%. On the import side, steel and grains
dropped by 11% and 61%, respectively.

Most analysts predict these trade trends will continue to some extent in
2002. In the first quarter of 2002, import expenditures were up 12%,
increased by goods and a rapid rise of travel expenditure. The combination
of
import duties, a 20% value-added tax and excise taxes on imported goods
(especially automobiles, alcoholic beverages, and aircraft) and an import
licensing regime for alcohol still restrain demand for imports. Frequent and
unpredictable changes in customs regulations also have created problems for
foreign and domestic traders and investors. In March 2002, Russia placed a
ban on poultry from the United States. In the first quarter of 2002, exports
were down 10% as falling income from goods exports was partly compensated
for
by rising services exports, a trend since 2000. The trade surplus decreased
to $7 billion from well over $11 billion the same period last year....