Internationalization and Economic Policy Reforms in Transition Countries

Internationalization and Economic Policy Reforms in Transition Countries

Edward M. Graham ´ Nina Oding Paul J. J. Welfens (Editors)

Internationalization and Economic Policy Reforms in Transition Countries With 77 Figures and 28 Tables

12

Dr. Edward Graham Institute for International Economics 1750 Massachusetts Avenue NW Washington, DC 20036-1903 USA [email protected] Dr. Nina Oding The Leontief Centre for Social and Economic Research 16, Voznesensky Prospect 190000 St. Petersburg Russia [email protected]

Professor Dr. Paul J. J. Welfens University of Wuppertal EIIW ± European Institute for International Economic Relations Rainer-Gruenter-Straûe 21 42119 Wuppertal Germany [email protected] www.euroeiiw.de www.econ.international.net

Research for, and production of, this publication have been generously funded by the Alfried Krupp von Bohlen und Halbach-Stiftung.

ISBN-10 3-540-24040-3 Springer Berlin Heidelberg New York ISBN-13 978-3-540-24040-2 Springer Berlin Heidelberg New York Cataloging-in-Publication Data Library of Congress Control Number: 2005930334 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer-Verlag. Violations are liable for prosecution under the German Copyright Law. Springer is a part of Springer Science+Business Media springeronline.com ° Springer Berlin ´ Heidelberg 2005 Printed in Germany The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Hardcover-Design: Erich Kirchner, Heidelberg SPIN 11371663

43/3153-5 4 3 2 1 0 ± Printed on acid-free paper

Table of Contents Introduction Edward M, Graham, Nina Oding and Paul J J, Welfens A. Structural Change, Natural Resources Sector Expansion and Growth in Russia

1

5

Paul J J, Welfens andAlbrecht Kaujfmann 1. Introduction 2. The Topic of Dutch Disease: A Theoretical Approach 2.1 The Model of Corden and Neary 2.2 Selected Complementary Issues

6 10 12 17

3. Structural and Long-term Perspective of the Oil and Gas Sector

19

4. Policy Implications

31

Appendix

34

References

44

Comment on: Structural Change, Natural Resource Sector Expansion and Growth in Russia Andrey P, Zaostrovtsev B. Monetary and Financial Stability as a Basis for Russia's Sustained Economic Internationalization

46

51

Jose Fajgenbaum 1. Introduction

52

2. Elements and Conditions for Monetary and Financial Stability 2.1 Monetary and Exchange Rate Policy 2.2 Fiscal Policy 2.3 Financial Sector 3. Conclusion

52 52 54 57 59

Comment on: Monetary and Financial Stability as a Basis for Russia's Sustained Economic Internationalization Christof Ruehl

61

VI

Table of Contents

C, Core Inflation in Russia - Different Approaches for the Period from January 1997 to April 2003 67 Cathleen Faber and Hans Gerhard Stroke 1. Basic Framework

68

2. Criteria for Selecting a Measure of Core Inflation

69

3. Different Approaches to Measure Core Inflation 3.1 Statistical Approaches

70 70

3.2 Econometric Approaches

73

4. Empirical Approaches for Russian Core Inflation

75

5. The Official Russian Measure of Core Inflation

83

6. Conclusions

84

References

86

Comment on: Core Inflation in Russia - Different Approaches for the Period from January 1997 to April 2003 Irina Eliseeva D. Russia's Banking System, the Central Bank and the Exchange Rate Regime

87

89

RalfWiegert 1. Introduction

90

2. Original Sin and Beyond: Sources for Banking System Instability. 92 3. The Unofficial Peg of the Ruble 4. The Central Bank, Competition in the Banking System and AUocative Efficiency

98 105

5. Conclusions and Policy Options

117

References

119

Table of Contents E. Russia and International Economic Structures

VII 121

Ruslan Grinberg 1. Introduction

122

2. Russia and International Economic Organizations 2.1 Russia and the International Monetary Fund 2.2 Russia and the World Bank of Reconstruction and Development 2.3 Russia and the World Trade Organization 2.4 Russia and the Organization for Economic Co-operation and Development

122 122

135

3. Russia and Regional Integration Blocs 3.1 Russia and the European Union 3.2 Russia and the Group of 8 3.3 Russia and Asia-Pacific Economic Cooperation 3.4 Russia in the Commonwealth of Independent States

140 140 144 147 149

References

159

Comment on: Russia and International Economic Structures PaulJJ, Welfens F.l An Increase of Energy Efficiency as a Major Tool for Achieving Energy Security Petra Opitz

127 131

161

165

1. Introduction

166

2. Increasing Energy Efficiency - a Major Challenge and Opportunity for Russia

166

3. Existing Barriers to Develop the Potential

168

F.2 European Energy Security: Opportunities and Problems for Cooperation EU-Russia

175

Peter Palinkas 1. Introduction

176

2. European Energy Sector

176

VIII

Table of Contents

3. The EU-Russia Energy Partnership 3.1 General Remarks 3.2 Why such a Partnership? 3.3 Objectives of the Partnership

177 177 177 178

4. Progress and Recent Developments in the EU-Russia Energy Partnership ; 4.1 EU Internal Gas and Electricity Market 4.2 Energy Infrastructure Projects of "Common Interest" 4.3 Gas Supplies and Long Term Contracts 4.4 The Legal Framework 4.5 Trade in Nuclear Materials 4.6 Electricity 4.7 Pilot Projects 4.8 Oil and Gas Security 4.9 Clean Coal 4.10 Energy Technology Center 4.11 Cooperation on Implementing the Kyoto Protocol

179 179 179 179 180 180 181 181 182 182 183 183

5. Summary

184

G. Diversification of the Russian Economy and Growth

187

Evgeny Gavrilenkov 1. Growth Mechanism is Changing

188

2. He is Able who Thinks he is Able

191

3. To Change and to Change for the Better are two Different Things

197

4. Vivat, Crescat, Floreat!

202

5. Three Ways of Restructuring 6. Does the Central Bank's Monetary Policy Stimulate Restructuring?

205 209

7. Government Aims at Diversification

211

8. Banking Sector Restructuring and Growth

213

References

217

Table of Contents

IX

H. Internationalization of Russian Regions: The Role of MNCs and Outsourcing with Respect to Domestic and Foreign SMEs.. 219 Nina Oding 1. Introduction

220

2. Role of FDI in the Globalizing World

221

3. Internationalization of Russia

226

4. Differentiations and Internationalization of Russian Regions

231

5. Competitive Advantages in Northwest Russia

235

6. Outsourcing: Opportunities and Challenges

240

Appendix

244

References

245

Comment on: InternationaUzation of Russian Regions: The Role of MNCs and Outsourcing with Respect to Domestic and Foreign SMEs 247 Christopher Schumann I. Do Export Processing Zones Attract FDI and its Benefits? Experience from China and Lessons for Russia

251

Edward M, Graham 1. Introduction

252

2. Some Background: the SEZs and the Opening of China to Foreign Investment during the 1980s

253

3. The 1991 Reforms and their Aftermath

258

4. The Period of the SEZs Re-examined

262

5. Implications of the Chinese Experience for Russia

266

References

271

Comment on: Do Export Processing Zones Attract FDI and its Benefits? Experience from China and Lessons for Russia Thomas Gries

273

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Table of Contents

J. The Baltic Sea Regional Integration and International Trade: A Gravity Model Approach Tiiu Paas

277

1. Introduction

278

2. Theoretical Foundations for Using Gravity Models in Studying International Trade Flows

279

3. Specifications of Gravity Equations for Exploring Regional Integration in Trade 3.1. Gravity Equation and Data 3.2. Exploring Deviations from the Traditional Gravitational Forces Explaining Bilateral Trade Flows of the Countries

281 281 282

4. Modeling International Trade Flows in the Context of EU Eastward Enlargement 4.1. The Specifications of the Gravity Equations 4.2. The Estimation Results of the Model 1 and Model 2 4.3. Behavior Differences between the Trade Flows of EU15 and CC12

287

5. Trade Integration in the Baltic Sea Region (BSR) 5.1. Modeling Bilateral Trade Flows of the BSR Countries 5.2. The BSR Role in the Baltic States' Trade Relations

289 289 290

6. Conclusions

292

Appendix

295

References

298

Comment on: The Baltic Sea Regional Integration and International Trade: A Gravity Model Approach Natalja von Westernhagen

285 285 286

301

Table of Contents

XI

K. Russia's Foreign Economic Relations and Regional Integration in CIS Countries: Theory, Problems and Options 305 Olga Nosova 1. Introduction

306

2. Russia's Foreign Economic Relations: Policy Performance and Development Perspectives

307

3. Political and Economic Issues of CIS Development

315

4. Regional Economic Integration in CIS: Problems and Development Prospects

320

5. Policy Conclusions

322

Appendix

324

References

326

Comment on: Russia's Foreign Economic Relations and Regional Integration in CIS Countries: Theory, Problems and Options.... 328 Grigori Feiguine 1. Conceptual Foundations of Empirical Studies

328

2. The Problem of Comparative Empirical Analysis and Benchmarking

329

3. Questionability of Certain Assertions

330

4. One-Sided Nature of Conclusions

330

List of Figures

333

List of Tables

339

List of Contributors

341

Introduction Edward M. Graham, Nina Oding and Paul J.J. Welfens Eastern Europe and the former Soviet Union have achieved sustained economic growth in first half of the new decade in the 2V^ century. EU accession countries which have joined the EU have benefited mainly from high capital inflows, a reduced risk premium - with shadow effects of this already occurring in the years before explicit membership - and growing trade. While system transformation has undermined trade between Eastern Europe and Russia for several years there are medium prospects for growing trade in the whole of Europe. Russia's case, however, is different from the EU accession countries as a major driving force of economic dynamics is the oil and gas sector which has considerable backward and forward linkages. At the same time this sector apparently is politically quite sensitive. The Transatlantic Transformation and Economic Development Research Group has organized several workshops within a major international research project. The project is devoted to analyzing the internationalization of the Russian economy and the associated changes in major policy fields. This book contains the revised analytical papers from the St. Petersburg conference in 2003 when the city celebrated its 300 year anniversary. We are very grateful to the Leontief Center for excellent organization of the conference. The paper by Paul J.J. Welfens and Albrecht Kauffmann looks at the role of structural change, natural resources expansion and growth in Russia. The analytical framework partly is within the framework of Dutch Disease models and suggests that Russia might face long term problems with sustained growth. However, the authors also point out that an extended period of high oil prices combined with technological progress in the natural resources sector should allow Russia to enjoy a growing role in international oil and gas markets in the long run. Many transition countries and Newly Industrializing Countries have opened up to the world economy, however, in some cases there has been no sustained internationalization; a failure associated partly with internal or internal shocks or with policy failure. Jose Fajgenbaum's contribution puts the focus on monetary and financial stability as a basis for Russia's Sustained Internationalization. He shows that monetary policy and exchange rate policy have to be considered as interdependent elements and that a cautious fiscal policy is important for long term stability. Moreover, financial sector modernization is crucial.

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Edward M. Graham, Nina Oding and Paul J.J. Welfens

Cathleen Faber and Hans Gerhard Strohe discuss critical problems of inflation dynamics and inflation measurement in transition countries and Russia, respectively. The authors point out a broad array of statistical issues as well as the merits of statistical approaches and econometric analysis. There are considerable differences between official inflation rates and core inflation in Russia. Ralf Wiegert's contribution is on Russia's banking system, the role of the central bank and the exchange rate regime. His analysis starting point is original sin problem - as dubbed by McKINNON - in transition countries/NICs. The approach presented shows that despite all talks about more exchange rate flexibility there is considerable exchange rate pegging in Russia. This strategy might lead to distortions in the allocation process which in turn are relevant for long term economic growth. Ruslan Grinberg's looks into the links between Russia and various international economic organizations where a long list of institutions is discussed, including the IMF, the EBRD, the WTO, the OECD, the EU, the G-8, the APEC and CIS. It is fairly clear that for Russia - as a former superpower - policy initiatives related to international organizations is a relatively new and difficult field. Efficient, effective and consistent policy games organized through the intermediation of international organizations certainly can be an attractive poUcy avenue in the 21st century when bilateralism seems to have become a less preferred policy approach (disregarding the US). Among the critical fields linking Western Europe and Russia in economic and security terms energy policy is crucial. The EU is characterized by a rising long term demand for primary energy while Russia is a traditional exporter of energy - and will raise energy exports in the medium term as higher energy efficiency of Russian industry and technological progress in the energy sector stimulate the Russian export potential. The contributions by Petra Opitz and Peter Palinkas take a closer look at the related issues and policy opportunities. Evgeny Gavrilenkov presents his view on the challenges of diversification of the Russian economy and the links to economic growth. His paper shows that changes in the Russian economic system and shifts in sectoral compositions not necessarily imply sustained growth and improved economic welfare. He questions whether the monetary policy of the Russian Central Bank is adequately supporting economic growth. Moreover, the analysis shows that efficient diversification cannot be achieved without swift restructuring of industry and the banking sector, respectively. The contribution by Nina Oding looks at the internationalization of Russian regions and the role of multinational companies and SMEs, respectively. Putting a particular focus on the Northwest in Russia it seems that not only labor intensive sectors stand to benefit from rising foreign direct

Introduction investment, but technology intensive sectors, too. Information and communication capital could become a dynamic sector in the Northwest, and global leaders of the industry could be attracted by the considerable locational advantages which include rich endowment with human capital. Edward Graham's contribution is on export processing zones as a strategic element to attract FDI where the author draws key conclusions from the experiences of China. His main conclusion is that special economic zones as established in China during the 1980s (these zones were meant to be more than export processing zones but export processing by foreign enterprises proved to be the main activity) were effective in drawing FDI. In addition, their success in this regard helped to propel economic reforms in China that were implemented during the 1990s. Two factors in the success of these zones were (1) there were a number of them and they operated independently from each other, such that each zone competed with others to draw foreign investment; this helped to reduce corruption and also created incentives for each zone to implement measures that were effective in attracting FDI; and (2) there was a strong willingness of the Chinese political leadership to allow these zones to act as experiments in economic reform. Graham warns that the political circumstances allowing the zones to succeed might not be replicated in many other nations. Tiiu Paas presents a new gravity model on regional integration and international trade. The paper looks at standard approaches, but also takes into account major aspects of EU Eastern enlargement. Gravity modelling has been useful for many regions of the world economy, and there is no doubt that such analysis is of key interest from a European perspective. As infrastructure modernization in Europe has accelerated in the 1990s one might assume that the distance variable could become less influential in the long run. The contribution by Olga Nosova puts the focus on foreign economic relations and regional integration in CIS countries. It is argued that Russia has a strategic interest in nurturing trade expansion and capital flows in the CIS. At the same time it becomes clear that many economic policy fields are influenced or distorted by other policy considerations. Given the fact that the process of transformation and economic opening up in CIS countries has yet to be completed there should be considerable potential for growing trade and investment. Critical comments by Audrey Zaostrovtsev, Christof Ruehl, Irina Eliseeva, Paul J.J. Welfens, Christopher Schumann, Thomas Gries, Natalja von Westemhagen and Gregori Feiguine are very much appreciated. We hope that this book will contribute to a better understanding of Russia and of Eastern European integration dynamics as well as the changing dynamics of trade, foreign direct investment and growth in the world economy. This book is part of an ongoing international EIIW research

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Edward M. Graham, Nina Oding and Paul J.J. Welfens

project generously supported by the Alfried Krupp von Bohlen und Halbach-Foundation. The European Institute for International Economic Relations has relocated its headquarter to Wuppertal University as of July 2003, but there is continued research of EIIW at both Potsdam and Wuppertal - for more information visit the websites www.euroeiiw.de and www.progressinfo.net. EIIW also has contributed to creating a new EUASEAN research network within the context of a Jean Monnet project (www.eu-asean-jean-monnet.net) We are very grateful for editorial assistance to Albrecht Kauffmann and Matthias Pintsch (both EIIW Center in Potsdam), Ekaterina Markova and Christopher Schumann (both EIIW in Wuppertal) and Michael Agner; the latter particularly has supported the editorial work in an excellent way which is strongly appreciated here. Washington DC, St. Petersburg and Wuppertal, May 2005 Edward Graham^ Nina Oding and Paul J J, Welfens

A. Structural Change, Natural Resources Sector Expansion and Growth in Russia Paul JJ. Welfens and Albrecht Kauffmann 1. Introduction 2. The Topic of Dutch Disease: A Theoretical Approach

6 10

2.1 The Model of Corden and Neary

12

2.2 Selected Complementary Issues

17

3. Structural and Long-term Perspective of the Oil and Gas Sector

19

4. Policy Implications

31

Appendix

34

References

44

Comment on: Structural Change, Natural Resource Sector Expansion and Growth in Russia Audrey P. Zaostrovtsev

Paul JJ. Welfens and Albrecht Kauffmann

1. Introduction Russia has achieved sustained growth under President Putin, who restored political stability and pushed for broader economic reforms, including remarkably radical reductions in tax rates; a flat income tax rate is expected to stimulate investment and growth, respectively. Given economic experiences from OECD countries - or taking into account basic theory - the growth rate of employment is positively correlated with changes in investment output ratio. However, how much additional employment is generated by a rise in investment output ratio depends on labor market dynamics and the structure of the economy. The Soviet Union was a major producer of oil and gas and so is the new Russia. Oil production decreased in the early 1990s but started to increase again at the end of the decade, and the Putin government has laid out ambitious plans for raising oil and gas production by 2020. Russia wants to raise production and exports. The speed of expansion in the oil and gas sector will mainly depend on the world market price of oil, which also sets the benchmark for gas. Among the many sectors of the economy, the oil and gas sector is relatively open in the sense that trade and transit play important roles. In the beginning of the 21'' century, it also seems that rising foreign direct investment inflows (FDI) have become crucial. Many distortions in Russia's political and economic system can be observed - some of them reducing FDI inflows - simultaneously with long-term opportunities for growth in output (VON WESTERNHAGEN, 2003; WIEGERT, 2003). A major puzzle of the transformation process in Russia has been some strange privatisation schemes in both the energy sector and the natural resources sector. The Russian oil and gas sector is capital intensive and thus requires high investment if expansion is desired. There are few doubts that large profitable Russian companies - sometimes in a joint venture with major Western oil companies - will finance considerable investment in the Russian oil sector. The same holds true for the gas sector, which is clearly dominated by Gazprom. This giant, diversified company is expected to reinforce its business with the (enlarged) EU but also seeks new business with China and Japan. Exploration and production of oil and gas is a capital intensive risky business requiring special expertise and a long-term investment horizon. Russian companies are obviously successful in their business (and certainly much better than Japanese companies which have a modest record in the oil and gas sector), and there are favourable prospects for both national energy firms and joint ventures. World energy demand will continue to rise, and in particular there are favourable prospects for the oil sector since oil can hardly be substituted in transportation in the medium term. Trans-

A. Structural Change, Natural Resources Sector Expansion and Growth

7

portation is growing worldwide, and this will stimulate oil business worldwide. At the same time, it is true that major oil producers are politically unstable countries, and with 2/3 of global oil reserves being in Arab countries, oil will continue to be a politically sensitive source. The global demand for gas is also increasing as is the phasing out of nuclear energy, and the global warming problems associated with burning of coal create a global rise in the demand for natural gas. Relatively high oil prices (around 30 $) - with marginal costs in Arab countries being close to 2 $ - create incentives for worldwide investment in the oil and gas sector. High gas prices in the US in the 1990s, when gas prices more than doubled, also have stimulated substitution from gas to other fuels in the US. Any long-term rise of the gas price will stimulate an international reallocation in production of energy intensive chemicals. Russia might try to stimulate growth of the chemicals sector by expansion of the gas sector plus rising gas imports. The deregulation of electricity and energy markets in OECD countries in the 1990s has stimulated the demand for gas, which is the basis for efficient combined heat and power generation. Taking a look at the basics of energy markets and the deregulated UK electricity market in particular (WELFENSA'ARROW, 1996), it is obvious that gas is a very competitive input in power generation. With energy deregulation in EU countries being phased in the first decade of the 21'^ century, one may thus anticipate a structural increase in the growth of gas in Western Europe. Taking into account the competitive pressure of the EU single market, it is clear that competitive advantages of gas for electricity production will remain crucial. Modernization of the energy sector in the rapidly growing EU accession countries should also reinforce the role of gas where some countries are actively seeking geographical diversification of gas sources. With Algeria, Norway, the UK, the Netherlands, Russia and Azerbaijan and Turkmenistan being major producers, there are, however, not many options for regional diversification. A major problem with respect to both oil and gas is the construction of safe pipelines that bring the natural resources to those countries and places where they are needed. Modem pipelines can effectively be controlled by electronic devices, but their routing is a politically sensitive issue. On the one hand, there are potential terror risks - strongly perceived after the terror attack of September 11 2001. While the risks associated with terrorism are relatively modest with respect to gas pipelines, it is a serious problem for transportation of liquid natural gas (LNG) which is economically profitable only over long distances; yet fear of terrorism will impair the LNG business. A particular topic in the energy sector is vertical integration which in the case of downstream investment could help stabilize the demand faced by the respective producer. From an OECD perspective, gas is

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Paul J.J. Welfens and Albrecht Kauffmann

less of a politically sensitive energy source than oil as Arab countries represent only about 1/3 of reserves. The EU is interested in establishing an energy partnership with Russia. Yet the European Energy Charter has not become a dynamic framework for energy cooperation between the EU and Russia. EU eastern enlargement might reinforce the interests of both Russia and the EU to reinvigorate the energy dialogue. At the same time US political pressure on Arab countries and the rise in Iraq's oil production - after the fall of the Hussein regime in 2003 - could contribute to a gradual rise of global oil supply. This could weaken the EU's interest in a strong long-term energy partnership with Russia. While political shocks and shifts are difficult to anticipate, it is nevertheless clear that there is some strategic interest of EU-25 in Russia as a stable source of primary energy sources. This, however, is different in the field of electricity trade, where West European firms seem to be relatively protectionist, and they are certainly well tied to their respective political system. Regarding investment in the natural resources sector and the energy business respectively, one may argue that such investment can stimulate long-term growth through three channels: • High investment in natural resources and the energy sector raise the overall investment-GDP ratio and thus should contribute to aggregate growth. • Rising employment in the natural resources sector and the energy sector can help reduce unemployment. A caveat is that the natural resources sector should not dominate wage bargaining because this indeed could raise the overall wage pressure and might result in higher unemployment than otherwise. • High profits in the natural resources sector and the energy sector contribute to tax revenues. These could be a source to finance diversification away from oil and gas. Much depends here on government education policy and innovation policy. At the same time there could be mechanisms that make a relatively large energy sector more of a burden than a blessing. Among the main issues relevant with respect to this one can mention that a large natural resources sector creates several problems: • It will contribute, assuming that the sector is highly concentrated, to a serious corruption at all layers of government. A counter argument is that resource abundant countries can afford to pay high salaries in the public sector that should reduce the risk of corruption. • High income growth in the natural resources sector, transitorily accompanied by a general increase in economic growth, could undermine the

A. Structural Change, Natural Resources Sector Expansion and Growth

•

•

•

•

•

9

incentives to both investment in human capital formation and the education system (GYLFASON, 2002). This will seriously undermine long term growth. As exploitation of natural resources goes along with rents accruing for those with favourable low-cost locations, the natural resources sector tends to be very profitable and thus to be a major source of tax revenues in many resource-rich countries; thus politicians are likely to favour the natural resources sector which brings certain profits compared to more risky returns in dynamic technology-oriented sectors of manufacturing industry; An expansion of the natural resources sector can go along with a longterm real appreciation of the currency as a consequence of high export surpluses. Such an appreciation will undermine the expansion of the manufacturing industry - a standard argument in the literature. As natural resources are located in specific regions, an expansion of the natural resources sector will create problems for fiscal federalism in the sense that interregional political redistribution is likely to be an important and conflict-prone issue. This in turn could prevent over centralization of economic policy that could indeed indirectly stimulate economic growth. As major oil and gas producing countries often have governments favouring, for political reasons, relatively low energy prices in the domestic market. There is also a structural incentive for the expansion of energy-intensive industries. These industries are, however, rarely technology intensive industries, and this could turn out to be a major disadvantage with respect to technological catching-up. Moreover, low domestic energy prices create a political arena for interference into the economy and this could lead to a structural interference of politicians in the economy, thus undermining overall growth. Finally, government might favour a strategy where part of the exploitation of natural resource sites is done by government owned companies which will invite all kind of inefficiencies in the natural resource sector. This directly undermines long-term growth.

The experience of major oil producers with expansion of the energy sector is not very encouraging; e.g. Saudi-Arabia has failed to develop a diversified industrial sector except for some production of chemicals. Venezuela has faced recurrent political turmoil which was partly related to conflicts over reducing the difference between world market prices and low domestic oil and gasoline prices. Kuwait has also not been successful in diversification of the economy. Only the UK and the Netherlands have become thriving producers and exporters of energy over a transitory period of two decades; the production of oil and gas seems to gradually be falling

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Paul J.J. Welfens and Albrecht Kauffmann

in the first decade of the 2V' century. Other successful examples with a more long-term history as natural resources exporters are Canada, Australia and Norway where the latter has been known in the 1990s for facing the nice problem of how to deal with budget surpluses related to high tax revenues from the oil and gas business. There is empirical evidence that countries with a large natural resources sector are underperformers in economic growth (SACHSAVARNER, 1995, 1999, 2001, see also STUNS 2001, 2003). In the following analysis we will take a brief look at some key issues of the so-called Dutch disease, the particular phenomenon that a rising share of value-added in the natural resources sector could undermine long-term growth. A priori it is unclear if Russia will face Dutch disease problems, and it also is an open question as to whether potential Dutch disease problems can be avoided with prudent economic policy. In section 2 we will take a look at basic theoretical issues of the Dutch disease, while section 3 puts the focus on some long-term aspects of the oil and gas business. Section 4 offers basic policy conclusions. We essentially believe that the expansion of the oil and gas sector is helpful for Russia's growth in the medium term, but there is the critical issue that the Russian master plan for the natural resources sector for 2020 does not discuss clear ways on how to also promote the manufacturing industry.

2. The Topic of Dutch Disease: A Theoretical Approach The question of whether a high share of primary commodities in output or exports, respectively, is a long-term economic advantage is an unresolved issue; natural resource abundance has certain benefits, but also creates some disadvantages. Two main areas of concentration are covered in comprehensive literature: The "general equilibrium effects of a minerals boom" and the "political economy of mineral rent generation and distribution" (STUNS, 2003). The standard analysis of the Dutch Disease belongs to the first of these approaches. The name to some extent refers to phenomena observed in the sequel of discoveries of gas in the North Sea and the Netherlands, respectively, when the share of people employed in manufacturing declined from 97.7 in 1971 to 76.3 percent in 1980 (HERBERG/ENDERS, 1984). Hence the expansion of the natural resources sector can go along with a relative decline of manufacturing industry - measured in terms of relative employment or value-added. Generally one can define the Dutch Disease phenomenon as a decline of manufacturing activities in connection with a country's export boom of commodities: with rising output and export of primary products (natural resources). We want to confine our investigation to natural resources like

A. Structural Change, Natural Resources Sector Expansion and Growth

11

fuel or metals. Taking into account the fact that high economic rents and profits, respectively, are associated with a natural resources boom, there are economic problems related to investment decisions, particularly the capacity to use natural resource profits for investment with a reasonable return (NORENG 1981, p. 23 f). High natural resource revenues and workers' income, respectively, can also create problems in the sense that discovery and exploitation of new natural resources sites brings a sudden rise in income which could translate into a rapid rise of consumption demand and imports of manufacturing goods, respectively. If the new sites contribute to a current account surplus, there will be the phenomenon of rising net claims vis-a-vis the rest of the world; hence, other countries have rising foreign debt and paradoxically a stagnation of domestic manufacturing industry which will face massive import competition. Profitable natural resources firms will bid high wages so that workers from the domestic manufacturing industry move to the natural resources sector. As the ratio of real wages to the real interest rate increases, a possible reaction of domestic manufacturing firms is to switch to more capital intensive production. If the country concerned is not a major producer of capital equipment itself, this will stimulate the import capital goods so that manufacturing in the rest of the world increases. To the extent that a more capital intensive production requires human capital as a complementary factor, there also can be the problem that the manufacturing industry in the resource boom country has problems with expansion due to a lack of human capital. Immigration will solve this bottleneck only to a limited degree in the short term. The response of the education system is typically slow. High rents from natural resources have, of course, some clear advantages. Profitable firms in natural resources can easily get loans for their investment projects as well as equity capital. From this perspective, the financing of oil and gas investment in Russia will not be a serious problem. More generally, functional global capital markets should indeed allow Russian firms to finance expansion of the natural resources sector as well as growth of manufacturing industry in the 2V' century relatively easily much easier than 100 years ago when financial bottlenecks were a main obstacle to developing infrastructure and manufacturing (GERSCHENKRON 1962, p. 131, 138). But "easy money" from oil and gas rents could also create problems and risks for the economy: A major boom in the natural resources sector and the energy sector can cause several problems: • overheating the economy and fuelling inflation, where a rise of nontradables could play a particular role; • real exchange rate appreciation which will undermine long-term growth of manufacturing exports and thus will contribute to a decline of manu-

12

Paul J.J. Welfens and Albrecht Kauffmann

facturing industry: Increasing imports of manufactured goods will crowd out domestically produced manufacturing goods; • government, facing higher tax revenues, could become more involved in the economy and create a structural bias as government consumption typically falls on nontradables, including services. The relative expansion of the nontradables sector implies a shrinking of the tradables sector: Taking natural resources plus manufacturing as a composite export good the implication of a natural resources export boom is clearly a structural shrinking of the manufacturing sector.

2.1 The Model of Corden and Neary Among the many models concerning the Dutch Disease problems, that of CORDON/NEARY (1982) is quite useful. In their basic model, they made the following assumptions for a small open economy experiencing a resource boom: • The economy covers three sectors: Two sectors (e.g. resources R and manufacturing M) produce tradable goods T at exogenous world market prices; the third sector - the service sector S - produces only for the domestic market at domestic prices equalizing the domestic supply and demand. • The economy produces with two factors; one of these (Capital K) is sector specific, the other (Labour L) is uniformly usable in all sectors. • All quantities of production factors are fully employed at the free floating wage rate w; there are no distortions in the conmiodity and service markets. • The source of the boom of the /?-sector is assumed as a Hicks-neutral technological progress (other sources of a resource boom will be later considered). • All goods are produced for final consumption. • Only relative prices, expressed in terms of the given price of the traded goods, are determined. • National output and expenditure are always equal. Trade is always balanced.

A. Structural Change, Natural Resources Sector Expansion and Growth

13

Source: Corden/Neary (1982), p. 828, Fig. Al. Effect of the Boom on the Labour Market CORDON/NEARY (1982) also analysed the cases of capital mobility between the M- and 5-sector and, finally, between all three sectors. For the young transition market economies, the basic model deserves particular attention. A central feature of their analysis of all three models is the distinction between two effects of the boom: The resource movement ejfecU and the spending effect^ that are pointed out in the following lines and pictures. Figure Al depicts the labour market: The wages on vertical axes are measured in terms of manufacturing goods, while the total amount of labour of the economy is represented by the horizontal axis 0^ 0^, In the preboom equilibrium the labour demand of the services sector meets the labour demand of the trades sector L^= L^ + L^ the labour demand of the services sector L^ in Point A. For the unique wage rate w^, the amount of labour employed in manufacturing amounts to 0^ M. Point A of fig. Al corresponds to the pre-boom-equilibrium of the commodity market, displayed as point a in fig. A2 and A3. This point lays on the pre-boom production possibility curve TS and meets the indifference curve /^, representing the highest utility of the combination of traded goods Yj, and services Y^. The slope of the touching graphs is the internal real exchange rate, measured as price of services in terms of tradeables.

14

Paul J.J. Welfens and Albrecht Kauffmann

Fig. A2. Resource Movement Effect of the Boom on the Commodity Market

Resource Movement Effect First let the real exchange rate be held constant. Due to the boom, the resource sector's labour demand increases proportional to the enlargement of technological progress, and the composite labour demand schedule shifts to L\. . The new equilibrium point is B at the wage rate Wj, causing labour to move from the services and the manufacturing sectors into the resource sector. The fall of employment from O^M to O^M' has the effect of direct deindustrialisaton. As a result of the extension of the resources production possibility, the production possibility schedule shifts out from TS to T'S. At a constant real exchange rate and thus unchanged slope of the tangent, the new production point would be point b, which lies to the left of point a in fig. A2. In order to separate the resource movement effect, we assume that the income elasticity of services is zero. In this case the income-consumption curve would be a vertical line through point a intersecting the r'5-schedule at point J. At the initial real exchange rate, the resource movement effect leads to excess demand and, in consequence, to real appreciation: the price of services must rise to push back the excess demand. The true point of production owing to the sole resource movement effect thus lies somewhere between point j and b, say at h.

A. Structural Change, Natural Resources Sector Expansion and Growth

15

Fig. A3. Spending Effect of the Boom on the Commodity Market Spending Effect For an isolated description of the spending effect, we now assume that the resource sector does not employ any labour. In this case L^ and L^ in fig. Al coincide, while the boom displaces the production possibility curve vertically upwards (see fig. A3). Point b representing the new relations of conmiodity production and consumption at the initially real exchange rate lies now vertically above point a. In place of the former assumption of inelastic demand for services we now assume that the demand for services rises with income, for example like the income-consumption curve On, intersecting the production possibility curve at point c. This point lies on the right hand side of b, indicating an excess demand for services. Thus also due to the spending effect, a real appreciation must occur to reach the new equilibrium, for example, at point k in fig. A3. The spending effect causes a rise of service production.

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Paul J.J. Welfens and Albrecht Kauffmann

Combining both Effects In light of the real appreciation, the services sector's labour demand schedule shifts upwards, say to L^ in fig. Al, where the final equilibrium point is G. The wage increases to w^ with the consequence of further shrinking of the manufacturing sector. This fall of manufacturing output from M* to M'* stands for indirect de-industrialisation, In any case the output of the manufacturing sector will decrease. This also applies unambiguously for manufacturing exports. The outcome of the service sector is ambiguous. For the cases of a booming oil or gas sector, the share of employment in these sectors is perhaps negligible so that a resource movement effect will not occur and therefore - if any - the spending effect will dominate. Other Sources of the Boom The assumption of Hicks-neutral technological change as the reason of the resource boom seems to be very restrictive in face of other sources suited to cause it: • Non-neutral technological progress can occur without the resource moving effect; however, the spending effect works like described above. • A rising price of the booming resource has the same effect on profitability and factor demands of the resource sector as technological change, but also has substitution effects on the commodity market. If services can substitute resources, the substitution effect works in the expected direction. In our model the resource moving effect appears unchanged, but the spending effect can change direction if the country is a net importer of the resource. In case the resource is used at an intermediate input, its rising price has the same effect on domestic production as a technological regress. If the manufacturing sector intensively uses the resource - e.g. energy - the rise in its input prices reinforces the effects of deindustrialisation. Dutch Disease and the Transition Process In the core model of the Dutch disease, the external real exchange rate RER, eP^ RER = ^— P with e: Nominal Exchange Rate, P^: Foreign Price: Level, P: Domestic Price Level, is silently assumed to be initially in equilibrium; the real appreciation caused by a booming resource sector is considered otherwise

A. Structural Change, Natural Resources Sector Expansion and Growth

17

under unchanged conditions. The reality of the transition process surely does not meet these requirements; particularly the real exchange rate is following a certain pattern during the process that begins with a sudden depreciation of the former, artificially-determined, overvalued domestic currency. After the initial macroeconomic stabilisation period, the RER starts to appreciate and gradually approaches its equilibrium path (see HALPERNAVYPLOSZ, 1996; KRAJNYAK/ZETTELMEYER, 1997; ROSENBERG/SAAVALAINEN, 1998; DE BROECK/SL0K, 2001). In case of the Dutch disease phenomenon, the fall of RER would accelerate after the beginning of the boom. Other features of the transition process may have influence on the RER equilibrium approach: non-enforceable or ill-defined property rights may impede the creation of new enterprises in the manufacturing sector and push more production factors into the booming resource sector and services. To the extent that real appreciation will effectively reduce competition in the tradables sector, this might impair Schumpeterian dynamics. Moreover, a slow-down of structural change could also occur. Finally, it is clear that a natural resources boom will strongly favour certain regions and strata of society so that rising income discrepancies will occur. This in turn could stimulate the expansion of redistribution policies thereby undermining allocation efficiency.

2.2 Selected Complementary Issues The outcomes of the CORDON/NEARY-Model are the result of an economic process under neoclassical, competitive conditions. In this respect there is nothing harmful, and the question rises regarding the application of the term "disease" for the phenomenon of the shrinkage of the manufacturing sector. The name refers to the point if there is something special about the sources of growth in manufacturing, e.g. sector specific external effects as "Learning by Doing", particularly if the expected revenues from the resource sector are limited in time. So it is not surprising that a lot of models consider such effects in their basic assumptions to get closer to reality. If there are external effects of manufacturing production the problem of subsidies in this sector has to be considered. VAN WIJNBERGEN (1984) solves the question of optimal intervention as a trade off between current welfare loss and future welfare benefits in a two-sector, two-period model. The Leaming-by-Doing effect in the traded good (T-) sector is modelled via a positive link between second and first period, while the non-traded good (N-) sector does not produce such an effect. Income from oil only flows during the first period. The outcomes of the model are similar to the

18

Paul J.J. Welfens and Albrecht Kauffmann

spending effect of the core model of CORDON and NEARY. After the oil boom, a crowding out of domestic production of tradable goods due to the real appreciation by rising prices of nontradables follows. Without increasing the subsidy for the T-sector the enterprise production optimum shifts away from the optimum production point from a whole economy's view. The dynamic two-sector-model of MATSUYAMA (1992) focuses on the resource-movement-effect of the CORDON/NEARY-model in an economy consisting of one agricultural and one manufacturing sector. The growth engine of the economy is driven by an external Leaming-by-Doing effect found only in the manufacturing sector. The cases of closed and open economies are under consideration. At first, an exogenous increase in agricultural productivity shifts parts of the mobile factor labour to the manufacturing sector and thus accelerates growth of the whole economy, while in the latter case the link between agricultural productivity and economic growth will be negative due to the shift of labour to the agricultural sector and de-industrialisation. One may conclude that trade restrictions could help to improve the economic growth rate, but the basic assumptions of the model are extremely special, and positive spillovers across the economies are not under consideration in the model but may exist in reality. Referring to the explanation of the Dutch disease phenomena, one can argue that particularly fuel production only scarcely uses the factor labour. SACHSAVARNER (1995) therefore extend the MATSUYAMA model for a sector of nontradable goods. Their model uses the sector framework of the CORDON/NEARY-model, combined with the assumption of human capital production as one external effect of only the manufacturing sector and is characterised by an overlapping generations approach. The main results of this model are similar to the spending effect of the core model, with the additional consequence of losses of future growth potential owing to the shrinkage of human capital growth after the resource boom. Although the empirical results of SACHSAVARNER (1995) clearly confirm the negative relationship between a high ratio of natural resource exports to GDP and averaged economic growth during 1970 and 1989, the impression that "developing countries should leave their natural resources undiscovered and/or unexploited" (STUNS 2001, p. 2) may be deceiving. In the Dutch disease models, economic growth is seen partially as a function of the relative size of the manufacturing sector. Other approaches consider the problem of bad economic growth performance of resource abundant countries from other points of view. For example, the politicaleconomic model of LANE/TORNELL (1995, 1999) is subjected on the rent-seeking behaviour of powerful groups in society via fiscal redistribution, and its resulting voracity effect leads to a future decline of the present

A. Structural Change, Natural Resources Sector Expansion and Growth

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booming sector. However, the results of the diverse Dutch disease models have to be interpreted cautiously as partial analyses made under strong assumptions.

3. Structural and Long-term Perspective of the Oil and Gas Sector There is a long debate in the literature about the role of manufacturing industry and the resources sector in resource-abundant countries. JUNGMITTAGAVELFENS (2003) have emphasized that the manufacturing sector is crucial for economic modernization and growth in transition countries and Russia, respectively. Among the many aspects relevant to the relative expansion of sectors, we will briefly consider the role of asymmetric technology spillovers. The basic idea is that the natural resources sector is capital intensive while the technology used in this sector has very limited or no cross-sectoral spillover effects. Subsequently, we consider the role of asymmetric technology spillovers, namely that manufacturing industry indeed has technology spillovers. One may also emphasize that the resource sector is not very labor intensive so that the direct employment effects of growth in the oil and gas sector will not contribute much to the reduction of the relatively high unemployment rate in Russia (see fig. A4). Since in a two sector model, aggregate capital intensity k=K/L (K is capital, L is labor; the ratio L/L is defined as •j) is given by: (la)

dk = (;-• Jdk^ +•, dk^ + [d^ /k^-k^)]

^^^^

There could also be a paradoxical development in the context of modernizing the oil and gas sector (sector 2). If there is relatively much foreign direct investment, capital intensity k^ will increase while excess labor in the natural resources sector is laid off and shifted into sector 1, that is the manufacturing industry. If the squared bracket term is high enough, aggregate capital intensity could fall, and this implies that aggregate per capita income would fall. Next, we turn to some additional analytical aspects related to asymmetric technology spillovers. Aggregate output in a two-sector is given by

20

Paul JJ. Welfens and Albrecht Kauffmann Russian Federation: Unemployment as Percent of Totai Labour Force

1996

1997

1998

Data Source: WDl 2002 Fig. A4. Russian Federation: Unemployment as Percent of Total Labour Force, 1989-1998 F = y , + y,

(2)

and hence (with g and a suffix denoting growth rates) we have : Sy = agy, + (l-a)g^

(3)

where a is Y/Y. We assume that there are asymmetric technology spillovers in the sense that the level of technology (T) in sector 1 positively affects output in sector 2; the level of technology in sector 2 is denoted as T. If we assume sectoral Cobb-Douglas functions (with output elasticity of fi in sector 1 andj5' in sector 2, respectively). Y, = TKfL,'"

(4)

Y = fC^'ttf^fi'T '-fi'

(5) We have the following marginal products of capital: •YAK=Tp/k,''^

(6) (7)

A. Structural Change, Natural Resources Sector Expansion and Growth

21

Profit-maximization will equalize the real interest rate and the sectoral marginal products of capital, which leads to the paradox result that the manufacturing sector will positively affect the marginal product of capital and hence investment in the natural resources sector. A country which has a structural investment bias against the expansion of manufacturing industries ultimately will thus have a smaller absolute size of the natural resource sector than otherwise. Gas and oil producers are unlikely to internalize the positive externality of the manufacturing goods sector. There are indeed three potential factors that might bias investment in favour of the oil and gas sector: • Managers in the oil and gas industry will have a bias in favour of investing profits in the natural resources sector, and this will undermine the prospects for expansion of the manufacturing sector. • Periods of high international oil prices will contribute to a real appreciation of the currency which will discourage exports of manufacturing products. • Once there is a high share of the oil and gas sector in the overall listings at the stock market and in stock market capitalization, respectively, a relatively high volatility of share prices of oil and gas firms will contribute to a high overall volatility of the stock market index which will raise the required rate of return; this holds in the context of the dividend-discount model and the capital asset pricing model. As regards the latter argument the reasoning is as follows: We assume that dividends D are proportionate to profits g' and hence the dividend g paid out is proportionate to profits (gO - that is g =z*g' - which gives the ratio of stock prices (P") to profits as determined by: Pyg' = z'(l-^g)/(s''-g)

^^^

The required rate of return s '^ will be given - according to CAPM - by: / - • - • , . , £ < . ,



Corruption/rent seeking

Fig. D3. Decision-Making by the Russian Central Bank, Competition and Efficiency in the Russian Banking System In short, the argument runs as follows: Efficiency in the Russian banking sector is spoiled by a large monetary expansion triggered by the Central Bank's policy to manage an unofficial exchange rate peg in times of a natural resources boom, leading to negative real interest rates and local asset bubbles. Efficiency is distorted as well by moral hazard behaviour when banks have access or simply rely on the Central Bank's exchange rate policy, which allows for currency mismatch. Different knowledge of the Central Bank's strategic decisions in this respect, however, hurts competition, because a prudent bank will avoid open foreign exchange positions and therefore hedge any such risks at a certain cost (or leave operations aside which lead to open positions), something a bank that is aware of the Central Bank's strategy is not supposed to do, provided the Central Bank's strategy is considered sustainable. Instead of a daily peg, banking supervision and regulation should enforce adequate hedging or provision

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for risks from currency mismatch (dotted line in fig. D3), but supervision and banking regulation in general is still weak. Together with problems in the overall legal environment and corruption (rent seeking activities), regulatory rules provide for barriers for market entry, which hurts again competition and therefore in the end leads to deteriorating banking sector efficiency. The status quo is preserved by a conflict of interest within the Central Bank as regards Sberbank and the introduction of competition, with politicians having little interest in changing the situation. Foreign banks, that might enhance competitive pressure and thus the efficiency level, are therefore very reluctant to enter the Russian banking market. One has to be careful, of course, that further opening up of Russian financial markets will enhance the probability for currency mismatch (or even original sin) and might force established banks to engage in even more risky investments in the face of lowering interest margins (arrow from competition back to moral hazard). Let us focus first on the consequences of the daily peg for the conduct of monetary policy and the monetization of the Russian economy. During times of high export earnings due to an oil price boom, maintaining the peg on a daily basis requires the central bank to absorb the high foreign exchange inflow resulting from increased export earnings by buying foreign exchange, while only in the medium-term a slow appreciation will be allowed. During times of comparably low oil prices (a situation that has not happened since 1999), the Central Bank will sell foreign exchange reserves to maintain the daily peg as the current account deteriorates if no other sources for foreign exchange inflow substitute for the export revenues, possibly higher foreign investment, a figure that is likely to increase with further growing Russian economy. In theory, the Central Bank could sterilize her interventions on the foreign exchange market by pursuing a contractive (defending against an appreciation) or an expansionary (defending against depreciation) monetary policy on the money market at home. With comparably high oil prices during the period from 1999 to 2003, the daily peg is associated with considerable costs and uncertainty on behalf of monetary policy. As fig. D4 shows. Ruble money supply (M2) increased more than fivefold in nominal Ruble terms from January 1999 to May 2003; this mostly reflects the large increase in foreign exchange reserves with the Central Bank, which saw an increase of more than seven

qn^ 'uq

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Source: CENTRAL BANK OF RUSSIA, Bulletin of Banking Statistics, various issues. Fig. D4. Money Supply Aggregates 1999-2003 in Billion Ruble

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times during the same period and indicates that the Russian Central Bank was unwilling (or simply unable) to sterilize monetary expansion via the foreign exchange market on such a grand scale. However, the expansionary effect was only partially transmitted into the real sector, because Russian banks still hold large compulsory and voluntary reserves with the Central Bank. In May 2003, a total of roughly 18% in relation to the Ruble money supply (M2) was held as banks' reserves with the Central Bank, given a (still comparably high) reserve requirement ratio of 10% (for foreign exchange funds and Ruble funds from legal entities) and 7% (for other Ruble funds, see CENTRAL BANK OF RUSSIA, 2003, pp. 29-32, for details). The fact that Russian banks hold voluntary reserves with the Central Bank can be explained by a general lack of other investment opportunities, which shows the underlying structural weaknesses of the Russian financial markets. The effects on the conduct of monetary policy and the effectiveness of its market-related instruments can be seen by looking at interest rates on the interbanking market vis-a vis the official interest rate for refinancing from the Russian Central Bank (see fig. D5). The refinancing rate is quite high and came down to 18% at the beginning of 2003, but in fact, this has no major effect on money supply, because interbanking rates (in particular the lending rate) are much lower (around 2-3% p.a. in Spring 2003). Judging from this, one may conclude that Russia has experienced too large a monetary expansion. Thus, the unofficial peg to the US-Dollar in times of high oil prices comes at the cost of a monetary expansion, which eventually distorts interbank money markets by making refinancing rather cheap; hence a central bank's usual monetary policy tools - interest rates for the refinancing of banks - have no major effect. Consequently, the Central Bank can govern the liquidity of the banking system only with mere administrative measures (e.g. changing reserve requirements, which have indeed been increased over the last couple of years). The Russian banking sector suffers from several structural and legal flaws that restrict its role as financial intermediary to a comparably small degree, but with increasing liquidity and the monetization of the economy, the economic costs of its backwardness increase as well, in terms of allocative inefficiencies and loss of growth potential. Negative real interest rates like in Russia in 2003 do not contribute to improving allocative efficiency of the financial sector; investment is only held back by a lack of investment opportunities, largely due to insecure property rights and bad corporate governance schemes as well as unreliable accounting methods that make decision-leading facts like credit records unavailable.

(% u!) a)ej )Sdja}U|

D. Russia's Banking System

Source: CENTRAL BANK OF RUSSIA, Bulletin of Banking Statistics, various issues. Fig. D5. Selected Interest Rates 2000-2004

111

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Once this situation changes - and it is likely to change with still strong growth and rising investment in 2003 (WORLD BANK, 2003) -, Russia will experience features of a bubble economy, including overborrowing on both the corporate and the consumer side, overheating consumer demand, asset prices too high, etc. To say Russia as a whole will experience this is not quite correct, because a bubble can only be created in areas where too much liquidity is available. This might be the case in Moscow, where signs of a bubble are already visible, but not in most of the other parts of Russia, where banking services are still pretty much underdeveloped and corporate or consumer credits from ordinary banks very rare. AUocative inefficiencies may result in local bubbles, but also in a very unequal regional distribution of financial funds, that is largely due to the legal and supervisory problems, some of which are displayed on the left part of fig. D3. Banks in the regions are often too small and inexperienced to cope with banking business of the financial centre in Moscow and the big banks in Moscow in return are reluctant to invest and operate in Russia's regions. Sberbank, which plays a special role from many points of view, has shown a strong increase in lending activities since 1999 and 2000. According to the survey of WORLDBANK (2002, p. 147), Sberbank increased its loan portfolio by 60 percent during the year 2000 alone (an absolute total in US-Dollar of about 3.7 billion). Given limited capacity for credit risk assessment, this seems to be beyond the borders of prudential lending activities. Consequently, the same report points out that in particular some of Sberbank's larger loans were extended to companies with a rather mixed record as regards their debt service. In addition, the bank's portfolio is quite concentrated, exposing it to considerable risk for default by single borrowers. Sberbank's own capital is at a rather low level. All this gives major cause for concern. All this taken together, the liquidity effects discussed here represent one of the consequences of the tight tracking of the US-Dollar by the Russian Central Bank. Thus the daily peg has lead to a large monetary expansion and distortions on the money market, leaving the Central Bank without market-related instruments for monetary policy and the banks with too much liquidity. While aggregated monetary figures for the entire country suggest there is even more monetization and amount of credit needed compared to other transition countries ~, Russian banks face only a very limited range of investment opportunities, probably all of which will show signs of a bubble without further bank restructuring and improving the banking and investment environment in most of Russia's regions. The next consequence of the daily peg refers to a typical moral hazardargument and brings us back again to the discussion on original sin and currency mismatch-related problems. The exchange rate policy of the Central Bank and in particular the high-frequency peg have not been an-

D. Russia's Banking System

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nounced thus far; there is no clear sign as to the perspectives of this kind of exchange rate regime. Banks may be able to exclude foreign exchange risk on a day-to-day basis, but cannot be sure if this regime might be changed in the near future. In addition, even if there is a significant tracking of the US-Dollar as regards monetary exchange rate data, simply looking at the exchange rate chart reveals that there is no comfort in relying on a longer term oriented peg of the Ruble to the US-Dollar. Thus banks have to make provisions for open foreign exchange provisions with a maturity of more than two to four weeks. Such a need for provision probably does not apply to state-owned banks and in particular banks associated with the Central Bank, like Sberbank. They enjoy an advantage over their competitors, given the uncertainty of the future of the currency peg and the fact that there is no official commitment to the exchange rate regime. It is very likely that those banks can rely on information asymmetry to their favour over their private competitors. They do not face uncertainty about the development of the exchange rate in the medium term and can operate ignoring open foreign exchange positions with the knowledge of the Central Bank's strategy. With its high international reserves, the Central Bank has plenty of discretion when choosing an exchange rate strategy. The knowledge of the strategy enables Sberbank to exploit an interest rate differential between Ruble and USDollar denominated loans, disregarding currency mismatch considerations and related provisions. Thus the unofficial daily peg distorts competition in the banking sector. To sum it up, two effects of the daily peg are relevant for our discussion. First the expansionary effect on monetary policy and second, the moral hazard effect on behalf of Sberbank (and possibly other state-owned banks). These effects are causing considerable costs in terms of allocative inefficiencies, and it should be asked whether the presumed reasons for pursuing such an exchange rate strategy outweigh these costs. It is not within the scope of this paper to do this, if it is ever possible; it is even so difficult to assess the success of the exchange rate strategy as regards the industrial policy argument mentioned above as well as its role for stabilizing the monetary sphere of the economy. The question of managing (i.e. keeping it undervalued compared to the market equilibrium level) the exchange rate as a means to give price advantages to Russian industrial enterprises on the world market has attracted much interest and is usually promoted by the industry lobby (DABROWSKI/PACZYNSKI/RAWDANOWICZ, 2002, p. 10). Here we have discussed threats for competition and efficiency of the banking system originating mainly from the exchange rate regime, but still there are other and possibly more dangerous threats from other sides. This refers to the role of the Central Bank as chief regulator and supervisor to-

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gether with its role as key player on the banking market through Sberbank. The incomplete nature of banking rules and regulation on the one hand and the conflict of interest between pushing for more competition and preserving the dominating role of Sberbank on the other pose serious obstacles for competition and the development of the banking sector. By and large, regulatory rules relating to prudential supervision are in place in Russia, but a myriad of technical details associated - e.g. with accounting, reporting and auditing standards - remain. This must not be dismissed, as it leaves room for malfeasant business practices including fraud. Typically, the Central Bank as banking supervisor focuses more on form rather than substance (WORLD BANK, 2002). But tough enforcement of rules relating to capital adequacy, reporting and accounting is essential, first to ensure a level playing field for the banking sector and second to prevent banks from developing too risky a currency or maturity mismatch. The playing field in the Russian banking sector is quite uneven, and disadvantages for private banks do not stop with information asymmetries regarding exchange rate developments. Public guarantee for deposits with Sberbank is one of the major distortions detrimental to the expansion of private banks on the retail banking market. While competition in the banking market is hurt by disguising the Central Bank's exchange rate strategy on the one hand, the Central Bank even used its monetary policy tools for giving Sberbank an advantage on the other. Until 2002, Sberbank's reserve requirements with the Central Bank were about half as high as those for other banks. The list of competition-distorting factors could continue: the current public deposit guarantee valid only for deposits at Sberbank or the government's decision to use Sberbank as its payment channel for various public funds, e.g. the pension system (WORLD BANK, 2002). Usually Sberbank's public duty to provide banking services in Russia's regions and more remote areas outside the big centres of Moscow and St. Petersburg, which is supposed to be associated with extracosts for the maintenance of a large branch network, is used to defend such measures. But it is never clear how much the branch network really costs and if it is really such a kind of liability for Sberbank. It may even be an asset that gives the bank a much broader base for activities compared to their new founded rivals. From a politico-economic perspective, there are three reasons why state ownership of Sberbank and in particular ownership by the Central Bank as well as a dominant role of Sberbank is preferential for politicians and Central Bankers and the introduction of a level playing field as a necessity for competition quite unlikely: • Tool for industrial and social policy issues or rent-seeking activities in general: State-owned Sberbank can be used as a tool for pursuing in-

D. Russia's Banking System

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dustrial or social policy goals without respecting commercial issues, e.g. by directing large-scale credit to enterprises or credit programmes to private households. Given the level of corruption in Russia, private rentseeking activities are likely as well. • Control of financial system: A dominant state-owned Sberbank allows politicians direct control over the development of the banking system, something post-Soviet politicians still might favour. From this point of view, a dominant state-owned Sberbank is the best means for blocking a Hungary-style foreign takeover of large parts of the Russian banking sector. • Restoring trust in banks by preserving Sberbank's role: A much touted argument is that Sberbank is currently the only bank which enjoys a necessary amount of trust among people, so that they are willing to put their money in its accounts. According to this view, changing anything, including ownership or public deposit guarantee, will endanger this trust and set back efforts for building up the banking sector in Russia. Especially the first and second aspects are supported by the comparably intransparent structure as regards accounting and publishing data on Sberbank's activities. This makes things particularly easy when trying to hide the true cost of financial support for industrial or social issues or other rent-seeking activities, including fraud. Without transparency and tight supervision, Sberbank's managers and interfering politicians simply cannot be charged for their activities. It should be acknowledged that the Russian economy is characterized by widespread rent-seeking activities, related to the phenomenon of public authorities as grabbing hands (FRYE/SHLEIFER, 1997) and state capture by enterprises (HELLMAN/JONES/KAUFMANN, 2000). Whereas certain exemptions for Sberbank act as competition-distorting factors and hence as barriers for market entry and expansion for its rivals, barriers for market entry occur through rent-seeking activities as well; the banking sector therefore is probably one the most active rent-seeking sectors in Russia (PLEINES, 2002; ALLAN, 2002). Competition may be badly hurt or even prevented from its very beginnings (particularly in more remote areas) with large-scale corruption and rent-seeking activities in place (WIEGERT, 2003). An enterprise panel revealed the Russian Central Bank as the prime target for state capture as regards public institutions in Russia (HELLMAN/JONES/KAUFMANN, 2000, p. 9). Regulatory rules may therefore be abused to prevent the market entry of likely competitors, a consideration often associated with the apprehension of foreign banks with respect to entering Russia's banking market. The three reasons raised above show that considerable forces exist that might hinder reform, mainly efforts associated with the introduction of

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transparency and competition in the banking sector. The ultimately political goal of keeping the Russian banking sector in Russian hands blocks the alternative for the argument of Sberbank as the main source of trust that is the large-scale participation of high reputable foreign banks, which will not only lead to an enhancement of trust in private banks but also to an enhancement of service quality and availability; foreign ownership usually improves the overall quality of banking services considerably in underdeveloped banking markets (CAPRIO/HONOHAN, 2001, p. 167). But without political support, foreign banks are quite reluctant to come to Russia on a large scale. Lack of support and the uneven playing field therefore act as major barriers for market entry and expansion. Further lifting of regulations preventing the inflow of foreign capital, in particular of foreign participation in the Russian banking sector and a deeper integration into world financial markets through liberalization efforts (capital account and foreign exchange market) - associated with likely membership in the WTO in the near future - might help to lower these barriers for market entry and eventually enhance competitive pressure, while at the same time possibly increasing threats for financial sector stability. Higher competition will lead to decreasing interest margins, which in turn will probably force banks to engage in riskier investment projects. Hence a tighter supervisory control and enhanced information processing from banks to the Central Bank is required. This holds particularly for Sberbank. Apparently, with increased financial integration following liberalization, high oil prices and - almost equally important - ongoing economic growth well above 4% per annum, financial risks in the sense of currency mismatch will increase, most likely also in the sense of original sin, especially if the Central Bank maintains its exchange rate strategy. This is due to continued high export earnings as well as to an increased inflow of foreign capital given such a scenario, both factors contributing to an appreciation of the Ruble exchange rate, which the Central Bank at its current stance might be willing to prevent. Given loose control efforts such an exchange rate policy will inevitably lead to further excess liquidity in the financial system, asset price bubbles and overborrowing, something that might turn out painfully unsustainable in the event of a changing economic environment. A bursting asset price bubble in a highly intransparent environment is the imminent danger Russia's financial sector will face today, not in the least for the largest actor, Sberbank. With negative real interest rates caused by excess liquidity, allocative efficiency of the financial sector is at odds, and Russian banks will have to cope a large debt write-off once an economic downturn occurs or the current account deteriorates. If this happens, the Central Bank might again be tempted to stabilize the economy by

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maintaining the exchange rate peg on a daily basis. Thus, as nominal interest rates at home rise again, Russian banks will increasingly look for financing abroad. This might lead to a situation similar to the classical original sin paradigm MCKINNON (2000) identified as a root cause for the Asean financial crisis.

5. Conclusions and Policy Options The Central Bank of Russia today faces the challenge of building up a sound financial sector. It has more power than most of the other central banks in the world, but at the same time is captured in a serious conflict of interest that possibly prevents her from creating the conditions for such a sound banking sector, first of which is to address the lack of enforcement of prudential regulation and the level playing field for competition. Still far behind the goal of enforcing tough regulatory rules, the Central Bank has resurrected a sort of exchange rate peg to the US-Dollar on a daily basis. As we have briefly discussed, there are several arguments for such a peg in a transition economy with a low developed financial sector. Indeed, it may help to switch off exchange rate risk in the short-term, but it is doubtful whether this works due to the unofficial nature of the peg. Whether it helps to encourage import substitution and export-oriented sectors is highly disputable. Still, there are considerable costs: the lower degree of control of the money supply and allocative distortions on the banking market leading to signs of an asset price bubble. Banks with adequate liquidity management with respect to exchange rate risk will have higher costs compared to banks which simply neglect this risk, either because they are associated with the Central Bank and therefore have an informational advantage or because they simply pursue a riskier business strategy. Until proper regulations and reporting standards are in place and enforced, resorting to high frequency pegging or to a fixed exchange rate is a remedy for the exchange rate risk problem in the short- to medium-term. With higher pressure for abolishing regulations concerning foreign exchange and capital account transactions in the near future in the wake of WTO membership, time is probably running out for that option. In 2003, however, open exchange rate positions do not seem to endanger financial stability. But the issue of currency mismatch and even original sin may become more relevant in a future economic downturn. By then, Russian banks and their regulatory and supervisory environment should be prepared. Therefore, action on the field of prudential regulation is required, because fluctuations in the exchange rate market will accelerate after the Central Bank abolishes most of its administrative measures currently

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regulating the market and making the task of high frequency pegging comparably easy. During the period of reform, a high frequency peg may be justified, but as there are high costs for maintaining such a peg, reform efforts thus have to speed up. In any case, an official announcement of the peg and related future commitments of the Central Bank would be desirable. The peg should not be realigned at a level artificially low, leading to massive interventions by building up foreign exchange reserves. In any case, the Central Bank should stop pursuing industrial policy by keeping the Ruble well below its true value. The task of smoothing the negative effects of the oil price boom on the tradables sector should be left to other instruments, such as a public stabilization fund that collects parts of natural resource revenues in good times to spend them in bad times. From 2004 onwards, such a fund will be created on the federal level. From the perspective of allocative efficiency, the Central Bank should stop intervening in the foreign exchange market on a scale shown from 1999 to 2003, in particular in times of Ruble appreciations, because this leads to an artificial blow-up of the Ruble money supply, making monetary policy quite ineffective. Parallel to an enhanced quality of supervision of banks' lending activities, institutional and legal problems - such as improving creditor rights and establishing instruments for tracking the records of debtors - have to be solved to let the money disperse more evenly across the country, giving enterprises in more remote regions access to external financial means. One must admit, however, that even with reforms and measures enacted on paper, access to external financing will at best only gradually improve in the medium term. For the sake of a competition-oriented banking sector and in order to resolve the conflict of interest within its own holding structure, the Central Bank should sell its stake in Sberbank. In the short-term, a full-fledged separation of Sberbank from the Central Bank is desirable, with a possible privatization of Sberbank in the medium term after an accounting for a true and fair view of Sberbank's operations, costs and earnings has been set in place. Rules governing the admission of foreign-owned banks to the Russian banking market have to be relaxed; ideally Russian and foreign banks should be treated equally. Stripping the Central Bank of its supervisory and regulatory powers may also be desirable, given its poor record on this field and the high potential for rent seeking activities associated with that function. But there is no real alternative in sight that might be able to replace the Central Bank in the near future. A clear separation of its monetary and supervision departments as regards all accountable aspects is therefore necessary (if that is ever really an option); possibly a new independent agency on the basis of the supervisory department should be founded.

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References ALLAN, D. (2002), Banks and the Loans-for Shares Auctions, in: LANE, D. (ed.), Russian Banking: Evolution, Problems and Prospects, Cheltenham: Edward Elgar, pp. 137-159. AUKUTSIONEK, S.P. (1998), Barter i Rossijskoj Prom'yshlennosti, in: Voprosy ekonomiki, Nr. 2/1998, 51-60. BUBULA, A., O T K E R - R O B E , I. (2002), The Evolution of Exchange Rate Regimes Since 1990: Evidence from De Facto-Policies, IMF Working Paper No. 155, Washington D.C. CAPRIO, G., HONOHAN, P. (2001), Finance for Growth: Policy Choices in a Volatile World, World Bank Policy Research Report, Washington D.C. CENTRAL BANK OF RUSSIA (2003), Bulletin of Banking Statistics, No. 7 (122), Moscow. COMMANDER, S., MUMSSEN, C. (1999), Understanding Barter in Russia, EBRD Working Paper Nr. 37, London. DABROWSKI, M., PACZYNSKI, W., RAWDANOWICZ, L. (2002), Fighting Inflation in Russia, in: Russian Economic Trends, Vol. 11. No. 2, pp. 7-14. EBRD (1999), Transition Report 1999, London. EICHENGREEN, B., HAUSMANN, R. (1999), Exchange Rates and Financial Fragility, NBER Working Paper Nr. 7418, Cambridge, Mass. EICHENGREEN, B., ROSE, A. (1998), Staying Afloat When the Wind Shifts: External Factors and Emerging Market Banking Crisis, NBER Working Paper No. 6370. FRANKEL, J.A., WEI, S.J. (1994), Yen Bloc or Dollar Bloc? Exchange Rate Policies in the East Asian Economies, in: ITO, T., KRUEGER, A. (Hg.), Macroeconomic Linkage: Savings, Exchange Rates, and Capital Flows, NBEREast Asia Seminar on Economics 3, Chicago: University of Chicago Press. FRYE, T., SHLEIFER, A. (1997), The Invisible and the Grabbing Hand, in: The American Economic Review, Papers and Proceedings, Vol. 87, 354-358. GAVRILENKOV, E. (2003), Macroeconomic Situation in Russia: Growth, Investment and Capital Flows, in: GAVRILENKOV, E., WELFENS, P.J.J., WIEGERT, R. (eds.). Economic Growth and Opnening up in Russia, Heidelberg and New York: Springer, pp. 203-220. HELLMAN, J.S., JONES, G., KAUFMANN, D. (2000), "Seize the State, Seize the Day". State Capture, Corruption and Influence in Transition, World Bank Policy Research Working Paper Nr. 2444, Washington D.C. MCKINNON, R.I. (2000), After the Crisis, the East Asian Dollar Standard Resurrected, in: STIGLITZ, J.E., YUSUF, S. (Hg.), Rethinking the East Asian Miracle, Oxford: Oxford University Press, Kap. 5, 197-246. PLEINES, H. (2002), Banks and Illegal Activities, in: LANE, D. (ed.), Russian Banking: Evolution, Problems and Prospects, Cheltenham: Edward Elgar, pp. 119-136. RECEP (2002), Russian Economic Trends - Monthly Update: October, Moscow. TOMPSON, W. (2000), Financial Backwardness in Contemporary Perspective: Prospects for the Development of Financial Intermediation in Russia, in: Europe-Asia Studies, Vol. 52, No. 4, pp. 605-625.

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WIEGERT, R. (2003), Transformation, Wachstum und Wettbewerb in Russland, Heidelberg und New York: Springer. WORLD BANK (2002), Building Trust. Developing the Russian Financial Sector, Washington D.C.: The World Bank. WORLD BANK (2003), Russia Economic Report, Moscow, August. YAKOVLEV, A. (2000), Barter in the Russian Economy: Classifications and Implications (Evidence from Case Study Analysis), in: Post-Communist Economies, Vol. 12, No. 3, pp. 279-291.

E. Russia and International Economic Structures Ruslan Grinberg 1. Introduction

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2. Russia and International Economic Organizations

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2.1 Russia and the International Monetary Fund 2.2 Russia and the World Bank of Reconstruction and Development 2.3 Russia and the World Trade Organization 2.4 Russia and the Organization for Economic Co-operation and Development 3. Russia and Regional Integration Blocs 3.1 Russia and the European Union 3.2 Russia and the Group of 8 3.3 Russia and Asia-Pacific Economic Cooperation 3.4 Russia in the Commonwealth of Independent States References

Comment on: Russia and Intemational Economic Structures Paul J.J. Welfens

122 127 131 135 140 140 144 147 149 159

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1. Introduction Russia has closely cooperated with international economic structures for a little more than ten years. Working relations between them started actually in 1992 with the country's admittance to the IMF and the World Bank. It is certainly not by chance that the start of the real interaction between Russia and international economic structures coincided with the time a new state was formed and radical market reforms were launched. From the very start of the systemic transformation, its initiators attached great importance to cooperation with international economic structures. These structures were expected, firstly, to render advisory and financial assistance in conducting the market reforms as such and, secondly, to facilitate the integration of Russia's previously autarchic economy into the world economy to facilitate the country's modernization. In this paper, an attempt is made to assess the ten-year experience of the cooperation between the Russian Federation and international economic structures and outline scenarios and prospects for its further development. The first part of the paper presents the characteristics of Russian participation in the IMF, the WBRD and the Group of 8 or 7+1, that is, in the organizations where it is a full member already, as well as in the WTO and the OECD, where it has still to accede. The second part analyses the current situation with and possible options for Russia's participation in regional integration blocs. Here special attention is paid to the issues of the country's positioning in the Commonwealth of Independent States (CIS) and estimating the chances of an integration project under its auspices. Additionally, the challenges and directions of Russia's cooperation with the European Union and the forum for AsiaPacific Economic Cooperation are considered.

2. Russia and International Economic Organizations 2.1 Russia and the International Monetary Fund Russia was admitted to the International Monetary Fund (IMF) in May 1992. The country's quota is SDR 2876 million (3% of the Fund's total quota), which does not allow Russia to influence the process of decisionmaking in the framework of IMF. In the first half of the 1990s, Russia was borrowing intensively from the IMF, which was caused by an objective demand for external financial sources. The IMF credits had the advantage of a lower interest rate. However, these credits were given on the condition that the Russian govern-

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ment implemented programmes coordinated with the IMF. Over the period from 1992 to 1999, Russia borrowed USD 21 billion from the Fund. In practice, access to the IMF's credits also meant more favorable conditions for getting funds from the world financial markets. Nevertheless, the volume of foreign direct investment attracted by Russia in the course of transformation was not that significant - from 1992 to 2002, it totaled a little more than USD 26.5 billion. Between 1990 and 1999, Russia's cooperation with the IMF was limited to getting credits on government progranmies aimed at attaining financial stabilization in the country, the main emphasis being laid on achieving quantitative indicators - such as the rate of money mass growth, the rate of inflation decrease, the exchange rate dynamics, the level of budget deficit, etc. - in the course of implementing the monetary-credit and budget-tax policies. By 1997, the inflation rate had been significantly reduced and the exchange rate stabilized, but macroeconomic stabilization had not yet been achieved. In the field of institutional change, the IMF paid the most attention to fostering rapid privatization and implementing the land and banking reforms, in a number of cases underestimating social aspects of market transformation. In 1997, for instance, an IMF expert mission suggested that the Russian government consider freezing pension payments to working pensioners for fiscal purposes. The IMF was also using double standards in its dealing with Russian and foreign economic agents. Thus, the Fund supported Russia's implementation of restrictive income policy to reduce inflation, at the same time taking the side of foreign investors during their conflict with the Russian government, when the latter made an attempt to introduce a tax on excessive wages for the firms with their participation. Yet the main mistake of the IMF, as far as its activities in Russia were concerned, was its inability to prevent the 1998 financial crisis. It should be noted that the interaction between the IMF and Russia was the most intense at that point. On July 20, 1998, the Fund made a decision to grant Russia SDR 8.5 billion in additional financial aid, but that aid came too late. The IMF recommended the Central Bank of Russia increase interest rates and spend currency resources to maintain the exchange rate in order to overcome the consequences of the South-East Asian crisis, though the problems accumulated in the Russian economy by that time were of a systemic nature and could not be solved by merely maintaining the exchange rate and reducing the budget deficit. Nevertheless, it would be unfair to blame the IMF alone for the 1998 crisis, as some of Russian and Western experts do. The Russian government was sovereign enough to regulate its budget-tax, debt and exchange rate policies. One should understand that it was the Russian authorities of

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that time who deliberately ignored an institutional component of reforms, including the creation of a stable banking system, transparent ownership relations, antimonopoly legislation, etc. In 1999, significant changes occurred in the relations between Russia and the IMF. Russia's relatively successful economic development enabled it to stop taking IMF credits and even to start repaying its obligations to the Fund, often ahead of schedule. Unlike more developed CEE countries, such as Hungary, Poland and the Czech Republic, however, who have paid off their debts to the IMF, Russia still has a considerable debt to the Fund. The unpaid credits amount to SDR 4134.15 million, and the projected payments to the Fund over the period from 2003 to 2007 are SDR 4102.27 (including credit interest). The year 2004 will see the peak of Russia's payments to the IMF - SDR 1179.442 million (www.imf.org). Marking a new stage of Russian relations with the Fund, the latter advises on economic programmes of the Russian government. Let us point out a number of IMF's positions on some issues of economic policy: The Fund's experts still regard reducing the inflation rate as one of the priority directions for Russia. J. Odling-Smee (ODLING-SMEE, 2003, p.67), the former Director of European II Department of the IMF, and K. Rogoff, Director of the Research Department of the IMF, mentioned this in 2003 (VREMYA NOVOSTEY, 2003). Rogoff emphasized the possibility of bringing the annual inflation rate in Russia down to 5%. However, the expediency of an accelerated reduction of inflation rate seems doubtful. The experience of CEE countries in the second half of the 1990s shows that when the annual inflation rate is moderate (up to 40%), it has practically no correlation with economic growth. To avoid a conflict of goals in the monetary-credit policy given the simultaneous monitoring of inflation and exchange rates by the Central Bank, IMF experts suggest a transition to a more flexible exchange rate regime. This actually means that the ruble will be given the opportunity to strengthen itself under the influence of market forces without Central Bank's interference, leading to an increase in money mass. At the same time, it is necessary to remember that excessive strengthening of the ruble may cause a negative effect on the foreign trade balance and in the longterm also cause fluctuations in the exchange rate of the ruble under the influence of unfavorable external factors (for instance, a significant fall in oil prices). Let us note that IMF Executive Directors mention this problem in their Conclusion on 2003 Article IV Consultation. Accordingly, a cautious and flexible macroeconomic policy will be necessary for smoothing over the contradiction between goals relating to inflation and exchange rate. They recommend that the monetary-credit policy focus on reducing the inflation rate and the budget-tax policy - on restraining the growth of real exchange

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rate (www.imf.org). This actually means it will be necessary to toughen the budget-tax policy in 2004. Analyzing the implementation of budget-tax policy in Russia, the IMF advocates reduction in government expenditures, as it did during the first stage of transformation. In this manner, the idea of the reduction of state involvement in economic activities is put into practice. At the same time, one should note that the Fund started paying more attention to measures aimed at increasing the revenue basis of the budget. For instance, the IMF supports the idea of creating a stabilization fund using oil exports revenues. IMF experts consider it necessary to further shift the tax burden to consumption, calling first of all for a reduction in the common social tax but not value-added tax (IZVESTIYA, 2003). The Fund's position on institutional transformations is changing gradually. In recent years, significant importance has been placed on the process of formulating IMF recommendations for economic policy. The Fund admits some mistakes, e.g. those related to accelerated privatization in Russia. Rogoff therefore argues that the creation of stimuli for real restructuring of enterprises is more important than their passing into the private ownership (VEDOMOSTI, 2002). In the field of institutional reforms, the IMF now recommends Russia speed up banking reform (introducing the international financial reporting standards and reducing the state's role in the banking sector), the state governance reform and restructurization of the market of communal services and natural monopolies. However, it is important to rightly estimate the consequences of these reforms. Thus the reduction of state involvement in the banking sector, understood as privatization of the two largest banks (Sberbank and Vneshtorgbank), may lead to the establishment of foreign capital domination in the banking sector. The reform of natural monopolies is in practice reduced to raising their tariffs, which has an obvious negative social effect. Many reforms are undoubtedly necessary, but the question on terms and scale of their implementation is still open. In the field of currency regulation, the IMF is against any controls on the inflow of long-term capital (portfolio as well as direct investment). However, it acknowledges the danger of speculative capital intervention into Russia and favors 'market-friendly... controls such as the Chileantype controls' (ODLING-SMEE, 2003). In principle, this approach is reasonable, but it does not touch upon other problems faced by the Russian economy, such as its doUarization and capital flight. In the situation where the tendency towards an increase in the capital inflow is beginning to appear, the Fund recommends Russia refrain from introducing new currency restrictions. Meanwhile, it seems that in this situation there is a need for promoting further attraction of production capital and preventing a significant inflow of speculative capital, which may de-

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stabilize the country's monetary-credit sphere. In addition, the currency legislation should provide effective first-aid measures in the case of crises involving the currency sphered IMF Executive Directors support the Russian authorities' intention to accelerate the development of the market of government ruble obligations (www.imf.org). On the one hand, this will give an impetus to the development of all Russian financial markets and provide more opportunities for them to effectively regulate liquidity by means of monetary-credit policy. On the other hand, it is crucial to approach the development of the government debt market cautiously, taking into account the 1998 experience. Now the issue of choosing the strategy of cooperation with the IMF is important, and different options are proposed. One of them suggests proceeding with the policy of not borrowing from the Fund. There are some arguments in support of this option, such as the inefficiency of IMF activities in general (thus in its report to the Congress, the US Account Chamber noted that only 11% of IMF's estimates of economic growth indicators are considered correct (IZVESTIYA, 2003)). Some of the developing countries are also gradually cutting down borrowing from the IMF, while others plan to do so. Among them are Indonesia, Thailand, Brazil, Ecuador, Bulgaria and Turkey. The IMF is also blamed for being unable to prevent numerous crises during the past decade (the Mexican crisis in the middle of the 1990s, the South-East Asian crisis in 1997, the BraziUan crisis in 1999, and the recent crises in Turkey and Argentina). This argument is raising doubts about the expediency of even advisory cooperation with the IMF. However, one has to admit that the Fund's assessments of national economic policies remain a significant factor in forming the attitudes of investors acting on financial markets. Let us note that the policy of cutting down credits to developing countries, including Russia, with the Fund's preserving its advisory role, is consistent with the US proposal on reforming the IMF. Developing countries adhere to another point of view, which seems to be closer to Russia's. They consider it necessary to increase their involvement in the Fund's decision-making process on a wide range of issues, including the building-up of international financial architecture. However, it is necessary to keep in mind that the current favorable economic conjuncture in Russia is mainly due to high world oil prices. Should oil prices fall, Russia might again need external financial assistance. For this reason, maintaining pragmatic cooperation with the IMF is consistent with this country's interests.

^ The RF govemment's project of the Law on Currency Control contains a set of such measures.

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2.2 Russia and the World Bank of Reconstruction and Development The activity of the World Bank differs from that of the IMF since it is aimed at the realization of certain projects in particular spheres rather than at eliminating macroeconomic disproportions. The World Bank does not impose tough restrictions on governmental economic policy, only adjusting it in some spheres. Fifty-eight projects valued at USD 13404.6 million were approved in the framework of cooperation with Russia between August 1992 and May 2003. The dynamic of WB assistance to Russia is illustrated in table El. Thus for the 1993-2002 period, the World Bank and Intemational Development Agency planned to invest USD 12.5 billion in the Russian economy, actually investing more than USDS billion. Table E2 outlines the biggest loans of the World Bank to Russia. Table El. Obligations and Expenditures of the World Bank/Intemational Development Agency Related to Assistance to Russia (1993-2002 Fiscal Years, USD Million) Before 1996 Obliga- 4631 tions Expen- 729 ditures

1996

1997

1998

1999

2000

2001

2002

Total

1816

1716

1629

1930

90

398

351

12561

981

2086

2172

657

606

455

376

8062

Source: The World Bank Group (www.worldbank.org), The table data show that the peak of relations with the World Bank, as far as big projects are concerned, was in 1997 and 1998. Since 1999, no loan has exceeded USD300 million. Assessments of World Bank assistance are different. Thus after having studied investment projects realization, the Account Chamber of the RF concluded that the usage of means for the main project components financing was behind schedule. Moreover, it observed the dissipation of resources among a big number of projects that are not connected with each other (VOPROSY EKONOMIKI, 2002, p.79). This last problem really demands special consideration. According to the Account Chamber, it was the result of a lack of a single national strategy for drawing the means from intemational financial organizations. At first sight, the list of World Bank projects for Russia recalls memories of the 'patching up' strategy. However, World Bank activity has certain clear directions important for the Russian economic development, such as financing social programmes (including social protection, healthcare, education), institutional changes (privatization, reforms, including that of public administration), restructuring the economy as well as environmental

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Table E2. The Biggest Loans of the World Bank to Russia Sum

Approving of loan date

Loan

(USD million)

06.08.1992

Rehabilitation loan

600

17.06.1993

The first oil rehabilitation loan

610

29.06.1994

The second oil rehabilitation loan

500

07.03.1995

The loan for the house-building project

400

16.05.1995

The loan for city transport

329

06.06.1995

The second rehabilitation loan

600

28.03.1996

The loan for bridges repair works

350

27.06.1996

The loan for restructuring the coal industry

500

05.06.1997

The loan for economic restructuring

600

25.06.1997

The loan for social protection restructuring

800

18.12.1997

The second loan for economic restructuring

800

18.12.1997

The second loan for restructuring the coal industry

800

06.08.1998

The third loan for economic restructuring

1500

22.12.1998

The loan for improving the road system

400

Source: The World Bank Group (www.worldbank.org).

protection. As for bolstering national priorities within these areas, this should be done by the Russian government. After several check-ups, the Account Chamber concluded that the realization of a number of projects had been insufficient. This was the case with the house building project, the privatization project, energy efficiency improvement and some others as well (VOPROSY EKONOMIKI, 2002, p.81). At the same time, the World Bank emphasizes that the project of coal industry restructuring was successful and notes that since 1998, the efficiency of project realization has increased. Many World Bank projects were not realized in time, which lead to Russia's financial losses in the form of additional commission for the means reserved and not used. The World Bank supposed that the reason of such delays was a lack of agreement in the Russian government about how to cooperate with the WB. Although the World Bank credit rate is lower than rates on the world financial markets, the realization of projects involves the participation of WB consultants, raising realization expenditures. Approaches to the Russia-World Bank relations began to change after the 1998 financial crisis. Then the World Bank started giving priority to investment loans instead of budget substitution (HEIFETS, 2002, p.111).

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Beyond this, as mentioned above, the improvement of the Russian economic situation resulted in a decrease in loan volumes. The World Bank's proposed Russian strategy for 2003-2005^ is to support the effective implementation of the government's reform programme, to help reduce the underlying risks to the sustainability of growth and to more widely extend the opportunities arising from the reform process among Russia's population. The World Bank focuses on three basic challenges: improving the business environment and enhancing competition, strengthening public sector management, and mitigating social and environmental risks. The Country Assistance Strategy for 2003 to 2005 envisages a program of lending and guarantees of up to USD 600 million per fiscal year (www.worldbank.org). Most recent World Bank recommendations on Russia's macroeconomic development are as follows: the necessity of capital repatriation and social orientation of economic growth (increasing social expenditures, reducing the gap between the rich and the poor) (KOMMERSANT, 2003). The World Bank assumes that economic growth will have a more favorable impact on the fight against poverty if based on small and medium business activity but not on the present highly concentrated production structure dominated by natural resources exports. On the one hand, the World Bank is warranted in stating that from the point of view of improving employment, small and medium-sized businesses have better opportunities, and an over-reliance on the natural resource sectors may have the negative consequences. Yet under the current conditions, it is impossible to maintain the country's competitiveness on the world markets without big world level companies. Among World Bank activities, the following recent projects relating to the social sphere are especially important for the Russian national economy: - the two USD600 million loans projected for municipal sphere modernization (engineer infrastructure development in Russian regions, house building combined with mortgage credits to population) (www.newsru. com) - A Russian-World Bank agreement on financing the pilot project of social restructuring in the Far North regions that came into effect in August 2002. Under this framework, the World Bank will have provided over USD 9 million in the third quarter of 2003, and USD 4 2 The strategy of the World Bank Group cooperation with Russia is a frame document, defining the main directions of the World Bank Group cooperation with the govemment of the Russian Federation for a 3-year period.

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million in the forth quarter. In 2004, the World Bank will pay out USD 45.6 million (PRIME-TASS, 2003). - A project for preventive and diagnostic measures as well as care for tuberculosis and HIV/AIDS patients (USD 150 million), approved in April 2003. Another important direction for current World Bank activity in Russia is facilitating support for small and medium businesses. In order to promote their development, the International Finance Corporation (a World Bank Group member) has recently increased credits to some Russian banks. This direction is prospective in general, but attention should be paid to some specificities of its realization. Thus, IPC gives credits mostly to those banks with which it intends to interact or to those with foreign capital participation (for instance, the Bank of Foreign Trade (Vneshtorgbank), which objectively strengthens foreign capital positions in the Russian banking system. Concerning the strengthening of public sector management, the World Bank will concentrate its efforts on the following primary directions: enhancing accountability mechanisms and information flows within and across different levels of executive power to reduce corruption, improving fiscal management at different levels as well as improving the efficiency and quality of public services. Of course, from a political pointof-view, these reforms are quite difficult to implement, but it is obvious that public sector reform is necessary. Advisory and information assistance of the World Bank is also worth mentioning, for example its estimation of the drafts of the Law on Credit Bureaus prepared in Russia. The WB Expert Group has preferred the draft proposed by the Ministry of Economic Development and Trade, emphasizing that it generally corresponds to best international practice. This draft specifies the frame rules for work by private and state credit bureaus (SKRIN-NEWS, 2003). Moreover, the Association of Russian Banks received the WB grant for working out the concept and methods of credit bureau functioning (VEDOMOSTI, 2003). For Russia, the adoption of the Law on Credit Bureaus is important, as it can facilitate development of the banking system and financial infrastructure in general. The complication of Russian relations with the World Bank may result in the government adopting an external loans programme for 2004, envisaging a significant reduction of loans from international financial organizations. Planning to curtail some programmes^ the Russian govern^ These programmes include 'Judicial reform support' (being realized since 1996), 'Assistance in social protection system restructuring' (since 1997), 'Assistance in coal industry restructuring' (since 1996).

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ment intends to receive four new loans from the World Bank. However, according to the WB-govemment agreement, the share of projects whose implementation is recognized as unsatisfactory cannot exceed 30%. Otherwise, maximum annual investment is reduced to USD 150 million per year. Now there are only 9% of such projects in Russia's portfolio, but should government plans be initiated, it could increase by up to 30% (VOSTOCHNOSIBIRSKAYA PRAVDA, 2003). It is worth mentioning that at the same time, the World Bank declares the necessity to limit external debt by 30% of GDP, in a situation in which external risks exist (PRIME-TASS, 2003). Future government projects include metro building in Kazan, highway construction in Moscow, the South way 'Don 4' construction and guarantees of non-commercial risks for SUAL holding. One can see that all these projects are practical and mostly relate to the transport infrastructure development. Thus such spheres as institutional changes, restructuring of the economy and social direction, which are still very important for Russian economy, move to the background. This way, the government forms a new system of priorities in its relations with the World Bank.

2.3 Russia and the World Trade Organization (WTO) At the stage of open economy formation, Russia strives to occupy a place corresponding to its demographic, scientific and production potential in intemational division of labor. At the same time, the main decisions on international trade rules are now taken collectively in the framework of WTO, making Russia's participation in this organization very important. Thus there are no more doubts about whether Russia is to accede to the WTO or not. From the political point of view, authorities, political circles and experts are access-oriented. Corresponding work and negotiations are conducted with more or less success and at a different degree of intensity, but there is no clear understanding about what economic consequences Russia is to expect from its accession, which of course drags out the process of discussion of its terms. Russian access to the WTO is connected with a significant scope of legislative activity. According to the Ministry of Economic Development, Russia is to adopt or revise over 100 laws and over 1000 departmental regulations (www.cio-world.ru). As a result, however, the state will possess a large and structured block of modern business legislation, corresponding with intemational law. Expert assessments of Russian legislation show that in the sphere of trade regulation, there is a need to strengthen the laws on protective

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measures and competition, the laws on the investment regime must be modernized, and service sphere legislation remains incomplete. In the sphere of investment, it is essential to make the investment attraction process in general less bureaucratic. But the most alarming situation is in the intellectual property protection sphere, whose reliability is vital for both foreign investments and high-technology export. A considerable amount of work is to be done in the standardization and certification sphere, which was formed during times in which the government bought and controlled the quality of most goods and services. Finally, the legislative preparation of Russian WTO access should include the revision and abrogation of the provisions discriminating against domestic business compared to foreign business. It is worth noting that most of the laws Russia promised its working group partners to adopt that are necessary to provide the correspondence of Russian judicial regulation of foreign trade and economy to the WTO requirements have either already been adopted or are under consideration by the State Duma. However, there is still a lot of work that must be done, and the process of adjustments and comprehensive consideration of the laws to be adopted will take a lot of time. At present, there are sore points for both parties in every field of negotiations that are as follows: 1. Energy tariffs. Russia is required to deregulate the energy market and equalize domestic and export prices for energy resources, primarily electricity and gas. This requirement is quite difficult for Russia, since it involves serious economic reforms and social consequences. In addition, there is no plan for gas industry reform, and the government's plan for electric power industry restructuring was adopted only recently. Thus it is a problem for Russia to determine its position on this issue. 2. Custom tariffs. One of the most important questions is Russia's joining the WTO Agreement on Civil Aircraft, which provides for zero import duties on aircrafts. Taking into account the present situation in the Russian aircraft industry, WTO requirements seem very difficult for Russia. Moreover, there is a block of other important questions on custom tariffs, related to automobile production, metallurgy, pharmaceutics, etc. 3. Services sector. The question involving the opening of the service market to foreign companies proved contradictory. Opinions about how negative the consequences of Western company entrance into this sector of the Russian economy may be conflicting. Russia clearly needs a strong national sector of financial services, which conditions

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the necessity of preserving (or introducing) controls on foreign capital within this market. 4. Agriculture. In the context of this issue, the level of state support for Russian agriculture after the country's accession to the WTO is being negotiated. This is a very complicated issue, as various types of state subsidizing divided into few categories are worth considering. The main point giving way to objection on the part of the WTO is Russian insistence that the level of subsidies be fixed, based not on the past 3 years' indicators but based instead on the amount of subsidies necessary for Russian agriculture to develop normally. The 20'*' meeting of the WTO Accession Working Group for Russia took place in Geneva in July 2003. Despite the fact that an agreement was reached on almost 85% of accession conditions, there has still been no serious advance in solving the main contradictory questions. During the meeting, relevant questions about the power industry, custom tariffs on a number of goods, subsidies to agriculture and problems of foreign company access to the Russian market of goods and services were discussed. The tariff policy in the power sector remains a sore point for Russia. The EU and WTO requirements to equalize domestic and external prices for energy resources seem illogical and unrealistic. In the event the West remains adamant on this point, the process of Russia's accession will be prolonged, as the Russian government is not ready to quickly acquiesce on its low domestic prices for gas, dismissing them through Russia's natural competitive advantage. This is where contradictions emerge. On the one hand, it is impossible not to admit that the gas price in Russia is the result of monopolistic activity. On the other hand, the question of gas industry reform has yet not been resolved. The fact that European colleagues have eased their requirements inspires optimism, now speaking not about equalizing domestic and export prices, but instead about the transparency of energy pricing. During recent Russian-EU negotiations, the exact prices for oil and gas were not discussed at all. The position of the Russian delegation has remained the same. The power industry is not included in the sphere regulated by the WTO, and Russia has failed to take any obligations relating to it. According to Maxim Medvedkov, Deputy Minister of Economic Development and Trade, head of the Russian delegation at the WTO accession negotiations, a compromise was reached, satisfying all parties including Russia and corresponding to its programmes for the development of concrete economic sectors. According to M. Medvedkov, Russia hopes to bring negotiation on foreign access to the Russian market to conclusion by 2003. Such a fa-

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vorable scenario may lead to Russian access to the WTO in 2004. The next Working Group Meeting is to take place in October 2003, and it is quite possible that after this round the prospects for Russian membership in the WTO will be clearer. The situation with automobile production is not any less complicated. This sector is a subject of contention between Russia and the WTO. The Russian government intends to encourage investment in automobile production by raising custom duties on imported cars from 25% to 35% in 2007. At the same time, the Ministry of Economic Development and Trade promises to reduce duties to 10%-15% after the transition period is over. Foreign car manufacturers are not enthusiastic about this idea, and analysts are convinced that these protective measures will prove useful only for Russian enterprises. An increase in duties on foreign cars may create additional difficulties during negotiations on Russian accession to the WTO, since Russia is required to keep import duty on cars below 25% during its accession to the WTO and 10% after the transition period. As a result, there is every possibility that intentions to raise duties to 35% will not be welcome. Let us now consider a situation by which foreign companies come to the Russian market of goods and services. According to Yevgeny Yasin, Academic Supervisor of the Higher School of Economics, 'there is no competition in many sectors [of Russian economy]; either companies are half-sleeping or markets are divided among the players. Russian firms need a shock, a challenge'. The appearance of a foreign player in any sector of the economy (for instance in the case of his buying an enterprise) provides such a challenge. There is also another positive aspect in the presence of foreign firms in the market, and many experts consider it the main one. It is not investments but rather the introduction of the Western business culture in Russia; it is not a secret that in most cases the level of foreign management is considerably higher than the Russian level. However, some questions remain unresolved. Nobody knows for sure what will happen in the event Russian owners sell the majority of interest in their enterprises to foreign investors on a large scale. From this point of view, another negative moment is that foreign investors today want to acquire large businesses (with rare exceptions), having a significant administrative resource. Foreign companies seem to have understood that making friends with the authorities is a necessary condition for the business to succeed in Russia and started feeling at ease with this instrument. It thus seems that there has been the adoption of Russian 'bad' norms by foreign companies rather than the adoption of Western 'good' norms by Russia. Moreover, preserving control of national capital over a number

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of sectors can be regarded as strategically important. This is the case of the financial sector and particularly of the banking system. Issues related to accession conditions were discussed during the meeting of the Ministry of Economic Development and Trade Board in the middle of July 2003. Having analyzed different scenarios of Russian accession to the WTO, the Higher School of Economics (HSE) reported that even under the most unfavorable conditions such as a dramatic reduction of import duties, membership in the world trade club would accelerate GDP growth. HSE experts have proven that the impact of duties on the economy is much weaker than that of the exchange rate. Thus one should not worry about individual branches that are poorly adapted to hard competition. Other than this an opinion was expressed that Russian-WTO negotiations can theoretically be terminated by the end of 2004, which means that after some necessary procedures, Russia could be admitted to the WTO after 2006. Nevertheless, it is necessary for the country to uphold its position on a number of key issues. In addition to the fact that the Russian authorities, including the President, disagree on dramatically increasing domestic gas prices as the EU would have, Russia is not ready to fully liberalize its financial market including insurance services, thereby providing free access of foreign companies to national telecommunications. There has been no progress in resolving the question of the level of state support for agriculture. Russia insists on investing in agriculture at a rate of USD 13 billion annually, while Australia, Canada and the New Zealand think that it should stop subsidizing agriculture. Moreover, WTO negotiators are not satisfied with the high import duties on automobiles and aircrafts. The Russian delegation does not want to sacrifice its positions in these areas. With all the above in mind, it is hard to expect that the latest prognosis of German Gref, let alone his previous one foreseeing Russian accession to the WTO by the end of 2004, will come true.

2.4 Russia and the Organization for Economic Co-operation and Development (OECD) The Organization for Economic Co-operation and Development (OECD) was created in 1961, and today it unites 30 of the most developed countries of the world. The main aim of the Organization is to achieve the highest sustainable economic growth and employment and higher standards of living in member countries, while simultaneously maintaining financial stability. The Organization itself admits that it is actually a

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'club' for exchanging the advanced experience in the field of economic and social policies. Over the past several years, the Central and Eastern European countries that made the most significant progress in the sphere of market reforms have become OECD members. These countries are: the Czech Republic (date of admittance - December 21, 1995), Hungary (May 7, 1996), Poland (November 22, 1996), and Slovakia (December 14, 2000). In 1994, the Declaration of Co-operation between OECD and the Russian Federation was signed in order to improve the political dialogue and to help Russia build up a market-oriented economy. In this Declaration, it was stated that 'the OECD will render assistance to the Russian Federation in the process of transition to a market economy, particularly in elaborating and implementing market reforms on macroeconomic and sectoral level, including the creation of a legal and institutional infrastructure and instruments of market economy, and in the development of statistics'. In 1996, Russia applied for the OECD membership. Russia's admittance to the OECD was announced as the final goal of cooperation at that stage. In 1997, the Protocol on the creation of the Liason Committee for OECD and Russia was signed. The Committee brings together the high representatives of OECD and Russian government bodies. It monitors the progress of economic reforms in Russia, analyses the results of implementation of the annual OECD programmes in Russia and gives recommendations on the prospective directions of cooperation (www.oecdmoscow.org). Since the summer of 1999, Russia has been granted the status of observer in a number of OECD working bodies. At present, Russian representatives participate in the work of 19 OECD Committees as observers. The latest programme of co-operation between the OECD and Russia includes the following main points of concentration: - promoting the improvement of state and corporate governance; - creating a favorable environment for the development of activities in several industrial sectors, proceeding with tax reform, strengthening anti-monopolistic legislation, stimulation of foreign investment, establishment of a stable banking system and struggle against corruption; - focusing on regional development with an optimization of the distribution of incomes between the center and regions; - assessing the progress of Russia and helping it correspond better to OECD practice and norms (www.oecd.org). Noting the success Russia has achieved in the past few years, OECD experts emphasize the need to replace the temporary external factors now in action with new sustainable sources of growth. Experts also draw at-

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tention to the continuing considerable capital flight from Russia and the weak small business sector. Poverty and underdevelopment of social policy infrastructure remain Russia's most serious problems. In June 2003, OECD Secretary-General Donald Johnston nevertheless expressed his opinion that Russia may already join this organization within the upcoming three years. The process of entering the OECD is quite complicated, specifically the decision on which country is to join the OECD and on what terms is taken by member countries at the meeting of the Council. A candidate country must share the basic values of the OECD, including having an open market economy. Moreover, it must announce its position on more than 160 OECD 'legal instruments' (decisions, recommendations and declarations). The country decides which of them it accepts and which of them it does not. In accession negotiations, two OECD Committees play the key role: the Committee for Capital Movement and Invisible Transactions and the Committee for International Investments and Multinational Enterprises. They evaluate the degree to which the candidate country is able to apply OECD Codes of Liberalization of Capital Movements and Current Invisible Operations. These Codes restrict the usage of the instruments of national economic policy regulating capital movements, foreign investment and trade in services (www.oecd.org). It is necessary to approach the issue of OECD accession pragmatically. On the one hand, it allows Russia to join the 'club' of the most advanced countries. Meanwhile, it is not to be forgotten that this country is already a member of GS"^, which is not, however, an official organization like the OECD. Among other advantages of OECD accession are the access to information about the governance of the market economy and 'gaining the rating' crucial for the external borrowing from intemational organizations and private investors. On the other hand, becoming an OECD member is necessary to take some commitments, particularly the observation of the Code of Liberalization of Capital Movements. To do so, CEE countries had to lift numerous restrictions on corresponding operations before and after the OECD accession. It is worth noting that Slovenia, the most advanced (according to per capita GDP) CEE country, which until recently maintained its restrictions on cross-border capital movement, is not yet an OECD member. In any case, prerequisites for Russian OECD accession do exist. The gradual growth of per capita GDP is one of them. Additionally, the fact "^ In this connection it is significant that in order to gain support for Russia's OECD accession it was proposed to conduct preliminary consultations with G8 members, who, of course, play the key part in the OECD.

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that Russia was removed from the black list of the Financial Action Task Force (FATF) is of great importance for the OECD, paying much attention to its fight against money laundering. For Russia, OECD membership is relatively a long-term goal, whose achievement depends on attaining an agreement on key issues. The main emphasis should be placed on cooperation with this organization in a number of areas important for Russia. One such important spheres is the improvement of corporate governance. According to the OECD, corporate governance is one of the key factors when considering investment in Russian enterprises. In June 2003, OECD representatives approved a reform of corporate governance in Russia. They noted that over the past three years Russia had seen impressive results in this area. According to the European Bank for Reconstruction and Development, Russia had one of the highest levels of corporate governance among CEE and CIS countries in 2002 (SKRINNEWS, 2003). Up to now, Russian businesses have realized the necessity of applying corporate principles to their activities, and some concrete steps have been taken in that direction. For instance, all stock exchanges have already introduced changes to its rules of listing, having set compliance with the code of corporate behavior as an obligatory condition for including companies in the Al-level quotation lists (PRIME-TASS, 2003). Russian companies and banks must also adhere to international accounting standards. The Russian Union of Industrialists and Entrepreneurs developed the Charter of Business Ethics. Progress in this direction would promote the gradual improvement of Russia's image as a country with developed economic standards. One area of priority of OECD activity in transition countries including Russia is the creation of the Anti-Corruption Network for Transition Economies. The main purpose of this Network is the exchange of experience and information between government bodies, non-governmental organizations and private sector representatives from different countries. Under the auspices of this project, emphasis is laid not on the 'police' aspect of fighting corruption, but on removing excessive legislative and administrative restrictions that hamper the development of businesses (for example, intentionally complicated procedures for the licensing and registration of new firms). The struggle against corruption will foster strengthening of the national economy and help to attract additional foreign investment. Another area of cooperation with the OECD that may prove beneficial for Russia is promoting competition within Russia. When tackling this issue, however, it is essential to take into account national specifics and social aspects of reforms in some of the natural monopolies. The positive

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conclusion OECD experts made on reforming the Russian railway sector can be used as an example here. It emphasizes the need to stop crosssubsidizing passenger transportation at the cost of goods transportation, which has important social effects through an increase in ticket prices. Furthermore, experts note that 'the risks connected with the delay of reforms may prove to be higher than the risk of speeding-up the reforms' (PRIME-TASS, 2003). Yet however important the reform of natural monopolies may be, it must be implemented with maximum efficiency rather than with maximum speed. The OECD activities bring about significant positive results for the Russian economy. For example, in May 2003 the OECD countries approved the basic principles of the Agreement on Reducing Subsidies for Metallurgy (INTERFAX, 2003). It is one of the cases where foreign trade liberalization on the intemational level is beneficial for Russian exporters, since the Russian government stopped subsidizing domestic metallurgical enterprises a few years ago. Moreover, OECD experts made a decision to move Russia from the fifth group of the OECD's credit rating system into the forth group in July 2003. This decision means that Russia will benefit from the lower costs of borrowing on the intemational financial markets. OECD's credit rating is taken into account by state insurance and investment agencies in developed countries. In connection to this, Russia's move into the fourth rating group allows it to reduce insurance costs by 2 percentage points. The decision made by the OECD is also important when foreign purchases of equipment guaranteed by the Russian government are concemed. It is worth noting that immediately following this decision by the OECD at the meeting of the FRG Interministry Committee, it was decided to abandon the limit of USD 1 billion on state guarantees for dealings with Russia connected with middle- and long-term credits (BIKI, 2003, p.2). The above examples are evidence that even before Russia accedes to the OECD, there are prospective fields of cooperation between them.

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3. Russia and Regional Integration Blocs 3.1 Russia and the European Union (EU) It is impossible to overestimate the significance of the European Union for Russia. This is especially the case with consideration of the EU enlargement process that will result in the Central and Eastern European (CEE) countries, traditionally having close relations with Russia, joining in May 2004. It is known that the EU is Russia's most important trade partner. In 2002, the EU share of Russian foreign trade turnover was 49% (including 47.5% of Russian exports and 54% of Russian imports). The dynamic of Russian-EU foreign trade in 1996-2002 is presented in table E3. Table E3. EU-Russia Foreign Trade, 1996-2002 (Million Euro) E U export E U import Trade balance

1996 19132 23392 -4260

1997 25539 27037 -1498

1998 21087 23172 -2084

1999 14772 25918 -11145

2000 19828 45334 -25508

2001 2002 27814 30300 47428 47500 -19614 -17200

Source: Eurostat During the past few years the Russian-EU foreign trade balance was positive for Russia (and negative for the EU), having increased as a result of world oil price increases from 1999 to2002. At the same time, Russia is a less important trade partner for the EU than the EU is for Russia. In 2002, Russia's share in EU trade turnover was only about 4%. In some areas, however, trade with Russia is extremely important for the EU. Thus, Russian oil accounts for 16% and Russian gas 20% of the total oil and gas consumption in the EU. As far as the volume of foreign trade turnover is concerned, Russia ranked 5^** among the EU partners in 2002, after the USA, Switzerland, Japan, and China. This demonstrates that the main articles comprising the Russian exports to the EU are fuel and raw materials. Manufactured industrial products and consumption goods represent most of the EU imports to Russia. Russian-EU relations were organized institutionally by the Partnership and Cooperation Agreement (PCA) signed by presidents or prime ministers of EU member states, the President of the European Commission and the President of the Russian Federation on Corfu in June 1994 and came into effect on December 1, 1997. The PCA is targeted as a long-term liberalization of mutual economic relations and the creation of a free trade zone between Russia and the EU.

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The fact that Russia became the first country addressed by the EU Collective Strategy adopted in June 1999 at the Cologne summit serves as testimony of the significance of Russian-EU relations. The Strategy envisages Russian integration into the common European economic and social space. In October 1999, Russia responded by adopting the Medium-term strategy for relations with the EU. For the practical realization of provisions on Russian-EU cooperation, the May 2001 summit decided to create a High Level Working Group to elaborate the concept of the Common European Economic Space (CEES). The main CEES objective is bringing Russian and EU economies, including norms and rules of their functioning, closer to each other. However, it is necessary to understand that in practice this 'bringing together' means Russia's passing over to the EU norms and rules, which are bound to limit freedom of action while pursuing the national economic policy. At the same time, this can bring about essential advantages. For instance, it will be easier for Russia to attract investment from Europe if they have similar legislation. The harmonization of norms can help in other spheres as well. For example, to sell electricity in Europe, it is necessary to follow certain ecological standards. If Russia complies with them, it can increase its electricity exports to the EU (BORDACHEV and ROMANOVA, 2003). In the area of foreign trade, as was mentioned above, the EU is aimed at creating a free trade zone with Russia. At the same time, it declares the necessity of Russian access to the WTO. At present, Russia has the status of most favored nation, which means that there are no quantitative restrictions on its export with the exception of that of foundry products (accounting for 4% of bilateral trade). However in modern practice, tariffs and quantitative restrictions are not the main barriers to foreign trade. Despite declarations about cooperation, there are still trade wars between Russia and the EU. For instance, after an antidumping investigation against Russian producers of technical carbon began in Brussels on April 1, 2003, the Russian government introduced 3-year quotas on poultry (1.05 million tones per year), pork (450 thousand tones), and beef (420 thousand tones) imports, the share of the EU in poultry import quotas being much less than that of the USA (KOMMERSANT, 2003). In connection with the role of oil and gas in mutual trade, the RussianEU dialogue on energy is of special significance. It is related to oil, natural gas, cooperation in integrating energy systems of the EU and Russia, and trade in nuclear materials. The EU is first of all interested in longterm and reliable deliveries of energy from Russia. Russia's energy complex, in turn, needs significant investments.

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There is an essential advance in this dialogue. In particular, an International Fund was created to hedge some of the non-commercial investment risks. A regional sputnik system for preventing accidents in oil and gas infrastructure is being created. In 2002, Russia suggested integrating its energy system with its European counterpart to be able to export electricity to Europe. The European Union for the Co-ordination of Transmission of Electricity (UCTE) is planning to provide a technical and economic foundation for this project (VREMYA NOVOSTEY, 2003). The EU is ready to further cooperate with Russia in the energy sector in the following fields: energy preserving strategy, stimulation and protection of investments, the right of access to energy transport infrastructure, independence of net operators from natural monopolies, sectoral regulation, reform of monopolies and tariff policy. However, it is in the area of tariff policy that one of the most serious contradictions between the EU and Russia lies. It is connected with the two-tier pricing of oil and gas. The EU requires that Russia raise domestic prices (see part 1.3). One of the arguments is that Russian goods produced using cheaper energy are more competitive by price on European markets. For a long time, this issue was a reason for the EU's hampering Russian accession to the WTO. Another problematic issue is the access of foreign investments to Russia. The EU suggests that Russia should hft the restrictions on foreign capital access to a number of sectors such as the services sector, including finance, telecommunications, transport, and banking markets. For instance, in March 2002 Pascal Lami, the European Union Trade Commissioner, sent a letter to Alexey Kudrin, Vice Prime Minister, insisting on giving Russia access to the European insurance companies (BORDACHEV and ROMANO VA, 2003). From Russia's point of view, there is a danger that foreign capital will come to dominate yet insufficiently developed branches of the services sector. The consequences of EU enlargement for its relations with Russia require special consideration. On the one hand, this will allow Russia access to a harmonized market with a population of 450 million. In addition to this, due to close relations with the CEE countries, Russia may expect some decisions advantageous for it to be taken within the EU (because the CEE representatives will participate in its structures). On the other hand, EU tariffs will worsen the terms of trade in some goods with the CEE countries. For example, now zero tariffs are imposed on gas and aluminum imports in the Czech Republic, but after joining the EU, these will rise up to 0.7% and 5%, respectively (RADIO PRAGA, 2003). Thus EU enlargement cannot be regarded as definitely beneficial for Russia.

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Not long ago, during the Italian presidency in the EU, S. Berlusconi, the Italian Prime Minister, declared that Russia could become a part of united Europe and join the WTO by the end of 2003. By the November Russian-EU summit in Rome, Berlusconi will present the documents on integration measures, including the creation of a permanent advisory body ('25 plus 1'), participation of the EU and Russian Ministers in the comprehensive discussion of common European problems such as transport, communication, high technologies, and security (CRAS, 2003). In connection to this, the opinion about the necessity of Russian accession to the EU is expressed more often. But such a scenario can hardly be regarded as realistic. What is more promising is the search for new concrete areas for EU-Russian cooperation, such as diversification of EURussian mutual trade, for example, through European investments in the branches of the Russian economy that require priority development; passing over to new standards of corporate governance; and the creation of common infrastructure (including the already mentioned integration of energy systems). There is already clear progress in these fields with many European companies actively investing in Russia. At present, the EU accounts for more than 50% of total foreign investments and 37% of foreign direct investments in this country. The realization of the Tacis programme, launched by the EU in 1991 to facilitate the CIS countries' transition to market economies, is an important concrete field of Russian-EU cooperation. Between 1991 and 2003, Russia received about euro 2.7 billion under the framework of this programme. The most significant assistance was provided for the following fields: private sector support and fostering the economic development (euro 352 million), nuclear security (euro 349 million), regional and other programmes (euro 306 million) and development of infrastructure nets (euro 305 million) (www.eur.ru). The application of the principle of four freedoms (freedom of free movement of goods, services, capital and labor) in Russian-EU relations now seems untimely. While in the field of goods trading the idea of a free trade zone can be viewed as promising, it will first be difficult for the EU to agree to open its borders for Russian citizens looking for job and second for Russia to lift all the controls over cross-border capital movement. Russia's economic development is not stable enough for the state to give up instruments that may be of use in case of external shocks. In general, the process of Russian-EU integration is a part of a wider process of Russia's integration into other international structures (the WTO, the OECD, the Group of 8), and in this regard, the approach from the point of view of national economic development should be a central priority for Russia.

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3.2 Russia and the Group of 8 The first gathering of the heads of leading economically-developed countries took place in 1975, when the French President Giscard d'Estaing invited the Leaders of Germany, Japan, the United Kingdom, the United States and Italy to Rambouillet. In 1976, at the summit in Puerto Rico, Canada joined the group of 6 countries. In 1977, representatives of the European Economic Community started taking part in the G7 summits. At the beginning the G7 forums focused on the tuning of short-term economic policies among participant countries. Gradually they tumed to a more global perspective, starting to tackle political and social issues. This lead to the decision, taken at the Denver summit in 1997, to invite Russia to join the group. The first G8 summit took place in Birmingham in 1998. Though Russia has taken part in G8 for five years now, the degree of its involvement in taking decisions on economic issues is still insignificant. In general, it is consistent with the policy of Russia under the framework of G8 to give priority to political issues, since this country's political weight on the international arena is bigger than its economic weights However, the degree of Russian involvement in the discussion of global economic issues is gradually increasing. It is partly due to the dynamic growth of this country's economy in contrast to the problems in other G8 countries' economic development, and partly due to the significant role it plays in world energy markets. After the Denver summit, Russia started taking part in the work of G7 Expert Groups on Employment and Development. It participated in the conferences on employment in Kobe (November 1997), London (February 1998), and Washington (February 1999). In January 1998, Russia was invited to the Expert Group on Development and was included in the dialogue on assistance to developing countries, received support for their integration into the global economy, right governance and transparency, fight against infectious diseases, etc. In October 1998, the Russian Deputy Minister of Finance took part in the G8 Ministerial Meeting on Development in Washington. Russia's involvement in the discussion of the problems of developing countries was promoted by a large amount of those countries' debt to the USSR and consequently to the Russian Federation. Thus, writing off the ^ In this respect it is significant that G7 tumed into G8 by inviting Russia but not China (as it was first planned), which has a considerably greater share in the world economy than Russia.

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debts of the world's most needy countries was the price of Russia's political participation in the club of leading industrially developed countries. At the Evian summit in June 2003, the question was raised about the possibility of writing-off the debts of the most needy/poorest countries. As a result, Russia declared that it would write off debt in the sum of USD 10 billion, while the USA agreed to write off USD 2 billion (PARLAMENTSKAYA GAZETA, 2003). Approximately USD 5.5 billion out of the USD 35 billion written off over the past five years belong to the category 'official development assistance to the most needy countries' (the initiative announced in the framework of G8 in 1996). Russia ranks third in the absolute amount of assistance and first in the ratio of this amount to GDP (KOMMERSANT, 2003, p. 10). Over the past few months, Russia dedicated USD 10 million to fund the Cologne Initiative, a debt-relief plan for the world's poorest countries. A sum of USD 11 million was granted to the World Food Program (LUKOV, 2003). Thus one of the concrete directions of Russian participation in solving global economic problems has taken shape. Unlike the above-mentioned international organizations, the Group of 8 is of an informal nature and possesses no legislative power. Nevertheless, the political and economic weight of G8 countries sometimes makes the enactment of decisions taken in its framework even more effective than is the case when such decisions are taken by formal organizations. Moreover, participation in the G8 certainly gives Russia additional weight. Unlike participation in other organizations (such as the IMF, the World Bank, the WTO, the EU, and the OECD), however, it does not reflect qualitative improvements in the country's economy. As was already mentioned, an increase in Russia's influence in the framework of G8 is mostly due to political factors. At the 2002 summit in Kananaskis (Canada), it was therefore declared that Russia is to host the G8 summit in 2006. Another important result of the Kananaskis summit was the decision to grant the CIS countries USD 20 billion over the next 10 years for the safe storage and elimination of nuclear weapons and radioactive materials. Approximately 80% of this loan is intended for Russia (VREMYA MN, 2002). It is evident that this decision, though an economic one, primarily has a political impetus. In February 2003, the Russian Minister of Finance, A. Kudrin, participated in the G8 Meeting of Ministers of Finance in Paris. Such issues as the fight against financing international terrorism, ensuring the progress of African economies, and creation of a new international credit system came under discussion (PRIME-TASS, 003). However, Russia's participation in such meetings remains limited, and the last day of the Paris meeting saw no presence of this country. Still, in the framework of G8, Russia's participation in the discussion of such issues as development as-

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sistance, fight against terrorism and money laundering is increasing. The removal of Russia from the FATF black list has also contributed to this. At the 2003 summit that took place in Evian (France), quite important economic issues were raised in the course of bilateral meetings. During the meeting with Jacques Chiraque, Vladimir Putin discussed the issues of broadening cooperation, as well as the questions of power production and supply and cooperation in the aerospace industry. During the meeting with G. Schroeder, an agreement was reached to hold the RussianGerman Forum on Energy, in the course of which experts would discuss the prospects of the international consortium for natural gas transportation to Europe (PARLAMENTSKAYA GAZETA, 2003). Unfortunately, because of the disagreements between industrially developed countries, the Kioto Protocol was not mentioned (ROSSIYSKAYA GAZETA, 2003) in the final communique, although the enactment of its provisions could have offered significant advantages for the Russian economy. The Evian summit showed that although the G8 is a flexible and effective mechanism for the settlement of international economic and political issues, first it depends to a great extent on the relations between national leaders, and secondly, it is likely to evolve over time. Experts note that the G8 has almost stopped considering the economic problems of participant countries, for which purpose it was created back in 1975 (VREMYA NOVOSTEY, 2003). Meanwhile, it is evident that without overcoming the recession in the leading industrially developed countries, it is difficult enough to solve many of the global economic problems. The final Protocol of the Evian summit contains the declaration on the confidence in an economic upsurge in the near future (ROSSIYSKAYA GAZETA, 2003). This declaration was made in order to calm down the world finance markets, but it was not supported^acked by any agreements between leading industrially developed countries about joint action to achieve this goal. Instead, it contains general declarations of intentions concerning strengthening market discipline and effective regulation, as well as enhancing corporate governance (www.g8.fr). At the same time, during the discussion in Evian, V. Putin noted that Russia can foster world economic growth through stability and foreseeable policies in general and in the areas of power production and supply, in particular. At least in this way, a means for Russia to contribute in overcoming world recession was outlined. The fact of inviting the developing countries' representatives to Evian may signify the intention to expand the G8. Taking the scale of their respective economies into consideration, China and India certainly deserve to be members of this 'club'. For Russia, however, these countries' admittance to the G8 will mean a certain decrease in its influence in the expanded organization. Nevertheless, Russia is unlikely to escape from set-

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tling the economic and financial problems under the G8 framework, rather involvement in the discussion of these problems lends to Russian interests. Thus, Russia will be able to take part in solving the issues crucial for the world economy, such as forming intemational finance infrastructure, creating mechanisms for the prevention of financial crises, etc. Russian participation in the G8 may help its accession to the WTO on non-discriminating conditions in the near future and to the OECD over the longer-term. Negotiations with EU leaders provide an opportunity for settling the problems of cooperation with this integration bloc. Cooperation with the G8 should be a constituent of the general process of Russian cooperation with intemational organizations.

3.3 Russia and Asia-Pacific Economic Cooperation (APEC) APEC is active in issues of foreign trade liberalization, business facilitation, economic and technical cooperation, youth and women. Twenty-one countries are APEC members, accounting for about 60% of the world GDP and 50% of its foreign trade. The fomm lacks a tough mechanism for compulsion and formal norms, operating on the basis of consultations and consensus. One of APEC's key goals, declared in 1994 in Bogor (Indonesia), is free and open trade in the Asia-Pacific region by 2010 for industrially developed economies and 2020 for developing economies. The Russian Federation became an APEC member in November 1998. For Russia, as well as for Vietnam and Peru, also admitted to APEC in 1998, a transition period of one year was fixed, after which these countries became full members of the forum. Russian accession to APEC was aimed at diversifying the country's foreign trade structure, dominated by European and CIS countries. It also gave an impetus to foreign trade development in the Russian Far East, whose main trading partners are Asia-Pacific countries, having suffered more seriously than the rest of Russia from the transformation decline between 1992 and 1997 (www.ide.go.jp). The Concept of Russian participation in the forum *Asia-Pacific Economic Cooperation', approved by the Russian President V. Putin in November 2000, lists the basic prospective fields of cooperation with this organization, including APEC's backing of Russian accession to the WTO, fostering investment in the Far East and Siberia, establishing broad contacts with the unions of industrialists and exporters of APEC countries, etc. At the same time, the Concept mentions the danger of Russian regions' excessive involvement with APEC countries and the weakening of links between these regions and the rest of Russia. Coop-

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eration with APEC should by no means threaten Russian territorial integrity. Organization of several joint forums in Russia became an important form of cooperation between this country and APEC. Thus in June 2002, the Russian Ministry for Anti-monopolistic Policy together with the APEC held the Forum 'International Business Cooperation in Innovation Entrepreneurship' in Moscow. Mrs. S. Kalayasiri, Inspector General, Office of the Permanent Secretary, Ministry of Industry, Thailand, noted: The Innovation Forum achieved its objectives. We could gain and share the experience in innovations, technology transfer, incubation, small and medium business financial and credit support, and innovation projects. At the same time, we had an opportunity to see the progress and success of the Russian new technologies. The Forum was organized very well' (http://apec.technet.ru). The intensification of bilateral international contacts with the South Korea, Indonesia, Malaysia, Taiwan, and Hong Kong was among the outcomes of the Moscow Forum, reported by the Russian delegation at the XVI Meeting of the APEC Working Group on Small and Medium Business, held in Malaysia in February 2003, as well as the creation of the Center for Business Cooperation between Russia and APEC, aimed at rendering assistance to businesses, primarily to small ones, in establishing international partner relations. The Vladivostok Forum, held in September 2002, met a wide response. However, its results proved quite modest. The Primorye authorities signed the treaty of intentions to attract USD 185 million of foreign investment, out of which USD 110 billion were supposed to be the contribution of foreigners. Potential investors were attracted by the mining and fishing industries, as well as by the chemical industry and power production. Recently, the Primorye Governor Sergey Darkin announced his intention to check the effectiveness of the contracts signed during the Vladivostok APEC Forum (FC NEWS AGENCY, 2003). The progress of several projects is already reported. Thus in the 4"" quarter of 2004, it is planned that construction be finished on a trade center at the Russian-Chinese border, where high-quality products from the central and southern Chinese regions will be sold (ZOLOTOY ROG, 2003). Aditionally, a diamond factory has already been opened in Vladivostok. As such, there are concrete outcomes of cooperation under the framework of APEC. In 2002, Russian foreign trade turnover with APEC countries made up USD 24.9 billion (16.4% of the country's total foreign trade turnover) and approached the value of the foreign trade turnover with the CIS countries (USD 25.8 billion); as the latter stagnated in 2002, however, the former grew by 9% (exports increased by 7%, imports by 12.7%)

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(PRIME-TASS, 2003). Thus, trade between Russia and APEC is gradually developing. Yet it is too early to talk about a full realization of its potential. There are still several problems in the relations between Russia and APEC. Among them are the uncontrollable migration to the Far East and Siberia, considerable volume of illegal foreign trade, poaching in Russian territorial waters, etc. Cooperation in the framework of APEC should also be directed to solving these problems. The creation of a free trade zone in the Asia-Pacific region is not reckoned among Russia's foreign trade priorities, so the long-term nature of the Bogor Goals and entering the free trade zone in 2010 or 2020 (depending on Russia's image on the international arena) do not contradict its interests. One of the prospective fields for further cooperation with APEC in the near future may be the involvement of the Far East and Siberia in APEC's Economic and Technical Cooperation (ECOTECH). Special attention may be paid to the following areas of cooperation: power production and supply, fishing industry, preservation of sea resources, and development of the infrastructure. For instance, the APEC Manual of Best Practice Principles for Independent Power Producers and the APEC Natural Gas Initiative are aimed at reducing risks connected with financing the projects of power infrastructure development (www.vladcity.ru). At the same time, the Forum's resources for financing individual projects are quite limited. For this reason, its participants should situate themselves first towards its information capacities, using this as a platform for business negotiations. Participation of Russian business representatives in the APEC Business Advisory Council and the Forum's various Working Groups may become an effective mechanism for this purpose. It is necessary to better use the opportunities of hosting APEC's events in Russia and to improve the effectiveness of these events, using the 2002 experience of Vladivostok, as well as China's successful experience in this area.

3.4 Russia in tlie Commonwealtli of Independent States (CIS) For more than ten years, the independent states have coexisted on the territory of the former USSR, allows for an attempt to reveal more or less stable regularities in their interaction. After a decade of independence in the former Soviet republics, there has been almost no doubt as to the intentions of the elites in connection to gaining national sovereignty. As a matter of fact, they planned to carry out modernization according to the Western European model. In this

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sense, the newly formed post-Soviet states were similar to the countries of Central and Eastern Europe. In both regions, aspirations were the same: pluralistic democracy, civil society, social market economy, open economy and participation in international economic relations on an equal-rights basis with the aim of increasing the competitiveness of domestic production and the share of high technology products in national production and export. Perhaps the only difference was that for the sake of achieving the said goals, the post-Soviet countries hoped to create a principally new regional bloc (the Commonwealth of Independent States), while the countries of Central and Eastern Europe (CEE) expressed their firm intention to accede to the European Union straight after the COMECON's disintegration. It should be mentioned here that at the moment the CIS was organized, its members did not raise the question about joining the EU, let alone the NATO, even in theory. These were the intentions, and now we shall consider the outcomes. Having freed itself from the totalitarianism, the former 'second world' not only failed to come closer to Western European socio-economic standards but found itself even farther away from them. Over the whole period of market reforms, only five post-socialist countries (Poland, Hungary, Slovenia, Slovakia, and the Czech Republic) has managed to reach pre-reform levels of private incomes, while the rest of the 'second world' is still far from that. The gravest situation is in the post-Soviet area, where an abrupt decrease in private incomes was accompanied by their strikingly unequal distribution. According to the UN, by the end of the 1990s the number of those living there on less than 4 dollars per day was more than 140 million, ten times as many as by the end of the 1980s. In 2001, real private incomes in Russia made up only 55.7%, in Azerbaijan - 73%, in Kirghyzstan - 19%, in Tajikistan - 12%, and in Ukraine - 32% of the level of 1991, and in Armenia - 37% of the level of 1992. According to the available data on the seven CIS countries, real private incomes exceeded the pre-reform level only in Byelorussia (by 37%). Therefore without any risk of exaggeration, one can say that the ten years of sovereignty have actually brought most of the former Soviet republics closer to the 'third world'. Yet this is not the only point. Almost in every CIS country, the tendency towards demodernization of public life manifests itself more or less vividly, and in some republics even a 'tragic transition backward to a pre-modem era' (COHEN, 1998) has taken place. First, in the majority of new independent states, authoritarian political systems were established instead of the anticipated pluralistic democracies, and in the rest of these states, fragile defective democracies were formed. Secondly, instead of a civil society, one can see an atomized one; people lose their motivation for self-organizing, and

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the paternalistic tradition of setting hopes upon 'wise' authorities revives. Thirdly, instead of a social market economy, a sort of clan-based peripheral capitalism with the tendency towards the primitivization of production and de-intellectualization of labor dominates in almost every new state. And finally, instead of a desirable integration bloc, an obviously disintegrated (fragmented) area has arisen in the territory of the former USSR. I would like to consider this last point in its different aspects with the greatest possible extent of impartiality. To begin with, almost all Russian experts in the problems of the post-Soviet region agree that a centrifugal tendency still dominates there. The attitude towards this tendency varies, however, and so do the views on both the prospects of the CIS and Russia's optimal policy towards this organization. I would characterize the first point of view as nostalgic, restorationoriented. Accordingly, the disintegration of the USSR is a 'mistake of history', caused mainly by the former Soviet republics' authorities, including Yeltsin's administration, striving for more power. The adherents of this point of view claim that by now, the peoples of the vanished state have realized all the fatal consequences of disintegration, and with due political will it is still possible to restore a single state. It goes without saying that this view is unrealistic to put it mildly. The second point of view can be called liberal, or westernizing. In diametric contradiction to the adherents of the above view, its supporters argue that the disintegration of the USSR is a 'gift of history', being an objective result of the preceding dynamics. The quintessence of this approach is the strong conviction that after getting rid of its less developed satellites, Russia can enter the civilized, i.e. the Western European, world much faster and at a lower cost. In other words, if Russia wants to solve the problem of low competitiveness of the home manufacturing industry in a shorter space of time, it must detach itself from the former Soviet republics. As for the reintegration with them, it can only help to preserve Russia's backwardness, creating a 'peculiar reserve of unpretentious demand' (SHISHKOV, 1996). By the way, most representatives of the western political establishment share these ideas concerning the structuring of the post-Soviet space, though, most likely for different reasons (I will address these later). As for the CIS, within the framework of the westernizing approach, it is regarded only as a 'liquidating commission', aimed at making the 'divorce' of the former Soviet republics more or less painless. At the same time, from the very beginning of the post-Soviet period, some influential adherents of this approach towards the reorganization of the USSR have implicitly proceeded from the concept of 'failing states'. According to this concept, the newly formed states will not be

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able to survive independently and will sooner or later try to become a part of Russia on conditions favorable to it. As is known, such expectations have also proven unrealistic. First, in spite of Russia's being a champion in reorienting its foreign economic relations from the Soviet republics to third countries (the share of the CIS countries in Russia's foreign trade decreased from 54.6% in 1991 to 17% in 2002, while the share of mutual trade in total foreign trade turnover of the CIS countries fell from 72 to 26 per cent over the same period), there is no sign of the modernization of the Russian thus far. And secondly, the new independent states, however grave their economic situation might be, are not yearning to become part of Russia, neither today nor in the foreseeable future. I would call the third view on how to organize the CIS officiallyoveroptimistic. In the time of Yeltsin, Russian authorities tried to adopt the model of integration a la EU, and one must admit that they succeeded to some extent. De jure integration was carried out. It was believed that since integration plans were implemented in Europe, the CIS would be better off following the European model with the only exception: while in the EU the way towards the integration took 40-50 years, Russia should move much more quickly due to a lack of time. What were the results of that approach? Numerous multilateral agreements were signed, but almost none of them worked. For some reason, it is considered that the agreements on the free trade zone, customs union, payments union, and currency union, formulated in the CIS in accordance with the corresponding European documents, are not being implemented simply because no appropriate mechanisms have thus been found. This is the worst kind of deception, that of self-deception. Actually, if there were a common interest in integration, the said mechanisms would have appeared almost automatically. But the fact is that there is no such interest. The fourth view on how economic cooperation in the post-Soviet area is to be organized can be characterized as privately-oligarchic. Here it is appropriate to speak about the attempts of privately-oligarchic reintegration of the post-Soviet economies, these attempts being conditioned by the specificity of consolidation of the big capital in the CIS and especially in Russia, whereby a 'new' remedy for all socio-economic difficulties is being propagandized most energetically: large business and its social responsibility. Actually, what is being suggested is the borrowed idea that can be expressed in one simple formula: 'What's good for General Motors is good for America'. The thesis about the organic weakness of the state during the period of systemic transformations is regarded as an objective law; in a transition period, the state cannot help being weak, corrupt and bureaucratized. Since it is so, the range of its activities should be sharply reduced, and the economy should be freed from all

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possible regulations. When applied to the post-Soviet area, it means a mere lifting of barriers for the movement of goods, services and production factors - this is said to be the only responsibility of the state, and the rest should be left to businesses that allegedly know better than anyone else how to promote effective economic cooperation within the CIS. What can be said about the prospects of the 'oligarchic' way of reintegration? First of all, one should realize that 'spontaneous integration' has no future. Both theory and practice are evidence that an integration bloc is effective only when spontaneous integration within its framework is accompanied by a tough systematic intergovernmental regulation. In a theoretical aspect, it is expedient to assess the current situation in the post-Soviet economic space using a reliable conceptual basis, such as the concepts of negative and positive integrations introduced by John Finder, the outstanding expert in this field. The term 'negative integration' is used to designate the process of eliminating the discrimination in relations between the market players of the member countries, i.e. lifting the barriers hampering the movement of goods, services and production factors. 'Fositive integration' refers to the development and implementation of the coordinated economic policy, aimed at reaching basic economic goals and increasing member countries' welfare. The experience of the European Union shows that the stable integration effects are observed when both types of integration supplement each other harmoniously. Market forces alone, however powerful they might be, are not able to secure the effective functioning of a potential integration bloc without systematic coordination of national economic policies and constant improvement of institutional and legal mechanisms of international cooperation. If we assess CIS integration maturity from these positions, the picture is clear enough. In the Commonwealth of Independent States, positive integration is mostly formal and has almost no influence on the economic relations between its members, except for bilateral agreements, which are certainly important and useful in themselves but bear no relation to real integration. The CIS has already celebrated its tenth anniversary, but there has been almost no multilateral coordination of its members' economic policies thus far. This is due first of all with the fact that the authorities of the new sovereign states, despite their regular ritual incantations about the benefits of integration, have chosen to develop independently of each other. Generally speaking, it is difficult to get rid of the impression that the leaders of the post-Soviet republics understand integration as a mutually beneficial economic exchange between countries without any supranational institutions restricting their national sovereignties.

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At the same time, with respect to the territory of the CIS, there is something that with certain reservation can be called negative integration. Under conditions of transparency and semi-transparency of new state boundaries, both physical and juridical persons of the previously single state perform an active economic exchange that is far from being completely reported officially. In most cases, one can see the spontaneous coordination, carried out by market players themselves, first, from the force of inertia, and second - taking into account an abrupt decrease in living standards -just to survive. In the process of economic exchange between the countries, various forms of payments are used^, which also happens absolutely spontaneously, without any multilateral agreements. On the one hand, this provides an opportunity for real sectors of CIS economies to at least cooperate to some degree. But on the other hand, it threatens this cooperation, as the known phenomenon of the untimely currency liberalization starts working, causing the strong to get stronger and the weak to get weaker. By the way, the current performance of the currency-financial mechanism of the CIS countries' economic cooperation shows no sign that an optimal currency zone is established there. The concept of an optimal currency zone was developed by the prominent researcher of integration problems, Robert Mandell. As is known, it was Mandell who found a theoretical basis for the gradual movement of areas under the process of integration towards the single currency, and this theory was recently put into practice when twelve European states gave up their national currencies for the Euro. Thus, there is practically no positive integration in the CIS, while negative integration is functioning. Unfortunately, however advanced the latter might be, it cannot compensate for the lack of the former. In addition, since there is no complementarity between the positive and negative integrations, there is no reason for being overly hopeful of the centripetal forces created by the spontaneous cooperation between market agents, irrespective of whether these are small retail-dealers or "heavyweight" oligarchs. Consequently, there are no conditions for full fledged integration in the post-Soviet territory, and one cannot expect them to appear in the near future. But unlike the anti-integrationalists representing the westernizing point of view, I think that this situation hampers Russia's sustainable economic progress rather than promoting it. I am also sure that the collapse of the USSR was not fatally predetermined. Certainly, his^ Hard currency and barter are prevailing. In the beginning of the 2000s national currencies accounted only for about 10% of mutual payments between the CIS countries, while the share of hard currency was 10-20%, and the share of barter 75-80%.

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tory knows no subjunctive mood, but it never lacks alternatives. It is not always the case that 'all that exists is reasonable'. It was no doubt possible to unite the twelve former Soviet republics into a single democratic state with a market economy. Due to many reasons, however, this opportunity was lost, and the events developed according to the scenario the institutional school of economic theory calls the 'route inertia' (D. North). In any case, after the signing of the Belovezhye agreements, it would be a mistake to believe that the failure of the reintegration plan on the territory of the former USSR is conditioned only by the lack of political will on the part of new independent states' authorities. Moreover, following the logic of Belovezhye, it is possible to regard the attitude of the CIS countries towards the CIS and other groupings as rational almost without reservation. With certain simplification, this attitude can be reduced to the following motto: 'maximum economic benefits in bilateral relations plus minimum (or zero) responsibilities officially agreed on a multilateral basis'. However, the truth is that the rationality of the new independent states' behavior towards each other is a forced rationality. What are the factors that make centrifugal tendencies dominate over centripetal ones in CIS territory? In the article I wrote together with Professor Leonid Vardomsky, the most widespread reasons for a failure of integration efforts in the post-Soviet area are discussed (GRINBERG and VARDOMSKY, 2001, pp.55-67). Here I will only draw attention to the most important factors that make a 'new integration' based on the Belovezhye model an extremely difficult objective (though not hopeless), however fervent the interest in this project on the part of its potential participants might be. First, all the new states have inherited the structure of economy and mutual exchange from the USSR that was shaped over decades without taking into consideration any market criteria. Therefore an abrupt change in the nature of the inter-republican division of labor, i.e. its transition from the command mode of operation to a market mode, could not but lead to a break in a considerable part of economic links that functioned according to the all-union priorities set in Moscow. It is important to understand that this effect is an objective consequence of a systemic transformation, not the result of the disintegrationist aspirations of the republics that became sovereign overnight. Hence, it is rather naive to assert that 'the CIS countries, having gone through the euphoria of the first years of independence and having realized how harmful the breaking of mutual relations can be, head for their restoration'. Secondly, it is necessary to take into consideration the specificity of Russia's position in the post-Soviet space. The point is that Russia is too vast to be a part of a multilateral integration formed on an equal basis. If

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one country accounts for more than two-thirds of the economic potential of a group of twelve countries, a serious objective problem of how to coordinate interests and take decisions on integration inevitably arises. Even if there were a common interest in these decisions, Russia's specific position in a potential grouping would face this grouping with a problem comparable to squaring the circle: on the one hand Russia's institutional and organizational domination in the CIS would be unacceptable for the rest of its members, and on the other hand the coordination on an equal basis would contradict Russia's interests more often than not. In connection to this, it is appropriate to emphasize that the success of the European Union as an integration bloc is based on the relative equality of the economic and political potentials of France, the Federal Republic of Germany, Italy and the United Kingdom. Thirdly, the great attractiveness of the European Union as a successful integration bloc 'close-at-hand' is a powerful centrifugal factor for the European post-Soviet countries. Irrespective of what the prospects of their accession to the EU are, they do want to accede, and this is what really matters in this case. By the way, this mere fact is enough to depreciate Eurasionism as a consolidating idea for the reintegration of the post-Soviet republics and to make the very possibility of its instrumentalization illusory. Fourthly, one cannot ignore the permanent strongly pronounced antiCIS position of the West. A considerable part of the Western elite manifests an irrational, if not a morbid, attitude towards any attempts of political and economic consolidation within the framework of the CIS. For all intents and purposes, there is an exaggerated fear of a recovery of the powerful Soviet empire, disguised as an advice to the new independent states to overcome a 'temptation of integration', which is said to be a complex. But actually the idea of integration is not a complex; it is quite a healthy idea. Nobody doubts the advantages of a uniform economic and currency zone over a fragmented one. Even with a current high degree of integration, the EU falls behind the USA as a completely homogeneous economic area. There should be no place for double standards here. And we should do our best to persuade our Western partners that trying to somehow organize and consolidate the economic relations between the former Soviet republics has nothing to do with Russia's imperial ambitions. Based on all these factors, what can be said about the near prospects of the CIS? As one of the formerly popular Russian politicians noted, 'it is always difficult to make prognoses, especially concerning the future'. But if we treat the issue with all seriousness, we have to rest upon another saying, which is a part of the famous adage: 'God, grant me the serenity to accept the things I cannot change, the courage to change the

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things I can, and the wisdom to know the difference'. I consider it very important to keep this in mind, since, as far as the structuring of the CIS is concerned, it is very easy either to fall into excessive pessimism ('disintegration is unavoidable') or to get in a trap of new illusions ('replace the authorities and manifest the due political will'). Because of this, I would like to point out some new circumstances that might decide the outcome of the structuring of the post-Soviet territory. I will designate those that seem to promote its consolidation as a 'plus', and those suggesting that consolidation would be a 'minus'. I will start with the hypothesis that the period of a multivectoral foreign policy of the new independent states will soon be over and, as far as the consolidation of the CIS is concerned, it is rather a minus than a plus. The growing threat of terrorism is a contra if the West becomes more active in providing anti-terrorist assistance to the CIS countries, but it may as well turn into a pro if Russia succeeds in playing the role of the guarantor of collective security. The effect of still remaining elements of the previously uniform Soviet system is fading away, i.e. 'Sovietism' is vanishing from different spheres of life (such as language, mentality, customs and traditions), which is an obvious disadvantage. But the general economic recovery in the main CIS countries as a factor promoting their mutual economic relations is a advantage. In the past 2 to 3 years, almost all CIS countries have reported substantial economic growth after a multi-year decline. In the CIS as a whole, GDP increased by 6.1% in 2001 and by 4.8% in 2002, industrial production grew by 7 and 4%, agricultural production by 8 and 2%, capital investment by 12 and 6%, goods transportation (without pipeline transportation considered) by 5 and 4%, and retail trade turnover 12 and 10% in 2001 and 2002, respectively. The growing determination of some CIS countries to become members of the European Union in combination with their autonomous access to the WTO is a minus, but under certain conditions it can be considered as a plus, since an effective means to compel the meeting of mutual commitments within the framework of the CIS appears. Based on these factors, the foreseeable future the Commonwealth of Independent States will linger at the first stage of the way to an ideal integration, a 'free trade zone'. One cannot expect the CIS to move any further. Certainly, it is necessary to take into account the risk of the wide spreading of indirect imports. On the other hand, however, with a growing interest of the CIS countries in meeting the mutual commitments and a sharp increase in the costs of unilateral protectionist measures, which actually follows from the mere fact of becoming a WTO member, countries in a free trade zone can avail themselves of the opportunities a

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common economic space provides without any infringement upon their national sovereignties. Under these conditions, the search for so-called 'de facto solidarities' seems possible and actually quite promising. This term, introduced by one of the founders of the EU, Robert Schumann, in 1950 before the European Coal and Steel Community was established, is used to designate the joint initiatives of the interested countries connected with the regulation of the selected markets of goods, services and production factors. If we consider integration maturity of the CIS and compare its dynamics with that of the EU, we can figuratively say that CIS countries are still somewhere in the 1950s, but they are quite able to initiate sectoral common markets, regional labor markets, near-border trade enclaves, coordination of sales and prices on the third countries' markets, etc. The search for such 'de facto solidarities' is the most realistic way to consolidate in the post-Soviet area. With regard to this, Russia's behavior is extremely important; the degree of its rationality determines the fate of the CIS. Ideally, Russian policy with respect to the CIS as a whole and to its separate members should be Pareto-optimal, which means it should be carried out so that the improvement of Russia's position does not cause positions of other CIS countries to deteriorate. This approach presupposes, first of all, the country's sustainable economic growth, accelerated in comparison to its partners, as well as giving up the discrimination of the partners, including a ban on unilateral protectionist measures. In addition, the country will have to make current concessions in exchange for future benefits, including those of a geopolitical nature, providing reasonable amounts of donor assistance in exchange for concrete opportunities for exerting influence (privatization, investment, etc.). And finally, Russia should emphasize the priority of economic cooperation between the CIS countries on a microlevel, providing maximum information and financial support for home businesses. The real preconditions for the transformation of the now amorphous CIS into a viable regional bloc will appear only when pleasing ambitions of integration are replaced with concrete goals, arising from a concrete collective interest. If Russia initiates a comprehensive programme of restructuring the post-Soviet economy on the basis of carefully chosen priorities and the wide spreading of modern technologies, this interest will spring up without coercion. I would designate it as a collective interest in the organization and development of competitive transnational corporations, able to be subjects, not objects of globalization, within the framework of the CIS. In conclusion, I will put forward a paradox, arising from Russia's redundant influence in the post-Soviet area: this country is too large for the

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integration a la EU to exist within the territory of the former USSR, but at the same time it is large enough that 'opened regionalism' in the postSoviet area cannot avoid being Russian-centered, provided this country demonstrates sustainable economic development.

References BIKI (2003), August 14, p.2. BORDACHEV, T. and ROMANOVA, T. (2003), Russia's Choice Will Determine Its Relations with the EU for a Long Period, Rossiya v Globalnoy Politike (Russia in the Global Policy), No.2 COHEN, S.F. (1998), Why Call It Reform? Nation, September 7. CRAS (2003), July 29. EC NEWS AGENCY (2003), August 25. GRINBERG, R. and VARDOMSKY, L. (2001), Ten Years of Evolution and the Prospects of Structuring the Post-Soviet Economic Area, Rossiysky Ekonomichesky Zhumal, No. 8, pp. 55-67. HEIFETS, B. (2002), Debt Problem Solution. World Experience and Russian Reality, Moscow: Akademkniga. INTERFAX (2003), May 16. IZVESTIYA (2003), Julyl6, 22. KOMMERSANT (2003), February 10, May 29, July 28. LUKOV, V. (2003), The Factor of Trust, Mezhdunarodnaya Zhizn, No 8, p. 10. ODLING-SMEE (2003), Russia's Rebound: Will It Last? IMF Survey, March 17, vol.32, No.5, p.67. PARLAMENTSKAYA GAZETA (2003), June 4. PRIME-TASS (2003), February 14, 25, May 28, June 2,4, August 14. RADIO PRAGA (2003), June 5. ROSSIYSKAYA GAZETA (2003), June 18. SHISHKOV, YU. (1996), Russia's Painful Way into the World Economy, Rossiysky Ekonomichesky Zhumal, No.l. SKRIN-NEWS (2003), March 14, August 14. VEDOMOSTI (2002), August 15, 26. VOPROSY EKONOMIKI (2002), No.3, pp.79, 81. VOSTOCHNOSIBIRSKAYA PRAVDA (2003), July 17. VREMYA MN (2002), June 28. VREMYA NOVOSTEY (2003), April 30, May 6, July 14. ZOLOTOY ROG (2003), August 12-17. www.cio-world.ru. www.eur.ru. www.g8.fr. www.ide.go.jp. www.imf.org. www.newsru.com. www.oecdmoscow.org.

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www.oecd.org. www.vladcity.ru. www.worldbank.org. http://apec.technet.ru.

Comment on: Russia and Intemational Economic Structures Paul JJ. Welfens The paper by Grinberg gives an excellent overview in the various links which Russia has to important intemational organizations. He argues that the IMF has been an important actor in Russia, with its poor advice having contributed to the 1998 crisis. As regards the World Bank, he argues that the list of projects implemented does not reflect a coherent Russian strategy. He also argues that the World Bank is not always consistent in its policy advice. The most important challenge - as underlined by Grinberg is WTO membership which requires Russia to embark upon a broad legislative overhaul. Moreover, there are difficult fields of disagreement in the WTO negotiations as the organization puts pressure on Russia to adjust domestic energy prices to world market prices. Grinberg considers this requirement which also is supported by the EU as illogical and unrealistic. Interestingly, the automotive sector also is a contested field as Russia would like to impose import tariffs. Grinberg next takes a look at the option of full OECD membership which he considers as important: Adding wisdom and pressure in the field of competition policy is one potential area of OECD membership, possibly serving as a catalyst for improving some crucial policy fields. The relations between Russia and the EU are difficult and the author highlights some of the controversial areas. Finally, Grinberg takes a closer look at G7/G8, the role of Russia within APEC and the CIS. The author covers a wide area of organizations and presents a truly comprehensive picture of a policy field which is relatively new for Russia. The former USSR had been a member of various intemational organizations in which it often played a politically leading role. For the new Russia the psychological and political situation is different. The country is considered a relatively poor country with per capita income close to that of Mexico. Russia itself is aware that it has only very limited political leverage to play a grand role in intemational organizations. Moreover, the West is highly critical of some traits of the new Russia which is a democracy but also has a strong president. Putin obviously puts pressure on the media which leads to a critical echo in the US and Westem Europe (perhaps except for Mr. Berlusconi from Italy). At the same time, Russia is portrayed as a country with oligarchic elements in the business community. This, however, is part of the problems faced by any Russian president. The Duma is subject to many influences, including those from

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powerful tycoons in the business community. A weak president could quickly face a stalemate in the political system. Does the president have a grand international policy strategy with a special role assigned to international organizations? This is rather unclear and some inconsistencies noted by the author might reflect the lack of a consistent Russian strategy with respect to international organizations. If Russia would carefully look at its policy options and evaluate the direct and indirect benefits from full membership, the country might obtain more influence in the international arena and be able to better pursue its interests. Russia would have to seek strategic partners in international organizations if those are to play a really useful role for Russia. As regards the IMF, the author rightly criticizes the global organization for an inconsistent policy toward Russia. There is no doubt that the Russian government itself has played a major role in triggering the 1998 crisis as fiscal policy was unsustainable. At the same time, it is absolutely unclear why the IMF advised Russia - with oil and gas being dominant in export revenues - to adopt a system of fixed exchange rates. The Kenen argument from the optimum exchange rate literature would clearly support flexible exchange rates as the country is weakly diversified in exports. World Bank membership is nice as it brings experience in project financing and could help to accelerate reforms in some fields. Given Russia's low per capita income, the country could benefit for many years to come from cheap World Bank loans. More important than loans could be access to technical expertise and networking through the World Bank As regards WTO membership, this will be a bumpy road. The topic of WTO membership is almost ideal for the West to put pressure on Russia in several fields. The US might want to put pressure on Russia in order to convince the government not to sign the Kyoto climate protocol. Negotiations will take quite some time as many economic and political issues are at stake. Russia might want to join the WTO quickly for many reasons. Full access to the EU single market for electricity would be one benefit of WTO membership. One should not underestimate the steps on the way to the WTO. Membership would also help to protect Russia against unfair dumping from the EU or the US. The strategic importance of OECD membership probably is underestimated in Russia. At the OECD setting, the agenda in influential committees can be quite important. The US dominates the organization. The long period of time during which Russia has had an observer status raises the question whether Russia does not see how important membership in the OECD really is. The EU and Russia is a difficult chapter. EU eastern enlargement clearly creates some short-term disadvantages for Russia, mainly trade diversion effects. Some of these effects have nothing to do with EU import tariffs,

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rather EU standards are a main problem; and the threat of anti-dumping clauses. After EU enlargement the EU is bigger than ever and for this reason might be slow in responding to Russia's demands for broader cooperation. At the same time this could imply that once relations have improved, such improvement would create a long-term impact. One can only warn that EU eastern enlargement should not seek to leave Russia out in the cold. Rather the EU should develop active relations with Russia in many fields and carefully nurture cooperation between EU-25 and the New Russia. There is some risk that Russia will become mentally and politically rather isolated if the EU-25 is not developing an active partnership. Partnership cannot mean that the EU-25 (Russia) simply imposes certain conditions and rules on Russia (the EU). Russia could also play a more active role in APEC and in the G7/G8 in the future. Much depends upon regaining economic strength and the ability to establish stable foreign relations with neighbouring countries. If Russia achieves high economic growth for another decade, the country will become a more respected and more active member in intemational organizations. A delicate issue is the role of CIS in the future. It is clear that Russia as a large country bridging Europe and Asia has a natural interest in regional networking. To the extent that there are common interests - which is not a uniform phenomenon across CIS countries - there will be a strong interest in cooperation. However, Russia has the natural disadvantage of always being in a dominant position, not least because CIS partner countries are relatively small. Much will depend on developing a careful concept of leadership which should not mean openly dominating partner countries. The more Russia is active in leading intemational organizations the more Russia could become an active player in intemational power games. However, it takes time to develop an adequate strategy and to gain a reputation that one is a reliable, influential and innovative player in intemational organizations. Russia still has considerable unexploited potential. It remains to be seen whether Russia will become more active in intemational organizations.

F.1 An Increase of Energy Efficiency as a IVIajor Tool for Achieving Energy Security Petra Opitz 1. Introduction

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2. Increasing Energy Efficiency - a Major Challenge and Opportunity for Russia 166 3. Existing Barriers to Develop the Potential

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1. Introduction Russia is rich in energy resources. It is the second biggest exporter of oil and the biggest natural gas exporting country in the world and plays an increasing role in supplying energy to the European Union. For the future EU-25, Russia's role as energy supplier will even increase. In 2003, the Russian Government approved the Energy Strategy of Russia to the year 2020, which highlights the central role of energy for the development of the Russian economy and for Russia's national security. The energy sector accounts for 22% of the Russian GDP and 30% of total industrial production. It provides about half of the income of the federal budget. In the past, energy efficiency improvement was not given first priority goal in Russia's energy and economic policy, although this could have an important positive impact on economic development. Energy intensity of GDP in Russia is among the highest of the world. It was 1.34 toe/1000 USD in 1992 and even increased up to 1996 (1.89 toe/1000 USD). Since 1997, energy intensity of GDP decreased slightly, and it was below 1992 levels for the first time in 2001.^ However, energy efficiency improvement proceeded at a much slower pace than in the Baltic States, where energy intensity was almost at the same level as in Russia at the beginning of the 1990s. The new energy strategy, however, seems to set higher priority on achieving energy efficiency improvements.

2. Increasing Energy Efficiency - a IVIajor Challenge and Opportunity for Russia The potential for improving energy efficiency in Russia is huge and has been assessed by different studies. According to estimations of the Russian Energy Strategy, energy saving potential in Russia through 2020 amounts to about 252-300 million toe, this is about 39-47% of its current energy consumption. The Strategy notes as well that the high energy intensity of Russia's GDP, which is 3.1 times that of the EU,^ is not only the result from special climatic factors and the vast size of the Russian territory. The energy intensive nature of the Russian economy, the growing technological gap in some parts of Russia's industry as well as the low energy prices, ^ lEA, Key Energy Data, various editions. 2 Energy intensity of GDP was twice as high as in Canada if GDP is measured in PPP. It was even more then five times higher than in Canada if GDP is measured in USD according to exchange rates. The TPES/GDP (toe per 1000 USD) was 1.72 for Russia in 2002 and 0.36 for Canada. Thefigurefor Germany at that time was 0.13 toe per 1000 USD. See TEA Energy Indicators by Country.

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which do not act as incentives for saving energy, have been identified as most important reasons.

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136 D Final energy consumption • Energy saving potential

82 75 - 96 65-75 54

16-20

20-25

_L Energy intensive

Private households &

industry

confimunal sector

Transport

other

Source: Russian Ministry of Energy^ Moscow Fig. Fl. Energy Consumption and Technical Energy Saving Potential in the Russian Economy in 2002, mn toe A sectoral analysis of the technical energy saving potential made in 2002 by the Ministry of Energy of the Russian Federation shows the following results. (See Figure Fl) The main bulk of the energy efficiency potential is within the Russian energy sector itself. According to the lEA, the energy sector accounts for an estimated 40% of the potential savings.^ Investment in new capacities and modernisation in the power and gas sectors made by RAO EES Rossii (the Russian power supply holding) and Gazprom have already had a certain positive effect on energy efficiency. However, other parts of the energy sector like the communal heating sector, which is mainly owned by the municipalities, have a huge potential for energy efficiency improvement as well. In addition, on the demand side, the final customers in the residential sector and the public sector as well as the industrial and service sectors could achieve considerable improvements in energy efficiency. As far as multi-storage residential houses are concerned, their actual energy consumption is about 0.22 Gcal/m^, which is more than five times 3 lEA, 2002, Russia Energy Survey 2002, p.223.

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higher than in Denmark (0,043 Gcal/m^). Adjustment for the Danish level of energy consumption to Russian climatic conditions would result in a level of about 0.077 Gcal/m^, which means an energy saving potential of about 550 million Gcal/a or about 72 billion m^ of natural gas, which is considerable compared to the annual natural gas export volumes to Westem Europe which amount to about 120 billion m^. Using this potential would allow Russia to not only secure its energy export potential, which has a major impact on the Federal budget. Export opportunities are of particular interest for the exporting companies because of the still considerable differences between prices on external markets an on the Russian internal market. However, this incentive might be useful only in a short and medium term perspective because in the long run, internal Russian energy prices would increase up to world market levels. Thus, a more important incentive would be the opportunity of strategic savings of Russia's energy resources for the development of future demand and the importance of market prices as incentives for structural economic change. High energy prices (i.e., prices at world market level) would push the Russian economy to be more competitive on the international market.

3. Existing Barriers to Develop tlie Potential Although it is often stated that a major barrier for energy efficiency improvement is lacking investment in modernisation both on the supply and the demand side, it becomes quite clear that it is not the lack of private and public money per se which is hampering energy efficiency improvement. Instead, it is the insufficient framework for energy efficiency investment which leads such funding to flow into much more attractive investment fields. This is, of course, true both for Russian and foreign capital. As there is no limitation any longer for Russian banks and investors to select from the most attractive investment opportunities over the world, their behaviour in setting investment priorities will be much the same as that of foreign investors and banks. For efficiency projects this results in the fact that they have to compete for investment with other projects; thus, a favourable investment framework for efficiency projects is a major prerequisite. The communal heating sector and the communal housing sector are characterized by special investment conditions, which are much worse compared to other energy sub sectors and therefore make the sector less attractive for investment. Institutional barriers, which prevent from improving energy efficiency in the communal sector, are the main obstacles. Economic incentives for energy efficiency increases are still weak. One of the basic preconditions for any economic incentive on the side of final

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costumers to save energy is a measurement of and payment for real heat and hot water consumption. This institution is still lacking. Contractual energy supply agreements with final costumers are mostly not in place, and the existing contracts with the housing organisations do not stimulate energy efficiency improvements. At present, a reorganisation of communal services is under way. Privatisation of these services could create incentives for energy savings if measurement and contractual basis for energy services would be improved. As far as the level of heat and hot water tariffs are concerned, special attention should be directed here. The actual system of tariff setting is based on a calculation method approved by the Federal regulatory authority, "FEK," applying a cost plus approach. Thus, tariffs cover existing costs of energy supply in Russia, referring also to existing fuel costs at the fuel price level, which is also set by the Federal regulatory authority. Having tariffs in place, which cover the internal costs on the Russian market, does not mean that all final customers in the residential and communal sectors in fact pay the tariffs at a 100% level. Many customers are subsidized by the local budgets. The share of budgetary subsidization of total energy supplied to private households and communal bodies differs between the regions and has decreased slightly over the last several years. As long as communal budgets subsidize energy services, they remain a major role player for investment in energy efficiency improvement even if services would be totally privatised. But communal bodies often incur huge debts, thus neither possessing their own financial means for investment nor the ability to obtain credits to this end. International cooperation could play an important role in overcoming these barriers. Technological, institutional and financial know-how has been offered by foreign companies. Energy savings in the communal sector is also a major issue in the West. Over the last couple decades, special financial schemes have been developed to overcome the barriers in the West, which was mainly lacking creditworthiness on the part of communal bodies and lacking know-how of communities in the efficient supply of services. Energy performance contracting, often called Third Party Financing, became a major tool to increasing investment on energy savings. Energy performance contracting, a variation of the ESCO"^ models, has been successfully implemented in many OECD countries. The crucial point of this model is that financing of investment is attracted and managed by a third party and repayment of the investment is financed from saved energy costs. The respective payback period is mainly determined by the amount of saved energy costs and the interest rate of credits used for pre-financing the investment. Different models are possible which in^ Energy Service Company

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elude variations of sharing saved costs between the contractor and the client, which would on the one hand extend the payback period but would on the other hand transfer benefits to the client earlier. The contractor, the company which undertakes the efficiency investment, brings the money in and is responsible for implementing the necessary efficiency measures. (See figure F2) fuel supplier realisation of modernisation

I fuel municipal heating company

contractor refinancing by saved r heat generation costs

Fig. F2. Contracting Scheme Adjusted schemes of the energy performance contracting could help in overcoming the barrier of low creditworthiness of the Russian communal bodies and their lack of individual capital. Although the overall framework for successfully implementing contracting schemes in Russia is still very weak, the Russian government has introduced some rules over the last several years, which make initial steps in this direction. Federal Government Decree No. 588 of June 1998, "On Additional Measures to Stimulate Energy Consumption in Russia," keeps energy-supply allocations constant for the payback period plus one year at federal facilities implementing efficiency projects.^ In April 2002, an additional decree on tariff setting for electricity and heat. Decree No. 226, was adopted and allows for the whole cost difference for heat generation, which appears after an efficiency investment is made, to be used for refinancing the investment over the whole payback period.^ Thus some steps have been made, however they are still not sufficient for implementing contracting schemes successfully.

5 lEA, 2002, Russia Energy Survey 2002, p. 241. ^ Government of Russian Federation, 2002, Postanovleniye ot 2 aprelya 2002, No. 226.

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In Russia, where the risk of non-payment even by government and communal bodies and enterprises is high, it is also necessary to lower this risk. Concerning such risks, awareness has increased, and there is an example of two Russian regions which tried to minimise this risk by introducing regional laws and budgetary provisions. These acts provide official payment guarantees. If an investment project would require hard currency credits, such communal guaranties would only be sufficient in the case that a communal body is highly ranked by Western creditors. This could then only be true for a very small number of cities like St. Petersburg, Nishni Nowgorod and a few others.^ State guarantees from the Russian Ministry of Finance would hardly be available for small scale projects. An alternative for securing the non-repayment risk could be created by changing the structure of the contractor itself. The contractor could be set up in form of a Joint Venture between reliable Western and Russian partners. Due to his regional know-how, the Russian partner would secure the risks of non-transparency of Russian rules and legislation, then the risk of non-payment would also be much lower. The Western partner would bring his creditworthiness and knowledge of Western technologies into the Joint Venture. The following schemes of refinancing investment could be implemented: 1. Repayment by the saved costs in roubles. Due to low fuel costs on the internal Russian market, the payback period could be quite long and take into consideration a possible currency risk, making the investment more expensive. For small scale projects (i.e., the modernisation of decentralised boilers), payback periods of 5-6 years would be usual. This is due to the fact that budgets have huge deficits, and real subsidies provided in actuality by government budgets - do not cover the whole costs. This means, in practice, that the full effect of cost reduction which is achieved by the investment is not available for refinancing at the time reduction takes place. In the event fuel prices on the internal Russian market increase and heat prices are adjusted to the increased costs, the payback period could be reduced, depending on the rate of fuel prices/heat cost increases. Finally, achieved cost reductions by energy efficiency investment will strive to ensure that the end customers pays 100% of the costs. Thus, after the investment would be refinanced by saved costs, 100% payment of tariffs or even a slight increase of tariffs would be feasible without increasing the total share of payment for communal services in the residents' budgets. ^ Surgut and other oil or gas reach regions might also be accepted as guarantiers like the EBRD projects show.

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2. Repayment by selling the saved fuel. This refinancing scheme would secure the currency risk and shorten the payback period substantially. From the point of view of the Western creditor, the use of this scheme repayment by exported saved fuel - seems to be the most attractive. Natural gas is well accepted as risk assurance. This is specifically true if the market income from fuel exports is shared between the fuel extracting company and the contractor. However, there are several obstacles to be overcome in order to use this model. These obstacles are mainly due to the present monopoly position of Gazprom and also the high transaction costs associated with the low volume of each individual project. Project bundling would be helpful in attracting the interest of Gazprom to such energy efficiency projects. On the other hand, the price system for natural gas on the internal Russian market is no longer homogeneous. Instead, there is an increasing split price system with low prices set by the Federal authority on the one hand, which are only valid for limited volumes of natural gas to be supplied. On the other hand, the purchase of natural gas above these limits is often had at much higher prices. A more private natural gas market is developing, which mainly involves financially solvent private companies as the major players. Most important for implementation of performance contracting schemes is the reliability of the respective municipality which ought to be the main partner of such a contract. As the contractor would not be willing to deal with the final customers on the one hand and with the subsidizing municipality in parallel on the other due to high transaction costs, the municipality as the owner of the communal heating company should guarantee the fixed amount of saved costs to be paid out of the budget. In fact, saved costs are thus treated as the major part of the subsidies, which could be reduced after investment is refinanced. In order to reduce risks, local administration must make budgetary provisions for the period which is necessary for refinancing the investment. Of course, this does not fully rule out possible poUtical risk. However, the contractor remains owner of the equipment until it is fully refinanced. The explained scheme could be used in many cases if the necessary legal and institutional framework were there. Cooperation and attraction of investment in energy efficiency could thus be sped up and could at least be a good field of cooperation between Western and Russian banks. It is an example of how energy efficiency improvement could be reached through market methods. Current developments in Russia, which tend to lead to full payment of heating and hot water tariffs by the end customers and to the establishment of communal service management companies would facilitate implementation of such schemes. The schemes would then need to be adjusted to the

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new framework. Budgetary guarantees and participation of communal authorities would thus no longer be necessary. Already today, Russia is the major EU partner for the supply of energy. In the future, Russia's role in an enlarged EU will certainly increase. A potential increase in Russian energy efficiency would serve as an important basis for securing increasing energy demand in Europe while at the same time enabling the dominance of market prices for energy consumption in Russia that help to avoid major social problems.

F.2 European Energy Security: Opportunities and Problems for Cooperation EU-Russia Peter Palinkas 1. Introduction

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2. European Energy Sector

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3. The EU-Russia Energy Partnership

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3.1 General Remarks 3.2 Why such a Partnership? 3.3 Objectives of the Partnership

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4. Progress and Recent Developments in the EU-Russia Energy Partnership 4.1 EU Internal Gas and Electricity Market 4.2 Energy Infrastructure Projects of "Common Interest" 4.3 Gas Supplies and Long Term Contracts 4.4 The Legal Framework 4.5 Trade in Nuclear Materials 4.6 Electricity 4.7 Pilot Projects 4.8 Oil and Gas Security 4.9 Clean Coal 4.10 Energy Technology Center 4.11 Cooperation on Implementing the Kyoto Protocol 5. Summary

179 179 179 179 180 180 181 181 182 182 183 183 184

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1. Introduction In order to improve the EU's energy security and EU-Russian relations in the field of energy both partners initiated the "EU-Russia Energy Partnership". On the occasion of the sixth EU-Russia Summit (SO'*" October 2000, Paris), it was agreed to institute an energy dialogue on a regular basis between the EU and Russia to enable progress to be made in the definition and arrangements for an EU-Russia Energy Partnership. As noted in the Joint Declaration adopted at this Summit, the energy partnership "will provide an opportunity to raise all the questions of common interest relating to the sector, including the introduction of cooperation on energy saving, rationalisation of production and transport infrastructures, European investment possibilities, and relations between producer and consumer countries.

2. European Energy Sector ^ EU internal energy resources, which currently account for around half of EU energy consumption, are drying up, whereas consumption is increasing. If no action is taken in the next 20 to 30 years, the environmental impact of energy will be untenable and the EU's external energy balance will rise to a level of 70 % on average, going up to 90 % in the case of oil products. This situation makes the EU vulnerable, particularly on account of severe dependence on certain types of energy, such as oil and gas; in particular, the EU will become dependent on certain exporting countries such as Russia for natural gas and the Middle East for oil. Furthermore, energy production and consumption in fact account for almost all the manmade emissions of carbon dioxide into the atmosphere.

^ See: Statement of Ms Loyola de Palacio (2001), Vice-President of the European Commission, conceming the progress report on the response to the Green Paper "Towards an European Strategy for the security of energy supply", SEC(2001) 1962.

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3. The EU-Russia Energy Partnership ^ 3.1 General Remarks In order to improve the EU's energy security and EU-Russian relations in the field of energy both partners initiated the "EU-Russia Energy Partnership". On the occasion of the sixth EU-Russia Summit (30'^ October 2000, Paris), it was agreed to institute an energy dialogue on a regular basis between the EU and Russia to enable progress to be made in the definition and arrangements for an EU-Russia Energy Partnership. This energy partnership "will provide an opportunity to raise all the questions of conomon interest relating to the sector, including the introduction of co-operation on energy saving, rationalisation of production and transport infrastructures, European investment possibilities, and relations between producer and consumer countries. The planned ratification of the Energy Charter Treaty by Russia and the improvement of the investment climate will be important aspects in this context".

3.2 Why such a Partnership? Russia and the European Union are natural partners in the energy sector. Some figures illustrate their interdependence in this field. Russian energy exports account, in value, for some 45% of exports to the EU. 53% of Russian oil exports (crude and products) of 181 million tonnes of oil equivalent (toe) were to the EU in 1999. Some 63% (130 billion cubic metres (Bcm)) of Russia's natural gas exports of 205 Bcm were delivered to European countries in the year 2000, with contractual requirements to increase deliveries to around 200 Bcm by the year 2008. Approximately 56% (73 Bcm) of the natural gas exported to Europe in 2000 was delivered to the EU. The energy sector in Russia represents a major opportunity both for foreign investment and for export revenues. The need for new capital in the sector has been estimated at between $460 and $600 billion by the year 2020. Moreover the EU and Russia have a mutual interest in enhancing the overall energy security of the continent. The energy dialogue is clearly being undertaken at the right time since both partners are defining the main orientations of their energy policies for the next 20 years, (cf. The Green Paper of the European Commission « To2 EU-Commssion: "The EU-Russia Energy Partnership" (25 April 2003): http://europa.eu.int/comm/energy_transport/en/lpi_en_3.html.

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wards a European strategy for the Security of Energy Supply » and the Energy Strategy of the Russian Federation for 2020). The Green Paper of the European Commission underlines the fact that the energy partnership with Russia will need to be considered as one of the key dialogues between energy producers and consumers.

3.3 Objectives of the Partnership The overall objective of the energy partnership, which will be established in the legal framework of the Partnership and Co-operation Agreement^ is to improve energy relations, while ensuring that the policies of opening and integrating energy markets are pursued. The energy partnership will cover oil, gas and electricity. The energy partnership is aimed at improving investment opportunities in Russia's energy sector in order to upgrade infrastructure, promoting energy efficient and environmentally friendly technologies, and enhancing energy conservation within Russia. Through the energy partnership, the EU wishes Russia to make concrete commitments in terms of fiscal stability and improvement of the production and protection of investment. It also aims to improve the legal framework in which European firms operate and to favour the creation of a fast track settlement procedure in Russian law. Finally, the question of access to Russian transport infrastructure will be part of EU's concerns. Russia aims to accelerate the reforms of its energy monopolies, to attract investments to increase its oil and gas exports by reorienting its energy production and consumption systems and to improve energy efficiency. The Commission's role in this process is mainly to facilitate discussions between the parties involved in order to identify concrete elements of actions notably regarding the improvement of investment opportunities in Russia's energy sector, the promotion of energy-efficient and environmentally friendly technologies in Russia, and the enhancement of energy conservation within Russia. Companies have expressed great interest in the initiative and have been active in helping to define those particular areas which require an improvement in the climate for investors.

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4. Progress and Recent Developments in the EU-Russia Energy Partnership ^ 4.1 EU Internal Gas and Electricity Market The establishment of an internal gas and electricity market in the EU in 2004 for non-household consumers and 2007 for every consumer will be a decisive step for the creation of a real internal market in energy. The Russian authorities acknowledged that the EU decision on market opening was irrevocable and expressed great interest in the possibility of being a full operator in what will be the largest integrated energy market in the world. They also underlined that they take as a reference some elements of the EU model for the reform of their own energy market, notably the separation of the transportation function from production.

4.2 Energy Infrastructure Projects of "Common Interest" The EU-Russia Summit of October 2001 identified a number of major energy infrastructure projects as being of "common interest" for the EU and Russia. Among these projects are: • the northern trans-European gas pipeline from Russia under the Baltic Sea to the EU, • the development of the Shtokman field in the Barents Sea, • a second Yamal-Europe gas pipeline network through Belarus and Poland, running parallel to the first.

4.3 Gas Supplies and Long Term Contracts In its decisions relating to the establishment of the internal energy market, the EU has confirmed the important role that long term natural gas supply contracts have played and will continue to play in ensuring the security of gas supplies into the EU market, by providing a risk sharing arrangement between producers and buyers which has enabled important new production and infrastructure projects to be undertaken. It is convinced that the internal gas market will continue to provide for the existence of such contracts, as EU gas purchasers recognise security of supply as a vital criteria.

^ See: EU Commission Staff Working Paper: Energy dialogue with Russia: update on progress since the November 2002 EU-Russia Summit, SEC (2003) 473.

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4.4 The Legal Framework The recently-announced planned major investment by BP in the Russian energy sector in the form of a joint venture with the Russian TNK oil company is a clear indication of increasing confidence of European companies in the investment environment in Russia. The third joint report by the two single interlocutors presented to the November 2002 EU-Russia Summit underlined that, to underpin the attractiveness of legal frameworks such as concessions and joint ventures for investments, it is important to ensure appropriate access to the energy transport networks and for appropriate rules providing a stable framework to ensure non-discriminatory access to the energy transport networks. It is also important that energy prices reflect the commercial imperative for investing companies so that at least the capital and operating costs can be recovered. Nonetheless, the Commission continues to believe that, for certain types of heavy investments and where, due to technical complexities, Russian companies may lack expertise"^. Production Sharing Agreements (PSA) will remain the ideal, indeed necessary, vehicle for some types of high risk investment. Without a comprehensive and efficient PSA regime, certain projects will just not happen. As recognised in the last joint report presented to the EU-Russia Summit of November 2002, it is also important to ensure appropriate rules providing a stable framework to ensure non-discriminatory access to the energy transport networks in order to encourage the use of legal frameworks such as joint ventures and concessions. This is an important precondition for significantly increasing investments.

4.5 Trade in Nuclear Materials As noted in the joint statement on energy from the May 2002 Russia-EU Summit, the existing situation with respect to the import of nuclear materials to the EU Member states is a matter of concern for the Russian side. With the objective of reaching a mutually acceptable solution, the Commission has elaborated a mandate for negotiation with the Russian authorities.

"^ Off-shore projects are typical examples.

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4.6 Electricity In the context of a closer integration of the EU and Russian energy markets, it would be inappropriate to leave aside the issue of the eventual interconnection of the EU and Russian electricity grids. The Commission's Green Paper on Security of Energy Supply has underlined the importance of better interconnections between the networks of the EU and those of the applicant countries and Russia and it is clear that preparatory work must be undertaken to examine all aspects of this issue in detail. Russia has been placing increasing importance on this in discussions and the EU electricity industry has shown considerable interest in the Russian electricity sector. For the EU, however, there are a number of prerequisites for Russia to sell on the European electricity market^. These include: • reciprocity in terms of market opening and the basic elements of market structure, • environmental protection, • a high level of nuclear safety comparable to that which exists in the EU Member states. In addition, there would evidently have to be compliance with the general trade regime of the European Community, notably with respect to the anti-dumping and anti-subsidy rules.

4.7 Pilot Projects Missions to Astrakhan in January 2002, Archangelsk in April 2002 and Kaliningrad in October 2002 prepared the ground for concrete pilot energy efficiency programmes. Work is now underway with the Russian authorities to produce specifications for technical assistance projects to be financed under TACIS programme 2003, with an overall budgetary envelope of some • 3 million. The combination of low energy prices in Russia and an undemanding Kyoto target for the first commitment period (20082012) means that energy efficiency and energy savings have not been given a high priority in the implementation of the overall Russian energy policy.

^ These must respect the conditions established under Article 19 of the Partnership and Co-operation Agreement between the EU and the Russian Federation.

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4.8 Oil and Gas Security Recent developments on the international oil market have served to underline the importance of extending the scope of the Energy Dialogue to examine possible ways of jointly promoting energy security and market stability on the European continent. Russia remains by far the world's largest exporter of natural gas and the second most important exporter of oil and oil products. It is estimated to hold the world's second largest reserves of crude oil and natural gas liquids after Saudi Arabia and over 30% of the world's proven natural gas reserves. In addition, both President Putin and Prime Minister Kasyanov have underlined that Russia is prepared to cooperate more closely with the EU on oil matters.

4.9 Clean Coal With the main provisions of Russia's "Energy Strategy until the year 2020" document projecting a 75% increase in coal production^ and for an increasing role for coal in electricity generation'^, it is important to encourage the use of modem, efficient and cleaner coal combustion technologies. For this reason, and in order to promote the most efficient EU Clean Coal Technologies, Russia has been considered a priority in both the 2001 and 2002 call for proposals^ under the CARNOT programme^ related to the promotion of the clean and efficient use of solid fuels.

^ From a 258 million tonnes in 2000 to between 340 and 430 million tonnes in 2020. ^ The Strategy calls for coal-fired electricity generation to increase from 17% of total generation in 2000 to 29% by 2020, which could double coal consumption in the power sector. ^Call for proposals for 2001. Published in the Official Journal of the European Communities, C 270 of 25.9.2001, page 8. Call for proposals for 2002. Published in the Official Joumal of the European Communities, C 64 of 13.3.2002, page 11. 9 Council Decision 1999/24/EC of 14.12.1998. Published in the Official Joumal of the European Communities, L 7 of 13.1.1999, page 28.

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4.10 Energy Technology Center The EU-Russia Energy Technology Centre^^ was opened in Moscow on 5^*" November 2002 in premises provided by the Russian authorities. The Commission is now working closely with the Russian authorities to ensure that it is developed as a highly visible focal point for technology collaboration and for promoting new energy-efficient technologies in Russia. As a result of a call for proposals for RTD actions under the specific programme for research, technological development and demonstration on 'energy, environment and sustainable development (1998-2002 ), a consortium of European entities has been selected to operate this Centre. Commission funding is being provided for a period of three years, alongside the funding provided by the consortium and Russia.

4.11 Cooperation on Implementing the Kyoto Protocol On the initiative of Russian President Putin, Russia will be hosting a World Conference on Climate Change in Moscow from 29'*' September to 3'^^ October 2003. However, Russia has yet to ratify the Kyoto Protocol and, in all the meetings with the Russian authorities in the framework of the Energy Dialogue, the Commission has underlined the importance of an early ratification. Ratification by Russia is a sine qua non for the Protocol to enter into force and would offer important opportunities to Russia. In particular, Russia will be able to take advantage of the flexible mechanisms foreseen under the Kyoto Protocol. First of all, Russia will benefit from emissions trading with other parties that have accepted targets under the Kyoto Protocol, including EU Member State governments. Secondly, investments in Joint Implementation projects will lead to the transfer and development of environmentally sound and modem technologies to Russian companies and generally enhance the pace of economic modernisation towards sustainable development. The Commission regrets the postponement of the Russian decision in this respect as it is delaying progress on co-operation in the field of energy efficiency which is expected to benefit significantly from the value of the C02 emission reductions associated with such projects.

1^ Further details on the Centre can be found at the following web address: http://www.technologycentre.org/eng.htm.

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5. Summary Russia is increasingly demonstrating a keen interest in playing an important role in the EU's internal market for gas and electricity, and the Energy Dialogue is proving an important framework for addressing relevant issues. Bearing in mind the forthcoming enlargement and the objective of the Energy Dialogue of enhancing the security and sustainability of energy supplies across the entire European continent, the Commission takes into account the interests and concerns of the Candidate Countries. With respect to the projects of common interest, it is evident that priorities between the various projects must now be defined. An important priority is clearly the northern trans-European gas pipeline. However, it is also necessary to examine the possibility of identifying additional oil pipeline infrastructures as an alternative to the development of new maritimebased projects. In this context, it is important to ensure that the full feasibility study to develop the proposed non-commercial risk guarantee fund is completed as rapidly as possible. In particular, the important progress made towards resolving the issue of the destination clauses which exist in certain long-term contracts for natural gas has been the result of this Dialogue and it is becoming increasingly important to rapidly resolve this issue as the EU market opens and expands. The Commission continues to underline the importance of making rapid progress on the completion of the PSA legal framework. Progress on the aspects relating to PSAs in the Tax Code was apparent towards the end of last year, but has since stalled. It is important that the momentum is reestablished and that PSA's do become an attractive vehicle for investments in high-risk projects which would otherwise remain unachievable. In addition, in the framework of the Energy Dialogue, the Commission and Russia have identified the importance of giving mutual access to one another's electricity markets on the basis of fair and equivalent trading and environmental conditions. This is becoming particularly important and urgent as certain accession countries are linked into the CIS-Russia electricity grid and not the continental European UCTE grid. Russia continues to underline the importance of an early discussion on the issue of trade in nuclear materials, where the Commission is awaiting the approval of the Member States on a negotiating mandate. It is also clear that, despite Commission efforts, Russia is currently not attaching sufficient priority to the projects on energy saving and energy efficiency. Russia is following closely the developments surrounding the Commission's proposal on safeguarding the security of oil and gas supplies, and

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has expressed its interest in participating in the proposed European Observation System. Finally, the Commission is examining ways of enhancing the practical involvement of the EU and Russian energy sector industry in the energy dialogue.

G. Diversification of the Russian Economy and Growth Evgeny Gavrilenkov 1. Growth Mechanism is Changing 2. He is Able who Thinks he is Able

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3. To Change and to Change for the Better are two Different Things

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4. Vivat, Crescat, Floreat!

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5. Three Ways of Restructuring

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6. Does the Central Bank's Monetary Policy Stimulate Restructuring?.. 209 7. Government Aims at Diversification

211

8. Banking Sector Restructuring and Growth

213

References

217

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1. Growth Mechanism is Changing Russia's economic performance in 2002, with GDP up over 4.3%, compared favorably with slow growth in Europe and the US. However, even this represents a slowdown in growth on previous years, even with high oil prices.^ It is important to consider that high GDP growth rates between 1999-2002 (6.4% annual average) have been achieved on the back of high oil prices, a strong balance of payments, healthy fiscal performance, and increased capacity utilization. Increased fiscal revenues (which largely resulted from high oil prices) easily allowed the government to raise wages in the public sector and stimulate domestic demand considerably. However, the period of «cheap» growth, as has been the case in recent years, has effectively come to an end. Higher capacity utilization, which contributed to rapid growth in productivity, is already out of the question^. Sooner or later oil prices are likely to go down and stabilize at some lower level, which will reduce export earnings. Apart from this, the recorded slowdown in economic growth in 2002 indicates that the existing model for economic growth has come to an end of its useful life. The drop in manufacturing concurrent with rapidly growing real disposable incomes in 2002 clearly proved that (fig. Gl). It is widely recognized that the structure of the national economy is skewed towards the fuel and energy sector, which accounts for 30% of industrial output, one third of consolidated budget revenues and over half of federal budget revenues. Exports of fuel and energy make up about 55% of total exports (for details see section 3). Russian manufacturing lacks competitiveness and thus the gap between rapidly growing incomes and domestic production was compensated for by increased imports in 2002 and early 2003. It is important to note that this occurred despite a relatively stable real effective exchange rate. In fact, this exchange rate actually decreased by 1.7% (chart 2) in 2002 due to that fact that the ruble gained slightly against the dollar in real terms, while strongly depreciating against the euro.

^ According to the most recent data the Russian economy grew 6.4% in 1999, 10.0% in 2000 and 5.0% in 2001. 2 Especially in the sectors which are able to produce competitive goods.

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Source: Goskomstat RF Fig. Gl. Growth of Output and Disposable Income (in %)

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Source: Goskomstat RF, Central Bank of Russia Fig. G2. Imports Increased on Back of Stable Real Effective Exchange Rate Growth slowed in 2002 as increased domestic demand saw consumer preference shift towards more expensive higher quality goods, a sector in which Russian manufacturers are unable to compete with imports. The food industry provides a clear example of how growing incomes have transformed consumer demand. In 1999-2000, when incomes were low,

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production of cheap foodstuffs (such as vegetable oil, bread, etc.) grew more rapidly. In 2001, as real incomes increased, production of those foodstuffs stopped expanding and the focus shifted to more expensive high-protein foods. In 2002 and early 2003, growth in the Russian food industry slowed further from 8.2% in 1H02 to 3.4% in 4Q02 and 3.6% in January-February 03. Since demand for food was almost entirely saturated, consumer demand shifted toward more expensive consumer durables and services (table Gl). Faster growth in services last year should be seen as a sign that the economy has become healthier as it has been able to react to rapid growth in real incomes by expanding the services sector and increasing production of consumer goods. However, it is too early to say that economic restructuring is complete. A lot more changes can be expected. Effectively, the structure of exports has remained relatively unchanged, with energy and semi-manufactured goods still the major source of export revenues and the economy therefore still highly dependent on international energy prices (in spite of the fact that in 2003 this dependence seemed to have fallen). In any case, a drop in oil price would mean less oil revenues coming in and a weaker current account weakening domestic demand. Services would be the first to feel the pinch. At the same time more progress in economic restructuring was seen in early 2003. Productivity seems to have increased considerably. Nevertheless, the problem of diversifying the economy and export basket and further improving the business climate remain as topical as before. More radical structural reforms are also still needed. Table Gl. Services Grew Faster than GDP in 2002, Change Y-o-Y, % 2001 GDP Goods Production Industry Construction Agriculture Service Production Market Services Transport and Communication Trade and Public Catering Non-Market Services

5.0 6.5 4.9 9.9 11.2 3.5 4.2 5.4

2002 4.3 3.3 3.7 2.7 1.6 5.3 5.8 6.0

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23

Source: Goskomstat RF In any case, the macroeconomic performance last year clearly indicate that the country can no longer rely on the advantages of easy growth and

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that repeating the same growth pattern which emerged after the 1998 crisis will be difficult for Russia if not impossible. Growth in the non-interest spending that took place in the past few years was able to stimulate domestic consumer demand to some extent. Now it is likely to stimulate mostly imports. Thus Russia seems to be on the brink of an intense structural transformation. This transition cannot be considered as an equilibrium state.

2. He is Able who Thinks he is Able (Budha, 6"^ Century BC) In his annual address to the Parliament in 2003, president Putin stated that Russia needs to double its GDP in ten years. This would require an average annual growth rate exceeding 7%, an attainable target at first glance. Many other countries such as China, Korea and Japan have demonstrated prolonged periods of rapid growth. The Soviet economy was also able to deliver fast growth in the early 1960s, as well as in previous decades. After the 1998 crisis, during the period from 1999 to 2002 the Russian economy grew, on average, about 6.4% a year. In 2003 growth is expected to be at the same level, or even higher. How sustainable is this growth? Would it be possible for modem Russia to repeat the success of Asian economies and maintain high growth rates over a decade? If yes, then what are the necessary conditions for it? Growth theory suggests that three major factors may contribute to economic growth, namely, labor, capital and total factor productivity (TFP). As analysis reveals, Russia's economic growth in the coming years can be driven by productivity in the first order, i.e. as has occurred in recent years (fig. G3 shows labor productivity has risen in line with growing output, and even exceeded it). Unlike China or other Asian countries that have demonstrated high growth in previous decades, the Russian population is declining in the long run. In addition Russia cannot rely on large quantities of cheap labor moving from rural to urban areas as occurred in China, Korea, and in other Asian economies and has significantly contributed to high growth rates in those countries. The share of the rural population in Russia (roughly 20%) is still high by European standards, but is much lower than was the case in the Asian economies at the start of the periods of rapid growth. So, accumulation of human capital, or more precisely of the labor force, cannot contribute much to economic growth in Russia. Moreover, according to demographic forecasts the situation will deteriorate in a few years as the demographic burden (the number of dependents per 1000 workers) will start growing rapidly due to the aging population.

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130

120

110

100

Jan-94

Jan-95

Jan-96

Jan-97 Jan-98

Jan-99

Jan-00 Jan-01

Jan-02

Jan-03

- Five basic sectors output —Labor productivity |

Source: Goskomstat RF Fig. G3. Labor Productivity and Output, Jan. 94 = 100%, Seasonally Adjusted Analysis has revealed that the Asian economies in the past decade also grew largely as a result of capital accumulation. In fact, capital accumulation was the major driver of economic growth in those countries. That was also the case in Soviet Russia. Capital accumulation in the Asian economies was financed both from domestic sources and by foreign capital inflows. Total Factor Productivity (TFP) in the Asian economies has also been growing but at a lower pace than capital. A decomposition of growth in developed economies displays a different picture: TFP usually grows more rapidly relative to labor and capital. The exact meaning of TFP cannot be specified. In the most general case it incorporates technological change, changes in capacity, knowledge accumulation, etc. It may also incorporate the contribution of such effects as openness to trade and investment regime, progress in basic and higher education, information technology, research and development. TFP cannot be measured directly: it must be estimated in an indirect manner, through for instance, growth accounting. The TFP therefore includes all uncaptured parameters and measurement errors. The decomposition of growth by factors by using growth accounting techniques enables a better understanding of where growth originates from, i.e. to estimate quantitatively the contribution of each factor to economic growth. However, there are certain methodological difficulties in

G. Diversification of the Russian Economy and Growth

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carrying out growth accounting, especially in the case of countries like Russia, which have demonstrated dramatic structural changes. Growth accounting usually employs some traditional production functions, namely the Cobb-Douglas function, which assumes constant returns to scale in the two major inputs, labor and capital. In the case of equilibrium and under the assumption that factor markets are competitive, the shares of capital and labor in the production function are considered as the share of rental payments to capital and the share of wage payments to labor of total income. The assumption of constant returns to scale also means that the economy is in equiUbrium and that all the variables of the model, such as output, labor and capital evolve essentially together. This usually seems to be the case for many developed countries, but for developing and transitional economies little evidence has been found. It is hard to accept that the Russian economy has ever attained long run equilibrium in the past: econometric analysis shows that there was no equilibrium even before the transition. It can be seen that over the thirty-year period from 1960 to 1990 Russia's output roughly tripled, while its measured capital stock grew eight times (see fig. G4). At the same time, effective labor increased roughly by one-third. In 1990, the capital-output ratio was nearly four times higher than in 1960, indicating strongly diminishing returns with respect to capital for the Soviet period. At the same time increasing returns with respect to labor should be considered as a possibility. This may highlight the fact that the economy has been operating below capacity not only in the 1990s, but in Soviet times as well. Over-accumulation of capital stock (part of which can be considered as the "wrong" capital stock, a result of the misallocation of investments) was not (and could not be) accompanied by the required growth of the labor force. Labor therefore became the limiting factor in the economy, which, in spite of rapid capital accumulation, had remained labor-intensive. As seen from the Chart output has an N-shape pattern, which can be roughly approximated by a polynomial function of the third order. If inputs are roughly linear (or can be approximated by a smaller than third-order curve), then returns to scale are most likely nonconstant. In addition, the basic growth model, which is based on the assumption of constant returns to scale, neglects such inputs as land and natural resources, which are of particular importance in the case of Russia.

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• ^ ^ A A A li i

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.^ .^ ^^ |-»-GDP -*-Capital ~«l*"Labor |

Source: Goskomstat RF, Kuboniwa and Ponomarenko (2000) Fig. G4. Output, Labor and Capital in Russia from 1960 - 2003 (1960=100) Similar doubts about the reliability of the assumption of constant returns to scale are not only relevant for the pre-transition period. After 1992 many old Soviet-type businesses disappeared, while new companies emerged without substantial investments as they were able to rent capital stock from the former state enterprises, though for different activities. Metal processing plants, for instance, located in city centers, could have leased office space to the emerging trade companies or banks. Thus with minor investments part of this capital stock was put back into operation, possibly yielding higher returns. Various substitution and reallocation effects have taken place during the transition period and this is still going on. So, at best it may be possible to consider some level of local equilibrium in the case of Russia. Correct estimation of factor shares is one of the major difficulties in growth accounting. The exact values of the factor shares are usually taken as 0.7 for elasticity of output with respect to labor and 0.3 for elasticity of output with respect to capital. In our simulations we vary factor shares within a reasonable range and use both the constant and non-constant returns to scale assumption. All in all, we will skip further methodological comments in this paper and for better interpretation of results will rely on sensitivity analysis providing some range of exogenous variables, such as TFP (for more details see Gavrilenkov (2003).

G. Diversification of the Russian Economy and Growth

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Source: Goskomstat RF, own calculations Fig. G5. High Growth Rates May be Secured only by Rise in Productivity Post-crisis growth in Russia originated largely from changed fundamentals, and should therefore be reflected by changes in total factor productivity. As mentioned the average annual GDP growth rate between 1999-2003 will exceed 6%, while both capital stock and labor have grown on average by 0.5%. This leads to the conclusion that growth was really driven by higher efficiency. As econometric analysis shows, in order to increase capital stock by about 0.5% to 1% per year investments in fixed capital should grow not less than 10% each year. Even if investments grow faster than this, capital accumulation will remain slow, especially in the near future given the fact that the current level of investments is low while capital stock is far larger. The latter originates from the existing structure of the Russian economy, in which capital-intensive sectors producing low value-added products still dominate in Russia. It is highly probable that employment on average will remain unchanged in the medium run, or not exceed a growth rate of 0.5% per year, i.e. as was seen between 1999-2003. Under those assumptions Russia needs to increase total factor productivity by 5,5% to 6,5% (depending on the type of production function used) each year in order to secure an annual growth rate of 7%. To secure a 6% average annual growth rate (as was the case in recent years) TFP should rise 4.5% to 5.5% each year (fig. G5). In theory

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BOX: In the case that the actual data do not suit the model based on the assumption of constant returns to scale, one should consider two possible means of dealing with this problem. One means is to adjust inputs, namely, labor and/or capital, by quality so that the adjusted data will fit the model based on the assumption of constant returns to scale. The other is to specify the model so that it will fit the measured inputs. The OECD's Productivity Manual suggests the first method, developing the methodology for adjusting measured inputs. In the case of labor it refers to a magnitude adjusted by self-employment, by working hours, by multiple job holdings, quality of human capital, etc. Capital inputs should be adjusted by age-efficiency profiles, asset retirement patterns, age-price profiles, efficiency declines due to decay of the capital stock, and others. Decay differs from depreciation since depreciation measures the loss in value of capital goods, while decay is in fact efficiency decline that reflects the loss of productive services delivered by capital goods. Instead of the gross capital stock, after the necessary adjustments, one derives the concept of net capital stock, Finally, the shapes of the labor and capital curves become similar to the shape of the output curve, so that some linear combination of inputs assuming constant returns - gets close to the output curve. It is, however, in the case of Russia practically impossible to do this same sort of adjustments of inputs. In the long run there is no major difference if one attempts to adjust inputs so that a better approximation of the actual curve may be obtained if constant returns to scale are assumed, or if one relies on non-constant returns model without adjusting inputs (below we denote TFP in those two cases as TFPl and TFP2). In both cases some closer approximation of the actual curve can be obtained and residuals between actual and fitted curves should become roughly the same. Thus if the nature of growth is understood as a process of structural transformation in which growth itself is becoming unbalanced then increasing returns should not be rejected. this does not look impossible, however this can only occur if investments are directed not only at the energy sector, but also at sectors with higher valued-added, such as services and manufacturing. Simulations show that if productivity remains unchanged than economic growth is unlikely to exceed 1%.

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3. To Change and to Change for the Better are two Different Things (German Proverb) The diversification of exports is increasingly being touted as one of the priorities of Russian economic policy. However, producing the goods, as it were, and fulfilling this task over the coming decade appears tricky, if not impossible. The roots of the country's dependence on natural resources exports run deeper than the economic transformation of the 1990s. Indeed, the Soviet economy experienced turbulence during periods of low prices, such as was seen in the second half of the 1980s, when a drop in oil prices forced the government to substantially boost foreign debt in order to finance imports. Table G2 takes countries with different incomes per capita (including developed countries and emerging markets) and compares their ratios of gross and net exports to GDP. As can be seen, both of Russia's ratios are fairly high, indicating that the economy is both heavily dependent on export revenues and unattractive to foreign capital. Unlike many other economies, particularly those in transition, Russia has managed to generate enough export revenues to finance economic growth in the last few years. At the same time, most transition economies have experienced strong capital inflows, which have boosted not only percapita income and the import of consumer goods but also the inflow of investment goods. The latter has helped these economies to diversify substantially and East European countries have been able to redirect trade flows to the West. Table G2. Gross and Net Exports of Selected Countries (as % of GDP)

u s (2001) Japan (2001) Euro zone (2001) China (2000) Mexico (2001) Brazil (2001) Russia (2002) Poland (2000) Czech Republic (2001) Ukraine (2002) Source: United Nations, ECE

Gross exports, % of GDP 7.2 9.3 15.3 23.2 25.6 11.6 30.9 22.8 58.9 45.3

Net exports, % of GDP -4.2 1.7 1.2 3.2 -1.6 0.5 13.3 -7.8 -5.4 1.7

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Table G3. Accumulated FDI per Capita in Selected Transition Countries, 19902001 Russia (2002) Poland Hungary Czech Republic Slovakia Kazakhstan Estonia Croatia Slovenia

FDI, $ per capita 190 916 2,392 2,761 1,115 744 2,097 1,371 1,021

Source: United Nations,ECE Similar developments took place in the Asian economies a few decades earlier. Foreign direct investment (FDI) and/or private foreign borrowing fueled major change in many sectors, the rapid expansion of manufactured exports and economic growth. Many of FDFs well-known spillover effects were also seen, including better business climates and higher production efficiency. However, as is often the case, Russia is charting its own path. FDI has yet to feature prominently: in recent years, the cumulative FDI per capita has been much lower than in most transition economies (see table G3). On an annual basis, Russia has attracted less FDI than countries like Poland or the Czech Republic, which have a much smaller population. Table G4. FDI Receipts by Sector Total Fuel Metals Machinery Wood Food Construction Transport Retail and public catering Finance Other

Source: Goskomstat RF

1995 100.0 13.0 3.0 5.0 4.2 12.4 10.0 0.5 23.2 7.9 20.8

1997 100.0 5.9 3.6 2.2 1.9 9.5 4.8 0.5 8.5 42.5 20.7

1999 100.0 27.9 1.7 3.0 3.3 22.6 1.4 12.1 14.0 0.7 13.3

2002 100.0 16.7 2.1 6.5 3.3 11.0 2.2 2.8 24.0 1.4 30.0

G. Diversification of the Russian Economy and Growth

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Meanwhile, the bulk of FDI that Russia did receive went to the oil sector (see table G4), which did nothing to diversify exports. And while the food, retail and finance industries were also major recipients, their goods and services are mainly for the domestic market. Another important factor is that the average annual FDI inflow of around $3 bin was not enough to change the economy's sectoral composition substantially. Finally, much of the foreign investment came from Cyprus and should therefore be treated as repatriated capital. As the capital-intensive oil and gas industry generates the bulk of export revenues, it received a substantial part of domestic investment. Manufacturing, however, received minimal investment, so was unable to increase the production of competitive goods for export. Furthermore, the reallocation of the export-oriented industries' "excess" capital over the last decade was practically impossible due to a generally poor investment climate, coupled with a weak financial system. The result was capital flight. Most of the attempts to reallocate the capital in major top-down businesses also largely failed. For example, domestic metals producers, who took control of many manufacturing and machine-building companies, were unable to modernize auto manufacturing at GAZ or UAZ. Admittedly, the situation started to change towards the end of 2002, as investment activity increased, followed by the apparent disappearance of capital flight in 1H03. However, the action against YUKOS in mid 2003 has dealt a serious blow to the investment climate and may have indeed ended this trend, although it is too early to judge. Consequently, as fig. G6 shows, the volume of exported manufactured goods (in dollar terms) has changed little over the past seven years. Nonmineral exports have hovered around $44 bin and, despite a slight increase since the 1998 crisis, are still a long way from dominating the picture.

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^

™ B Chemical products tH Machinery

M

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•Timber, cellulose Dmetals, precious stones I Other products, excl. minerals • Mineral products

Source: Goskomstat RF Fig. G6. Domestic Exports by Commodity Groups ($ Bin.) The largest increase has clearly been in the export of mineral products, mostly oil and gas, which chart 5 reiterates. As seen from these two graphs, energy resources, metals, timber, cellulose and chemical products account for around 85% of exports. Given the rather small share of machinery and other manufactured products, real exchange rate fluctuations have little influence on exports, unlike changes in metal or energy prices. On the basis of these statistics, the export structure looks unlikely to change substantially in the coming years. Oil companies' expansion plans, particularly to finance the construction of new pipelines and terminals, will guarantee substantial exports in that sector, even given lower oil prices. The manufacturing sector has no possibility to increase exports in the medium term. At the same time, metals and chemical products are unlikely to see any major growth, as every time Russia has attempted to boost these exports in physical terms, prices have been falling. This explains the minute change in dollar revenues over the years.

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Source: Goskomstat RF Fig. G7. Breakdown of Domestic Exports by Commodity Groups (%) In the oil and gas industry, the bulk of export receipts are generated by only a few large, listed companies: YUKOS, LUKoil, Sibneft, TNK and Surgutneftegaz. The same is true of the metallurgical industry. In the ferrous sector, most of the export cashflow comes from Magnitogorsk Metal, Novolipetsk Metal and Severstal; in the non-ferrous sector, from Norilsk Nickel, SUAL, RusAl and Alrosa. Given the reasons outlined above, it is hard to envisage how these companies will substantially boost export volumes in the coming years. It can be seen that Russia's export structure closely mirrors its stock market, with only small-cap companies existing outside the oil and gas and the metals industries. The pulp and paper industry is set to expand rapidly in the future, mainly on the back of more export growth. First, however, all legal problems related to ownership in the sector need to be solved. Admittedly, like the machine-building industry, expansion here will not change the structure of exports massively. However, the greater use of technology will require more investment and know-how. Elsewhere, in the near future, we expect strong companies to emerge in the consumer industries, such as the food, agriculture, retail and service sectors. That said, these are more domestically oriented.

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4. Vivat, Crescat, Floreat! (May it Live, Grow and Flourish!) In spite of obvious advantages high oil price and capital inflows create a number of macroeconomic problems and challenges at the same time: it is expected that on the back of massive foreign exchange inflows in 2003 the ruble will appreciate rapidly, thus negatively affecting the competitiveness of the Russian economy. But this is only one side of the coin. On the other hand massive foreign exchange inflows and appreciation of the ruble creates an extremely favorable environment for the restructuring of the economy. In theory rapid appreciation of the ruble creates well-known problems competitiveness of domestic manufacturing falls, profitability of the exporters also goes down. In principle it may negatively affect economic growth. On the other hand, however, strengthening of the ruble is a challenge: it stimulates more intense structural change, in the first order cost reduction. A strong ruble is harmful for the "old" economy, inherited from the Soviet period. At the same time a stronger ruble may stimulate investment activity, given the fact that the stronger the ruble, the more investment goods can be imported. As seen from fig. G8 investment activity was closely correlated with the real exchange rate: the faster the ruble appreciated the higher the growth rate of investments that was recorded in the post-crisis period. As a result the Russian economy in the entire 1999-2002 period was growing on the back of a real appreciation of the ruble. It now appears to be a propitious moment for more active restructuring of the Russian economy. Several factors have converged to provide this moment. A stronger ruble means that more investment goods can be imported. It could, of course, be argued that the ruble was even stronger in 1996-98, a period when investment activity was low. However, Russia now offers a far better investment climate, with improved institutions and a lower tax burden, to cite just some of the advances made. At least some government efforts have paid off. Due to massive capital inflows and the strong current account, money was also cheap in Russia in 2002-2003 and interest rates were low. The fact that the government has been able to run a budget surplus explains the aridity of the Sovereign bond market and the negative real interest rates on what bonds there are. Deposit rates were also negative in real terms most of the time (see figures 9 and 10) and ruble appreciation has prompted much turning of backs on dollar savings. Stagnation on global markets means that there was no reason to export capital; on the contrary capital inflows have been massive in the first half of 2003, until the YUKOS afair.

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Source: Goskomstat RF, Central Bank of Russia Fig. G8. Real Investments and Effective Exchange Rate (1999=100%)

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