COUNTRY COMMERCIAL GUIDE--RUSSIAN FEDERATION
FISCAL YEAR 2000
II. ECONOMIC TRENDS AND OUTLOOK
Major Trends And Outlook
Russia’s 1998 economic crisis, sparked by spillover effects of the East Asian crisis, low oil prices and a fundamental fiscal imbalance, led to a loss of confidence in Russia's economy. Investors withdrew from government securities, driving yields to unsustainable highs and putting significant pressure on the ruble. When a $4.2 billion IMF tranche disbursed in July 1998 failed to restore market confidence, investors continued to leave, placing additional pressure on the ruble and Russia's foreign exchange reserves. On August 17, 1998, Russia became the first country in modern times to announce a restructuring of its domestic government securities. Simultaneously, the Central Bank declared a moratorium on certain loan repayments, imposed new capital controls and widened the ruble exchange rate band (originally set at R6.0-6.2/$ to R6.0-9.5/$).
The ruble quickly hit, then broke through the upper limit of the new wider band. Facing dwindling reserves and continued pressure, the Central Bank switched to a policy of a "managed float." The ruble ended the year near R2l.1/$ and has been relatively stable in 1999, buoyed by stronger energy prices and more stringent foreign exchange controls. As of July 8, 1999, the ruble was trading near R24.4/$.
In 1998, Russia's banking sector suffered a systemic collapse. Large banks were heavily invested in domestic government securities. Many were also active in the equity market, which plummeted. Many large Russian banks were active in forward foreign exchange markets and were left insolvent by the devaluation. The payments system ground to a halt, many banks defaulted on external borrowings (including Eurobonds) and large numbers of depositors were unable to access their funds. The Central Bank has since succeeded in resuscitating the payments system. Depositors in some institutions were able to recover a portion of their funds from a Central Bank program to transfer small accounts to state-owned Sberbank. Progress towards closing or restructuring insolvent banks has been slow.
A devaluation-triggered inflationary spike followed the August crisis, with monthly inflation hitting 41.5% in September 1998. Yearly inflation for 1998 was 84.3%, but inflation has decelerated in 1999. Predicted inflation for 1999, according to IMF and World Bank figures, will be approximately 30%.
Monthly inflation in May 1999 was 2.2%, down from April 1999 rate of 3%, but still up significantly from the .5% monthly inflation registered in May 1998 and running at 116% year-on-year.
Tight monetary policy after the crisis allowed the Central Bank to prevent inflation from spinning out of control. However, the Russian economy has been slow to recover. In 1998, GDP contracted by 5.2% and was down 4% in the first quarter of 1999. Although industrial production also fell by 5.2% in 1998, a modest recovery began at the end of the year. Industrial production has risen moderately in 1999, with preliminary figures showing April output up 1.5% year-on-year, on pace toward a 3.5% annual rate.
Currently, the Russian government does not have access to capital markets, either domestic or international, as a result of its restructuring of domestic debt and its announced intention to seek restructuring of a portion of its external debt. This, combined with the lack of an IMF program, has forced the Government to get serious about addressing Russia's persistent fiscal imbalance. In the first quarter of 1999, the federal budget showed a primary surplus (before debt servicing) of 1.2% of GDP, compared to a primary surplus of .2% for the first quarter of 1998. Encouragingly, progress has been made on both revenues and expenditures. Revenues grew from 10.6% of GDP in the first quarter of 1998 to 11% of GDP in the first quarter of 1999. Non-interest expenditures fell from 10.3% of GDP in the first quarter of 1998 to 9.8% of GDP in the first quarter of 1999. In light of this performance, the IMF and World Bank are expected to approve 1999 programs in the summer and to disburse funds if Russian performance meets program standards.
Russia's balance-of-payments dynamics have changed markedly since 1998. Exports and imports have dropped in dollar terms. Exports fell from $18.5 billion in the first quarter of 1998 to $15.6 billion in the first quarter of 1999. Imports collapsed following devaluation, from $18.3 billion in the first quarter of 1998 to $9.4 billion in the first quarter of 1999. Accordingly, the trade surplus has risen from $200 million in the first quarter of last year to $6.2 billion in the first quarter of 1999. Exports are expected to grow in the second quarter of 1999, due to stronger prices for energy (which in the first quarter of 1999 accounted for 40 percent of Russia's export revenue) as well as greater competitiveness of other exports. Recovery in imports will be constrained by current low real income levels and the higher competitiveness of lower-priced, domestically-produced import substitutes.
The crisis has also curbed investment. Annual foreign direct investment into Russia fell from $4 billion in 1997 to $2.2 billion in 1998. Portfolio investment fell even more sharply, from $17.3 billion in 1997 to $8 billion in 1998. Investment is not expected to recover in 1999. Russia's official external debt is currently $152.4 billion. The Government has announced that it cannot meet its 1999 external debt payments of $17.2 billion. Instead, the 1999 budget envisions payments of $9 billion. Russia has missed scheduled payments on its rescheduled London and Paris Club debts, although creditors to date have opted not to declare Russia in official default. As of July, 1999, the Government has continued to meet scheduled payments on its Eurobonds (total par value S15.9 billion) and debts to international financial institutions. The Government has tapped Central Bank foreign exchange reserves to meet external debt payments, with the Bank granting roughly $7.1 billion in such financing from August 1998 to May 1999.
Principal Growth Sectors
Domestic production received a boost from the devaluation, which priced many imports out of the market. Domestic producers have picked up some of the slack. Sectors that have experienced growth include chemicals, forestry, pulp and paper, food processing (more than 10 percent production increase from 1998 to 1999) and to a lesser extent, machine building, non-ferrous metals, construction materials, glass and porcelain.
However, many Russian firms remain hampered by lack of working capital, impeding their ability to raise output to fully capitalize on their relative price advantage following the devaluation. Lower real incomes have also constrained demand. Preliminary data showed average dollar wages of $59.7/month at the end of May 1999, compared with $134.4/month at the end of 1998. A sustained increase in domestic demand is unlikely to come in the absence of a recovery in real incomes.
Exporters who are paid in dollars but whose costs are ruble-denominated also received a boost from devaluation. This is especially true of energy producers, who have also benefited from rising world oil prices. The price of Brent crude had risen 50 percent during the first half of 1999, providing a significant boost to both production volumes and revenues. Exporters in other sectors, including chemicals, non-ferrous metals (especially aluminum) and minerals, fertilizer and paper, have also registered production increases.
Regional Perspectives
While Moscow and St. Petersburg are the most affluent and concentrated markets, especially in the consumer sector, business in Russia is expanding into the regions. Highlighted below are snapshots of Moscow, Russia’s wealthiest city; St. Petersburg, the heart of northwest Russia; the industrialized areas of the Urals and West Siberia; and the Russian Far East, Russia’s window to the East Asian and trans-Pacific economy.
Moscow and Environs:
The 10 million people in Moscow City proper and another 6.5 million in surrounding Moscow Oblast make up over ten percent of Russia’s total population and is the largest and wealthiest metropolitan consumer market. Moscow is Russia’s undisputed political and financial center, home to a large percentage of its nascent middle class, and is the city in Russia with the most diverse economy, and most modern transport and communication services and other commercial infrastructure. The Moscow Oblast Customs Department processes fully one-third of Russia's total trade turnover. Communications and road modernization have been top priorities of the city and oblast administrations and are proceeding apace despite the country’s broader economic downturn in 1998. The number of cars on Moscow streets has more than quadrupled during the past decade. Despite a heavy bureaucracy, the city has taken advantage of its position as Russia’s financial capital and transportation nexus to foster a growing foreign business community. Costs for business services, while the highest in Russia, have fallen marginally since autumn 1998.
Moscow Oblast offers a unique mix of opportunities to local companies and foreign investors. Although the oblast surrounds the capital, it generally does not have prices, rent or production costs as high as those found in the city itself, yet is nearby enough to benefit from the capital’s economic vitality, infrastructure and large market. In both Moscow City and Moscow Oblast, companies generally do not face the liquidity problems endemic in other Russian regions.
St. Petersburg and Northwest Russia:
St. Petersburg is Russia’s second largest city and the fourth largest in Europe, with a population of five million. The surrounding Leningrad Oblast adds another 1.8 million. St. Petersburg is a major financial, commercial, and industrial center, and a key educational and research hub. Its factories produce everything from heavy machinery and electronics to consumer goods, and its ports and rail links comprise a major transportation center, tying Russia to Scandinavia and the rest of Europe. Combined, St. Petersburg and Leningrad Oblast form a substantial market for consumer and industrial goods.
During the last three years, Northwest Russia has attracted more foreign investment than any other area of Russia save for Moscow, and has distinguished itself by the progressive outlook of its political and economic leaders. Novgorod Oblast was the first region in NW Russia to adopt a foreign investment law, providing up to 100 percent local tax holidays for incoming investors. In 1997, it won the American Chamber of Commerce in Russia’s “Region of the Year Award.” Leningrad Oblast has the highest per capita investment in the country, and the U.S. ranks as the largest investor in both St. Petersburg and Leningrad Oblast. Currently, over 200 U.S. companies are operating in Northwest Russia.
In 1996, St. Petersburg raised $300 million through a Eurobond program. Despite the crisis, the city has been able to make interest payments on the bonds (although a new issue planned for 1999 has been postponed). Leningrad Oblast, which obtained syndicated bank financing, has not defaulted on its loans, although it has been delinquent in making payments.
With their proximity to European cargo routes, St. Petersburg and Leningrad Oblast are a natural transportation hub. The Port of St. Petersburg is Russia's largest commercial seaport by volume, and handles over a third of Russia's imports. Although the economic crisis only resulted in a slight 3 percent decline in traffic at the port in 1998, this figure was nearly 10 percent below the expected turnover for the year. Commercial seaports are also located in Murmansk, Kaliningrad, and Arkhangelsk, and several cargo port projects are being developed in Leningrad Oblast. Presently, Russian ports are generally not sufficiently equipped to provide modern services, and commercial opportunities exist for U.S. firms in modernizing port handling facilities, developing modern freight forwarding systems and constructing cargo-processing terminals in the ports.
St. Petersburg is also enjoying significant growth in other transport facilities. Capacity at Pulkovo-2 is being taxed with increasing passenger traffic, and a feasibility study estimates that the number of passengers will increase from 1.45 million in 1998 to 3.66 million by 2008. In response, the EBRD has approved a loan for construction of Pulkovo-3, a new international passenger terminal. The Pulkovo-3 program envisions airport, runway, and infrastructure development, and longer-term development of the surrounding area, including the construction of a hotel, business-centers, warehousing, and other related projects. A new cargo airport in Vyborg on the Russian-Finnish border is also under consideration. The St. Petersburg area also has an extensive rail network connecting it to Western Europe, Moscow, and other Russian regions.
According to UNESCO, St. Petersburg is the only Russian city ranked among the world’s top 10 cities in "tourism appeal." Despite a still underdeveloped tourism infrastructure, over two million foreign tourists will visit St. Petersburg in 1999 (down slightly from 1998 due to the economic crisis and the Kosovo conflict). Tourism is expected to grow 6-9 percent annually over the next five years, creating a burden on the city's hotels, which are booked during the summer. Moreover, St. Petersburg has few mid-range hotels, and is in need of international-standard 3-star hotels. The city is seeking to cultivate joint ventures with foreign investors and hotel chains and to conclude management contracts with international chains that can invest in hotel renovation.
Outside of the St. Petersburg-Leningrad Oblast metropolitan area, Northwest Russia offers many commercial opportunities. As in the rest of Russia, the weaker ruble has stimulated domestic production in the northwest. Small investments can bring substantial returns and help build a base in Russia, since these areas have a number of underutilized enterprises with good equipment and an educated workforce. Murmansk Oblast, above the Arctic Circle, has abundant mineral, oil and gas deposits, as well as established mining, metallurgy, and fishing industries. Neighboring Arkhangelsk’s largest investment is Conoco’s Polar Lights project, providing a market for petroleum processing products and services. Pskov, which links St. Petersburg and Northwest Russia with Kiev and Southern Russia, offers opportunities in agriculture, food processing, and tourism. Karelia’s main sectors are logging, wood processing, and pulp and paper, as 85 percent of the territory is covered by state forest stock. Vologda also holds opportunities in forest products as well as chemicals.
The market in Northwest Russia is generally receptive to U.S.- manufactured goods. However, U.S. new-to-market exporters should note that a number of European firms, primarily from Scandinavia and Germany, have already established their distribution networks in Northwest Russia and pose significant competition in many industries. In most cases, the primary competitive factors to be considered are pricing/financing, terms of delivery, adaptability of the product, and a well-established representation or distributor network.
Central Russia’s Urals and Western Siberia territories cover an area larger than the United States east of the Mississippi, and are home to over 40 million people. They are some of Russia’s most resource-rich regions, with minerals, fossil fuels and vast forests. During the Soviet period, the Urals region was a leading center of heavy industry (metallurgy and machine building), as well as defense and aerospace plants. Today, those industries remain concentrated in Chelyabinsk, Perm and Sverdlovsk Oblasts. In Western Siberia, Tyumen Oblast is known for its prolific gas and oil reserves.
In addition to fossil fuels and heavy industry, the telecommunications and food processing industries offer opportunities for American firms. The telecom infrastructure around urban centers has developed rapidly over the past four years. Local landline services are concentrating on data communications and digital switching upgrades. Cellular Tel services are now available in most of the region's major cities. Food processing also has been expanding, particularly since last year's ruble devaluation has priced most imported foodstuffs out of this market. The region is home to over 6,000 food processing firms, many of which seek imported processing and packing production lines to meet the increasing demand for high quality, competitively priced foodstuffs.
Russia's nationwide financial crisis has affected the Urals and Western Siberia in much the same way as other parts of the country. Low world oil prices into early 1999 and U.S. antidumping action against Russian steel exacerbated economic difficulties in this region. At the same time, its marketable natural resources and industrial capacity with export potential promise that it should be one of the first areas of the country after Moscow to recover economically.
Sverdlovsk Oblast (4.6 million residents) is one of Russia’s most urbanized areas. Its capital, Yekaterinburg (1.6 million inhabitants), is Russia’s third or fourth largest city. Sverdlovsk Oblast has the largest GDP of any oblast in the Urals, producing 5 percent of Russia’s industrial output and ranking second only to Moscow Oblast in that category. Ferrous metallurgy and machine building form a large chunk of Sverdlovsk’s economy, much of it defense-related. Services have grown to 40 percent of regional GDP. Yekaterinburg is a major road and rail transport hubs, with regular air service to several European cities. Its banking infrastructure is the best in the Urals, with 31 banks and 17 branches of commercial banks from other regions. In 1997, Sverdlovsk became the fourth oblast in Russia to receive an international credit rating. Sverdlovsk Oblast leads the Urals in attracting investment, and several large U.S. firms have substantial investments here. The oblast’s top exports are steel, copper, chemicals, aluminum, titanium and radioisotopes. According to oblast statistics, 1998 trade was valued at $2.9 billion, of which trade with the United States totaled $400 million. Non-ferrous metallurgy remains a growth sector, and the world’s second-largest titanium producer (VSMPO, a supplier to Boeing and other multinational firms) is found here.
Perm Oblast Heavy industry, primarily metallurgy and machine building are still a large sector of the economy of Perm Oblast (3.1 million residents). Much of this industry is defense-related, and production of aircraft engines, Proton rockets and space control systems continues. Perm produces 30 percent of Russia’s paper and 98 percent of its potassium-based fertilizers. The oblast is also a regional center for electricity generation. The oblast capital, the city of Perm (population 1.2 million) is a major river port (on the Kama, with access to the Volga), has two airports and is situated on the Trans-Siberian railway. In 1998, Perm's foreign trade was valued at $1.5 billion, including $87 million with the U.S. The oblast’s 1998 imports were valued at $300 million. Perm's top exports are refined oil and petrochemical products, fertilizers and metals. Perm has over 100 known deposits of oil and gas and two oil refineries. Annual extraction exceeds 9 million metric tons of oil and 500 million cubic meters of gas. Fifty percent of Russia’s magnesium, 98 percent of its potassium and most of its titanium ore come from Perm.
Chelyabinsk Oblast (population 3.6 million) ranks fifth in Russia in industrial output. Oblast officials estimate 1998 foreign trade turnover at $2.3 billion, including $350 million with the United States. Ferrous metallurgy and machine building play a key role in the oblast’s economy. Metals account for 85 percent of the oblast’s exports and over 40 percent of total output. The oblast is rich in iron ore, copper, bauxite and gold. It is situated along the Trans-Siberian railway. Over 70 percent of its exports of ferrous metals come from the giant Magnitogorsk Metallurgical Works.
Tyumen Oblast (population 3 million) is Russia’s third largest oblast in terms of territory, and includes two autonomous districts, Khanty-Mansiysk and Yamalo-Nenets. Tyumen is rich in oil and gas: its combined output of both exceeds 7 percent of Russia’s GDP (including over 90 percent of Russia’s natural gas and 60 percent of its oil). GAZPROM dominates the gas industry in Yamalo-Nenets, while LUKOIL, YUKOS, Sibneft and Tyumen Oil Company are the oil leaders in Khanty-Mansiysk. Southern Tyumen Oblast is predominantly agricultural. Several U.S. and European firms have established joint ventures in the region for production and sale of crude oil. Tyumen is an important electric power producer, accounting for 7 percent of Russia’s electricity. It also produces a third of Russia’s automobile batteries. The oblast has drawn up plans for revitalization of the Tobolsk petrochemical plant and creation of a new oil-producing center in the Uvatskiy area.
The Russian Far East:
Separated from the world market for most of its history, the Russian Far East (RFE) is only today becoming a full participant in international trade. This presents both unique opportunities and challenges for U.S. exporters. The RFE market has four time zones, 6.2 million square kilometers (two-thirds the size of the continental U.S.), a population of 8 million, and ten cities with over 100,000 people.
The 1998 devaluation of the ruble has been the key recent economic event in the rapidly changing resource-based economy of the Russian Far East. The markedly weakened ruble has made many Russian Far East (RFE) industries newly competitive in world markets. Though the decline of the ruble has been bad news for many U.S. exporters (particularly food exporters), it has created new opportunities for U.S. equipment exporters as Russian factory managers try to retool aging facilities in order to step up production. Though the regional economy is still very depressed, pockets of recovery are visible in the wood processing, food processing, and fishing sectors.
U.S. companies face considerable obstacles to business in the Russian Far East, as elsewhere in Russia. Obstacles unique to the RFE include remoteness and isolation from the rest of Russia; lack of frequent, reliable flights and transport; comparative lack of sophistication and international experience of many RFE business and government leaders; inadequacy and continued deterioration of infrastructure, including transport, heat, telecommunications, water, electricity, medical services, and housing; and regional travel restrictions, often holdovers from the Soviet period.
After four years of growth, U.S. exports to the region declined in 1998, as U.S. food sales (mainly chicken and meat) fell in favor of local Russian production. However, we have witnessed more requests from suddenly competitive local Russian manufacturers for industrial equipment.
Exports to the Russian Far East (millions USD)
1994 1995 1996 1997 1998
U.S. Exports 227 372 425 470 270
World Exports 650 1748 1683 2100 1500
The number of U.S. firms active in the market is climbing:
Region #Firms 1997 1998 1999
Primorsky 30 36 45
Sakhalin 25 26 34
Khabarovsk 30 27 35
Magadan 5? 13 14
Kamchatka 5? 12 10
Amurskaya ? 5 3
Yakutsk ? 4 1
Total 95 123 142
While difficult to estimate precisely, existing and potential U.S. investment in the region is substantial.
U.S. investment in the RFE (millions USD)
Sector Existing L/T Potential
Oil and gas 500 35,000
Mining 10 270
Ports 5 220
Fishing 4 100
Forestry 44 10
Environmental 25 15
Food processing 40 15
Retail 3 0
Real estate 2 0
Total 633 35,630
As shown by the table above, though U.S. activity in other extractive sectors is substantial, the chief U.S. business interests in the RFE are the Sakhalin offshore oil and gas projects (which could bring $35 billion in investment over the coming decades -- six times the sum of cumulative U.S. investment in Russia to date).