Russia And The Global Economic Crisis

By: Deborah A. Palmieri, Ph.D. Issue: Global Trade Section: Jewel Of Collaboration Russia and the global

Russia, as most countries in the global economy, faces its own set of woes coping with the financial downturn. It was a bitter pill to swallow for Russia, whose economy had taken off under the leadership of Vladimir Putin with a reform minded economic growth strategy. The Russian economy had grown at an average of 7% annually for at least 5 years, and rising oil and commodity prices allowed Russia to accumulate one of the largest stockpiles of currency reserves in the world and a budget surplus of almost $400 billion. But, by early 2009, Russia confronted the perfect storm, and the economy and financial system went into a tailspin.

Crisis, Russian Style

Many factors converged to deepen Russia’s crisis. The ready cash flow into the national treasury from sales of oil and natural gas began to dry up, and export earnings plunged, thus negatively impacting and shrinking the national budget. Credit availability virtually disappeared, creating what many refer to as the “one-two punch”- a decline in export earnings coupled with a decrease in credit access. Russia’s oligarchs, many of them reflecting the values of “new money” seriously over-leveraged themselves, only to find themselves highly over-extended as the crisis hit, and having to sell off assets at low prices to finance other obligations, or simply to default on them.

Starting in fall 2008, major Russian stock exchanges including MICEX and RTS lost 70% of their value. Trading was suspended many times during various bouts of market turmoil. Losses were especially severe in finance and energy. Add to all of this bank failures, plummeting real estate values, the devaluation of the ruble and capital flight, and the depth and severity of Russia’s crisis mirrored that of countries across the globe.

The onset of the financial crisis coincided with Russia’s conflict with Georgia in South Ossetia in August 2008. In response to Georgian ground attacks on South Ossetia, Russia began a military campaign against Georgia. This move was widely interpreted in the West as Russian aggression and risky Russian behavior, and as a result, capital outflows only a month after the invasion were estimated as high as $40 billion. Investors were spooked in a tough break for Russia. Many rating agencies such as UBS AG reduced prices of Russian assets due to the perception of increased political risk.

Russia continues to experience a sharp decline in GDP, industrial production and household consumption. GDP is expected to shrink in 2009, and while analysts differ by how much, anywhere from 1%-6%, for Russians it’s disappointing after the economic boom whereby nominal GDP soared from $200 billion in 1999 to $1.7 trillion in 2008. The national unemployment level now stands between 10% - 11%. The Ministry of Economic Development reported that almost 2 million people lost their jobs in the first quarter of 2009 alone. Industrial production declined nearly 14% year over year in March 2009 and over 14% in the first quarter of 2009. There has been an increase in inflation, which is now running at approximately 14% annually, not out of control, but several percentage points higher year-on-year.

While Russia ran a budget surplus for years, as high as $121 billion, many Western counterparts were mired in debt. Now, that surplus is dwindling as the government cuts into the Stabilization Fund (where the surplus was stored), there are some projections that the Fund could be depleted by 2010 or 2011.

Some experts project that Russia’s budget deficit could total 10% of GDP by the end of 2009. In early 2009, Russia’s trade surplus had decreased 62% from the same period in 2008. Both export and import activity has declined significantly in 2009 over 2008 - exports were 48% lower and imports, 36%. Said one government official, “It’s bad everywhere in the world and Russia’s feeling it, too.”

Government Response

The response to the crisis by President Medvedev and Prime Minister Vladimir Putin has been swift and impressive. Many of these initiatives were laid out in a March 2009 report issued by the government which highlighted the official anti-crisis program for 2009.

Like other Western governments, they initiated an aggressive bailout and stimulus plan beginning in the fall of 2008, which included bailing out failing banks and enterprises. The government poured money into major backs including OAO Sberbank, VTB Group and OAO Gazprombank. A ruble devaluation strategy was put into place to try and revive export dependent industries. The Medvedev administration substantially increased social welfare spending, to try and ease the burden on Russian citizens. They took measures such as delaying tax increases on companies, such as the Unified Social Tax, and postponed other planned tax increases. The personal income tax was maintained at its flat rate of 13%. Tariffs on many imports were increased. They bought out the foreign loan obligations of select companies to avoid the collateralization of their assets abroad. They pledged further assets to expand Russia’s oil and gas expansion in Europe and Asia, planning for future growth and recovery. They began to pay more attention to the long-term modernization of the economy.

Central Bank Chairman Sergei Ignatiev and the Ministry of Finance undertook measures to loosen lending markets including cutting the reserve requirement on liabilities, injecting billions of rubles into state controlled banks, compensating certain banks for loan losses, broadening the definition of eligible securities available for collateral and providing for funding through new instruments such as unsecured loan auctions.

Tax stimulus was another element of Medvedev’s strategy. In November 2008, a tax stimulus package was initiated. Corporate tax profits were cut by 4%; advance payment rules were eliminated and various tax deferral measures were put into place.

In the midst of all this, President Medvedev has undertaken a firm anti-corruption campaign and has emphasized strengthening the judicial system.

Comparison with 1998 Financial Crisis

It is worth looking back in history to view the current crisis in relation to the 1998 financial collapse. While it is different from the crisis faced by Russia just 11 years ago, there are lessons to be learned and perspectives to be gained.

Beginning in the summer of 1998, Russia experienced a financial crisis that spilled over into all realms of the society and economy. A $22.6 billion rescue package from the IMF barely made a dent. Just before the August 17 devaluation of the ruble, George Soros aptly expressed the pessimism of the times, “The meltdown in Russian financial markets has reached the terminal phase.” Another market trader was equally gloomy: “If you had to sum up the mood of investors in one word it would be despair. Investors have completely lost faith in the government.” Yet another said, “It’s all going horribly wrong.” There were concerns about Russia defaulting on its $135 billion in foreign currency obligations. Ratings of Russia from Moody’s and other international agencies plunged to the bottom. In a rating of world banks, Russia stood right at the bottom of 73 countries, worse off than countries like Puerto Rico, Estonia, Panama, Kuwait, Malta, Croatia and Slovakia, and only a notch above Kazakhstan, Tunisia, Thailand and Pakistan. Russia and the global The problem of wage arrears had become so severe in the military and the prospects so dim for payment that the Defense Ministry had advised soldiers to fish, hunt and gather mushrooms until the Government could afford payments. One ministry official said, “People really need this to survive somehow.”

The teetering democracy under the leadership of Boris Yeltsin was strained to capacity. He had strived mightily to overcome 76 years of communist legacy and had fought for survival since 1991, pleading for assistance from the West, and received very little. The Russian people braced to survive another crisis in their history. Sighed one weary citizen, “Crises in Russia are permanent. They only change qualifiers - political, governmental, market, financial, economic.” Through the course of the crisis, many Russians lost everything they had - any money they put in the bank, real estate and more. There were panicked bank runs, people tried to convert rubles to dollars, and others hoarded food, fearful of higher prices and even shortages.

By comparison with today’s crisis, there are no alarm bells about the fundamental solvency of the Russian economy and state. There is no fear about the collapse of the Russian state, or a return to communism as there was in 1998.

It is clear that Russia is taking proactive measures to try and contain the depth and severity of the crisis. In this instance, it is likely that if the global downturn is prolonged, Russia will suffer, along with everyone else, no better, no worse.

Trade and Investment with Russia

In 2008, total foreign capital in the Russian economy equaled more than $264 billion, including more than $103 billion in foreign direct investment. In terms of foreign investors by country, the largest investors in Russia in 2008 included Cyprus ($60 billion), Netherlands ($46 billion), Luxemburg ($34 billion), Britain ($31 billion), Germany ($17 billion), Iceland and France (each at $10 billion). The U.S. lagged behind all of these countries at a mere $8.8 billion. In terms of foreign investment by sector in 2008, most foreign investment dollars were sunk into manufacturing ($34 billion), wholesale and retails trade and household goods ($24 billion), real estate transactions ($15 billion), oil and gas extraction and mining ($12 billion), and several billion each in finance, transport, communication, electric power, and construction. While foreigners are investing in Russia, the Russian’s are investing abroad, and in 2008, they invested $114 billion, an increase of 53% over 2007.

In 2009, foreign direct investment dropped 43% in the first quarter compared to the same period in 2008. Foreign investment overall declined as a function of the global economic crisis, along with the perception of Russia as a high risk market. The Russian economy contracted 9.5% in the first quarter of the year, and forced analysts to revise their forecasts downward for the rest of the year.

The structure of foreign trade has remained consistent over the past several decades. The chart detailing the structure of Russia’s foreign trade displays a pattern long evidenced in Russia: heavy exports in the area of mineral products and metals, and imports heavy in food products, machinery and equipment and chemicals. Russia’s foreign reserves are heavily dependent on the price of oil, which has fluctuated wildly, from a high of $146/barrel last year, to lows of under $40/barrel. With a shrinking global economy, there is less need for Russia’s exports. But as the crisis subsides and economics begin to recover, the demand will return. Russia’s import demand will fall, but they are still buying, just less.

Russia and the WTO

A key issue for Russia is accession into the World Trade Organization (WTO). It is important to belong to this organization to take advantage of reduced tariffs and benefits among member countries.

Russia has applied since 1993 (it was then the General Agreement on Tariffs and Trade or GATT). Until early June 2009, Russia was part of a number of bilateral and multilateral commitments and has cooperated with the WTO’s Working Party on Russia. But it has still not been approved by the WTO General Council for accession (see www.wto.ru, Russia’s official website on the issue for more details.)

In a surprise move announced by Prime Minister Putin on June 9, Russia abruptly abandoned its separate talks with the WTO, and announced it would be forming a customs union with Kazakhstan and Belarus. The three countries are aiming to launch their customs union on January 1, 2010, and to complete all formalities in forming the customs space by July 1, 2011. This would be the first application to the WTO as a customs union. Itar-Tass quoted Mr. Putin as stating, “Entry into the WTO is our common priority, but we want to do it as a common customs space.”

There are many opinions as to why Russia, the largest economy not belonging to the WTO, has chosen this path. Some speculate that Russia tired of endless delays and stipulations by the WTO process over the last 16 years. Many Russians believe the delays were deliberate. Others believe Russia hopes to bring on board other countries of the former Soviet Union into the union to strengthen its bargaining position. Some argue that there is really not much benefit for Russia to belong to the WTO anyway. Its main exports, oil and gas are already open, and other industries such as agriculture would be placed at a disadvantage through membership. Right now it is too early to tell. Kazakhstan and Belarus had also faced delays in the process and there may be motives that are yet unclear. It is not clear also how the WTO will react to an admissions bid by a customs union. Meanwhile, the move is not expected to have much of an effect on the current pattern and trend of Russia’s trading behavior.

Political Relations

Russia and the global After a relatively frosty period in U.S.-Russian relations during the Bush Administration, despite strong personal ties between Mr. Bush and Mr. Putin, relations are slowly experiencing a thaw between the new presidential administrations of President Obama and President Medvedev. Both nations are focused on pressing domestic issues, and both face serious consequences from the global economic crisis. The Bush initiative to set up a missile defense system in Poland, the European Interceptor Site (EIS) and set up a radar tracking system in the Czech Republic deeply angered the Russians. This plan is under evaluation by Secretary of State Hillary Clinton and other top officials, and it is currently not clear which direction they will take on the issue. But for now, there is agreement on a key issue, the renegotiation of START, the Strategic Arms Reduction Treaty, which expires in December of this year. This is the most complex arms treaty in history to limit the arms race. Both sides are committed to signing a new agreement by the end of the year.

Vice President Joseph Biden signaled a new era in U.S.-Russian relations when he called for “resetting the button”, implying that both sides needed to move beyond old disagreements and forge a new agenda for the future. Cooperative political and diplomatic ties are always good for business relations, and both sides are above all pragmatic. This will serve to create a more positive environment to incentivize the growth of U.S.-Russian business relations in the years ahead.

Concluding Remarks

Despite historical problems and structural barriers, the future is promising for the growth of U.S.-Russian trade. Russia, as the world’s largest country, offers a wealth of natural resources in demand by the requirements of American industry, including oil and gas and strategic minerals. Russia needs processed food and agricultural products, meat, manufactured goods, chemicals, high-tech electronics and other products produced by the U.S. As politics become more pragmatic and the Cold War fades into the distant past, the forging of a new relationship will allow Russia and the U.S. to realize the enormous economic potential to benefit both nations. The current low numbers of U.S. foreign investment into Russia, and trade turnover suggest there is potential and opportunity for growth.

Deborah A. Palmieri, Ph.D. is the Honorary Consul General of Russia in Colorado and is the President and Founder of Deb Palmieri Russia LLC. Contact Dr. Palmieri at 1552 Pennsylvania Street, Denver, CO 80203, 720-980-4829 or at Deb@DebPalmieriRussia.com.