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NEWS & COMMENTARY 2008 SPEAKERS 2007 2006 2005

Friday, November 03, 2006

Russia at a glance: 2006-07


Russia's domestic political scene has been relatively quiet in recent months, as foreign policy issues have dominated the agenda and the headlines. The public approval ratings for the president, Vladimir Putin, which had slipped slightly in 2005, have climbed back to about 80%. Although speculation continues about Mr Putin's intentions in 2008, when his term as president expires, the most likely outcome is that he will choose a successor and step down, as required by the constitution. The Kremlin is tightening its grip on key sectors of the economy, as Russia continues to move towards a form of state capitalism. Although fiscal policy is being loosened, high oil prices will keep the budget in surplus throughout the Economist Intelligence Unit's forecast period. Inflation will decline only gradually as budget spending stokes demand and strong foreign-exchange inflows prove hard to sterilise. Real GDP growth will be sustained by high oil prices and will slow only moderately in 2006-07.

Key changes from last month

Political outlook

Tensions between Russia and the US have increased significantly in recent months. Russia’s increasingly assertive foreign policy is irritating the US and has exacerbated long-standing strains in a number of areas. Relations with China are becoming increasingly close, although a fully fledged strategic alliance is not on the cards.

Economic policy outlook

The targets of the Russian Central Bank (RCB) for real rouble appreciation in 2006 imply that the RCB will no longer allow the rouble to appreciate in nominal terms, as it had at the beginning of this year in an attempt to curb inflation.

Economic forecast

Preliminary estimates from the RCB show that the current-account surplus surged to US$28bn in the first quarter of 2006, a 38% increase on the same period in 2005. We have thus made a slight upward revision to our forecast for the 2006 surplus, which is now expected to top US$90bn.

Outlook for 2006-07: Domestic politics

Russia's domestic political scene has been relatively quiet in recent months, as foreign policy issues have dominated the agenda and the headlines. Probably related to this, the public approval ratings of the president, Vladimir Putin, have climbed back to about 80%, having slipped slightly in 2005.

The constitution does not allow Mr Putin to stand for a third term in the 2008 presidential election. The possibility that he might change the constitution to be able to contest the election cannot be excluded altogether, but it is far more likely that he will step down in 2008 and seek to secure the election of a loyal successor. Mr Putin is a formalist and has repeatedly stated, in unequivocal terms, that he will respect the constitution; there are no signs of any moves to prepare for constitutional change; and Mr Putin appears to value his international standing in the G8. The Kremlin will seek to manage a smooth transfer of power in 2008. Nonetheless, the process of choosing a successor could be potentially fractious, given tense relations between the various factions in the Kremlin. This raises the risk of political volatility in the run-up to the 2008 poll.

Irrespective of the succession issue, there will be no relaxation of the administration's pursuit of "managed democracy"—now a form of soft authoritarianism. Following the clampdown on independent media and various measures taken to weaken the political opposition, attention has turned to non-governmental organisations (NGOs). Mr Putin has signed into law a bill giving the authorities extensive powers to monitor and control the activities of NGOs. Although other countries also have legislation limiting the scope allowed to NGOs, in the context of recent Russian developments the strict new law can be seen as a part of ongoing efforts to increase state control over most spheres of public life.

The Kremlin is also tightening its grip on the economy as Russia continues to move towards a form of state capitalism. The state's ambitions are now extending beyond the energy sector, as the concept of "strategic sectors" is interpreted ever more elastically. In 2005 the state regained control of about one-quarter of oil production, and extended its reach into the automotive, heavy machinery and other sectors. The latest target of rumour about a planned state takeover is the giant metals company Norilsk Nickel. Acquiring Norilsk Nickel would be of political significance because the company was, like Yukos and others, sold cheaply in the mid-1990s under the "loans for shares" scheme. The owner of Norilsk Nickel, Vladimir Potanin, was one of the architects of the scheme; squeezing him out of Norilsk Nickel would therefore mark another victory for Mr Putin over the so-called oligarchs.

Outlook for 2006-07: International relations

Tensions between Russia and the US have risen significantly in recent months. Russia’s increasingly assertive foreign policy is alarming the US and has exacerbated long-standing strains in a number of areas. Russia’s courting of the Palestinian militant group Hamas and its divergent approach to the recent Belarus election have irritated the US administration. The Pentagon recently publicly accused Russia of giving Saddam Hussein intelligence on US troop movements during the 2003 US invasion of Iraq, prompting vehement Russian denials. This follows increasing US criticism earlier this year of Russia’s statist economic policies, internal political trends and Russia’s behaviour during its gas dispute with Ukraine. Mr Putin has accused the US of putting up artificial, politically motivated obstacles to slow Russia's entry to the World Trade Organisation (WTO). The US Congress has also yet to lift the Soviet-era Jackson-Vanik trade restrictions, in stark contrast to the removal of trade restrictions against Ukraine.

All this is complicating the management of the uneasy mix of co-operation and rivalry that has characterised the bilateral relationship for some time. Relations have deteriorated steadily since the brief period of warmth in 2001 following the September 11th terrorist attacks on the US. A breakdown in relations is nevertheless unlikely. Despite its political and economic resurgence, Russia remains far weaker than the US and cannot afford confrontation with the world’s sole superpower. The US is in turn interested in Russian support on issues such as fighting terrorism and dealing with Iran.

Mr Putin will have welcome reports of pressure from German business groups on Chancellor Angela Merkel to soften her criticisms of Russia so as not to harm Germany’s economic interests. Germany remains by far Russia’s most significant economic partner in the EU, with which relations have also been somewhat strained in recent years. Russia provides Germany with 35% of its oil and 40% of its gas, with bilateral trade in 2005 reaching US$47bn.

In contrast to the frostiness in relations with the West, Russia's relations with Asian countries, especially China, are assuming increasing importance. Relations with China are largely driven by energy co-operation, a shared interest in limiting US global influence, as well as Russian interests in its Central Asian "back yard" (see box: Russia and China: not yet a strategic alliance). Relations are also slowly thawing with Japan, and ties with India have traditionally been close—Russia remains a key arms supplier to that country.

Outlook for 2006-07: Russia and China: not yet a strategic alliance

Vladimir Putin’s fourth official visit to China on March 21st-22nd—on which he was also accompanied by a thousand-strong retinue of Russian officials and businessmen—underlined the increasing breadth of common interests between Russia and China. The relationship is driven by economic and energy issues, and a common desire to limit US global influence. Strengthening relations with China has for Russia also been a response to what it sees as a Western "encirclement strategy" of Russia. As permanent members of the UN Security Council, both countries emphasise the role of the UN, and uphold the principle of non-interference in internal affairs. Authoritarian and statist trends in Russia have also reduced the "ideological distance" between the two countries. Despite this, both sides are keeping their options open, and an eye on relations with the US. A strategic alliance between China and Russia as a counterweight to US global predominance is not yet on the cards.

Russian-Chinese relations are better now than at any point since the early 1950s. Border issues have been resolved, and the mutual animosity that soured bilateral relations since the Sino-Soviet split in the late 1950s appears to be a thing of the past. The extent of the improved relationship was demonstrated in August 2005, when Russian and Chinese military forces participated in their first ever joint exercises. Closer ties are also manifested in the six-member Shanghai Co-operation Organisation (SCO), a security-oriented international body comprising China, Russia, Kazakhstan, the Kyrgyz Republic, Tajikistan and Uzbekistan. Both countries use the SCO to curb Islamist militancy in Central Asia, protect their influence in this strategically crucial region and limit US influence there. There are other focal points for the Russian-Chinese relationship, notably efforts to contain nuclear proliferation in North Korea and Iran. In both cases, China and Russia have resisted US efforts to apply military threats to deal with the problem.

Expanding trade

Strongly expanding economic ties have been a key feature of mutual relations. Russian-Chinese trade reached US$29bn in 2005, the highest ever total, up by 38% from the previous year. In 2004 Russia and China agreed to raise bilateral trade to US$60bn-80bn by 2010. Given current growth rates, this does not seem like an unrealistic figure. China's rapidly growing demand for raw materials and energy complements Russia's ample resources. Mineral products, fuels, chemicals and base metals account for around half of China's total imports from Russia. However, this does not sit easily with Russia’s desire to reduce its reliance on the export of raw materials and hydrocarbons.

Mr Putin would like Russia to regain its importance as a supplier of machinery and equipment exports to China, as in Soviet days. Although in 2005 China's imports from Russia rose by 31% year on year, imports of machinery and electrical equipment fell by 37%. China's imports of Russian machinery will continue to focus on military or energy-related fields. China is already buying Russian jet engines, naval vessels, cargo planes and air-defence technology (and would like to buy more), and Russia is providing equipment and expertise for China's civilian nuclear-energy programme (China plans to build 27 nuclear plants in the next 15 years).

Hungry for energy

China's aim is to gain access to Russia's energy reserves. Co-operation on this issue would appear to be mutually beneficial, as China is seeking to secure its energy supplies and Russia wants to diversify into other export markets. China also wants to diversify its energy sources: natural gas provides only around 3% of its total primary energy supply (oil constitutes around 20%). Russia has the world's largest supplies of natural gas but exports none to China, and Russia's oil and gas exporters have long professed a desire to gain access to Asia-Pacific markets.

A deal was announced with much fanfare during Mr Putin's March visit for Gazprom to supply China with vast amounts of natural gas via two pipelines from Siberia. This colossal project, estimated to cost around US$10bn, is aimed at eventually supplying 60bn-80bn cu metres of gas to the Asia-Pacific region—double China's total gas consumption in 2004. There are, however, serious doubts as to whether Russia will be able to follow through with the plan, given the enormous cost of building the pipelines and doubts over whether Russia will have sufficient gas production capacity in the next decade to provide large quantities of gas to China while also meeting domestic demand and its existing European export obligations.

China's imports of Russian oil—at present only around 5% of China’s total oil imports—are constrained by the fact that they must be transported by rail. China has long been pushing to get Russia to build a pipeline from its eastern Siberian oilfields to the city of Daqing, the site of China's largest oilfields and its largest petroleum production base. Such a pipeline could supply 600,000 barrels/day, just over one-quarter of China's net crude oil imports of 2.35m b/d in 2005.

However, Russia's general wariness about China's economic expansion, and its desire to extract concessions from other would-be purchasers (such as Japan), have prevented it from making a firm commitment to the pipeline. Thanks to strong lobbying from Japan, in 2004 Russia agreed to build a pipeline to Perevoznaya, near Nakhodka on its Pacific coast. Russia could still use the pipeline to export oil to China by transporting oil by rail from Skovorodino, where the first leg of the pipeline ends, or by building a spur from the pipeline to Daqing; however, no firm plans have been announced.

Strategic concerns

The lack of a definite decision over a pipeline to China has certainly undercut some of the recent goodwill in Chinese-Russian relations. Russia's prevarication reflects its concerns about Chinese control over its natural resources. This is linked to vague fears about Chinese immigration into and economic dominance of its sparsely populated eastern regions. Russia has also been reluctant to sell key assets in its oil sector to Chinese investors.

Despite the increasing closeness of the overall relationship, Russia remains reluctant to get too close to China. China in turn is also not prepared to go so far as seriously to alienate the US. Thus Russia and China have stopped well short of forming an explicit anti-US alliance. The disagreements and Russian prevarication over concrete energy co-operation illustrate the fact that Russia is still keeping its options open.

Outlook for 2006-07: Policy trends

Although relatively prudent macroeconomic policies will be maintained, few advances in structural reform are likely in the run-up to the 2007-08 elections. Economic policy will focus on implementing the "national priority projects", designed to raise standards of living through increased public spending on health, education and housing. The government will also continue with its policy of establishing state control over the so-called strategic heights of the economy—which largely, although not exclusively, means Russia's energy and metals resources.

After 14 years of negotiations, Russia needs only three more bilateral agreements—with Australia, Colombia and the US—to secure WTO membership. At one stage it seemed possible that Russia could become a member in time for the July G8 summit that Russia is hosting. However, there has been very little progress in recent negotiations and mid-2006 membership no longer seems possible. Russia has accused the US of putting politically motivated obstacles in the way of Russia’s membership, but Russia’s progress to the WTO has also been slowed by its tough negotiating position and resistance to demands for less protection for agriculture, the aircraft industry and financial markets. Protection of intellectual property rights and energy pricing are also areas of disagreement. EU states, in particular, want the spread between export and domestic prices for gas and electricity to be narrowed sharply.

Russia’s tough negotiating stance reflects the fact that the economic benefits and drawbacks of membership for Russia’s economy appear to be more finely balanced than for most other countries. The raw materials that form the bulk of Russia’s exports—oil, gas, minerals and timber—are not covered by the WTO regime. The same applies to arms exports. WTO-related increases in domestic energy prices would threaten the competitiveness of a range of energy-intensive enterprises. Reduced protection could set back hopes for Russia to diversify the economy—for example, it is questionable whether Russia’s aircraft industry could survive the abolition of import duties on aircraft. Nevertheless, these considerations are likely to be trumped by Russia's strong political interest in joining the WTO, and the Economist Intelligence Unit expects that compromises over outstanding issues will allow this to happen towards the end of 2006 or possibly in 2007.

Outlook for 2006-07: Fiscal policy

Federal budget expenditure for 2006 has been revised upwards in the expectation of higher oil prices than previously assumed. Revenue is now targeted at Rb5.6trn (US$200bn) and expenditure at Rb4.3trn, yielding a surplus of around Rb822bn (US$29bn) after revenue has been transferred to the Stabilisation Fund, compared with a previous target of Rb776bn. Furthermore, upward expenditure revisions are likely over the course of 2006, as pressure to spend is mounting in the wake of a rising oil windfall. Nonetheless, we expect the 2006 budget surplus to be near the official target, or even higher, as the positive effects on revenue of higher inflation and oil prices than have been officially forecast offset the impact of likely expenditure increases and any tax cuts.

Outlook for 2006-07: Monetary policy

The twin and contradictory objectives of monetary policy—both to dampen inflation and maintain price competitiveness—continue to be difficult to achieve given strong foreign-exchange inflows, a dearth of sterilisation instruments and reluctance to allow the rouble to appreciate. Although the Russian Central Bank (RCB) has occasionally prioritised inflation-reduction, this has not been sustained; concern about the impact of steady real appreciation on the real economy has most often taken precedence.

The RCB has stated that it wants to limit money supply (M2) growth to 25% in 2006. Technically this could be done by raising the mandatory reserve requirements and the interest rate on central bank deposits. However, attempting to reduce the rate of M2 growth significantly would reduce liquidity in the money market, possibly destabilise the financial markets and dampen economic growth. The RCB has traditionally underestimated money supply growth, and a concerted attempt to curb it seems unlikely, especially if inflation starts to slow.

Outlook for 2006-07: International assumptions
International assumptions summary
(% unless otherwise indicated)
2004 2005 2006 2007
Real GDP growth
World 5.1 4.6 4.3 4.1
OECD 3.2 2.6 2.5 2.3
Euro zone 12 1.9 1.2 1.8 1.9
EU25 2.4 1.6 2.1 2.3
Exchange rates
¥:US$ 108.1 110.1 113.3 104.5
US$:€ 1.24 1.24 1.25 1.34
SDR:US$ 0.68 0.68 0.68 0.65
Financial indicators
€ 3-month interbank rate 2.1 2.2 2.9 3.7
US$ 3-month Libor 1.6 3.6 5.3 4.9
Commodity prices
Oil (Brent; US$/b) 38.5 54.7 60.0 55.3
Gold (US$/troy oz) 409.5 445.0 525.0 500.0
Food, feedstuffs & beverages (% change in US$ terms) 8.5 -0.2 -0.5 -2.3
Industrial raw materials (% change in US$ terms) 21.0 10.5 11.7 -15.8
Note. World and regional GDP growth rates weighted using purchasing power parity exchange rates.

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International oil prices will continue to be the main driver of Russian economic performance during the forecast period. The outlook for Russia in this respect is highly favourable, given that the average price of dated Brent Blend in 2006 is expected to be US$60/barrel, before declining—albeit only to 2005 levels—in 2007. Although our baseline forecast is for robust growth in the world economy in 2006-07, there are a number of threats that could drag down global economic performance significantly. In particular, exchange-rate risk is high, as the large US external deficit weighs on the US dollar. Since Russian oil exports are priced in US dollars, a collapse in the US currency would have an effect similar to that of a sharp fall in oil prices, posing a threat to Russia's economic growth. The risks related to avian influenza (or bird flu) appear especially acute for Russia, given its already daunting health problems.

Outlook for 2006-07: Economic growth
Gross domestic product by expenditure
(Rb bn at constant 2000 prices; % change year on year in brackets unless otherwise indicated)
2004a 2005a 2006b 2007b
Private consumption 7,446 8,256 9,106 10,023
(11.2) (10.9) (10.3) (10.1)
Public consumption 2,380 2,423 2,476 2,563
(2.1) (1.8) (2.2) (3.5)
Gross fixed investment 2,706.8 2,991.0 3,290.1 3,632.3
(11.3) (10.5) (10.0) (10.4)
Final domestic demand 12,533 13,670 14,873 16,219
(9.4) (9.1) (8.8) (9.1)
Stockbuilding 367 433 450 430
(0.3)c (0.5)c (0.1)c (-0.1)c
Total domestic demand 12,900 14,104 15,323 16,649
(9.5) (9.3) (8.6) (8.7)
Exports of goods & services 5,209 5,501 5,809 6,170
(11.9) (5.6) (5.6) (6.2)
Imports of goods & services 3,862 4,488 5,127 5,928
(22.5) (16.2) (14.2) (15.6)
Foreign balance 1,347 1,013 682 243
(-1.2)c (-2.4)c (-2.2)c (-2.7)c
GDP incl statistical discrepancy 14,191 15,101 16,004 16,891
(7.2) (6.4) (6.0) (5.5)
a Actual. b Economist Intelligence Unit forecasts. c Contribution to real GDP growth.

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Real GDP increased by 6.4% in 2005. Growth is nevertheless below what could be expected at current oil price levels, and activity weakened in the first two months of 2006. We forecast annual average growth to fall to 6% in 2006 and 5.5% in 2007 as a result of sluggish performance in key industrial sectors—most notably oil extraction, where output rose by only 2.5% in 2005, compared with growth rates of 9-11% in 2002-04.

Export volume growth was sluggish in 2005, and with oil sector output still constrained by high marginal taxes and infrastructure bottlenecks, there is little reason to expect an export rebound in 2006-07. However, investment held up well in 2005 and is likely to remain high over the forecast period. Private consumption will also continue to be an important engine of growth, even though real rouble appreciation is fuelling strong import demand. The increased state control over broad swathes of the economy will also act as a drag on growth, not least because of the low efficiency and high wastage of the state-owned monopolies.

Outlook for 2006-07: Inflation

Monthly inflation subsided to 0.8% in March, and year-on-year inflation of 10.7% in March was lower than the February figure of 11.2%. Consumer prices have nevertheless increased by 5% since the start of the year, which makes it highly unlikely that the government will meet its inflation target for end-2006 (initially set at a range of 7-8.5%, and informally raised to 9%). Even with some administrative curbs, the strong foreign inflows, a fiscal loosening and reluctance to allow further nominal rouble appreciation mean that inflation is very unlikely to fall below 10% by the end of the year. It is expected to decline further in 2007, but only modestly.

The authorities want to keep inflation in check by applying anti-monopoly measures in the food and fuel sectors, reducing or even scrapping import duties on selected goods, and regulating utility tariffs and Russian oil product prices. Such moves are unlikely to curb inflationary pressure in a sustained way. In addition to the unrelenting pressure emanating from strong foreign-exchange inflows, the main driver of inflation is budget spending, which is boosting nominal personal income and demand.

Outlook for 2006-07: Exchange rates

The rouble appreciated by 5.9% in real effective terms in the first three months of the year. This significant appreciation resulted from high inflation as well as nominal rouble appreciation. During the first quarter of 2006 the RCB allowed the rouble to appreciate in nominal terms to try to combat rising inflation, but the central bank will now seek to prevent further significant nominal appreciation. Allowing nominal appreciation appears actually to have been counterproductive, as it has encouraged inflows of capital and thus money supply growth.

The extent of real appreciation in recent years has by now eroded the competitiveness gains to Russian producers from the 1998 devaluation. Although the RCB will seek to prevent further nominal rouble appreciation, large-scale foreign-exchange inflows and the dearth of sterilisation instruments at the disposal of the RCB mean that continued real appreciation is inevitable.

Outlook for 2006-07: External sector

Figures for the current-account surplus in 2005 have been revised downwards slightly, to US$84.2bn from the initial official estimate of US$86.6bn. Preliminary RCB estimates show that the current-account surplus surged to US$28bn in the first quarter of 2006, a 38% increase compared with the same period of 2005. The current-account surplus is forecast at about 10% of GDP in 2006 and nearly 8% in 2007. Large trade surpluses will more than offset large deficits on the income and services accounts. Rising interest payments, in particular, will reflect the rapid expansion in corporate foreign borrowing in recent years, which is set to continue.

RCB data show that foreign direct investment (FDI) into Russia reached US$14.6bn in 2005 (a slight downward revision of initial estimates). FDI at similar levels is expected in 2006-07. Many investors will be attracted by strong market opportunities and remain—at least outside the energy sector—unaffected by Russia's increased statism and imposition of restrictions on foreign involvement.

Outlook for 2006-07: Forecast summary
Forecast summary
(% unless otherwise indicated)
2004a 2005a 2006b 2007b
Real GDP growth 7.2 6.4 6.0 5.5
Industrial production growth 7.3 4.0 4.8 4.4
Gross fixed investment growth 11.3 10.5 10.0 10.4
Unemployment rate (av) 8.2 7.6 7.5 7.4
Consumer price inflation (av) 10.9 12.7 10.5 9.5
Consumer price inflation (year-end) 11.7 10.9 10.2 8.5
Central bank refinancing rate (year-end) 13.0 12.0 12.0 12.0
Federal budget balance (% of GDP) 4.9 7.5 4.5 3.4
Exports of goods fob (US$ bn) 183.5 243.6 269.9 292.3
Imports of goods fob (US$ bn) 96.3 125.3 142.3 170.9
Current-account balance (US$ bn) 59.9 84.2 92.7 82.8
Current-account balance (% of GDP) 10.2 11.0 10.2 7.8
External debt (year-end; US$ bn) 211.5c 215.3c 222.0 228.2
Exchange rate Rb:US$ (av) 28.81 28.3 28.5 28.1
Exchange rate Rb:US$ (year-end) 27.75 28.8 28.3 27.6
Exchange rate Rb:€ (av) 35.84 35.2 35.6 37.6
Exchange rate Rb:€ (year-end) 37.81 34.2 37.3 36.3
a Actual. b Economist Intelligence Unit forecasts. c Economist Intelligence Unit estimates.

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