Can the Boom Last?

With a $2.7 billion international debt repayment looming for Russia, the International Monetary Fund mission left Moscow in November without reaching an agreement. The IMF has decided that Russia has enough cash to pay off its debt. Revenues from high global energy prices as well as reports of higher-than-expected Russian GDP growth are causing some analysts to conclude that the Russian economy has turned the corner.

Unfortunately, some recent economic reports show this is not the case. There are disturbing indications that if oil prices plunge, Russian prosperity will evaporate. Even IMF officials acknowledge that, with the exception of the flat income tax set to begin on Jan. 1, little has been done in terms of real economic reform.

According to the Heritage Foundation?€™s 2001 Index of Economic Freedom, Russia is ranked No. 127, trailing countries like Poland, Hungary, the Czech Republic and Estonia in such categories as free trade, inflation and foreign investment. Even more worrisome, while over the last five years Central European and Baltic countries have improved their Index scores by from 15 percent to 30 percent, while Russia is falling behind by at least 10 percent.

Russia remains mired in corruption, has an abysmal track record implementing the rule of law and has shown little progress carrying out structural reforms. Foreign investment per capita in Russia is much lower than in Eastern Europe and capital flight resumed in full force after a short hiatus in late 1999. A recent World Bank report titled "?€?Seize the State, Seize the Day:?€™ State Capture, Corruption and Influence in Transition" argues that corruption in Russia remains a daunting problem. The study found there is a 90 percent probability of losing foreign direct investment in Russia within five years, as compared with a 25 percent in Hungary.

A survey of companies by the authors of that study found that Western businessmen consider Russian courts corrupt, unfair, unreliable and incapable of enforcing decisions. Russia still has a high level of "state capture," in which companies pay bribes for legislation and executive decisions.

Until Russia develops a credible legal system that recognizes and protects property rights, especially in the real estate and agricultural-land markets, economic prosperity will be limited to the boom-and-bust cycles of world oil prices. Without a transparent government and clear rules, Western lending and optimistic public relations are not going to do the trick. Domestic capital flight will continue and foreign investors will not come.

True, some progress has been achieved from the extremely low baseline of the post-crisis 1998. GDP is up 13 percent since the 1997 nadir. It is projected to grow 7.3 percent in 2000. Investment for 2000 will be up 14 percent. Russia now boasts a strong current-account surplus of $23.9 billion. It is recognizing its obligations to international financial institutions such as the IMF and the World Bank.

However, this macroeconomic nirvana will not last long. First, it is driven by the high oil and commodities prices worldwide. Second, it is a direct result of the 1998 de facto default on foreign obligations. Third, the 75 percent devaluation of the ruble in 1998 helped to protect Russian asset prices and ruble-denominated debts while simultaneously decreasing the cost of labor. Fourth, the economic bounce is driven by price controls on domestic inputs such as electricity, transportation and other commodities. This is a de facto subsidy paid to industry by the government. This government support has stimulated the revival of moribund industrial capacity, primarily for export substitution and low-cost commodity production.

As a result of the improved balance of trade and accounts, the treasury does not need more international financing. Nevertheless, the Finance Ministry is planning to borrow $1.2 billion from the IMF and $900 million from the World Bank, just in case oil prices plunge and because it is easier to borrow than to raise revenue domestically.

According to the data collected by Richard Ericsson of Columbia University, real wages have fallen 23 percent since 1997, when they were not too high to begin with, and aggregate consumer buying power remains low. Consumption is down 1.3 percent since 1997.

Tax reform ?€” hailed as the biggest achievement of the Putin presidency so far ?€” is incomplete. Taxpayers do not trust the newly declared benign tax policy and are scared by the government?€™s promise to abandon the flat income tax rate of 13 percent once everyone declares their income to authorities.

According to the World Bank, only 25 percent of Russian companies claimed in a survey their property rights are protected, compared with 75 percent of companies in Poland and Estonia. Seventy-two percent of Russia?€™s land still is in state hands and only 0.03 percent is changing hands each year. There is no land market to speak of.

Russia must also face the crisis of its obsolete industrial base. Some of Russia?€™s power-generation equipment dates back to the 1900s, a spokesman for electricity monopoly UES admitted recently. To turn the tide, UES will need $70 billion in the next five to seven years, otherwise severe electricity shortages will continue to plague Russia. Another $80 billion is needed to replace Soviet-era equipment and pipelines in the cash-generating oil and gas sector, otherwise output will start declining.

Considering all these factors, it is no surprise, then, that foreign investors take note and prefer the relatively calm waters of Eastern and Central Europe to Russia?€™s "wild, wild East."

Ariel Cohen, Ph.D., is the research fellow in Russian and Eurasian studies at the Heritage Foundation. He contributed this comment to The Moscow Times.