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.

16

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

19

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: / - • - • , . , £ < . ,

<"

where / is the interest rate of a risk-free asset, • \ ^j is the price of risk (depending on the degree of risk-avertiveness) and E*\^j the expected volatility of the stock market. The price earnings ratio thus will negatively depend on stock market volatility. This aspect could be quite relevant for domestic or foreign investment funds which consider the option of investing in a Russian stock market index certificate. A one-off increase in oil exports and gas exports can be expected if the Russian government should really support a closing of the large gap between domestic oil and gas prices and the respective world market prices.

22

Paul J.J. Welfens and Albrecht Kauffmann

The following graph shows that artificial fixing of a low domestic oil price (Pj) will reduce the export of oil (A *B instead of AB) where we have assumed that Russia is a price taker in world markets. Fully switching to world market prices would strongly reduce domestic consumption of oil and gas so that exports would increase.

Fig. A5. Domestic Oil Market, Price Differentiation and Exports The larger the Russian oil and gas exports relative to overall exports, the more important a prudent choice of the exchange rate regime, namely flexible exchange rates, will be. It is fully in line with the KENEN argument of optimum currency areas if Russia would opt for flexible exchange rates. Fully flexible exchange rates, however, will reduce the prospects for low interest rates and massive portfolio capital inflows, respectively. This, however, would indeed be to the disadvantage of other sectors which might need both short-term and long-term capital inflows to finance rising investment. The exchange rate regime aspect is thus indirectly creating a path-dependency in the sense that the role of the oil and gas sector is reinforced - an argument not discussed in the literature so far.

A. Structural Change, Natural Resources Sector Expansion and Growth

23

Long-Term Aspects In an historical perspective, it is clear that oil was a political resource even before the creation of OPEC and the creation of the OPEC cartel, respectively. Oil is extremely crucial for transportation, including military transportation. The fact that no cheap fuel substitute for ships, planes and trucks were available for decades has made oil a quite important resource militarily. If hydrogen or other alternatives would become available on a broader scale, the political relevance of oil would fall. As regards the demand side of the oil market, one may assume that growth of global population and the rise of per-capita income - stimulating transportation needs as the income elasticity of tourism exceeds unity imply a clear pattern of long-term growth in the demand for oil. Oil is found in geological sites and locations with different costs. The economically natural sequence in exploration is to first focus on large and relatively easily-accessible deposits. As the number of easily accessible deposits fall globally over time - unless high-technology geology facilitates find large, new sites - there will be a natural tendency for oil prices to rise over time provided that there is no offsetting technological progress or rising supply of substitutes (e.g. natural gas, renewables). Taking a look at the long-term development of oil prices, it is obvious that the nominal price - in present US dollars - of oil has remained almost constant in the period 1880-2002, namely around 20 US dollars. The creation of the OPEC cartel lifted the oil price above its long-term average, but whether the OPEC will maintain market power after 2010 is unclear. As the price level of output - e.g. proxied by the US price level - witnessed a continuous increase over time in the 20"" century (except during the Great Depression), the real price of oil had a tendency to fall in the long run. The following graph shows the long-term development of the oil price (fig. A6). Middle East countries have accounted for some 2/3 of proven oil reserves at the beginning of the 21'^ century (figure is based on BP, 2003), Russia for about 10%. As exploration is increasing outside of Arab countries, one could anticipate the share of Middle East countries in proven reserves to fall over time, but it will stay relatively high for many decades with Saudi-Arabia playing a key role not only as a major producer but also as a producer with considerable reserve capacity.

24

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A. Structural Change, Natural Resources Sector Expansion and Growth

25

As regards natural gas, the Middle East countries account for only a bit more than 1/3 of proven reserves while Europe and Euroasia represent some 60%. Russia is a key player in the field of natural gas, and the giant Gazprom company also has contracts with Azerbaijan and other CIS countries. As a result, Gazprom is not only a major producer of gas but is increasingly becoming a trader in the gas business. Building pipelines in Euroasia is, however, a risky business, not in the least as there are several regional conflict potentials in Eurasia. This in turn means that natural gas markets of Russia and Gazprom, respectively, will continue to be politicized fields. Over large distances, liquid natural gas (LNG) could help to enlarge the market radius. However, fear of terrorism will probably slow down the expansion of LNG business in the early 21'' century. Russia's oil and gas sector will expand in a long-term perspective for three major reasons: • EU-25 growth of energy demand will increase in the first half of the 21'' century; growth of energy demand in transportation will increase particularly, and part of this increase is related to EU eastern enlargement and the associated long-term growth of trade and per capita income in accession countries. Hence, EU-25 will represent a growing market in Russia's proximity. • Russia's government will be eager to maintain and stimulate a sector whose value-added is a safe basis for government revenue. • Foreign direct investment in the oil and gas sector will continue over many years as Russia has several large oil sites and gas deposits which will attract investors from the US, Canada, Western Europe and possibly Asia. Foreign direct investment will not only help to increase exploration and production in the oil and gas sector through higher investment; of similar importance is the international transfer of technology and know-how transfer plus modem management approaches which are quite important in the risky long-term energy business. Innovations will thus help to cut costs where there will be both one-off effects in the context of systemic transformation and a more gradual technological catching-up in the course of economic modernization and growth. As long as the oil price is not falling to a range below 15 US dollars over many years, there are prospects for an expansion of the Russian oil and gas industry; expansion is defined relative to the 1991 level of output. Exports can be expected to grow more than output since the expected gradual increase of domestic energy prices - plus modernization of the capital stock - implies a long-term fall in domestic demand. Such a longterm fall in demand might not occur in a decade with very high growth rates of real output in Russia, however. As the country will at some point switch to relatively modest growth rates (slightly above or close to EU fig-

26

Paul JJ. Welfens and Albrecht Kauffmann

ures), there are clear prospects for rising long-term exports of oil and gas from Russia. There is one main caveat, and this concerns the long-term real exchange rate development. If Russia would face a major long-term real appreciation of the currency, then foreign investment inflows - including those in the oil and gas sector - would fall. The link between the real exchange rate and FDI flows has been discussed from a theoretical and empirical point by FROOT/STEIN (1991), who has emphasized that the real exchange rate in a world of imperfect capital markets is critical for the international mergers and acquisition business. A foreign investor can put up more equity capital, in terms of the FDI inflow into the country's currency, if there is a real depreciation of the currency of the inflow country. The more equity capital a foreign investor has, the better the prospects for success in the bidding process; that is, the larger the loans a foreign investor can mobilize for a takeover bid. Which factors are crucial for the real exchange rate defined as eP^*/P^ (where e is the nominal exchange rate, P^ the price of tradables and * denotes foreign variables)? The foreign price of tradables can be considered exogenous; the domestic price of exported tradables P^ in turn is determined by domestic factor costs and monetary policy, respectively. The latter determines the aggregate price level P which for a given equilibrium relative price of tradables to nontradables implies a certain level of P^). At any given domestic cost structure the exogenous world market price for oil determines the scope of profitable investment in the oil and gas sector in Russia. As regards the real exchange rate, there are two main variables which are crucial: • The trade balance (more strictly: the current account position): the higher cumulated current account surpluses are, the higher the nominal exchange rate. This simply follows from the BRANSON model of flexible exchange rates which says that a rise of the stock of foreign bonds - this will occur in the context of a trade balance surplus - must go along with a fall of the nominal exchange rate (an appreciation) if the interest rate abroad, /*, and at home, i, are constant. • As regards capital flows one may note, that the time preference at home and abroad will have an influence in the sense that poor countries tend to have a high time preference and thus would like to engage in borrowing abroad which implies net capital inflows (portfolio inflows); if the capital account is dominant, the mirror effect will be a trade balance deficit. Russia as a relatively poor country thus would normally have a trade balance deficit. However, as the country has a structural problem of capital flight, there are "natural net capital outflows" whose mirror effect under flexible exchange rates is the net export of goods and serv-

A. Structural Change, Natural Resources Sector Expansion and Growth

27

ices. Moreover, with the oil and gas sector set to expand, a long-term current account surplus could occur which will bring about a real appreciation. This appreciation will reduce the burden of foreign debt - an argument which will lose weight as the ratio of foreign debt to GDP gradually begins to fall in a setting with a current account surplus. Russia's real exchange rate in the definition ePyP, with P standing for the price level), has fallen in the first transition stage, followed by a steep real depreciation in the 1998 economic crisis; after this another long-term real appreciation of the real exchange rate has taken place (see fig. A7). To some extent, we may associate a long-term real appreciation with the Balassa-Samuelson effect and economic catching-up, respectively. Indeed, other transition countries have also recorded a real appreciation in the 1990s - with the case of Bulgaria and Romania showing much larger volatility than the EU accession countries. However, there is no doubt that Russia's real appreciation would have been more modest in the 1990s and in 2001/02 if Russian oil exports had not contributed to a large current account surplus. Russian Federation: Real Excliange Rate

Data Source: Russian Economic Trends Fig. A7. Russian Federation: Real Exchange Rate (e*PVP)

28

Paul J.J. Welfens and Albrecht Kauffmann

O CO

o CO

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lO CO

1992

1994

1996

1998

2000

2002

Data Source: IMF Financial Statistics, own computations.

Fig. A8. Real Exchange Rate Developments of Belarus, Russia and Ukraine A long-term real appreciation of the ruble would reduce FDI inflows and undermine both the growth of natural resources exports and of the export of manufacturing goods. Imports of manufacturing goods in turn would increase. Such a structural real appreciation of the ruble would undermine long-term growth since the manufacturing sector would shrink so that Russia might have a Dutch disease problem. Moreover, the reduction of overall FDI inflows also implies a slow-down in capital accumulation and technological modernization. Worse, since a major share of global trade is intra-company trade of multinational companies, the implied lack of multinational investment would also undermine the growth of Russian trade. To the extent that trade growth contributes to output growth this would further undermine long-term growth prospects of Russia. Finally, a strong relative expansion of the oil and gas sector stands for the expansion of a relatively capital-intensive sector so that there is a considerable risk of high long-term unemployment.

A. Structural Change, Natural Resources Sector Expansion and Growth

29

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Fig. A9. Real Exchange Rate Developments of Selected Transition Countries Another special aspect of the expansion of the Russian oil and gas sector is the problem of the respective oil and gas firms to invest high profits. With high sector FDI inflows to be expected in Russia, there are limited opportunities to reasonably invest full profits in the oil and gas sector. Thus Russian oil and gas companies naturally will consider FDI in the natural resources business abroad - but for political and other reasons they will face limited potential in this field. The alternative is investment in vertical integration or in the building of conglomerate expansion. Judging by the structure of major Western oil and gas firms, it is not efficient to invest much in vertical integration and certainly not in conglomerate expansion. However, managers of Russian oil and gas firms can be expected to indeed pursue such an expansion strategy in the long run, not least of which because managers like to be leaders of ever larger companies. The final alternative to high profits in the oil and gas sector would be to increase the percentage of dividends paid out which in a traditional dividend-

30

Paul JJ. Welfens and Albrecht Kauffmann

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Fig. AlO. Real Exchange Rate Developments in Bulgaria and Romania discount model implies a rise of stock market prices, in turn stimulating consumption and investment. Part of the relative development of the oil industry versus the gas sector will depend, of course, on relative prices. The following graph (fig. A l l ) shows that there have been considerable changes in the relative oil-gasprice. As long as hydrogen does not become a major substitute for oil in transportation, one may assume that there will be a long-term increase of the relative oil price since global transportation demand is growing strongly in a long-term perspective.

A. Structural Change, Natural Resources Sector Expansion and Growth

31

Russia: Domestic Oii Price • Gas Price Ratio

Data Source: Goskomstat, Russian Economic Trends Fig. All. Ratio of Oil Price to Natural Gas Price in Russia

4. Policy Implications Russia has few alternatives in going ahead with economic modernization. Since exports of manufacturing goods have reduced relative to GDP in the 1990s and since FDI inflows were sluggish in the 1990s, it is clear that Russia will want to fully exploit the transitory advantage of having enormous reserves in oil and gas. It thus seems too clear that Russia will continue to have an important and transitory growth in its oil and gas sector, shaped by very large companies in both the oil sector and in the gas sector. It is very doubtful that the supergiant Gazprom company can be split up given its unique power and many links to politics. Russia's gas business will place its central focus in EU-25 markets. Since Russia has allowed the German company Ruhrgas to take a minority stake in Gazprom, it has built a strategic bridge to reinforce technological modernization and to secure broader access to the EU gas market. As Russia plans to gradually reduce the gap between domestic energy prices and world market prices one may anticipate that Russian exports of oil and gas as well as electricity will grow quite strongly in the long run. Moreover, technological modernization impulses from various joint ventures also will contribute to the expansion of the natural resources sector and rising exports. The main policy implication of the preceding analysis

32

Paul JJ. Welfens and Albrecht Kauffmann

is not that Russia's economic policy should artificially slow down the expansion of the oil and gas sector. Rather government should aim at stimulating the growth of manufacturing industry adequately so that a slight overall current account deficit will be achieved through the combination of a high sectoral export surplus in oil and gas and a high sectoral import deficit in the field of manufacturing goods. However, a high import surplus in the manufacturing industry will only occur if there are large imports of machinery and equipment, which can only be expected if there is a combination of sustained growth of Russian output and rising exports of manufacturing goods (in addition high FDI inflows in some sub-sectors of manufacturing industry are necessary). Following the finding of GYLFASON (2002), it is most important that government avoid underspending in the education system and also encourage people to invest in human capital formation. In a resource abundant economy, this is quite important as pitfalls in human capital formation can hardly be corrected. Hence a special education tax might be levied on oil and gas producers where the extra revenue should be earmarked to both investment in public schools and the university system on the one hand; on the other hand, one should give special tax breaks for a few years - referring to the start of the career - for those who complete a higher degree of education. This proposal which is supposed to encourage long-term growth is not easily reconciled with the idea of a flat income tax rate which has been applied in the new Russia. Government might consider lower corporate tax rates for the manufacturing sector in order to promote growth of this industry. However, one may anticipate fierce political lobbying from the resources sector to obtain uniformly low tax rates. This, however, will not solve the problem of Dutch disease nor eliminate the underexpansion of industry. Taking into account the experience of countries which have successfully caught up in the second half of the 20'*' century, such as Finland, Canada or Japan, it is clear that rapid structural change will be a normal element of catching-up. It suffices to remember that the share of textiles plus chemicals in Japan's output was 33% in 1960 but stood at only 2% in 2000, while the share of technology-intensive production has tripled over the same period. Long-term catching up will thus have to go along with rapid structural change. A crucial trait of successful economic catching up must be technological catching up, and this naturally can be achieved only through expansion of trade in manufacturing products. Taking a role at economic history, long-term growth of exports in manufacturing has been a consistent element of catching-up, and there are no arguments that Russia could really pursue a totally different trajectory. As regards national income and geographic proximity the main trading partner should be the EU which also has become the dominant trading partner for smaller eastern

A. Structural Change, Natural Resources Sector Expansion and Growth

33

European countries. However, EU eastern enlargement will bring about considerable trade diversion effects for Russia as the country aims to conquer major markets outside Europe as well. Growth of Russian manufacturing exports is impaired by protectionism from the US and the EU as well as trade-diverting effects of EU eastern enlargement. There is ample evidence that the EU has not encouraged Russia's integration into the world economy that much; rather the EU pursues a relatively protectionist trade policy vis-a-vis Russia, most notably in the field of manufacturing industry - in particular steel - and agricultural products (HAMILTON, 2003). This brings us to the role of WTO membership. The longer it takes to bring Russia into the WTO the more disadvantaged the manufacturing sector will be; implicitly this means that a slow WTO negotiation round will reinforce the role of the natural resources sector in Russia. Since neither the EU nor the US seems really interested in quickly embracing Russian WTO membership, this reinforces the bias in favour of an expansion of the natural resources sector in Russia. Overexpansion of the oil and gas sector will, however, draw Russia more strongly into all major political conflicts related to major energy-producing countries. The bottom line is that one may thus anticipate that after a transitory acceleration of growth in the context of an expansion of the oil and gas sector, Russia will not only face Dutch disease problems but also become more involved into international conflicts than would otherwise be the case. In 2003 oil and gas contributed to roughly 25% of Russia's GDP; only 1% of the workforce is employed in this sector. Oil and gas exports of Russia (Kazakhstan and Azerbaijan, respectively) stood at 52.5% (50.6; 88.8%) of total merchandise exports in 2002 - roughly an increase by 10 percentage points compared to 1999. As a percentage of GDP oil and gas exports amounted to 16.3% (21.1; 33.6%) which shows the strong dependency on oil and gas (EBRD, 2003, p. 48). High foreign direct investment inflows into the oil and gas sector will reinforce the role of that sector. The manufacturing industry is partly driven by the expansion of the oil and gas sector; pipeline construction and building of new railway cars - for the transport of oil and gas are two obvious examples. The high current account surplus contributes to an appreciation of the ruble which in turn undermines the expansion of the manufacturing sector.

34

Paul JJ. Welfens and Albrecht Kauffmann

Appendix Russian Federation: Gross Fixed Investment as Percent of GDP

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Data Source: WD12002 Fig. A12. Russian Federation: Gross Fixed Investment as Percent of GDP, 19892000 Russian Federation: Gross Fixed Investment in Constant Prices of 1995, Bn. RuR

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Data Source: WDI2002, Fig. A13. Russian Federation: Gross Fixed Investment in Prices of 1995, Bn. RuR, 1989-2000

A. Structural Change, Natural Resources Sector Expansion and Growth

35

Russian Federation: Annuai Growth Rate of Gross Fixed Investment

Data Source: WDI2002. Fig. A14. Russian Federation: Gross Fixed Investment, Annual Growth in Percent, 1989-2000

Russian Federation: investment in basic fonds, Percent of GDP

Data Source: Statisticheskij Ezhegodnik, Goskomstat, 2000. Fig. A15. Russian Federation: Investment in Basic Funds as Percent of GDP.

36

Paul JJ. Welfens and Albrecht Kauffmann

Russian Federation: Investment in fuel, Percent of total investment

1990

1991

1992

1993

1994

1995

1996

1997

Data Source: Statisticheskij Ezhegodnik, Goskomstat, 2000. Fig. A16. Russian Federation: Investment in Fuel as Percent of Investment in Basic Funds

Russian Federation: Structure of Investment in Fuel Industries

TTT H

H

I a Investment in fuel: oil mining (1998: oil)

30% 20% 10% 0% 1991

1992

1993

1994

1995

Ea—I—essa—,—usu—,—CK 1996 1997

Data Source: Statisticheskij Ezhegodnik, Goskomstat, 2000, Fig. A17. Russian Federation: Structure of Investment in Fuel Industries

A. Structural Change, Natural Resources Sector Expansion and Growth

37

Russian Federation: Oil Export Price to Domestic Oii Price Ratio (Percent index)

'•• ''i '• ^

i-.f

\ * :

T

l O < O C O C O C O C O C O N N . h » r ^ N h » 0 0 0 0 0 0 0 0 0 0 0 0 0 > 0 > 0 > 0 > 0 > 0 > O Q O Q O O T - T - T - ^ T - T - C M C V J 0 > C D O > 0 > 0 > 0 > 0 > 0 > 0 > 0 > 0 > a > 0 > 0 > 0 > 0 > 0 >

0>

0

>

0

>

0

>

0

>

0

>

C

F

>

0

>

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Data Source: Bank of Russia Fig. A18. Russian Federation: Oil Export Price to Domestic Oil Price Ratio (Percent Index)

Russian Federation: Real Oii Price index (Jan 1996 =100)

o > o > o > G > 0 ) 0 > o > o > o > o > o ) o > a > a ) o > a > o >

c^

cvi

c\i

cvi

M

N

c\i

5 i S S 8 § ^ S ^ S S 8 S ? S ! S S 8 S ? 2 ! S S 8 § 5 5 5 ! g S g § o j i i g S g g o 5 ! g S

Data source: Russian Economic Trends, Goskomstat, Bank of Russia, Fig. A19. Russia: Real Oil Price Index (Jan 1996 =100)

38

Paul J. J. Welfens and Albrecht Kauffmann Current Account as Percent of GDP

O 0 —

Australia Canada —Germany

—H—Netherlands -

- - United Kingdom

— U n i t e d States — • — Russian Federation

1992

1993

1996

1997

1998

1999

2000

Data Source: WDI2002 Fig. A20. Current Account as Percent of GDP, 1992-2000

Russian Federation: Fuei production /OOn

^ " -^

600

,,

^

H

^

-

D

- B

• - Oil production Mn t a

* V^

'

Gas production bn cbm

— A t — C o a l production Mn t

400-

- * "^

0 1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

Source: Russian Economic Trends 2002, own computations Fig. A21. Russian Federation: Fuel Production, 1990-2001

2000

2001

A. Structural Change, Natural Resources Sector Expansion and Growth

39

Russian Federation: Fuel production, half year periods

Source: Russian Economic Trends 2002, own computations Fig. A22. Russian Federation: Fuel Production, 1990-First Half of 2001

Russian Federation: industrial Employment, 1000 persons

1991

1992

1993

1994

1995

1996

1997

1998

* Industrial producing personnel, 1000 persons ** In Industry employed persons, 1000 persons Source: Rossiskij Statisticheskij Ezhegodnik 2000, Tab 6.S f *j and Tab. 6.6 f **j. Fig. A23. Russian Federation: Industrial Employment, 1000 Persons

40

Paul J.J. Welfens and Albrecht Kauffmann

Russian Federation: Employment in IVlining, Quarrying and Energy Industry, 1000 persons

— # — Oil production H I — Gas industry -A—Coal 0 "yk"

Oil processing Iron and Steel Industry

- -0- - • Non ferrous Metalls 1

Electric supply

— e — S t e a m and hot water supply

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

*Industrial producing personnel Source: Rossiskij Statisticheskij Ezhegodnik 2000 Fig. A24. Russian Federation: Employment in Mining, Quarrying and Energy Industry, 1000 Persons. Russian Federation: Shares of l\/lining, Quarrying and Energy Industrial Employment as Percent of Industrial Employment*

- • — O i l production H i — G a s Industry -A—Coal - e — O i l processing - -)if - - Iron and Steel industry • • • • Non ferrous Metalls I

Electric supply

- Q — S t e a m and hot water supply

1990

1991

1992

1993

1994

1995

1996

1997

1998

^Industrial producing personnel Source: Rossiskij Statisticheskij Ezhegodnik 2000, own computations Fig. A25. Russian Federation: Shares of Mining, Quarrying and Energy Industrial Employment as Percent of Industrial Employment

A. Structural Change, Natural Resources Sector Expansion and Growth

41

Russian Federation Sliares of IVIining, Quarrying and Energy Industrial Output (current RuR) as Percent of Industrial Output

- # — O i l production • H i — G a s industry -A—Coal 0 ">^"

Oil processing Iron and Steel industry

• -o- • - Non ferrous Metalls 1

Electric supply

- e — S t e a m and hot water supply

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

Source: Rossiskij Statisticheskij Ezhegodnik 2000, own computations Fig. A26. Russian Federation Shares of Mining, Quarrying and Energy Industrial Output (current RuR) as Percent of Industrial Output

Russian Federation: IVIining, Quarrying and Energy Industry Output as Percent of total Industry Output

Mining, Quarrying and Energy Industry - • - O i l and Gas Production

1990

1991

1992

1993

1994

1995

1997

1998

Source: Rossiskij Statisticheskij Ezhegodnik 2000, own computations Fig^ All. Russian Federation: Mining, Quarrying and Energy Industry Output as Percent of Total Industry Output

42

Paul J.J. Welfens and Albrecht Kauffmann

Russian Federation: Employment in IVIining, Quarrying and Energy Industry as Percent of total Industrial Employment

^ ^ ^ ' ^ ' —•-Mining, Quarrying and Energy Industry - • - O i l and Gas Production

— ' - " • " " ' " ' ' ^ ^ ^ ' " ^

^ ^ ^ - ^ ^ ^ ^ •—'

1

_ • 1990

——«1991

— ..

•

•

1992

1993

1994

—•

—• "•

1995

1996

"" 1997

1998

1999

^Industrial producing personnel Source: Rossiskij Statisticheskij Ezhegodnik 2000, own computations Fig. A28. Russian Federation: Employment in Mining, Quarrying and Energy Industry as Percent of Total Industrial Employment

42

1

Paul J.J. Welfens and Albrecht Kauffmann

1992

• 1993

• 1995

—• 1996

—• "•

^ ^ ^ ' ^ ' — ' - " • " " ' " ' ' ^ ^ ^ ' " ^

— .. 1994

"" 1997

1998

—•-Mining, Quarrying and Energy Industry - • - O i l and Gas Production

Russian Federation: Employment in IVIining, Quarrying and Energy Industry as Percent of total Industrial Employment

^ ^ ^ - ^ ^ ^ ^

1991

——«-

•—'

•

_ 1990

^Industrial producing personnel Source: Rossiskij Statisticheskij Ezhegodnik 2000, own computations

1999

Fig. A28. Russian Federation: Employment in Mining, Quarrying and Energy Industry as Percent of Total Industrial Employment

44

Paul J.J. Welfens and Albrecht Kauffmann

References BP (2003), BP Statistical Review of Worid Energy, London. Broeck, M. de, Sl0k, T. (2001): Interpreting Real Exchange Rate Movements in Transition Countries. IMF Working Paper 01/56: International Monetary Fund. Corden, W. M., Neary, J. P. (1982): Booming sector and de-industrialisation in a small open economy. - The Economic Journal 92, 825-848. Froot, K. A., Stein, J. C. (1991), Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach. Quarterly Journal of Economics 106: 1191-1217. Gerschenkron, A. (1962): Economic Backwardness in Historical Perspective: A Book of Essays. Cambridge, Massachusetts: Belknap Press. Gylfason, T. (2002), Natural Resources and Economic Growth: What is the Connection. Munich-Center for Economic Studies Paper No. 530, University of Munich. Halpem, L., Wyplosz, C. (1996): Equilibrium Exchange Rates in Transition Economies. IMF Working Paper 96/125: International Monetary Fund. Hamilton, C.B. (2003), Russia's European Economic Integration: Escapism and Realities, CEPR Paper No. 3840, London. Herberg, H., Enders, K. (1984): More on the consequences of a resource boom and the cures of the dutch disease. - Siebert, H. (ed.): The Resource Sector in an Open Economy. Berlin Heidelberg New York Tokyo: Springer, 47-94. Jungmittag, A.; Welfens, P. J. J. (2003), Innovation, Growth and Wage Structure in Transforming Economies. In: Lane, T., Oding, N., Welfens, P. J. J.: Real and Financial Economic Dynamics in Russia and Eastern Europe. Berlin, Heidelberg: Springer. Krajnyak, K., Zettelmeyer, J. (1998): Competitiveness in transition economies: what scope for real appreciation? - IMF Staff Papers 45, 309-362. Lane, P. R., Tomell, A. (1995): Power Concentration and Growth. Discussion Paper No. 1720: Harvard Institute of Economic Research, Harvard University, Cambridge, Mass. Matsuyama, K. (1992): Agricultural productivity, comparative advantage and economic growth. - Journal of Economic Theory 58, 317-334. Noreng, 0 . (1981): Petroleum revenues and industrial income. - Barker, T., Brailovsky, V. (eds.): Oil or Industry? Energy, Industrialisation and Economic Policy in Canada, Mexico, the Netherlands, Norway and the United Kingdom. London: Academic Press, 21-41. Rosenberg, C. B., Saavalainen, T. O. (1998): How to Deal with Azerbaijan's Oil Boom? Policy Strategies in a Resource-Rich Transition Economy. IMF Working Paper No. 98/6: International Monetary Fund. Sachs, J. A.; Warner, A. (1999), The Big Push, National Ressource Boom and Growth. Journal of Development Economics 59: 43-76. Sachs, J. A.; Warner, A. (2001), The Curse of Natural Resources. European Economic Review 45: 827-838. Sachs, J. D., Warner, A. M. (1995): Natural Resource Abundance and Economic Growth. NBER Working Paper 5398: National Bureau of Economic Resarch.

A. Structural Change, Natural Resources Sector Expansion and Growth

45

Stijns, J.-P. C. (2001): Natural Resource Abundance and Economic Growth Revisited. Paper presented at the Western Economic Association International 2001 conference in San Francisco. RePEc Economics Working Paper at WUSTL in its series Development and Comp Systems # 0103001 and SSRN Working Papers: University of CaUfomia at Berkeley, Department of Economics. Stijns, J.-P. C. (2003): An Empirical Test of the Dutch Disease Hypothesis Using a Gravity Model of Trade. Paper accepted for presentation at the 2003 Congress of the EEA, Stockholm, August 20 to August 24: University of California at Berkeley, Department of Economics. Tomell, A., Lane, P. R. (1999): The Voracity effect. - The American Economic Review 89, 22-46. Welfens, P.J.J.; Yarrow, G. (eds.) (1996), Telecommunications and Energy in Systemic Transformation. Heidelberg, New York: Springer. Westemhagen, N. von (2002), Systemic Transformation, Trade and Economic Growth: Developments, Theoretical Analysis and Empirical Results. Berlin, Heidelberg: Springer. Wiegert, R.. (2003), Transformation, Wachstum und Wettbewerb in Russland. Berlin, Heidelberg: Springer. Wijnbergen, S. van (1984): The 'Dutch Disease': A Disease after All?. - The Economic Journal 94,41-55.

Comment on: Structural Change, Natural Resource Sector Expansion and Growth in Russia Audrey P. Zaostrovtsev This article may otherwise be titled something like "The Russian Road to the Dutch Disease". It contains systemized real facts, models and political implications. It no doubt offers a valuable contribution to the studies of modem problems in the Russian economy. Further in the text, it also draws attention to the political economy of the receipts against this phenomenon. Yet it first briefly describes the essence of "Dutch Disease" in order to make its arguments easier to follow. It is a well-known fact that the "Dutch Disease" is usually initiated by a significant increase in revenues from raw material exports. This boom results from a favorable market juncture that draws the production factors, labor and capital, out of traditional industries sector in the raw-material and service sectors of an economy, thereby deteriorating the conditions for traditional manufacturing sector, causing it to decline. Although in the short-run the country enjoys an improved economic situation, in the long run it faces the risk of a slow down in its development. Thus, the country should trade off the relatively short-time benefits of being a raw material «rantier» and the future disadvantages of sluggish economic growth. The intuition behind this trade-off can be best illustrated by the figure below (Moiseev A.V., 1999, p.4). The country's gain from the increase in value of its export is represented by the square SI between the solid and dashed development trajectories (1 and 2, correspondently) before the moment of stagnation prevalence, T*. This is the moment when the effect from squeezing out manufacturing starts playing its adverse role. From this moment on, the economy finds itself in a less advantageous position and moves along a less productive path of development.

Comment on: Structural Change, Natural Resources Sector Expansion

47

GDPi L

/ ^ Jump due

to

/

the jmce

y^ ^^^^ 2

'

T*

• Time 1

Fig. A29. "Dutch Disease": The "Present Benefits - Future Losses" Trade Off The discount rate is responsible for the relative sizes of squares SI and S2. The greater this rate, the more valuable the increased oil revenues SI and the less important the gap S2 between the welfare along the two patterns of growth 1 and 2. The idea of government intervention in this case is to sacrifice part of the present wealth, which is the result of the high world oil prices for the sake of the future (after T*) growth acceleration. Welfens and Kauffmann see the lobbying of the oil companies and the short-time horizon of politicians as the main impediments to this government induced redistribution. This is true, but we should emphasize that this political myopia is based on the high discount rate of the majority of the population in Russia. It is possible that its discount rate is even higher than the politicians' one. This goes against general assumptions in economic literature, but in the Russian case it is necessary to mention the following peculiarities: 1. Very low average life expectancy (especially for men) combined with the population structure shifted in favor of the middle-aged and oldaged; 2. The pensioners are the "decisive voter" in Russia - most of them take part in the elections while the younger generations usually abstain from voting (and, by the way, one should remember that it is present-day pensioners who suffered most severely from the loss of their savings in 1992); 3. Very low living standards and incomes of the majority of the population outside Moscow and few regions with rich oil fields;

48

Andrey P. Zaostrovtsev

4. A strong disbelieve in the promises of a future paradise after many years of communism and bias towards egoism (perhaps the latter one contradicts with the legend about "generous Russian soul" but have a look at one of the lowest birth rates in the world!); 5. A high propensity toward consumption of present conveniences and a neglect of the long-term benefits (alcohol is often preferred to healthy way of life). This list of peculiarities could be continued, but the mentioned items are quite enough to assert that the vote-maximizing politician is not able to ignore the high discount rate of the voters. Otherwise he will fail. This problem is similar to the well-known intergenerational problem in the case of public borrowing. Thus square ^2 is less than square S^ in the previous figure in the Russian case, and the bright prospects of oil-extracting in Russia for at least the next 15-20 years supports this conclusion. In reality, the Russian people do not make any plans for such a long-term period. There are different ways to transfer present gains to the future. One way suggested by Welfens and Kauffmann involves intensive government investments in human capital: "Hence a special education tax might be levied on oil and gas producers, whereby extra revenue should be earmarked to both investment in public schools and the university system on the one hand; on the other hand, one should give special tax breaks for a few years - referring to the start of the career - for those who complete a higher degree of education. This proposal, which is supposed to encourage longterm growth, is not easily reconciled with the idea of a flat income tax rate, which has been applied in the new Russia" (p.28). First of all, it should be noted that the real Russian problem in this case lies not in the flat tax but rather in the very low income tax rate (13%). The bulk of tax revenues in Russia are received due to the different taxes on business and indirect taxes like excise taxes. This is the main reason why the Russian people are not sensitive to tax breaks. The next reason may be that many people are involved in the black economy, where no taxes are levied at all. The low incentives to accumulate human capital are not usually the result of "high income growth in the natural resource sector" (p.5), but much more due to the fact that the Russian society is a so-called "rent-seeking society". "The quality of the school system will decline, in the extreme case to the point where education (at least higher education) becomes an inferior good, and the returns will shrink, since the competitive value of a good education will be reduced in the situation where political connections decide who will end up where. If so, investment in human capital is likely to take a different form, one which is strongly biased towards rentseeking..." (Lundahl, 1997, p.44)

Comment on: Structural Change, Natural Resources Sector Expansion

49

Another way of curing the "Dutch Disease" in Russia, according to Welfens and Kauffmann, is through the introduction of lower taxes in the manufacturing sector. "Government might consider lower corporate tax rates for the manufacturing sector in order to promote growth of this industry. However, one may anticipate fierce political lobbying from the resources sector to obtain uniformly low tax rates." (p.28). It is very close to the proposal to start "subsidizing the manufacturing sector at the expense of taxing all the other industries of the economy" (Moiseev, 1999, p.6). The theoretical justification for such a policy rests on the positive externalities produced by the manufacturing: "...Paradox result that the manufacturing sector will positively affect the marginal product of capital and hence investment in the natural resources sector" (p. 17). While "gas and oil producers are unlikely to internalize the positive externality of the manufacturing goods sector" (p. 17). First of all it is not difficult to reveal that oil producers in Russia carry the essential additional tax burden in comparison to the manufacturing goods sector. It is enough to refer to excise tax, export duties and the new tax on the extraction of minerals. According to the "Lukoil" report, the state share in the amount of extracted oil increased from 36% in 2001 to 47% in 2002 due to the latter tax, and the share of the net profit of the company decreased from 17% to 14% in spite of the price rise. Besides this, there is an indirect subsidy from oil and gas producers to manufacturing represented by the gap between world and domestic prices. For instance, in March 2003 the world price (Urals FOB) jumped from $20 to $30 per barrel, but this did not have an effect on the domestic prices that remained at the extremely low level (minimum level of $3,4 per barrel). The leading Russian company "Lukoil" sold 36% of raw oil and oil products within the domestic market (Lukoil, 2003). It is questionable that further government injections and other favors will be beneficial for manufacturing, especially if we keep the development of advanced technologies in mind. The policy of favors distribution prevents restructuring and keeps the monsters of the "rusty belt" - resource devastating enterprises that are not able to survive in the open market economy - alive. Thus valuable resources are artificially stuck to the sectors that devaluate them and we finally are met with the value reducing production. It does little good for those manufacturing enterprises that are really able to follow the technical progress and produce competitive goods. There are some doubts about the general ability of the government to calculate spillovers, internalizing them through tax discrimination. The onmiscient and benevolent government that pursues the efficiency (and nothing else) is a well-known dream of the "founding fathers" of market socialism. But clearly this is not the case in Russia.

50

Andrey P. Zaostrovtsev

Finally, some words relating to "political lobbying from the resources sector to obtain uniformly low tax rates." Of course, such political lobbying exists. But with equal validity, it is possible to argue that the idea of lower taxes for manufacturing is the product of political lobbying from backward manufacturing sectors as well as the military-industrial complex.

References Lukoil (2003). Perspektivy razvitiya neftyanoi otrasli v srednesrochnoi perspektive. Lundahl, M. (1997), Inside the Predatory State: The rationale, methods, and economic consequences of kleptocratic regimes, Nordic Joumal of Political Economy, Vol.24, 31-50. Moiseev, A.V. (1999), Analysis of influence of the "Dutch Disease" and taxation on economic welfare. Example of the Russian economy. Working paper#BSP/99/030/. Moscow, New Economic School.

B. Monetary and Financial Stability as a Basis for Russia's Sustained Economic Internationalization Jose Fajgenbaum

1. Introduction

52

2. Elements and Conditions for Monetary and Financial Stability

52

2.1 Monetary and Exchange Rate Policy

52

2.2 Fiscal Policy

54

2.3 Financial Sector

57

3. Conclusion

59

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

52

Jose Fajgenbaum

1. Introduction My presentation will focus on the importance of monetary and financial stability (or macroeconomic stability) for Russia's integration in the global economy. Clearly, we at the IMF see such macroeconomic stability as a key component for creating an environment of strong sustained growth, reduced vulnerability to crises, and on this basis, deeper integration in the world economy. At the same time and before going more fully into the points I wish to make, I wish to stress that monetary and financial stability is a necessary, but not a sufficient condition for sustained economic growth and global integration. Continued structural reforms are needed to promote sustained growth and an outward-looking, diversified economy that would reduce Russia's dependence on the volatile oil sector and potential Dutch disease problems. I will not say much more on structural reform issues, as many other presentations in the workshop will touch on them, but let me reiterate that these are central to further integrating Russia in the world economy. In my discussion today, I will first outline what I see as the key policy elements for achieving monetary and financial stability over the medium term, as well as the steps needed to attain this objective from a short-term perspective. Much of this will not be a surprise to people here, as these are issues that the Fund has long focused on in Russia. These views reflect our discussions with the Russian authorities in the context of the IMF's recent Article IV consultation (staff reports for this consultation and the conclusions and recommendations of the Fund's Executive Board can be found on the IMF's website at http://wwwJmf,org),

2. Elements and Conditions for Monetary and Financial Stability 2.1 Monetary and Exchange Rate Policy Looking at monetary and exchange rate policy in Russia, we see that in practice the Central Bank of Russia (CBR) has been pursuing dual objectives: targeting the exchange rate and the inflation rate. Until recently, the authorities' strategy of slowing the real appreciation of the ruble by intervening in the foreign exchange market has been successfully paired with a moderate reduction in inflation, as the liquidity injections associated with the CBR's interventions have been absorbed by faster-than-expected growth in real money demand and sizable fiscal surpluses. While, as I have just noted, the authorities have had some success in reducing inflation, the

B. Monetary and Financial Stability as a Basis

53

targets have been consistently missed because the pursuit of a monetary policy with these dual objectives has a built-in inflationary bias. Moreover, the dual objectives have become increasingly difficult to reconcile in the context of very large foreign exchange inflows since late last year, reflecting high oil prices and the strengthening of capital flows. In these circumstances, inflation has remained stubbornly high. Let me note that some real appreciation of the ruble is inevitable in Russia, and it need not have an adverse impact on growth provided that it takes place gradually and is accompanied by productivity gains. Admittedly, it is very difficult—and perhaps undesirable—^to allow the rapid ruble appreciation that would result from the pressures currently faced by Russia due to strong foreign exchange inflows. The risk of a reversal, should oil prices drop sharply, should not be underestimated. In our view, the CBR would therefore need to maintain a pragmatic approach and be prepared to cut back on intervention in the foreign exchange market, thus allowing for greater exchange rate flexibility while increasing its sterilization efforts. The exchange rate flexibility seen thus far in 2003 is encouraging, but more could be done. Fiscal policy will need to assume a greater share of the burden in resisting real ruble appreciation. In our view, a key element of monetary and financial stability is indeed price stability, and therefore the authorities need to give greater priority to their inflation objective and allow for greater exchange rate flexibility. Russia has made relatively slow progress in reducing inflation in recent years; other transition countries have achieved much faster disinflation, with little sign of significant output costs. In addition, Russia does not benefit from low inflation, which helps growth by encouraging investment and a proper allocation of resources. By not reducing core inflation more rapidly, Russia faces the continued efficiency costs of high inflation as well as the risk that inflationary expectations could become entrenched, increasing the costs of future disinflationary efforts. In this respect, the authorities should consider moving over the mediumterm to an inflation targeting framework. The other conventional nominal anchors—namely, exchange rate pegging and monetary targeting—are not suitable anchors for Russia given the uncertainty about the scale and volatility of external flows and shocks and about the pace of remonetization. Instead, an inflation target would allow the CBR to use all available information to determine the best course for monetary policy. By choosing inflation as the primary objective of monetary policy, the CBR would help influence inflationary expectations by signaling that it would be prepared to accept greater exchange rate flexibility if the conflict between the exchange rate and inflation objectives became binding. Inflation targeting would reduce the scope for discretionary policy changes, and is a framework readily understood by the public and thus

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Jose Fajgenbaum

highly transparent, allowing for greater accountability of the central bank. While conditions are not appropriate for an immediate move to inflation targeting, a credible commitment to the inflation objective could bring forward some of the benefits of a single nominal anchor. I should point out that while the adoption of a full-fledged inflation targeting framework is some years away, Russia is well advanced on many of the preconditions for inflation targeting, and some could be established without much difficulty. In particular, many of the macroeconomic preconditions for inflation targeting— including an absence of fiscal dominance and a stable external position—are well advanced. As I will soon discuss, a fiscal rule combined with an oil stabilization fund would be essential in this regard. Additionally, the CBR already has some operational independence, and this could be enhanced by a simple amendment to the CBR law specifying that achievement of the inflation target is the primary objective of monetary policy. Greater accountability to the public would also be important, including providing fuller explanations for monetary and financial policies and greater disclosure of CBR financial operations. In other areas, meeting the preconditions for inflation targeting requires: • continued efforts to understand better the effectiveness of the transmission mechanisms of monetary policy; • a strengthening of CBR's monetary policy tools. Some progress has recently been made, but greater development of these tools is needed to ensure that the CBR has the instruments necessary to affect monetary conditions; • an improvement of the payment system, which remains fragmented and inefficient, impeding on the development of the CBR's monetary and market operations; • continued financial sector reform and greater financial deepening, which would help improve the effectiveness of monetary policy; and • increased capital account liberalization to allow capital flows to help offset the large terms of trade movements (particularly as a share of base money). I should note here that this liberalization should go pari-passu with the strengthening of the banking sector.

2.2 Fiscal Policy Fiscal policy is the next element of macroeconomic stability that I would like to discuss. Russia has made impressive strides in consolidating its fiscal position following the 1998 crisis. It is this fact, coupled with the associated improvement in debt vulnerability indicators, that most distinguishes the current environment from that prevailing before the crisis (of

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course, Russia's sizable external reserves and the significant structural reforms introduced in recent years are also key distinguishing elements). Moreover, by saving oil revenue windfalls and thus building up deposits at the central bank, fiscal policy has helped to resist inflationary and ruble appreciation pressures in recent years. However, underlying fiscal policy—the fiscal stance corrected for movements in world oil prices—has weakened since 2001. Let me clarify that this fiscal loosening does not pose immediate threats to Russia's debt sustainability, nor does it significantly deepen Russia's vulnerabilities. As reflected in the current spreads for Russian external debt, market perceptions of risk in Russia have certainly fallen considerably. But political momentum is swinging toward further fiscal loosening in the form of tax cuts. This is certainly due in part to continued high oil prices and the upcoming elections, both of which seem to have softened enthusiasm for tightfiscalpolicy. I have some sympathy for the arguments that Russia has high nominal tax rates, and that a reduction in taxes would lower distortions and provide a boost to the economy. (As a side note, from the standpoint of economic efficiency, it would be more urgent to reduce the UST, which hampers employment and distorts investment decisions, than to reduce the VAT, which is a tax on consumption.) Nonetheless, at this stage, I would argue that tax rate reductions should be paired with base broadening and tax simplification measures so that many of the benefits of tax reform can be realized without loosening the fiscal stance. Alternatively, expenditure cuts to cover the revenue losses would be necessary. In the absence of such measures, tax reductions will have the adverse impact of increasing the government's dependence on highly volatile oil revenues. During the Article IV consultation discussions with authorities, we stressed that fiscal policy would usefully be guided by—and formalized in—afiscalrule set out through legislative or other means. Given Russia's macroeconomic objectives mentioned above, as well as its vulnerability to movements in world oil prices, we have recommended that medium-term fiscal policy should aim for a roughly balanced budget over the oil price cycle, in other words, a roughly balanced budget when world oil prices are over the long-run at an average of about US$18-19 per barrel for Urals. This would imply a tightening of about 1 percent of GDP relative to the current budget, and would provide more support to the disinflation effort and help put downward pressure on the real exchange rate. Such a fiscal rule could serve as a tool in lessening discretionary intervention in the economy and supporting implementation of a stable fiscal policy. That would mean that government expenditure would not be subject to fluctuations in world oil prices. Moreover, it would facilitate the development of multi-year budgeting which, in turn, would reinforce the

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stability and predictability of economic policies, and thus reduce mediumterm risks. Similarly, the fiscal rule could help in de-politicizing budget formulation and in guiding the medium-term budgetary framework. Of course, experience around the world indicates that fiscal rules cannot prevent unsound fiscal policy, and that a fiscal rule is not necessarily a prerequisite to sound policies. Ultimately, however, we consider that a rulesbased fiscal policy would provide important political economic benefits for Russia and is essential to the implementation of inflation targeting as it would help reduce the monetary impact of volatile oil revenue. Another important element of fiscal policy that has received wide attention in Russia is the establishment of an oil stabilization fund intended to protect oil and gas sector proceeds from short-term political demands and to help mitigate the macroeconomic impact of fluctuations in oil revenue. Such a fund could help smooth the impact of fluctuating oil receipts on the budget, accumulating assets during periods of higher-than-baseline oil prices and providing transfers to the budget when oil prices are low. A stabilization fund is, in practice, a complement to the fiscal rule, serving as a fiscal management or accounting tool. On the basis of cross-country experience, however, it would be critical that such a stabilization fund be transparent, accountable, and fully integrated within the budget. Funds set up as autonomous and separate from the budget have most often significantly complicated fiscal management and led to serious governance problems. There are a number of practical issues related to the introduction of the fiscal rule. For example, should the rule be established through legislative action; how should the impact of changes in oil prices be reflected in the budget target; and should some margin for discretionary policy be built into the rule. I do not want to take a view on these points today, but would underline that the challenge in designing fiscal rules is to ensure they provide the needed discipline, while allowing some room for needed discretion. Similarly, I do not want to take a stand on the technical details of a proposed oil stabiUzation fund; these would include the determination of the baseline oil price; the timing of contributions to or withdrawals from the fund; or potential caps on the accumulation of assets in the Fund. I would stress, however, a few points. First, in the event of a large and prolonged downturn in the price of oil, it would be prudent to adopt fiscal measures that offset at least part of the oil revenue shortfall. Otherwise, there is a risk of a sharp build-up in public debt if the fiscal adjustment to the lower oil price is slower. Second, as I mentioned earlier, a stabilization fund should be fully integrated within the budget and thus provide some constraint on overall fiscal policy; in this respect, asset and debt management should be integrated to prevent the situation, for example, whereby the treasury would have to borrow to finance the non-oil fiscal deficit, while at the same time making contributions to the fund. Third, mecha-

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nisms should be put in place to ensure that the trigger price for the oil stabilization fund be adjusted if it appeared to be diverging from trends in the market. Before moving on, I want to reiterate that irrespective of the institutional arrangements chosen, the authorities would be well-served by a tighter fiscal policy than currently pursued. The objectives of restraining the real appreciation of the ruble and strengthening competitiveness are best achieved through strong fiscal policy and, ultimately, structural reforms, rather than relying on monetary policy, which is best left to the critical task of reducing inflation.

2.3 Financial Sector Crucial to the establishment of monetary and financial stability is, by definition, the financial sector. Sounder financial institutions and more effective financial intermediation are important to reduce vulnerabilities and create a climate more conducive to private sector activity and investment. The first step in ensuring a sound financial system is establishing a healthy banking sector. The IMF and the World Bank recently carried out an assessment of the Russian banking sector in the context of the Financial Sector Assessment Program (FSAP). The FSAP concluded that the banking system is fragile and vulnerable to a downturn in energy prices, and is characterized by a lack of transparency and weak—albeit improving— prudential supervision. However, given the relatively small size of the financial sector, and the low level of bank lending, the direct cost of financial sector distress would be serious, but not nearly as large as that experienced in 1998. Looking forward, a stronger and more vibrant banking sector would reduce the vulnerability of the system to potential shocks, and would improve the effectiveness of monetary policy operations, allowing the central bank to better respond to changes in monetary conditions. The role of foreign banks in strengthening the banking sector, by bringing expertise and know-how to Russia and by increasing competition, should be enhanced by allowing greater entrance on the part of these banks. A sound banking system also promotes stability through more effective financial intermediation, including by channeling savings from the oil and other natural resource-rich sectors to the rest of the economy and thereby stimulating growth. Currently, the underdevelopment of the banking system results in limited extension of credit to activities outside of the natural resources sectors, and in particular to small- and medium-size enterprises. As a result, the diversification of the Russian economy is stunted, leaving

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Russia more dependent on the natural resources sectors and, therefore, more vulnerable to shocks that may undermine financial stability. On the basis of the work done in the context of the FSAP mentioned earlier, there is a number of areas where the authorities need to move forcefully in the period ahead, focused on reducing vulnerabilities in the sector, enhancing competition, and boosting efficiency: strengthening banking supervision to allow proactive and aggressive assessment of the operating condition and integrity of banks. The CBR should also close non-viable banks that transgress supervisory norms, or prohibit them from soliciting household deposits; • enhancing corporate governance and the protection of creditor rights; • introducing International Accounting Standards (IAS); • addressing the uneven playing field in part caused by the large size of Sberbank and the deposit guarantee it enjoys along with other stateowned banks. In the short term, this would mean holding Sberbank to the same standards as other banks (including all prudential ratios), ensuring that it operates on a fully commercial basis with a hard budget constraint, and considering other measures to limit risks in its lending activities; and • developing medium-term options for Sberbank, ranging from privatization to transformation into a narrow bank, in the context of a comprehensive strategic review. The Russian authorities are well aware of these needs. While we fully support establishment of a deposit insurance scheme, there is a need for a stronger improvement in the CBR's ability to effectively supervise banks, including through the introduction of IAS. Regrettably, the timetable for introducing IAS has now slipped from 2004 to 2006 or 2007, which will seriously hamper the assessment of banks' suitability for participation in the proposed deposit insurance scheme. Russia would also benefit from a well supervised and more developed domestic securities market, which would support greater monetary and financial stability in two respects. First, enterprises would have access to a wider pool of financing and financing instruments, thereby providing access to a larger pool of borrowers and boosting growth in enterprises engaged in activities outside the natural resources sector. Second, greater diversification of financing sources would better spread risks in the financial system, thereby aiding stability. In addition, monetary operations would be enhanced through greater development of the domestic securities market. Recent developments in the markets for both government and corporate sector ruble-denominated debt are very encouraging, although the size of the markets remains very small. Further efforts are needed. In addition, given that most of Russia's public debt is foreign currency-denominated,

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increased ruble-denominated bond placements to retire external debt would help achieve a more balanced public debt structure. The current strong push for liberalizing the external capital account is welcome, provided it is accompanied by reforms to strengthen the financial system and improve prudential regulations on market and credit risks. The experience of other countries—for example during the Asian crisis— has shown that liberalizing the flow of capital without first putting in place the necessary mechanisms to assess and contain risks is fraught with danger. Thus, as corporations begin to access international markets in growing numbers and foreign investors move into the domestic financial market, it will be critical to enforce prudential rules strictly and to monitor the nature and volumes of these external flows so as to ensure that the leverage and foreign exchange exposure of the Russian corporate sector remains manageable. Finally, as Russia prepares to open its capital account, it will be all the more important to implement consistent and prudent macroeconomic poUcies in order to send the right signals to market participants and attract the right kind of capital into the economy.

3. Conclusion In the above discussion, I have outlined the components of macroeconomic stabilization in Russia, and summarized the key steps needed to achieve it. These efforts have important impUcations for Russia's integration in the global economy. Lower inflation will lead to lower nominal interest rates, and with less uncertainty, will most likely lead to lower real interest rates over the medium-term. Inflation is a distortion to the functioning of prices in an economy; thus, ultimately, lower inflation will allow for a more efficient allocation of resources, which will provide a better environment for private sector activity, investment, and trade. Furthermore, lower inflation in Russia should lower uncertainty and boost demand for ruble-denominated assets. A stronger and more stable public flnance position will support the anti-inflation effort, and lead to lower spreads for sovereign debt with important spillover benefits to the Russian corporate sector. Financial sector reform will be central to boosting Russia's integration within the world economy. A stronger and more developed banking system sector in particular, and financial sector in general, would be in a better position to intermediate domestic and foreign savings, thus leading to higher investment, faster growth and a more open capital account. All these areas are crucial for Russia's integration in the world economy. However, I want to stress that these are necessary, but not sufficient, conditions. Russia's integration in the world economy will accelerate through the implementation of its structural reform program. Improve-

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ments to the business climate by streamlining red tape and corruption are central to attracting foreign investment. In this regard, progress on public administration and civil service reform will be essential. An accelerated effort on trade reform in the context of WTO accession is necessary to boosting integration with the rest of the world. Disputes on energy pricing, industry-specific import protection, and foreign access to services markets will need to be resolved. Once they are, this will lead to a substantial pickup in international trade. Reform of the natural monopolies, in particular in the energy sector, will be essential for getting prices right and creating a level playing field in the economy, a crucial step toward boosting investment and trade. Of course, reforms in other areas are very important as well. I am very optimistic about Russia's future and find the recent economic performance impressive. Continued progress toward macroeconomic stability, and committed implementation of structural reforms, will be necessary for Russia to achieve its full economic potential and become truly integrated in the world economy.

Comment on: Monetary and Financial Stability as a Basis for Russia's Sustained Economic Internationalization ChristofRuehl The basic premise of Dr Fajgenbaum's contribution, that the triad of monetary, financial and fiscal stability (why is the latter not in the title?) is a necessary but not a sufficient condition for sustained growth and for Russia's integration into the global economic system, is impossible to dispute. The same is true about his second assertion, the need for structural change a.k.a. "continued structural reforms", if Russia is to continue along the road to (economic) prosperity. My comments therefore focus on two more detailed aspects: First, the relative importance of the three components of Dr Fajgenbaum's triad not in general, but for Russia today, given her current state of economic development and history of reforms; and second, the relationship of the different components of this triad to the "other", the structural reform agenda. On the first, Dr Fajgenbaum emphasizes, as does his institution, the fight against inflation as the most important ingredient ~ if not of the three conditions, than certainly as an object of monetary policy. I think this is correct in general, but in the case of Russia, it threatens to address a battle which has been fought and won already. Inflation is declining, perhaps not as fast as most would like, but it has missed annual targets only ever so slightly, if at all. No one has a planning horizon shortened by unpredictable price level increases anymore. Transactions and nominal prices have returned to Ruble denomination. The budget has been in surplus for four years in a row. All told, the devastating experience of hyperinflation in the early years of transition, combined with the post1998 refusal to inflate away the fallout of the crisis, suggest good reasons for looking at the inflation problem from an angle that is different from the need to strengthen "the authorities" anti-inflationary spine - i.e., to look at monetary policy rather more from the perspective of a Central Bank that has a problem on the technical level, namely the problem of how to manage the very substantial Petro-DoUar inflows, which Russia experiences. Inflationary pressures (or a lack of willingness to fight them) are, in other words, not per se the most troubling source of instabihty, but become troublesome in the context of exchange rate management. And the latter, in Russia, is linked to structural reforms in more ways than one.

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The basic problem is to identify policy measures that enable the Central Bank to walk the fine line between managing real exchanging appreciation and facilitating the productivity increases without which the underlying tendency toward real appreciation will inevitably hurt competitiveness. This is addressed in the paper, but I believe the underlying institutional problems are much bigger and the link between real exchange rate development and structural change in Russia more complicated than suggested there. One of these links is the lack of monetary instruments of the Central Bank (CBR), together with the fact that the same institution is also in charge of supervising a very weak banking system. Before coming back to these links, it is useful to take stock with regard to the capacity of monetary policy to actually influence real exchange rate movements. Unsurprisingly, this capacity has its limits. Fortune smiled on Russia at least three times since the exchange rate was liberalized in the summer of 1998, and since oil prices started their relentless increase shortly thereafter. First, when during the re-monetization of the economy in 1999-2000 large scale barter relations (as well as unpaid salaries and salary payments in kind) were replaced by monetary transactions, the resulting increase in the demand for money was a potent absorber of injections of high powered money. Second, the still-ongoing return of trust in the banking sector increases the multiplier, by shifting money from cash into bank accounts, thus in turn making it easier to absorb a large increase in base money. (The rapid deepening of credit markets which we currently observe, works in the same direction). And third, just when the oil price around the Iraq crisis jumped again (the price for Russian oil increased by 28 percent in the run-up to the Iraq war), the US Dollar, in which most of Russia's exports are denominated, started to depreciate against the Euro, in which most of Russia's imports are denominated, thus easing capital inflows by relieving pressure on the balance of trade. The point, of course, is that these truly exceptional circumstances, combined with a very supportive policy of fiscal restraint which ruled the post-crisis period, made it possible to "manage" very sizeable capital inflows with an extremely limited tool box (of monetary policy instruments), but without bringing the real exchange rate back even to the level of August 1998. To the present day, the CBR relies more or less on the purchase and sale of US dollars as its main policy instrument, together with an opaque system of transferring state bonds mostly to the Savings Bank that conveniently happens to be owned by its supervisor (the CBR). No functioning secondary market for government bonds, which would include a long term yield curve, has been established in Russia; there is no overnight repo-market; and auction rules on the existing market allow for the largest player to become the only bidder. Hence, the Central Bank

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carries on accumulating huge reserves, while attempting to square the impossible: combining a stable price level, a stable exchange rate, and sometimes even interest rates, by using the one available policy instrument, selling and purchasing currency. Meanwhile, neighboring countries such as Kazakhstan demonstrate the depth of financial sector and monetary policy reform possible under dire circumstances (and similar initial conditions), while the Ministry of Finance increasingly supplements favorable external circumstances in holding at bay the pressures toward real ruble appreciation. Why should this matter? On the surface, it matters because it suggests a more pressing need for immediate action on the side of institutional and capacity building to upgrade the policy capability and the monetary policy "toolbox" of the Central Bank. Dr Fajgenbaum suggests that control of the inflation rate and a more liberal attitude toward nominal exchange rate fluctuations are desirable to avoid instability going forward. This may or may not be the case, but given the current institutional capacity, the advice is unlikely to be translated into effective monetary policy action for the simple reason that fine tuning is impossible if instruments are clumsy. On the other hand, not much hay has been made while the sun shone and external circumstances and the Ministry of Finance helped to prevent the real exchange rate from taking a turn for the worse. (Note, I am not suggesting the CBR could or should manipulate the real exchange rate in the long term. But it can and should build up the range of instruments which make more effective targeting possible.) The second, and in the long run perhaps more important consequence relates to the interplay of the three components of Dr Fajgenbaum's triad, i.e. monetary policy, fiscal policy and financial sector reform. They have not been developed at equal speed or effectiveness in Russia, and it can therefore be misleading to discuss them on an equal footing. In fact, fiscal policy appears to be most advanced of the three: Many of the issues requested in Dr Fajgenbaum's paper, such as targeting the social tax or building a stabilization fund, are already in implementation. One may dislike certain aspects of their implementation, but at least there is a broad reform momentum and no standstill. Overall, tax and fiscal reforms did indeed succeed in accomplishing what matters most, namely to broaden the tax base, to restrain government, and to balance the budget at the same time (plus, as we saw, fiscal policies contributed greatly to the effective sterilization of capital inflows in the past). In terms of success and advancement, monetary policy comes in at second place. But it really is financial sector reform to which more attention needs to be given. And financial sector reform again is taking place by and large under the tutelage of the Central Bank.

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This leads back to the question as to where the productivity advances will come from, that ultimately are needed to counterbalance the real exchange rate's impact on competitiveness. They will come from new firm creation and, to some lesser extent, from restructuring those inherited enterprises that can be restructured. However, at present most of Russia's new investment, in particular investment in the new SME sector and, more generally, in new private companies, is financed by retained earnings. As pointed out by Dr Fajgenbaum, the financial sector, for a whole variety of reasons, is not yet capable of effectively intermediating savings and investment. This is highly detrimental to long term growth, in particular since Russia's economy depends on the ability of transferring its natural resource proceedings into investment across the economy. Here is not the place to discuss this in any detail, but lack of financial intermediation is one of the most serious impediments to sustained growth in Russia. In addition, a broader and more robust financial sector would also be a highly desirable cushion against the vagaries of international hydrocarbon prices, which currently have the potential to interrupt economic activities both in the private and the public sector at a moment's notice. That a deeper financial sector is also capable of absorbing some of the inevitable pressure on the exchange rate that will continue to accompany high capital inflows, has already been pointed out. To sum up, Russia is a country where about one percent of the work force in the oil and gas industry produces about 20 percent of GDP. One only needs to look at this number to realize that (a) there will be an inevitable tendency toward real exchange rate appreciation, while (b) this one percent will not be able to solve the income and employment problems of the remaining 144 million people by means of transfer payments (as is practiced by a few large hydrocarbon producers with much smaller populations); (c) a sudden and/ or profound decline of oil and gas prices will create massive strain on the economic system; and (d), monetary policy, fiscal policy, and financial sector reform need of course to be intertwined as effectively as possible to guarantee stability and sustainable growth. I find little disagreeable in Dr Fajgenbaum's paper, in which it essentially argues the position summarized under (d). However, the history of economic reforms in Russia, the composition of its economy, and the sheer scale of the potential macro-problems looming behind points (a) to (c) above, call for more from an economic analysis than balancing carefully the three components of the triad, in a way which seems universally applicable. In particular, it requires deducing priorities for reform policies. In this respect, financial sector reform appears the one segment (out of those three) where work is most urgently needed. On balance, fiscal policies are better on track than they are given credit for, monetary poli-

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cies could benefit from better instruments and some streamlining, and financial sector reform seems to be in need of a serious push forward. For there cannot be sustained growth without proper finance.

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

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2. Criteria for Selecting a Measure of Core Inflation

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3. Different Approacbes to Measure Core Inflation

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3.1 Statistical Approacbes

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3.2 Econometric Approacbes

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4. Empirical Approacbes for Russian Core Inflation

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5. Tbe Official Russian Measure of Core Inflation

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6. Conclusions

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References

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Comment on: Core Inflation in Russia Different Approaches for the Period from January 1997 to April 2003 Irina EUseeva

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1. Basic Framework The notion of core inflation and underlying inflation, which are used synonymously in economic literature, are more or less theoretical terms created by economic theorists and most of all by central bankers. Core inflation is supposed to give a better indication of the virtual inflation trend than the official consumer price index (or headline inflation rate). One practical implication is the need of monetary policy makers to be able to decompose headline inflation figures into a trend component reflecting persistent sources of inflationary pressure, on the one hand, and a transient, reversible component, on the other. It is the first of these components that incorporates the most relevant information from the perspective of a monetary policy maker. In the line of these policy needs, it is normally routine for national statistical agencies and central banks to report and analyze an array of core inflation measures. In Russia and other transitional countries, neither statistical agencies nor central bankers reported this information prior to this year. Since January 2003, the Russian State Committee for Statistics (GOSKOMSTAT) has been publishing core inflation data (6a30BbiH KujXQKC noTpe6HTejibCKHx I^CH) and the Russian Central Bank has been using these in its assessment of economic developments in Russia. But their method of estimation as well as the resulting core inflation rates is questionable. Therefore, this paper discusses different methods of measuring core inflation for Russia during the five-year period from January 1997 to December 2002 and additionally for the first four months of 2003 using data on consumer price indices (CPI) and other economic times series. The following chapter points out some relevant criteria for selecting a core inflation measure from among different approaches are discussed in literature. Chapter 3 describes different statistical and econometric approaches to generally measure core inflation in light of its advantages and disadvantages regarding the selection criteria from chapter 2. Chapter 4 delivers empirical results for Russia with its specific estimation problems for the period from January 1997 to December 2002. Chapter 5 compares the authors' estimation results with core inflation rates and core inflation method published by Russian official statistics for the first four months of 2003. The paper ends with conclusions summarizing the results from chapter 4 and 5 and gives some recommendations for further research and work in practice.

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2. Criteria for Selecting a l\/leasure of Core Inflation Regarding several publications on core inflation (see for example VEGA and WYNNE, 2001, p. 16-20, LANDAUER, 2000, p. 23-26, and WYNNE, 1999, p. 15-16), the following criteria for selecting a measure of core inflation are to be taken into consideration: Tracking trend inflation (1) Tracking mean: Core inflation should be the same as the measured headline inflation on average over time. Otherwise if there are large differences between measured headline inflation and core inflation over a long period of time, it a signal that not only temporary shocks were eliminated but also parts of the persistent component and trend were taken (ROGER, 1997 and 1998). As a result false signals for monetary policy were sent, and monetary policy makers were misled. (2) Reducing volatility: Filtering transient developments should lead to lower volatile inflation trends than headline inflation. (3) Robustness: In the literature, robustness and time invariance to changes of observed period of time were often demanded. Frequent revisions of former core inflation data leads to reliability problems in the communication of results to the public. Furthermore, statements regarding actual trends are afflicted with high uncertainty. Computable in real time Data on core inflation should be available in time with publication of new data on measured headline inflation. Forward looking Substantial information of core inflation regarding future inflation trend is one of the most important criteria for selecting a measure of core inflation. Monetary policy requires foresighted perspectives due to long and variable lags of transmission of monetary impulses. However, only the persistent part of actual measured headline inflation contains information on future trends; transient components do not play a future role. Core inflation showing the persistent part of inflation must incorporate all available information on future headline inflation. Understandable by the public Calculation methods for core inflation should be understandable by the public to improve the acceptance of the indicator. This does not mean that all technical details must be completely comprehensible by all. Rather general ideas of measure methods should be communicable.

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Theoretical basis The way of constructing a measure of core inflation should correspond to a certain economic idea or better an economic theory, i.e. headline inflation should not be arbitrarily smoothed in order to obtain a sort of core inflation, but should be transformed in an economically sensible way.

3. Different Approaches to Measure Core Inflation Research on core inflation in the 1990s can be separated into the following two approaches that roughly correspond to focuses on the two main problems in the core inflation literature: - Statistical approaches - Econometric approaches Statistical methods focus directly on the problem of how to measure core inflation using existing, contemporaneous data. They typically take published price indices and inflation rates as a staring point and ask how the available data can be exploited to provide a core inflation measure. Econometric methods combine contemporaneous and time series information and estimate models based on monetary theory. They take a behavioural definition of core inflation as a staring point. In the following two sections, typical methods will be introduced and shortly described. Several advantages and disadvantages will be discussed. In the literature, a lot of variants and other methods exist. We restrict ourselves to the most common and widespread methods.

3.1 Statistical Approaches Statistical methods calculate core inflation using contemporaneous price data only. These methods mostly modify the weighting matrix or scheme of the official consumer price index. They can be sunmiarized as reweighting methods. In this section, three statistical approaches are discussed: the traditional "Ex. food and energy" measure, the Edgeworth index and trimmed mean approach. The abbreviations in brackets will be used in chapter 4 to mark the results of the various methods when applied to the Russian case. „Ex, food and energy'' measure (CPI ex) The exclusion of most volatile index components is the most widespread method of measuring core inflation. Certain index components are com-

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pletely and systematically excluded from the headline inflation rate. Arguments in favour of this are that these components are influenced by temporary price shocks and are less informative about changes in the underlying inflation trend. These components are mostly food (due to seasonal price influences) and energy products (the price is influenced by international oil prices but should not be influenced by national monetary policy). One large advantage of this procedure is that it is rather widespread. Namely, all national central banks publish it. "Ex. food and energy" method is easily understandable by the public; it is clear and transparent. No major revisions are necessary. One criticism of this methodology is that the selection of components to be excluded is rather arbitrary. The measure is also inflexible regarding future shocks, and the results are not always smoother than the headline inflation rate. Edgeworth or variance weighted index (CPI Varl/2) These re-weighting method calculates weights by means of the strength of the „signal" in monthly price changes because of the desire to use all potentially useful information about underlying inflation trends contained in food and energy prices, too. The weighting of a single index component should be inversely related to the volatility of price changes in this index component. Arguments in favour of this procedure are that the higher the volatility of an index component, the less likely its inflation signal for future trends. We can distinguish between two types of variance weighted indices. Variant 1 (CPI Varl) considers the officially given weights w. divided by the historic volatility (variance) •^:

w^'

of

They are divided by their total in order to standardize their new sum to 1. Variant 2 (CPI Var2) completely turns away from the official weights and considers the reverse of historic volatility (variance) '^ only, again standardized to the sum 1:

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Varl

W:

=•

^'

The great advantage of each of these variants is the consideration of all components of the consumer price index. They are very flexible, and it is possible to use time variable weights. Yet the preservation of the mean is difficult over time. Decisions about weighting intervals are subjective. Furthermore, a revision of weights is necessary. Variant 2 especially offers a large discrepancy from the general price index concept. Trimmed mean (CPI Trim/Med) For the trimmed mean method, the desire to use all potentially useful information about underlying inflation trends contained in all index components is the basic goal. Within this approach, estimators are preferred that give less or no weight to outliers (limited influence estimators). To estimate core inflation rates according to trimmed means method, the observed price changes at a particular date have to be ordered from smallest to largest. Then a certain equal percentage of both ends of the crosssection distribution has to be trimmed. There are two extremes of trimmed means: Core inflation is a weighted sample median if the trim parameter is equal to 50%, or core inflation is equal to the headline inflation rate if the value of trim is equal to 0%. An optimal value of the trim parameter between 10% and 40% should be found by trial. The time-related consideration of certain index components is an advantage of trimmed means for calculating core inflation. This way of exclusion of index components is data driven and not systematic, as is usual within the ex food and energy method. How to choose the value of the trim parameter is a critical question within this approach. The preservation of means cannot be secured. The more skewed the cross-section distribution of the observed price changes at a particular date, the larger the difference between core inflation (especially trimmed median) and headline inflation. Furthermore, trim parameters are dependent upon time. Nevertheless intertemporal disaggregating of the core inflation results is difficult, because at certain points of time certain index components represent core inflation. At its extreme, this means that in one month a food item could represent core inflation while in the next month a baby carriage or CD player would do it.

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Beyond these methodologies, so-called aggregated statistical approaches that use the full sample of aggregated data and statistical techniques (typically aggregated filters) are used, in which the inflation series is smoothed to uncover a trend. They focus on the information contained in the dynamics of the aggregated headline inflation. Research along these lines includes simple averaging, as is done with year-over-year calculations or averages over other horizons and seasonal adjustments. The year-over-year headline inflation is a very simple measure of core inflation, as it applies a 12-month, one-sided, moving-average filter to monthly inflation rates.

3.2 Econometric Approaches Econometric methods are characterized by combining contemporaneous price data and other economic time series information to calculate core inflation. Per definition, they are based on economic or monetary theory. Problems appear in operationalizing economic theory. In theory, one deals with price levels and the output of an economy. In practice, only price changes are measured. As for output, several items are questioned in practice: gross domestic product (quarterly published) does not have the same periodicity as monthly price data or potential of production. In this paper, structural VAR-measures and the P* (or P-star) approaches will be introduced. Structural VAR (P-SVAR) This modeling approach involves an attempt to define core inflation and make it operational. In general, inflation is estimated by a bivariate structural autoregression (SVAR) model containing the change in inflation and the change in real output (QUAH and VAHEY, 1995). Two types of endogenous and uncorrelated shocks are considered in this model:

rAy\ fA„(l) Ap

0

.

^ where

- •y - monthly real output changes - •p - monthly changes in headline inflation - •^ - non-core inflationary shocks - •^ - core inflationary shocks The main issue of this model is the separation of the shocks corresponding to the time horizon of their impact on the level of real output. While shocks •* are thought to influence the level of real output in the longrun, the long-run impact of the other shock •^ on real output is restricted to

74

Cathleen Faber and Hans Gerhard Strohe

zero. Both of them are assumed to influence the price change. QUAH and (1995) define •^ as non-core inflationary shocks and •^ as core inflationary shocks. Since they had no strong prior knowledge about which types of shocks influence inflation in the long and short run, they preferred to be agnostic on the exact interpretation of these shocks. This approach provides the advantage that it draws a direct link between policy and core inflation as the inflation that is controllable through monetary policy. The main drawback of this model-based measure of core inflation is that the resulting core inflation measure is likely to be quite sensitive to the assumptions underlying the model. Thus, operationalizing is very difficult. The availability of new data results in a change in the historic core inflation series produced by the model. As a whole, the sensitivity of the results undermines the credibility of the core inflation in public discussions and makes it unsuitable as a target for policy, particularly if core inflation based on an economic model is generated directly by the policy maker rather than by a statistical agency. Furthermore, the concept is rather complex and therefore difficult to communicate. We did not apply this method on the Russia case. VAHEY

p'^-measures (P*) With p* (or p-star), we denote a kind of log-run equilibrium price level (or its logarithms) in the meaning of econometric time series models. Thus, to measure monthly core inflation on the base of p*, one has to determine the long-run equilibrium level of prices. The model is based on some simple variant of quantity theory of money:

-

P - r = M-ywhere P - nominal price level (consumer price index with a fixed base) Y - nominal output (industrial production or GDP) M - nominal money supply (stock of base money M3 or in Russia M2) V - velocity of money Therefore the long-run model is: p * = m - 3; * +v *

where - p - logarithm of nominal price level - m - logarithm of nominal money - y - logarithm of nominal output - V logarithm of velocity of money

C. Core Inflation in Russia

75

The *-sign indicates the long-run equilibrium. In practice, p* indicates the long-run price level estimated on the base of this equation. For y*, the potential of industrial output is used. Normally v* is zero, because in the long-run velocity is constant and does not have an effect on the long-run equilibrium level of prices. Until now in Russia, velocity of money is still changing, but for simplifying the model this assumption has been made for Russia as well. Furthermore, a given change in the stock of base money is presumed to affect all prices equi-proportionally. The advantage of p* measures is the theoretical foundation. But the model assumptions are quite strong and for the Russian case often not likely to be fulfilled. Another problem with this method is that repeated revisions of the model are necessary. Furthermore, it is hardly understandable by the public.

4. Empirical Approaches for Russian Core Inflation The primary data source for this paper is the consumer price index of Russia published by GOSKOMSTAT. For the statistical methods of calculating core inflation, monthly data from January 1992 to April 2003 are available. The data of the overall or headline inflation rate (CPI) and of the three main groups or categories of the Russian consumer price index - food, non-food, and services were used. The weighting scheme of the official index was estimated by the authors (figure CI), because GOSKOMSTAT has not yet published data about it (FABER / STROKE, 2000, p. 226). The weights were calculated yearly based on the following linear equation, with the monthly CPI and its components given: CPI=w,,CPL, all

food

+ w ,,CPI food

non-food

,, +w non-food

services

CPI services

where - CPI^^^ - Consumer Price Index for all goods and services - ^foodinon-food, services) " ^^ight of food Itcms (uou-food Itcms, services) in the consumer price index - CPhoodinon.food,seMces)" cousumcr pdcc ludex of the category food (non-food, services) The weight of the consumer price index of food within the all item consumer price index varies from 47% in 1992 to 60% in 1999 and is approximately 54% in 2003. The share of non-food went from 40% in the beginning of the 90s down to 25% in 2000 and up again to 31% in 2003.

76

Cathleen Faber and Hans Gerhard Strohe

Services have the smallest weight within the official Russian consumer price. Its share is approximately 6% in 1994, 17% in 2002 and 16% in 2003. The last column in figure CI represents an average weighting scheme for the whole period from 1992 to April 2003, estimated over all periods of time.

^

n

^S

-\

U

19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sfood B non-food Dserv

Fig. CI. Weighting Scheme of Official Consumer Price Index in Russia

total

C. Core Inflation in Russia

77

Figure C2 gives an overview of core inflation weighting after different re-weighting methods of core inflation are used.

Fig. C2. Weighting Scheme of Core Inflation with Different Re-Weighting Methods The next figures show empirical estimations of Russian core inflation from 1992 to 2002. Figures C3 (ex. food and energy method) and C4 (trimmed mean approach) look similar for the first four years because in most points of time the changes in food prices were lower than the changes in the other categories. Therefore trimmed mean like the ex food and energy method excludes changes in food prices from the upper end of the cross-section distribution and deUvers similar results. At the beginning of 2001, both methods supply different results due to the fact that from this time on food prices often represented the median of the cross-section price distribution. In addition to the development of the trimmed mean core inflation, it could be interesting to look at the trimmed frequency (table CI) of the three main index categories at the lower and upper end of the distribution.

78

Cathleen Faber and Hans Gerhard Strohe

* Note: 1,2 in this figure indicates an inflation rate of 20% per year, 1 indicates no inflation Fig. C3. CPI and CPI ex in Russia from January 1997 to December 2002 (Changes in Year-over-Year Inflation Rate)* It is remarkable that for 80% of the periods the consumer price index for services is cut and in most cases at the upper level of the cross section distribution. That means that the inflation rate for services in two of three points of time was higher than the price changes in food or non-food. Table CI. Frequency of Trim within the Trimmed Mean Measure of Core Inflation (Quantity of Trims over the whole Period of Time in Percent) total at the lower end at the upper end 0,206 food 0,588 0,382 0,096 non-food 0,551 0,456 0,654 services 0,816 0,162 Source: summary results from the trimmed mean measure

C. Core Inflation in Russia

CO -D

^ ^

79

(0 -:>

•CPI

CPI Med

Fig, C4. CPI and Trimmed Mean Measure from January 1997 to December 2002 (Changes in Year-over-Year Inflation Rate) Totally different core inflation rates are shown in figure C5 (Edgeworth index). Both variance weighted indices are quite smoother than the official headline inflation rate. Especially during hyperinflation times in autumn 1998 and December 1998, when the consumer prices rise by more than 100% over the previous year, variance weighted core inflation measures supply relatively smooth results. That is not surprising considering the characteristics of the concepts. In general, both Edgeworth indices deliver the minimum level of core inflation of all approaches. For econometric methods, further time series on money supply (M2) from January 1997 to December 2002 and data on industrial output from January 1997 to December 2002 were used.

80

Cathleen Faber and Hans Gerhard Strobe

•CPI

CPI Van

-CPIVar2

Fig. C5. CPI and Edgeworth Index from January 1997 to December 2002 (Changes in Year-over-Year Inflation Rate) Figure C6 presents results from the econometric P* method for core inflation. For these measures, a long-run equilibrium price level p* was estimated according to the quantity theory of money using OLS method (standard errors are given in square brackets):

C. Core Inflation in Russia * p'*'

=-

m -2.05 - 2.33 y* + 0.68 duml

81

[0.13] [0.08] [0.23]

(R'=0.93718) where - p* - Russian consumer price index, (log of) CPI values based on Dec. 1996=100 - m - base stock of money M2, data from the Russian Central Bank, (log of) nominal values - y* - (log of) potential of industrial production, calculated by applying a Hodrick-Prescott-Filter on industrial output data published by the Russian Central Bank - duml - dummy for the autumn crisis in 1998, equal to 0 before September 1998, equal 1 for September 1998 and than reduced by 1% from month to month. The coefficient of the stock of base money was set 1, due to the model assumption that a given change in the stock of base money is presumed to affect all prices equi-proportionally. For measuring core inflation, this p* long-run equilibrium is used to calculate a so-called price gap (p-p*) and estimate an error correction model for the core inflation again using OLS estimation: •P

=

0.11 •m + 1.30«y + 0.31 dum2 + 0.09 dum3 + 0.14»p., + 0.14»Pj + 0.05 (p-p*)., [0.02]

[0.34] [0.30] [0.01] [0.01] [0.03] [0.03]

(R^ = 0.95461) where - • m - increase rate of stock of base money M2 - • y - increase rate of potential of industrial output - • p.i - last month changes in consumer prices - • P.2 - changes in consumer prices two months before - (p-p*).i - error correction term, price gap between long-run equilibrium price level and official last month price index

82

Cathleen Faber and Hans Gerhard Strohe

- dum2 - dummy for the autumn crisis 1998, equal to 1 for September 1998, 0 else - dum3 - dummy for the after effects of the autunm crisis in December 1998, equal to 1 in December 1998, else 0 For the estimation of the coefficients, two other dummies, dum2 and dum3, have been included. Between 1997 and 2002, the most important determinants of changes in inflation are changes in industrial output, the autumn crisis 1998 and the changes of inflation in the last two months. The coefficients of •m and the error correction term (p-p*).i were not significant at the 5% level. One source of misspecification is definitely the lack of data representing the target inflation of the Russian Central Bank. Such data were not available at the time of estimation. In the model presented, we assume a constant target inflation. Thus in the error correction model where first differences were used, this term is zero. Despite the weakness of some coefficients, we use the model for estimating core inflation. But the two dummies representing temporary shocks have to be set equal to zero. The results are given in figure C6.

•CPI

Fig. C6. CPI and Core Inflation Measure based on p* Approach for Russia from January 1997 to December 2002 (Changes in Year-over-Year Inflation Rate)

C. Core Inflation in Russia

83

5. The Official Russian IVIeasure of Core Inflation Recently, the Russian State Statistical Office (GOSKOMSTAT) has started publishing a kind of core inflation (6a30BbiH HHACKC noTpe6HTejibCKHx ^eH) beginning with January 2003. But unfortunately until now, an official description of the methodology used has not been released. Due to internal working materials of GOSKOMSTAT (2003), it seems to be an approach according to the "ex. food and energy" measure. Prices from the following index categories where excluded: • Food items - Potatoes - Vegetables - Fruits • Non-food items - Petrol - Fuel • Services - Transportation (selected items like tickets for bus, tram, trolley, train, flight) - Communication - Payments for housing and communal living - Legal services - Banking services In general, the positions excluded from the overall headline inflation rate take a share of 17% according to GOSKOMSTAT (2003, p. 6). Based on papers about the economic situation in Russia published by the Russian Central Bank, core inflation has a share of 49% which means that 51% were excluded. Here the following question would arise: How useful is a core inflation rate if one-half of the headline inflation rate were excluded? Another question is the selection of items excluded from the index by Russian official statistics. The selection of transportation is especially questionable. Prices for city buses, train and trolley were excluded, while prices for taxi, commercial bus and inter-city buses remain in the core inflation index. It seems to be a strict separation of administratively-priced transportation services and those of a commercial or private nature. More detailed methodological publications will give answers to these questions. Table C2 compares the published official core inflation results with the estimations according to the "ex. food"- method from the previous years, given in this paper.

84

Cathleen Faber and Hans Gerhard Strobe

Table C2. Core Inflation for the first four Months of 2003 (Percentage Changes over the previous Month) CPI Core inflation GOSKOMSTAT Core inflation (own calculations based on ex.foodmethod)

Jan 2.4 1.2

Feb 1.6 0.9

Mar 1.1 0.7

Apr 1.0 0.6

2.3

2.1

1.2

1.1

Source: GOSKOMSTAT data published under www.gks,rUy own calculations.

Because of the small amount of official data available, it does not pay to offer a more detailed comparison of the patterns of the curves in a diagram. Our "ex. food"-measure is relatively high compared to the official headline inflation and published core inflation rates in the first four months of 2003. This difference has methodological reasons. During these months, the changes in service prices were large (4.4% in January and 4.2% in February over the previous month). Exactly these services got a larger weight within the "ex. food"-approaches for core inflation. As a result, core inflation is necessarily larger than official headline inflation. In March and April 2003, the changes in services items were much smaller than before but still higher than changes in food and non-food prices. Therefore our core inflation is still larger than headline inflation. The official statistics did not only exclude seasonal changing food prices. Additionally they excluded administrative prices. In January and February 2003, the prices for communal living services became more expensive (more than 7% per month). GOSKOMSTAT excluded this factor from the headline inflation rate to get lower core inflation results.

6. Conclusions Figure C7 displays a summary of our empirical estimations of a core inflation for Russia from January 1997 to April 2003 and the official consumer price index. The minimal and maximal core inflation rate estimated can deliver a sort of confidence interval for the core inflation rate, where mostly the variance weighted methods (CPI Varl/2) indicate the lower benchmark and the "ex. food"-approach an upper limit. In principle, all measures calculated show the same tendency of more or less smoothing the headline inflation rate. Thus each of them fulfils the demand for a measure of long-term persistent inflation to some extent. As long as more perfect data are not available, the estimations given could be

C. Core Inflation in Russia

85

provisional but useful information for bankers and economic policy makers.

2.5 2.4

•CPI

•CPI ex

CPI Var1

•CPI Var2

"CPI Med

Fig. C7. All Russian Core Inflation Approaches from January 1997 to April 2003 (Changes in Year-over-Year Inflation Rate) The authors intend to carefully watch the corresponding figures published in official Russian statistics in order to find out similarities and differences compared with their own calculations. The comparison will be completed by the methodological aspect as soon as GOSKOMSTAT unveils the method used. The approaches used by the authors can be improved by the exploitation of more detailed data concerning the structure of the Russian consumer price index for the statistical methods and more economic data with the same periodicity as CPI for the econometric ones.

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References FABER, C. and STROKE, H.G. (2000): Consumer Prices in Russia and Transforming Official Statistics. In: WELFENS, P.J.J, and GAVRILENKOV, E., eds. (2000): Restructuring, Stabilizing and Modernizing the New Russia Economic and Institutional Issues. Berlin, Heidelberg, New York: Springer. GOSKOMSTAT (2003): HocTaHOBJieHHe o6 yxBep^c^teHHH „MeTOAOJiorHHecKHx peKOMCH^^ai^HH no pacnexy 6a30Boro HH^^CKca noxpeGHxejibCKHx i^en (6a30BOH HH4)JiaiZHH)" (Dccrec on methodological recommendations to estimate a basic index of consumer prices) from January , 17th, 2003 (not published). LANDAUER, B . (2000): Keminflationsraten - Ein Methodenvergleich auf der Basis westdeutscher Daten. Diskussionspapier 4/2000. Volkswirtschaftliche Forschungsgruppe der Deutschen Bundesbank. Frankfurt/M. ROGER, S. (1997): A Robust Measures of Core Inflation in New Zealand, 194996. Reserve Bank of New Zealand Discussion Paper G97/7. ROGER, S. (1998): Core Inflation: Concepts, Uses and Measurement. Reserve Bank of New Zealand Discussion Paper G98/8. QUAH, D. and VAHEY, S.P. (1995): Measuring Core Inflation. The Economic Journal Vol. 105 (September), pp. 1130-1140. VEGA, J.-L. and WYNNE, M . A . ( 2 0 0 1 ) : An Evaluation of Some Measures of Core Inflation for the Euro Area.. European Central Bank Working Paper Series, Working Paper No. 53. Frankfurt/M. WYNNE, M . A. (1999): Core Inflation - A Review of some Conceptual Issues. European Central Bank Working Paper Series, Working Paper No. 5. Frankfurt/M.

Comment on: Core Inflation In Russia - Different Approaches for the Period from January 1997 to April 2003 Irina Eliseeva Prof. H. Strohe and Ass. C. Faber's paper is particularly interesting and important in the case of Russia. Inflation should be taken into account by monetary policy. The method of evaluation of the optimal timing of monetary policy proceeds as outlined in the following: In ''step zero'' a series of measures of weak core inflation (ie. inflation which is forecastable in the medium and long term using available information from the past) are computed. At present, these measures comprise of well-known first generation measures such as percentile and truncated means (the Cechetti measures) with optimally selected truncation points, exclusion means, various types of exponential smoothing, Kalman filter measures, etc. (for a description and review of most of these measures see Roger, 1998 and Wonziak, 1999). Some of these methods require only times series of aggregate price indices. Nevertheless, for limited influence measures more detailed information on individual price indices and aggregation weightings are required. Using panels of datasets of individual price indices and weightings for an extended period of time (at present, for Poland datasets starting at 1994 are used), these measures are computed and aggregated into an optimal (in the sense of minimizing ex-post forecast errors) index of weak core inflation. In step one, this index is in turn optimally combined with experts' inflation forecasts, produced independently by a group of renowned policy analysts. Results as both point and interval (probabilistic) forecasts of inflation for the subsequent 1-24 months are computed. Step two leads to the MIRE index by computing a measure (forecast) of strong core inflation, which does not generate a real effecting the medium and long-term. The methodology applied here is a development of the general idea given by Quah and Vahey (1995). It uses a simple two-equations vector autoregressive (VAR) model with inflation and first differences in the index of industrial production and endogenous variables. Comparison of the weak and strong core inflation measures leads to MIRE and, consequently, to a statement regarding the potential efficiency of monetary policy. An analysis of series of MIRE forecasts gives an indication of a possible climate for undertaking active monetary policy. A similar ex-post analysis helps in evaluation of the efficiency of the policy previously undertaken.

D. Russia's Banking System, the Central Bank and the Exchange Rate Regime RalfWiegert 1. Introduction

90

2. Original Sin and Beyond: Sources for Banking System Instability

92

3. The Unofficial Peg of the Ruble

98

4. The Central Bank, Competition in the Banking System and AUocative Efficiency

105

5. Conclusions and Policy Options

117

References

119

90

RalfWiegert

1. Introduction Since the collapse of the Russian financial system, banking reform has been one of the main priorities on the political agenda. Yet little progress has been achieved thus far. All the more, Russian banks still seem quite illprepared for the consequences of further integration and opening-up to the world economy, which will come up with future Russian membership in WTO. Many of Russia's banks are not able to cope with the minimum capital requirement set by the Central Bank, which in turn has therefore given them additional time for compliance - rules will be applied not earlier than 2005. Banking reform virtually stalled in 1999-2001, despite some restructuring efforts performed by the restructuring agency ARCO under supervision of the Russian Central Bank. Only since the change on the top of the Central Bank did banking reform and, in particular, the enforcement of rules and guidelines for accounting and capital adequacy gain some momentum. As most of Russia's 1200 banks are quite small, the rest of the banking sector is quite concentrated with a large share for state-owned banks. At the top is Sberbank, of which the Russian Central Bank owns the majority of its shares. Russian banks usually do not perform the role of financial intermediaries, i.e. they do not provide enterprises with external financing - this occurs only between banks and enterprises which together are part of a common holding structure. And trust among private savers is very low, so that private deposits are negligible as a source for financial funds for banks, with the notable exception of Sberbank, at which deposits are guaranteed by the state, an exclusive advantage private banks do not enjoy. Lending activities have picked up since 2000, but still, company financing is restricted mainly to internal flows in holding structures or to a few selected blue-chip companies. The reliance of many enterprise groups on internal financing has prompted GAVRILENKOV (2003, pp. 212-218) to call this kind of financial development the "Chaebolization" of the Russian economy, refering to the financial structure in South Korea in the 1970s and 1980s. In contrast to almost all other central banks in the world, the Russian Central Bank performs a fourfold role with mixed experience of independence from government and legislature. First, it performs monetary policy. Second, it regulates the foreign currency market (and determines more or less the exchange rate regime). It also hands out and cancels banking licences and acts therefore as a banking supervisory body. Finally, with its majority ownership of Sberbank and Vneshtorgbank, it is de facto the single most important player in the banking market itself. This fourfold role brings about a wide array of conflicts of interest, and this paper cannot cover all of them to the extent they deserve. But it will

D. Russia's Banking System

91

discuss some features of the quite important issues related to probably the most pressing problems in the Russian banking and financial markets. This paper argues for a clear separation of the functions within the Russian Central Bank for four primary reasons: • Appropriate design of the exchange rate regime of the Ruble (against the US-Dollar) • Effectiveness of monetary policy • Introduction of competition to the banking system and pushing ahead reform • Minimizing rent seeking and corruption in the banking system As long as the Russian economy is highly doUarized, the choice of the exchange rate system affects control over monetary policy directly. Furthermore, the actual choice of the exchange rate system - a de facto peg against the US-Dollar, as will be shown below - has consequences of a more indirect nature for banking system stability, that being its reform and the introduction of competition as well. Thus this choice features prominently in our discussion on the many powers the Central Bank enjoys. About half of Russia's exports are related to energy resources and raw materials, in particular oil and gas. This share of exports is still increasing in 2003 (WORLD BANK, 2003). Thus price fluctuation on the international market for crude oil affects export earnings and the supply of foreign currency considerably (international gas price usually follows oil price rather closely). Shocks in the international oil market therefore have consequences for the external value of the Ruble, making the prediction of the future exchange rate quite difficult and even more problematic; the conduct of monetary policy in the face of fixed exchange rates is burdened with the duty of intervening on the foreign exchange market when the market rate is in danger of passing the floor or the ceiling of the band previously announced. The following paper is divided into four sections. Section 2 will consider theoretical aspects of fixing the exchange rate as a means to secure financial system stability. Section 3 empirically analyses Russian exchange rate policy vis-a-vis the US-Dollar before, during and after the financial crisis of 1998 until recently. The Central Bank's powers and decision-making are discussed in Section 4 with respect to competition and efficiency considerations for the banking sector. Finally, the fifth section concludes and provides some policy options.

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RalfWiegert

2. Original Sin and Beyond: Sources for Banlcing System Instability Basically, banks face three kinds of risk with respect to their balance sheet when regarding the necessity for liquidity. First is the liquidity risk that appears in the case of a maturity mismatch between assets and liabilities; second, in the event of an interest rate change when either flexible and fixed exchange rates contracts are distributed unevenly between assets and liabilities or when assets (liabilities) have to be rolled over, assuming that there is no corresponding item according to the maturity on the liabilities' (assets') part of the balance sheet; third - and most important for the following considerations - in case of a mismatch between the currency denomination of assets and liabilities. In developed economies with sophisticated financial markets, banks are able to cover or hedge any of these risks through a countervailing transaction. Banking supervision usually oversees banks' transactions to determine whether banks do so and whether they comply with common risk standards. In most countries in the world and in almost all transition countries, such a highly-developed financial market with transactions denominated in local currency does not exist. A common feature is a maturity structure for transactions in local currency that is restricted to one or two years or even less. Often the country lacks a government bonds market that usually provides a landmark for the issuance of long-term corporate bonds. Regularly, like in many transition countries, basic institutional conditions for such bonds markets are not in place. Thus banks cannot finance longterm projects (more than one or two years) in local currency without maturity mismatch due to the absence of a long-term capital market segment. Maturity mismatch is one consequence of incomplete financial markets. The other one is a currency mismatch and the inability of banks to hedge foreign exchange risks due to missing futures markets or the availability of hedging instruments only at rather high costs. EICHENGREEN/HAUS MANN (1999, p. 3) called this situation where "the domestic currency cannot be used to borrow abroad or to borrow long-term, even domestically" the original sin of financial markets - a situation, in which financial fragility is unavoidable by the structure of financial markets. MCKINNON (2000, pp. 223-224) points out an established stylised fact that in most of these incomplete financial markets, private borrowing is mostly short-term and denominated in foreign currency, very likely in USDollars. Medium or long-term borrowings occur only when sovereign bonds (or the largest blue chip companies) issue bonds, again almost all of which are denominated in foreign currency and traded at a premium several percentage points higher than the international bonds market average.

D. Russia's Banking System

93

But private borrowing is restricted to the short-term and usually to foreign exchange denomination - interest rates for foreign exchange denominated loans appear to be much lower than for loans in domestic currency - and thus prone to maturity mismatch and exchange rate risks. Hedging or covering these risks is unlikely, because the opportunity cost of doing so would nullify the interest rate gains from the interest rate differential between foreign and domestically denominated loans, provided the borrower ever finds someone on the other side of the market who is willing to take the hedging risk. With high interest rate differentials and in case of fixed exchange rates between the centre country, in which currency full-fledged markets exist and interest rates are comparably low, and the country with incomplete financial markets and rather high interest rates, overborrowing is very likely. If the US is assumed to act as such a centre country, low interest-bearing Dollar deposits are taken in order to extend high-yielding Ruble loans; there is an inflow of foreign short-term capital and its extension in highyielding loans denominated in the domestic currency, but only as long as the risk premium for a sudden and unexpected change with respect to the exchange rate regime is lower than the interest rate differential between loans denominated in the anchor currency and in the domestic currency. With a sudden shift of confidence, the risk premium increases considerably and the conditions for capital inflows therefore no longer exist; hence short-term loans are not rolled over, and the country might eventually slide into financial and currency crisis. This is more or less the explanation MCKINNON (2000) gives for the outbreak of the financial crisis in East Asia in 1997. As incomplete financial markets and a considerable interest rate differential are expected to persist in the medium-term, the question arises of how the exchange rate risk together with the overborrowing syndrome can be remedied. According to MCKINNON (2000, pp. 223-226), either tight regulations on open foreign exchange positions of banks may be imposed virtually no open positions on day-to-day trading should be allowed -, or, as long as a tight grip of the banking supervisor is not a realistic option, a very short-term-oriented peg for the domestic currency might help to extinguish exchange rate risk. Except for the case of a crisis, he dismisses capital controls as an efficient option for controlling the overborrowing syndrome. Even for the case of a "tight grip", he favours a short-term peg against the exchange rate risk. The short-term peg he favours is governed as an intra-day management of the exchange rate and thus as a quasi-peg in the short-term, in order to avoid sudden changes - he calls that kind of fixing "high frequency exchange rate pegging"; in the medium-term, smaller fluctuations may occur. MCKINNON (2000, pp. 212-217) empirically shows that the crisis coun-

94

RalfWiegert

tries of East Asia have indeed resorted to such high frequency pegging somewhat after the immediate symptoms of the crisis were over. To what extent are such considerations valid for Russian financial markets? Of course, before August 1998 and in particular during 1996/1997, Russia experienced short-term capital inflows in its government bonds market (GKO) and a loss of confidence during the months before the crisis broke out; Russian banks thus already had the experience of failure due to currency mismatch on a large scale. But the difference between Russia and the East Asian countries is the fact that overborrowing was not attributed to private loans, but to the (unsustainable) borrowing on the part of the public sector and in particular the federal government. This is documented in the vast literature on the liquidity problems of the Russian private sector, where loss-making enterprises struggled to survive by introducing non-monetary forms of payment. Yet even profitable enterprises find it hard to get external finance as well (COMMANDER/MUMMSEN, 1999; EBRD, 1999; AUKUTSIONEK, 1998; YAKOVLEV, 2000). Table Dl. Loans and Deposits with Credit Institutions* Deposits

Loans I

II

III

IV

v

VI

VII

VIII

Ruble loans

Forex loans

Ratio I/II

Total loans

Forex deposits

Ruble deposits

Ratio VA^I

Total deposits

1998 II

123,19

298,38

0,413

421,57

155,59

148,46

1,048

304,05

19991

188,30

285,43

0,660

473,73

173,12

189,00

0,916

362,12 461,59

1999 II

292,72

304,10

0,963

596,82

225,01

236,58

0,951

20001

383,48

318,40

1,204

701,88

266,34

304,00

0,876

570,34

2000II

588,34

368,00

1,599

956,34

337,38

358,43

0,941

695,81

20011

759,84

421,30

1,804

1181,14

413,25

428,17

0,965

841,42

2001 n

972,64

494,85

1,966

1467,49

455,24

516,34

0,882

971,58

20021

1093,10

622,50

1,756

1715,6

523,81

611,21

0,857

1135,02

2002II

1283,94

745,00

1,723

2028,94

608,52

753,81

0,807

1362,33

2003**

1427,86

781,36

1,827

2209,22

627,09

879,04

0,713

1506,13

* All data in Ruble, end of each period (half year). **End of April 2003. Source: CENTRAL BANK OF RUSSIA, Bulletin of Banking Statistics, various issues.

Quite remarkably, this situation seems to be about to change as regards the total volume of loans extended by credit institutions. Table Dl shows data on the total amount of loans extended and deposits taken by credit institutions in Russia. In the first column, we can see that in the immediate aftermath of the 1998 crisis, the total amount of loans denominated in Ru-

D. Russia's Banking System

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ble recovered soon. Between the second half of 1998 and the second half of 2002, the total amount of Ruble loans increased more than tenfold, with data from 2003 suggesting that this growth still persists. This increase is even more remarkable when we consider the amount of loans extended in foreign currency (mostly in US-Dollar). Loans denominated in foreign currency experienced an increase far more modest in comparison to the development of Ruble loans; thus the ratio of Ruble loans to foreign exchange loans increased from 0.413 immediately after the crisis (1998 II) to 1.723 in 2002 II. Switching to deposits, we can see that a similar development has occurred. Since 1999, the ratio of foreign exchange deposits to Ruble deposits has been decreasing slowly, with an accelerated decrease in 2002, which might somehow reflect a reversal of doUarization and an increased degree of Ruble monetization of the economy. However, such a parallel increase in both Ruble and foreign exchange-denominated deposits points not only to the prevalence of a double monetary standard in Russia, but also on growing - albeit limited - confidence in the banking sector. The existence of original sin on a broad-based macroeconomic scale should lead to a large increase of Ruble loans together with an increase in short term borrowing in hard currency, such as US-Dollar deposits and other financial instruments, relative to borrowing in Ruble. The latter occured in the pretext to the Asian financial crisis in 1997, as pointed out by MCKINNON (2000), but this clearly is not the case in Russia/(9r now, in 2002/2003, at least not on the macroeconomic scale as a possible cause for a near future financial crisis. This conclusion is confirmed by examining the development of Russia's foreign debt (fig. Dl). Total debt (not shown, it amounts to the aggregated total of the four items displayed in fig. Dl) has decreased from 1999 to 2003, largely thanks to a settlement for debt inherited from the Soviet era and further debt repayments. Only corporate foreign debt shows a distinct upward trend, reflecting the improved access of a few major Russian enterprises to international financial markets. But the chart line for foreign debt of the banking sector remains virtually flat. In contrast, original sin would suggest an increase in banking and corporate foreign debt. Even net international reserves - the difference between liquid foreign assets and short term liabilities - show a high positive value, mostly due to the stock of foreign currency reserves with the Central Bank (RECEP, 2002).

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BOIion

01.01.1999

01.01.2000

01.01.2001

01.07.2001

01.01.2002

01.07.2002

01.01.2003

01.(W.2003

Hme |-Ch New Russian -•-Debt of the former - ^ Debt of the Banking -•"Debt of Non-financial Debt USSR System Hnns

Source: CENTRAL BANK OF RUSSIA, Bulletin of Statistics, various issues,

Fig. Dl. Russian Public and Corporate Foreign Debt Having concluded that original sin like in the pretext to the Asian crisis in 1997 has not taken root in Russia's financial sector, this does not exclude the possibility for any such developments in the financial sector any time soon, especially not if the economic boom in Russia leads to the development of attractive financial instruments like the GKO-market in 1997 or to large lending by external investors to Russia's big industrial conglomerates. Up until 2003, the Russian banking sector has simply lacked opportunities to exploit the interest rate differential and to create original sin on a broad scale. This is attributed to the much-acclaimed underdevelopment of the financial sector, with unsecure property rights and associated hesitance of banks to lend money at all (TOMPSON, 2000). Despite that, however, the total volume of Ruble loans has seen an unprecedented rise; from the perspective of original sin considerations and hence exchange rate risk, this is not necessarily cause for worrying, at least as long as this upswing is not financed through an inflow of foreign funds. Despite that, there might be considerable concern for original sin on a microeconomic basis, given interest rate differentials and an unofficial peg of the Ruble/US-Dollar-exchange rate, as will be shown later. Probably the

D. Russia's Banking System

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double monetary standard alone suggests that there is considerable exchange rate risk for single banks, in particular in the face of low supervisory pressure and the absence of strictly-enforced rules restricting open foreign exchange positions of financial institutions. However, since the term original sin refers to incompleteness of entire financial markets, for the sake of clarity it would be more appropriate to speak of currency mismatch with banks as a cause for liquidity problems. For a single bank, it is quite attractive to finance its Ruble loan portfolio with cheap US-Dollar deposits, in particular if the exchange rate is supposed to be stable. A likely candidate for such a behaviour would be Sberbank, which has increased its loan portfolio largely and is known for its loose internal control mechanisms, not to mention external supervision. The entire structure of the Russian banking sector with the large Sberbank on top therefore poses a risk to the stability of the financial sector. With Sberbank in liquidity trouble, the whole banking sector might be shattered again; however, in this case a bail-out is quite likely, but this would come only at very high fiscal cost. With the regulation record of the Central Bank in mind (WORLD BANK, 2002), all this is quite worrying with respect to the stability of the Russian banking sector. Following the arguments of MCKINNON (2000), pegging the Ruble exchange rate against the currency of the second monetary standard in Russia - the US-Dollar - on a high frequency basis might be a temporary solution to the problem of currency mismatch. At least the exchange rate risk would be eliminated, if the peg is credible and sustainable. One prime argument against such a peg is that in the face of currency mismatch (original sin), it might trigger moral hazard on the part of banks, leading to an even higher increase in the overborrowing syndrome, with interest rates remaining much different. With a fixed exchange rate, banks will have an incentive not to care about the remaining risk of regime change and thus will continue to exploit the interest rate differential. Others claim there is a stabilizing effect of a fixed exchange rate which will eventually narrow the interest rate differential and hence the very reason for overborrowing, leading to a completion of financial markets in the longer run. A fixed exchange rate might even have a disciplining effect on politicians (EICHENGREEN/ROSE, 1998) implying that they pursue a transparent policy without major unexpected changes. The next chapter will show that the Russian Central Bank has indeed adopted an unofficial, short termoriented peg of the Ruble to the US-Dollar.

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3. The Unofficial Peg of thie Rubie In a financial system where original sin prevails, a certain degree of stability can only be achieved when the associated risks are reduced externally, that means outside the banks which ultimately face the risks. The exchange rate risk may therefore be reduced by fixing the exchange rate or, alternatively, by pursuing very tight management of the foreign exchange market, which brings about a stable development of the exchange rate at least in the short-term and allows only for appreciations in the medium perspective. MCKINNON (2000) has shown that the latter case applies for most of the former crisis countries in East Asia, and his empirical analysis, which builds upon considerations and a related regression model of FRANKEL/ WEI (1994), will be applied to the Russian case in the following. This model consists of a multiple regression equation, which is estimated for each respective country at any applied time with OLSmethodology. It is necessary to find a suitable currency, which is required not to be fixed in a direct or indirect manner to any of the other currency in question and which exchange rate changes against the anchor currency (the US-Dollar, USD) can be explained by changes against other major international currenies or possible anchor currencies. In the case of the Ruble, the Swiss Francs can be accepted as such a reference currency. Apart from the potential anchor currency, the Japanese Yen (YEN) and the Euro (EUR; before 1999, the German Mark) are taken into the regression as explanatory variables. Each currency appears with its value against the reference currency, the respective exchange rate. The exchange rate data are on a daily basis with first difference of logarithms. The equation is as follows, in general form: Local currency/CHF = R, + R, EUR/CHF + 6^ YEN/CHF + 63 USD/CHF + •

(1)

and in order to look for an anchor currency of the Ruble: Ruble/CHF = R, + &, EUR/CHF + 6^ YEN/CHF + 63 USD/CHF + •

(la)

with 6Q, 6,, 62 and 63 as regression coefficient of the constant, the exchange rates of Euro, Yen and US-Dollar to the Swiss Franc and • as a well-behaved error term which follows N(0,»^). With the Ruble being pegged to one of the currencies in question (Euro, Yen or US-Dollar), the estimated value of the respective regression coefficient will be approximately one. The estimated value of the other coefficients should therefore be somewhere near zero, because Euro, Yen and US-Dollar are assumed to float freely against each other (FRANKEL/WEI,

D. Russia's Banking System

99

1994). Thus, if the Ruble is pegged de facto to the US-Dollar, the estimated value of 63 will approximate one, whereas 6, and 62 will be around zero. Table D2 displays the regression results for the exchange rates on a daily basis. In order to be able to compare the results of the Ruble regression, the results from MCKINNON (2000) are shown for the case of China and South Korea, of which the former maintained a fixed parity of the Yuan to the US-Dollar during the whole period; the results for China act therefore as a point of reference. The period covered in the analysis January 1994 to May 2000 for Yuan and Won and January 1998 to June 4, 2002 for the Ruble - is divided into three subperiods, whereas the first represents the pre-crisis period, the second the time of crisis itself and the third the period after the crisis. For the pre-crisis period, rather clear results can be obtained. Whereas the estimated values of Euro and Yen, b, and \ , are near zero, the estimated value of coefficient h^ for the US-Dollar is near one; this is what was predicted in case of a peg of the local currency to the US-Dollar. According to the results of MCKINNON's estimation, the Chinese Yuan shows the strongest pegging against the Dollar with a value of h^ at 0.996, a standard deviation of 0.003 and a t-value (hypothesis h^ = 0) of the estimated coefficient of 332. South Korea has a similar, but less strict pegging of the Won to the US-Dollar with a bj-value of 1.021, standard deviation of 0.016 and a t-value of 64. Russia, which in contrast to most of the East Asian countries had a officially announced exchange rate peg to the USDollar, shows a value for b3 of 1.007 and a t-value of 36.66 (standard deviation 0.027) for the period before August 17, 1998. This is also consistent with a strong peg of the Ruble to the US-Dollar, but somewhat less strict than that of South Korea. It might be attributed to a rather broad exchange rate corridor within which the Ruble was allowed to float. All t-values of the currencies in question point to a rejection of the hypothesis b3 = 0 and hence to a significant influence of the US-Dollar on the development of their exchange rates. The peg to the US-Dollar is confirmed when testing the hypothesis bj = 1, where we obtain t-values for South Korea and China of around 1 and for Russia of 0.262, which means that this hypothesis cannot be rejected with a level of probability • of 5% or 1%. The high values of R^ point out that the estimated equation fits quite well for explaining the mean variation of the observations. The period during the crisis is displayed in the middle part of Table D2. In MCKINNON's (2000) analysis, the crisis period lasts 18 months; for Russia, this can be shortened considerably, albeit somewhat arbitrarily.

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Table D2. Exchange Rate Regime in Russia, China and South Korea on Basis of Daily Data bo

(constant)

b, (EUR)'

b. (YEN)

ba

R^

(USD)

partial R'*(USD)

F-statistics

Pre-crisis ' (observations: 159 (Ruble), 889 (Yuan,Won) Ruble Yuan (China) Won (Korea)

0,000 (0,000) 0,000 (0,000) 0,001 (0,001)

0,043 (0,056) 0,012 (0,007) -0,032 (0,041)

0,009 (0,017) 0,000 (0,003) 0,006 (0,017)

1,007 (0,027) 0,996 (0,003) 1,021 (0,016)

0,911

0,897

528,09

0,996

k.A.

67 142,17

0,883

k.A.

2 236,68

During the crisis^ (observations: 99 (Ruble), 412 (Yuan, Won) Ruble Yuan (China) Won (Korea)

0,012 (0,010) 0,000 (0,000) 0,001 (0,001)

6,639 (3,600) 0,000 (0,001) 0,179 (0,413)

-0,498 (0,860) 0,000 (0,000) 0,160 (0,139)

-1,567 (1,763) 1,001 (0,000) 1,086 (0,226)

0,042

0,008

1,39

1,000

k.A.

0,087

k.A.

1289 001,65 12,95

Post-crisis^ (observations: 1195 (Ruble), 350 (Yuan, Won) Ruble Yuan (China) Won (Korea) Ruble (1999/2000)' Ruble (2000/2002)' Ruble (2003)'

0,000 (0,000) 0,000 (0,000) 0,000 (0,000) 0,001 (0,000) 0,000 (0,000) 0,000 (0,000)

-0,095 (0,088) -0,001 (0,001) 0,147 (0,090) -0,335 (0,240) 0,013 (0,026) 0,033 (0,054)

-0,086 (0,031) 0,000 (0,000) 0,070 (0,030) -0,146 (0,065) 0,021 (0,011) -0,036 (0,029)

1,038 (0,037) 1,000 (0,000) 0,957 (0,045) 1,069 (0,092) 0,989 (0,011) 1,009 (0,023)

0,498

0,403

393,21

1,000

k.A.

0,706

k.A.

1492 141,09 276,75

0,277

0,225

58,90

0,958

0,929

4398,00

0,959

0,928

1157,44

0,516

21,99

Monthly Data (observations: 54) Ruble (Jan 1999July 2003)

-0,007 (0,003)

-0,0010 (0,370)

-0,163 (0,115)

0,975 (0,135)

0,569

Standard deviation is given in brackets. Values of t-statistics are not included in the table due to high error probability with respect to the fact that the data of MCKINNON (2000) is given only to the thousandth part. *See text below. 'For the Russian Ruble: 06.01.1998 -16.08.1998, for the other currencies: January 1994 - May 1997. ' For the Russian Ruble: 17.08.1998 - 31.12.1998, for the other currencies: June 1997 - December 1998.

D. Russia's Banking System

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Table D2 continued: ' For the Russian Ruble: 01.01.1999 - 31.07.2003, for the other currencies: January 1999 - May 2000. ^Coefficient 6j is related to ECU/Euro in case of the Ruble, in case of the other currencies to the D-Mark (DEM). 'For the period 01.01.1999 - 14.10.2000, observations: 466. ' For the period 15.10.2000 - 31.12.2002, observations: 578. 'For the period 01.01.2003 - 31.07.2003, observations: 152. Source: MCKINNON (2000), pp. 214-218; own calculation on basis of Datastream data, The entire crisis period is assumed to last from August 17, 1998 to the end of that year (the comparably short period might be justified by the fast recovery of the Russian economy). The only currency that maintains a strict peg to the US-Dollar is the Yuan. For the Korean Won, there is still a significant influence of the US-Dollar, but the peg is much looser than before. For the Ruble, an influence of any of the three currencies in questions - Euro, Yen and US-Dollar - cannot be obtained at standard significance levels. Quite interesting are the results for the post-crisis period. China still maintains its fixing to the Dollar, and Korea resurrected its unofficial Dollar-standard; the estimated value of h^ is 0.957 and the hypothesis 6 = 0 cannot be rejected with respect to standard probability levels according to a t-value of 21, which confirms the influence of the US-Dollar on the Won exchange rate. Even more interesting, the Ruble seems to have returned de facto (not officially) to its pre-crisis exchange rate regime, hesitating a bit however. For the period from January 1, 1999 to the end of July 2003, we obtain an estimated value for h^ near one, that is 1.038, with a t-value of 28.327 (standard deviation = 0.037). Therefore, the US-Dollar exerts a significant influence on the Ruble exchange rate as well. This confirms a de facto pegging of the Ruble to the US-Dollar on a daily basis after the financial crisis of 1998. However, the pegging of the Ruble got closer between 1999 and 2003. It is even possible to mark a point of change in the development of the Ruble exchange rate with observing residuals from the equation cited above (January 1999 to July 2003). The model probably is mispecified somehow, because by estimating the period from January 1999 to July 2003, we obtain residuals for the estimated model which differ according to their altitude in largely two subsequent subperiods, with the first half of October 2000 being the point of reference that shapes them. The first one runs from the beginning of 1999 up to October 2000, while the second one starts there and ends together with the observation period. The assumption of

102

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homoskedasticity seems to be violated for the total period, which can be shown by running the CUSUM-test. Including a dummy variable whose value is one for the period from January 1, 1999, to October 14, 2000 and zero for the rest does not change that. This leads to the conclusion that during the respective subperiods, several external shocks happened which the model cannot explain. Probably this simply refers to a temporarily looser policy strategy towards the US Dollar exchange rate by the Russian Central Bank. It is worthwhile to check the model for other influential factors, e.g. the trading volume on Moscow foreign currency exchange. Factors like the oil price or the stock of international reserves do not seem to have an influence on the shape of the two subperiods. Simply dividing the total period into three subperiods, whereby the first runs from January 1, 1999, to October 14, 2000, the second from October 15, 2000, to December 31, 2002, and the third from January 1, 2003, until the end of the observation period, yields interesting results as well. With regard to the first period, we obtain an estimated value for b3 of 1.069 with a t-value of 11.571 (standard deviation 0.092). For the second period starting on October 15, 2000, the estimated value of b^ is even closer to unity with 0.989, and a t-value of 86.431 (standard deviation 0,011). This represents a period of an ever closer relationship between the Ruble and the US-Dollar which lasts until the end of our observation period on July 31, 2003. To have an impression of how close the daily peg of the Ruble to the US-Dollar still was in the first half of 2003, we ran the regression for the first seven months of 2003, with the result of an estimated bj-value of 1.009 and a t-value of 43.696. Besides, the different values of R^ indicate that the estimated values for the coefficients fit quite well for explaining the mean variation of the observations (0.958 and 0.959 for 2000/2002 and 2003, respectively, in contrast to 0.227 for 1999/2000). The influence of the US-Dollar can still be made clearer by excluding the Dollar from the regression equation above. The value of R^ for the modified equation shows that part of the mean variation of the observations which the remaining estimation parameters are able to explain. The explanatory part of the parameter h^ - the partial R^ - of the US-Dollar can thus be obtained with the following equation: R^,,, = (R^-R^^J/(1.R^„J

(2)

with R^uso ^s partial R ' for the US-Dollar, R ' for the original and R'^^ for the modified regression equation. The values of partial R^ for the US-Dollar (last-but-one column. Table D2) point out that the coefficient attributes a large contribution to the

;•

Source: Datastream.

D. Russia's Banking System

5 &

Fig. D2. Exchange Rate Development RubleAJS-DoUar for Selected Periods (Daily Data)

103

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RalfWiegert

explanation of mean variation of observations, in particular before the crisis and during the period 2001/2002. Before the crisis, the partial R^ was 0.897, and for 2000/2002 it increased to 0.929 (for 2003, 0.928); immediately after the crisis, R^^g^ was comparably low but was still far from being dismissible. With a close relationship between the Ruble and the US-Dollar demonstrated on a daily basis, it seems reasonable to take a look at a longer term perspective. Estimating the same regression model employed above with monthly data (simple monthly average of the respective exchange rates) for the period from January 1999 to July 2003 yields similar results (see Table D2): we obtain an estimated value for h^ once again near one, that is 0.975, with a comparatively low, albeit still significant t-value of 7.300 (standard deviation = 0.135). Therefore, the US-Dollar exerts significant influence on the Ruble exchange rate in a longer term - monthly - perspective as well. Fig. D2 displays the Ruble/US-Dollar exchange rate (daily data) in chart form, with different periods (each lasting one and a half years) and with the Ruble/Swiss Franc exchange rate as a means of comparison. The firstbut-one chart from above shows the Ruble/US-Dollar exchange rate for January 1999 to June 2000; the exchange rate is comparably volatile and resembles more of the development of the Ruble/Swiss Franc exchange rate (second chart from below) rather than to the Ruble/US-Dollar exchange rate during the official pegging (January 1997 to June 1998 shown here, chart furthest below). Keep in mind the nevertheless existing influence of the US-Dollar. The picture changes as regards the Ruble/USDollar exchange rate if we take the period from January 2001 to June 2002 into consideration. Now the chart is almost as flat as is seen in the official pegging - and slightly increasing, too, meaning a slow depreciation of the Ruble. By and large, deviations from the underlying imaginary trend line are almost non-existent here. Taking all this into consideration, we can conclude that after October 2000 in particular and until the end of the period under observation, the exchange rate of the Ruble was pegged closely to the US-Dollar on a daily basis by the Russian Central Bank. According to the results of our estimation, the daily peg for this period was at least as tight as during times of the official fixing of the Ruble before the crisis. This is somewhat different from the kind of exchange rate system BUBULA/OTKER-ROBE (2002) assumed for the Russian Ruble; they put it as "other managed floating" instead of "tightly managed floating". One must keep in mind, however, that Russia has not officially adopted any kind of peg of the Ruble to the US-Dollar. Yet de facto, the Russian Central Bank has installed an exchange rate regime which empirically shows the same results like a slowly depreciating crawling peg within a band of reasonable width.

D. Russia's Banking System

105

It would be very interesting to know the volume of interventions on behalf of the Central Bank on the foreign exchange market. But as one might expect, the Central Bank does not publish any related data. Therefore one can only resort to the change of foreign exchange reserves held by the Central Bank, a figure, that shows a steady increase nearly throughout the period from 1999 to 2003 (see fig. D4 in the next chapter where we will discuss further implications). This indicates that during the respective period, the Ruble would have substantially appreciated against the US-Dollar without foreign exchange regulations and the interventions of the Central Bank on the foreign exchange market. The next chapter will briefly discuss possible reasons for such a strategy and look for the consequences as regards financial sector's allocative efficiency and stability.

4. The Central Bank, Competition in tlie Banking System and Allocative Efficiency The exchange rate strategy of the Russian Central Bank has a wide array of consequences, and some of them may indeed provide a rationale for the Central Bank to intervene on the foreign exchange market to such a scale. Basically from the perspective of the Russian Central Bank, one may consider the following four aspects relevant: • Exchange rate as a tool for industrial policy: In particular during an oil price boom, the Russian Ruble is bound to appreciate, making it harder for the Russian industry to compete on the world market with a real exchange rate still more appreciating due to the high inflation rate at home. Therefore the Central Bank intervenes on the foreign exchange market to lower the appreciation of the real exchange rate by letting the nominal rate depreciate. This was already acknowledged by DABROWSKI/PACZYNSKI/RAWDANOWICZ (2002, p. 10) and resembles in a way the strategy of the Chinese government in 2003, which keeps the Yuan undervalued against other major currencies, in particular the USDollar, in order to give their industry an advantage on the world market. • Avoiding liquidity problems on behalf of financial institutions: Highfrequency exchange rate pegging can partly switch off exchange rate risk for banks with open foreign exchange positions (currency mismatch). Such a peg may act as a temporary alternative to tighter regulations. Yet, it is an open question whether this makes sense in the Russian case, particularly if we consider a medium to long-term perspective and the multiple functions performed by the Central Bank. Even more worrisome, banks are prone to moral hazard and thus might pursue a credit extension policy that uses the Ruble/DoUar-interest rate differen-

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tial for arbitrage without taking the remaining systemic exchange rate risk seriously. • Fixing the exchange rate as a nominal anchor and a stabilizer for the economy: This basically refers to the standard argument for resurrecting a fixed exchange rate system as was in existence from 1994 to 1997 for stabilizing the monetary sphere in order to minimize distortions for the real sector of the economy. In the case of Russia, fixing the Dollar exchange rate should also have a stabilizing effect on the current account, because Russia's trade balance is highly disproportionate, first as regards the kind of goods exported - more than half of exports are related to the raw materials sector - in contrast to imports, second as regards exports earnings - which are received mostly in US-Dollar - in comparison to imports, most of which must be paid in Euro. • Containing the foreign debt burden on the federal budget: Public foreign debt and related payment obligations are extraordinarily high in 2003/2004 compared to prior years. The annual burden for debt and interest payments will decrease over the forthcoming years. From a treasurer's perspective, a stable, non-depreciating exchange rate prevents the debt burden from growing further in Ruble terms. Provided there is consent between the Ministry of Finance and the Central Bank, fixing the exchange rate and defending it against depreciations may therefore be a goal of the Bank's policy. However, from 1999 to 2003, there were periods in which the Ruble should have appreciated, given the large current account surplus (with a booming Russian economy the probability for that further increases), which means that this argument would have been counterproductive by then. It also contradicts the industrial policy argument above. But given the large public foreign debt burden, this might still be a target of second order during times of depreciative pressure on the Ruble exchange rate. Now, what are the consequences of the peg and do they justify it, in particular as regards the reasons mentioned above? Does the tight tracking of the US-Dollar together with the current state of the banking sector and related restructuring efforts bring about stability and allocative efficiency to the Russian financial sector? Fig. D3 (see next page) summarizes an answer to the questions raised above. Basically, one can divide the figure into three main parts, of which the first one consists of external influences (components of balance of payments: current account and capital account aspects) on the right hand side in the middle and below; these translate into effects on the Russian financial sector (the second part of the story) via both the exchange rate and the foreign exchange market, including its effects on monetary policy (area above the center). The third part are legal, regulatory and supervisory affairs, on the left hand side.

D. Russia's Banking System

107

(Unofficial) Exchange rate peg Banking regulation and supervision •Licences •Accounting •Reporting •Capital adequacy •Deposit insurance

Exchange rate risk (currency mismatch)\

Capital account liberalization

SBERBANK

Foreign banks

Natural resources (oil price)/ current account

Legal framework: • Insolvency • Auditing • Creditors' rights

Barriers for market entry/ V market exit >

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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RalfWiegert

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

D. Russia's Banking System

109

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|

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

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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-

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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-

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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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2.1 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

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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

176

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

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8. Banking Sector Restructuring and Growth

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References

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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

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- 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

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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

'^ ^ ^ ^ ^' ^ •'• i- A ^ ^ * * A i ^ - ^ ^ ^ A ih A ^ A .

.^ .^ ^^ |-»-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).

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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

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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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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.

G. Diversification of the Russian Economy and Growth

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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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G. Diversification of the Russian Economy and Growth

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5. Three Ways of Restructuring Wer Nichts Waget, Der DarfNichts Hojfen (Who dares nothing need hope for nothing, Friedrich Schiller) The long-awaited acceleration in economic performance recorded in early 2003 was accompanied by a number of structural changes that could have long-lasting effects: • Strengthening of the ruble. • Faster growth in energy prices; these had already grown substantially over the previous few years, however electricity prices rocketed up 12% in the first quarter of 2003. • Ongoing rapid increase in real wages. These all imply a rise in costs, however this was offset by a rapid increase in productivity in early 2003. Employment was up 2.8% y-o-y, while output from the five basic sectors rose 6.7%. There are also other important indicators of a change in the growth mechanism:

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• Preliminary estimates for first quarter balance of payments show negligible net capital flight, due to external borrowing of around $4.9 bin by Russia's non-financial sector and banks. As a result, the country's dependence on the oil price has decreased. • Not only exporters, but also industries targeting the domestic market were able to up production substantially in early 2003. Higher domestic demand was partly down due to increased non-interest spending by the government on areas such as defense. • Meanwhile, increased investment activity has stimulated production in those industries that produce investment goods. The rise in costs placed significant pressure on industries, particularly those targeting the export market. These had previously benefited handsomely from a combination of cheap domestic costs and high global market revenues, guaranteeing considerable profits. The excessive value-added was used to fund a large proportion of Russia's capital flight, while the price distortions brought about implicit subsidization, with some sectors of the economy benefiting at the expense of others. The greater these distortions, the greater the role of the government and the higher the degree of administrative control. As a result, the changes should provide a stimulus for a restructuring of the economy. The need to reallocate the "excessive" financial resources generated by export-oriented sectors to the rest of the economy used to be and to some extent still is one of Russia's key problems. There are in theory three possible routes for reallocation: Higher Taxation Simple administrative reallocation through the higher taxation of exporters has to some extent already been tried in the past (notably in the final years of the Soviet system) via high export duties. This mechanism has not proven to be very efficient. The more the government collects in taxes, the more it tends to spend on simply financing the economy, laboring under the belief that the greater the amount paid to pensioners and public sector employees, the better for the economy. The upshot of this is continuous inflation. What is more, growing incomes prompt a shift in consumer demand from cheap to more expensive, higher-quality goods, such as consumer durables (see section 1 of this paper), a market in which Russian producers are less able to compete. This fiscal policy will therefore stimulate growth in imports, even with a weaker ruble (as was the case in 2002), unless industries are restructured.

G. Diversification of the Russian Economy and Growth

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Reallocation of Property Another way of reallocating value added is through the reallocation of property. There were indications that raw material exporters had acquired a large number of manufacturing firms and begun investing more broadly across the economy. In the short to medium term, this could contribute to a substantial improvement in Russia's macro numbers, with higher growth rates achievable in both investment and consumption. For long-term consequences such as progressive inefficiency of investment and slowing growth rates, see Gavrilenkov (2002). Institutional and Structural Reform The third method of reallocating the value added from a limited number of exporters to the rest of the economy is associated with institutional and structural reforms, above all through adjustments in relative prices. As we have stated, Russia's previously distorted relative price structure has allowed some sectors to be subsidized by others. Cheap energy, for example, has offered a competitive advantage to certain sectors of the economy, but is a disadvantage for the economy as a whole. In fact, Russia will experience all three mechanisms. However, there are more advantages to be gained from the third. A rise in energy prices, even if they are not brought immediately into line with international levels, should force energy-intensive exporters of semi-finished goods, such as ferrous/non-ferrous metals and chemical products, to start considering energy savings, cost reduction and modernization, thus beckoning in the long-awaited restructuring. This means that a larger part of the value-added now generated by those exporters would be reallocated to manufacturing on market principles, namely through increasing domestic demand for more efficient technology, machinery and equipment, as well as higher energy payments. This echoes the government's desire for diversification of the economy and will also help reduce Russia's dependence on the oil price. Econometric analysis shows that the relationship between the oil price and macroeconomic indicators is currently not as strong as it has been. The change began in mid 2002, when Russian companies started to borrow more heavily on international markets, and has continued into 2003. The graph below (fig. G12) shows that y-o-y industrial growth was closely correlated with the oil price until mid 2002 and that this relationship has now all but been broken. Apart from increased foreign borrowing, this has reduced Russia's dependence on the oil price, volume crude exports have also grown steadily, thus contributing to a strong current account at a lower price for crude.

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G. Diversification of the Russian Economy and Growth

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on higher capacity utilization (and respectively higher productivity), which developed after the 1998 crisis, became defunct last year, the only way to grow is now through increased investment. This will in turn increase productivity, not through higher capacity utilization, but rather through modernization. As stated above, a stronger ruble may stimulate investment, but that a stronger ruble (as well as other price signals above) can also thereby stimulate productivity.

6. Does the Central Bank's Monetary Policy Stimulate Restructuring? "Necessity Delivers Us From the Embarrassment of Choice" Luc de Clapier de Vauvenargues, French moralist, 1715-1747 Calls to "stop" ruble appreciation, which causes the so-called "Dutch disease", are heard regularly from businessmen and government officials alike. The general view was that "ruble appreciation" over 2001-02 had been a cause of rapid growth in imports and a consequent drop in growth in Russia's own industry. Another commonly held belief is that the Central Bank has changed its exchange rate policy to favor a stronger ruble. In fact, it is most likely that developments on Russia's foreign exchange market have largely been the result of an unprecedented inflow of foreign currency and changes in the dollar/euro exchange rate. This would leave the monetary authorities with only short-term mechanisms for affecting the market, such as buying and selling foreign currency in an attempt to smooth out the fluctuations. In the longer term, the Central Bank has faced the option of printing rubles to buy up oil windfalls, or if growth in reserves was not a priority simply allowing the ruble to appreciate. We think that in choosing rapid reserve accumulation it has opted for the most natural and reasonable policy. The fluctuations in ruble/dollar exchange rate are not enough to gauge appreciation or depreciation in the value of the ruble. In fact, Europe accounts for the single largest chunk of Russian trade and the euro, as well as the euro/dollar exchange rate, therefore plays a major role. Talk of progressing "Dutch decease" is probably inappropriate for Russia on an aggregate level (although this is valid for certain markets) for a number of reasons. As was discussed in section 1, the deceleration in growth recorded in 2001 and early 2002 came on the back of a relatively stable real effective exchange rate. The ruble has appreciated against the dollar, but depreciated against the euro, especially in 2002 and early 2003. Statistics show that in 2002 in terms of the real effective exchange rate the

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ruble was 25% below the 1997 level, in contrast to more than 40% in early 1999. However, economic growth accelerated at the end of 2002 and in early 2003, on the back of a stronger ruble. No one can guarantee that the economy will once again grow as fast as in 2000, even if the ruble should for some reason depreciate back to the level of 1999 or 2000. As was pointed out before, the growth mechanism that emerged after the 1998 crisis and contributed to an economic upturn is largely exhausted. As said, this mechanism was based on increased capacity utilization, but after a number of straight years of growth, most sectors now lack spare capacity. Even a cheaper ruble cannot therefore guarantee a return to the 10% economic growth rate seen in 2000. Ruble appreciation may indeed be causing problems for the "old" economy, but the other side of the coin is that it also acts as a stimulus for economic restructuring: in 2003 increased costs, attributed to a strengthening ruble, force companies to cut back where they can, an obvious target being excessive labor forces. As a result, productivity has again been growing. At the same time, the need to reduce costs and increase productivity forces companies to invest in production capacities. It therefore looks only natural for investment activity to have increased substantially in 2003, and not only in the oil and gas sector. 160 u.

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G. Diversification of the Russian Economy and Growth

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comparisons show that the higher the per-capita income in a country, the smaller the gap between the PPP exchange rate and the market exchange rate. The figure G14 shows that Russia has already moved some way toward diminishing this gap over the past few years, as its economy has grown. This will continue, as a strong current account and repatriation of export earnings, or capital inflows through the capital account, finance economic growth and push the ruble up at the same time.

7. Government Aims at Diversification Men and Nations Behave Wisely Once They Have Exhausted All the Other Alternatives Abba Eban, Israeli diplomat Future economic growth is associated with the growth of new businesses, which still have not emerged and expanded as intensively as would be possible. To improve the existing growth mechanism and deliver sustainable growth Russia needs: a) to remove the remaining «red tape»; b) to carry out financial sector reform (banks in the first order). In this case the current account surplus will be compensated not for capital outflows (as occurred largely in the past), but for increased savings recorded in the capital account, thus contributing to growing capitalization of the banks and monetization of the economy. In fact sustainable economic growth requires more active financial inter-mediation, which should contribute to a transformation of the sectoral structure of the economy. Diversification of the economy is seen by the government as one of the top priorities. As was shown, 2003 may really become some sort of breaking point. On the back of expected overall growth of investment, investment activity is likely to pick up in the non-energy sector as well as money remains cheaper as never before. The most recent government medium term strategy proposes specific measures, which should contribute to more diversified growth: thus there is a good combination of natural factors and government policies. In the new strategy drafted in early 2003 the government admits to the following limitations on business growth in Russia: 1. Too frequent interference by the state. The reallocation of resources, administrative barriers, excessive tax burden and the direct production of market goods and services. 2. Failure of existing institutional infrastructure to meet business needs. The fault of incomplete reform of the judiciary and law enforcement bodies.

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3. The Russian economy is closed off to foreign trade. Excessive customs and currency regulations. 4. The mechanism for energy pricing is still inadequate. The energy/output ratio in Russia is still high compared with other countries and housing is of poor quality. 5. Poor-quality social services as a result of low public sector wages. Hinders human capital development. 6. Excessive dependence of the economy on oil and gas. Threat to stable development. To solve the above problems in the coming few years the government will concentrate on: 1. Administrative reform: more active de-bureaucratization is the main objective. 2. Reducing the share of resources reallocated by the government or with its participation: more aggressive structural reforms. 3. Improving the way in which legal institutions meet demand from business: accomplishing legal reform, strengthening market institutions. 4. Supporting new sectors: stimulate growth in the high-tech sector. 5. Establishing a favorable environment for export diversification and stimulate growth in the non-energy sector: stimulate capital flow from the raw materials sector to the high-tech sector (tax breaks in high-tech sector, intellectual property rights, possibly increasing taxation in the raw materials sector). 6. Increasing transparency of the economy and companies. 7. Developing an energy strategy: liberalize energy prices, stimulate energy saving, increase production efficiency. 8. Increasing the effectiveness of social services In addition the government will continue tax reform. The tax reform plan includes abolishing the sales tax as of January 1, 2004, which will hit the regions as the levy brings in around 3% of their budget revenues. There are plans to compensate this by introducing a "new system of property tax", which could mean either increasing property tax or improving tax collection. In 2004, the government is to increase the income tax privilege on the acquisition and construction of residential space. The government will also introduce an investment premium mechanism. This will allow companies to claim 25% of the value of equipment with a service life of over five years against income, which will compensate for the abolition of the investment privilege in 2002. The government also plans to reduce the unified social tax rates later on. The expected decrease in social tax raises the question of reforming the social funds (the pension, social insurance and medical insurance funds) financed by this tax. The government does

G. Diversification of the Russian Economy and Growth

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not want to decrease the average tax burden on oil companies and will actually increase mining taxes. This will increase the relative attractiveness of the non-oil sector and encourage investment in other sectors.

8. Banking Sector Restructuring and Growth But whanne that schal come that is parfit, that thing that is of parti schal be auoidid ''But when that which is perfect is come, then that which is in part shall be done away'' 1 Corinthians 13:10, John Wyclif 14th century Russia's international reserves reached nearly $65 bin as of mid 2003, up $17 bin from the start of the year. This has already surpassed the increase for the whole of 2001 ($6.6 bin), 2002 ($13.3 bin) and a record high 2000 ($15.4 bin). Growing reserves and rapid money supply growth not only stimulate economic growth but contribute significantly to increasing monetization of the economy and capitalization of the banking system. This happens because the large foreign currency purchases by the monetary authorities cause the money supply to increase. As Russia's M2 to GDP ratio is still low (around 20%), this growth is rapid and has even accelerated in 2003. The problem of low monetization in Russia stems from high inflation in the early 1990s and continuous capital flight. In the 1990s, capital flight was one of the major sources of macroeconomic instability and attempts in recent years by the authorities to stem the flow administratively have, unsurprisingly, failed. However, the situation changed considerably in 2002 and early 2003. According to the Central Bank the Russian economy recorded net capital inflow in the first half of 2003. This was largely due to increased foreign borrowings by Russian banks and the non-financial sector. Also, Russia's improved business climate until the YUKOS affair was attracting more foreign investment, some of which can be treated as repatriated capital. Besides capital outflows, the authorities are also concerned about capital inflows, of which private foreign debt is undoubtedly one of the riskiest types. But this problem should not be overestimated. According to the Central Bank's deputy chairman, the major threats to the economy are accelerating real ruble appreciation and potential problems with the balance of payments. As seen from the figure G15 private foreign debt was growing on the back of decreasing pubUc debt, so that the country's total foreign debt remained relatively unchanged. At the same time one should admit that at

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least part of foreign borrowing will be allocated to productive capacities which will increase productivity and the efficiency of produciton. Borrowing internationally is the only way for big Russian companies to raise funds: a lack of liquidity in the banking system and its structure remain one of the major obstacles for sustainability of growth and economic restructuring. At present, the Central bank lacks the instruments to limit foreign capital inflows and its sterilization policies are quite weak. Therefore, as was the case with capital outflows, the government and monetary authorities want to introduce more administrative restrictions on capital inflows. The new "Law on Foreign Currency Regulation and Control", which has passed the first reading in the Duma, should provide the legislative groundwork needed to limit foreign exchange inflows via additional indirect taxation. However, while both outflows and inflows are obviously a problem for the Central Bank, administrative methods may again not be the right way to solve the issue.

98 36 01/01/02 04/01/02 07/01/02 10/01/02 01/01/03 04/01/03 07/01/03 m Public debt — Private debt

Source: Ministry of Finance RF Fig. G15. Private Debt Grows on the Back of Decreasing Sovereign Debt In reality, it is impossible to ensure the efficient administrative regulation of capital inflows. A sound macroeconomic policy and stronger market institutions can do this much more effectively, as large amounts of speculative money will not flow in if the necessary instruments are not there (as was the case on the GKO market in 1996-98). Moreover, in Rus-

G. Diversification of the Russian Economy and Growth

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sia today, using foreign exchange inflows to build up reserves seems the only macroeconomically safe way to increase the liquidity of the banking system, monetization of the economy and accumulate capital. In this regard, administrative restrictions aimed at limiting capital inflows may restrict economic growth. The threat to stability of the balance of payments also seems overestimated. As the decline in public foreign debt offsets the growth in private foreign debt, the overall figure for the country remains stable. Besides, the money that comes into Russia is more or less "long", making the situation on the currency market predictable. All in all, at this stage we consider foreign debt growth to be a positive, as those who borrow do so to increase production. Moreover, given Russia's underdeveloped banking sector and small financial market, external borrowing seems the only way for major domestic companies to raise funds. What is also important, increased foreign borrowing, economic growth and gradual long-term ruble appreciation in the post-crisis period have contributed to the gradual de-dollarization of the economy: the proportion of deposits in foreign currency has been falling (see figure G16).

Source: Goskomstat RF, Central Bank of Russia Fig. G16. The Share of Dollar Deposits is Falling Due to low liquidity within the banking system, Sberbank and Vneshtorgbank alone are able to extend large loans to the corporate sector. This forces major Russian companies to borrow abroad. Preceding mid 2002, lending to the private sector was growing faster than banking assets or

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monetization of the economy, i.e. private sector lending as a percentage of assets was increasing. Since mid 2002, the ratio has stabilized at around 50% and is unlikely to grow as before. As the balance of payments shows, the corporate sector borrowed around $12 bin on the global market in 2002 and, as mentioned above, this borrowing continued in early 2003. Together with high oil prices, which have kept the monthly trade surplus at around $5 bin, this puts pressure on the ruble. Nevertheless, in early 2003, euro appreciation against the dollar caused the real effective ruble exchange rate to appreciate slightly (2.6%), despite slight y-o-y depreciation. A relatively stable ruble therefore makes foreign borrowing quite attractive. Smaller companies that are unable to borrow on global markets issue domestic corporate bonds, which allow them to attract capital from small creditors. Table G5 provides a fair overview of Russia's banking sector, despite containing only the top 15 banks. Table G5. Assets of the Largest Banks

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

01.07.03 01.01.03 Assets, $ mln Assets, % of Assets, $ mln Assets, % of total total 29,4 42,2 35,1 Sberbank 29,7 4,8 6,8 6,0 Vneshtorgbank 5,1 4,0 5,8 4,7 Gazprombank 4,0 Alfa-bank 3,9 5,6 5,0 4,2 4,2 International Indus3,2 2,9 3,8 trial Bank Bank of Moscow 3,6 2,5 2,9 2,5 2,2 MDM-bank 2,4 2,8 3,1 Rosbank 2,6 1,8 1,8 2,1 2,5 Moscow Interna2,0 2,4 1,7 tional Bank Uralsib 2,1 1,4 1,2 1,4 78,5 54,7 Top 10 56,1 66,2 Promstroybank 1,9 1,4 1,3 1,5 1,8 Raiffeisen 1,2 1,2 1,4 Citibank 1,7 1,2 1,6 1,9 Menatep (St. Pe1,5 1,0 1,3 1,1 tersburg) 0,8 0,9 Petrocommerce 1,2 1,0 86,6 60,3 Top 15 62,1 73,3

Source: Central Bank of Russia, Expert

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As table G5 shows, the top 15 banks control over 60% of total assets, while the others (over 1,300) control the remaining 40%. Also, the market share of the top 10 or 15 banks grew over 2002, a trend that is likely to continue. Consolidation in the sector looks inevitable, although it will probably take place gradually as there is no clear restructuring plan yet. The two state-controlled banks, which have certain privileges, clearly dominate the market and to some extent distort it. Until the government decides how to restructure them, they will continue to affect the money markets more than the other banks. As well as remaining a major government creditor, the table shows that Sberbank is the only bank that can extend large loans to major companies such as YUKOS, Gazprom and LUKoil, which require amounts of $0.5 bin or more. However, for very large sums, companies need to turn to global markets. Reforming the financial system should be also considered as a key element of the government's policy of economic diversification in order to secure high growth rates in the long run.

References Evgeny.Gavrilenkov: Economic Growth and Crises: Evidence from Russia and Some Other Hysteretic Economies, Camegie Moscow Center, Working paper No.5 2002. Michael Sarel: Growth and Productivity in ASEAN Countries, IMF Working paper, WP/97/97, August 1997. Mark Setterfield: Rapid Growth and Relative Decline. Modelling Macroeconomic Dynamics with Hysteresis, Macmillan Press Ltd., 1997. Masaaki Kuboniwa and Alexei Ponomarenko: Revised and Enlarged GDP estimates for Russia, 1861-1990, in Konosuke Odaka, Yukihiko Kiykawa and Masaaki Kuboniwa (eds.), Constructing a Historical Macroeconomic Database for Trans-Asian Regions, lER, Hitotsubashi University, March 2000. OECD Productivity Manual: A Guide to the Measurement of Industry-Level and Aggregate Productivity Growth, Paris, March 2001.

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

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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: Internationalization of Russian Regions: The Role of l\/INCs and Outsourcing with Respect to Domestic and Foreign SiViEs Christopher Schumann

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1. Introduction Modem world economy development is characterized by internationalization (globalization), with multinational corporations (MNCs) as its prime mover. Globalization lowers barriers to trans-boundary goods, capital and services flows, unifies national regulations and thus transforms the world into a single economic space. On the other hand, this process exacerbates the interdependence of nations and their vulnerability to external factors. It is universally recognized that the main method for a country to join the world economic system is to provide conditions for inflow of foreign capital that comes not in the form of financial resources alone, but also brings modem technologies and management techniques in its wake. Among all types of intemational economic relations, the leading role currently belongs to foreign direct investments (FDI), provided by MNCs. The role of intemational capital flows, particularly FDI, is the fundamental issue of the twenty-first century. The increased attention paid to investment promotion activities suggests that the advantages FDI can offer are quite widely acknowledged as of today. In addition to capital inflows, FDI can lead to transfers of technology and know-how, improve access to intemational markets and spur competition. As growth is the single-most important factor affecting poverty reduction, FDI is central to achieving that goal. However even in countries receiving considerable numbers of FDI, they can produce negative as well as positive effects for the local economy and populations. This paper addresses the following questions: • Are FDI and MNCs activity essential for successful economic development? • What is the role of intemational investment in Russia development? • What is known about current activity and practices? • Is intemational cooperation cmcial for Russia? • What kind of regional differentiation is currently in Russia? • Where might there be potential for intemational cooperation? • What are the limits to capacity building? • What kinds of competitive advantage exist for North-West and in which way could it be used? The paper first reviews the discussions about the role of FDI and MNC in contributing to successful and equitable economic development. It then looks at how FDI contributes to Russian development. The following chapter describes how the current regional differentiation is also reflected in the investment sphere. Then it focuses on the northwest of Russia as an

H. Internationalization of Russian Regions

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example of internationalization through the outsourcing activity of the ICT sector.

2. Role of FDI in the Globalizing World Until recently, trade relations were viewed in economic literature as a more important system-forming factor of the world economy than FDI. Among other things, this view was supported by the fact that unlike international trade (governed by WTO rules), there is no organization regulating FDI worldwide. John H. Dunning (2000) reviews the genealogy of scholarly thought on the determinants of foreign direct investment (FDI) considered to be the main stream economic and behavioral theories, which since 1960 have sought to explain one or more aspects of FDI and/or foreign-owned production; he also explores how each of these has contributed to our understanding of the changing international economic involvement of firms and countries. Since the mid 1970s, the evolvement of the eclectic paradigm has necessitated an increasingly inter-disciplinary approach to a full explanation of 'why', 'how' and 'in what form' firms internationalize their activities and of 'why' and 'in what way' countries are increasingly reliant on cross-border transactions to further their economic objectives. All in all, rapid development without importing best practice from abroad is not possible. Experience in the USA, the world's largest exporter and importer of capital, has provided ample evidence to that. In the 1990s, for example, the Japanese companies investing in the US automobile industry established over 20 research, design and development units. The average car-assembly labor inputs and numbers of end-product defects at Japanese facilities were substantially lower, which forced American car manufacturers to update their production capacities and to develop new management techniques. (ZIMENKOV R., 2003, p.27). In the late 1980s and 1990s, more attention was given by trade economists to incorporating foreign production variables into their models of international transactions while there was a renewal of interest in FDI as a financial phenomenon, and also in its relationship with foreign portfolio investment. The changing context of FDI and international production post 2000 are identified (DUNNING J.H., 2000): • Technological change, notably advances in biotechnology, computer and instrument engineering, electronic commerce, organizational systems, etc.

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• The governance of the world trading et al system. New forms of supraand sub-national governance. • The emergence of new players on the global economic scene. On the other hand, there are many new significant changes - competitive advantages of enterprises, first of all - that allow us to efficiently harness, coordinate and leverage knowledge-related resources and capabilities from different locations in the world and to do so in an innovative way as well as to motivate and upgrade the intellectual and creative qualities of the work force, including managers, in a cost-effective manner. The end of the 20"" century saw a surge in investments in developing countries, as well as a surge in debates on the role of FDI. While average growth benefits the poor, there are a number of countries in which this has not happened. Discussions on this have reflected an intricate interplay of various interests, including the issues of national development, economic policies, as well as budgetary and national debt problems. The poverty-reduction impact of FDI by MNCs has become an issue of special concern. (Graham Ed. M., 1995) concludes that the negative effects of FDI can arise from the market power of large foreign firms (multinational corporations) and their associated ability to generate very high profits, or from domestic political interference on the part of multinational corporations. Empirical research, however, suggests that the evidence of negative effects from FDI is inconclusive, while the evidence of positive effects is overwhelming. The paper by (ROEMER M. and GUGERTY M.K., 1997) finds that the growth of average income for the poorest 20% and the poorest 40% of the population are regressed against the growth of GDP per capita. These results indicate that on average, the poor do benefit from economic growth. Moreover, the result of the study reveals that income distribution changes only very slowly, and that a policy aimed at redistributing income at the expense of economic growth may have very low payoffs in terms of poverty reduction. Yet in a number of countries, poverty reduction has not occurred despite FDI. Different countries may well require somewhat different approaches to ensure that growth leads to poverty reduction (World Bank, 2000c). The most common argument against FDI considered in (KLEIN M., AARON C. and HADJIMICHAEL B., 2001) is that multinational companies tend to locate production in countries or regions with low wages, low taxes and weak environmental and social standards. It is certainly true that these features of the business environment play a significant role in the decisions of multinationals. However, these items are all just part of the cost side of a business. In the end, it is not costs that matter, but profits. Foreign investors balance cost considerations with others that determine the productivity of operations in a particular country.

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In recent years through the debate on globalization, several new issues have emerged. First is that MNCs do adopt dual standards on labor welfare, contribute to the degradation of the environment and finally concentrate economic power, posing a threat to local interests. (BALASUBRAMANYAM V.N., 2001). In practice (at least in Russia) MNCs, however, tend to pay high wages because of competition with local companies. Moreover they can help improve environmental and labor standards, because foreign investors tend to be concerned about reputation in markets where high standards are seen as desirable. Besides, FDI can help improve the management of the social safety net, particularly service delivery to the poor (e.g., water supply). The explanation of the unsatisfactory performance of many developing countries lies in the interplay of economic and poUtical factors that vary by country (WORLD ECONOMIC OUTLOOK, 2000). Experience in the poorest countries highhghts poor education and health, ineffective governance, weak rule of law, and wars as frequent impediments to prosperity. Policies that introduce fiscal discipline and macroeconomic stability, however, are found not only to raise overall incomes, but also to have an additional income distribution effect. Nevertheless, experience in the successful developing countries clearly points to macroeconomic stability, sound institutional arrangements, and openness to trade as factors associated with high sustainable growth. Today multinational companies dominate world trade and investment. Over half of the world's trade and over eighty percent of foreign direct investment are undertaken by MNCs based in the G7 countries, namely the United States, Japan and the large countries of Western Europe, determined by advantage in unification of rules for FDI. According to the (WORLD INVESTMENT REPORT, 2001), the top 100 non-financial MNCs - General Electric being the first - comprise a formidable force in the global economy. The investments of these MNCs outside their home countries have grown faster than world trade which itself has grown faster than the world economy as a whole, being an index of globalization itself. MNCs own $2 trillion in assets abroad and employ 40 million workers abroad; the sale of their foreign affiliates was $14 trillion (over twice the volume of world trade). International production by these companies accounts for one-tenth of the global "gross domestic product" (GDP). The growing importance of FDI by MNCs in an environment of globalization is evident from the increased volume of investments in developing countries (from USD 13 biUion in the mid-1980s to USD240 biUion in 2000), as well as from the emergence of a new group of FDI exporters. MNC operations in so-called new industrial nations (namely Hong Kong, Taiwan, Malaysia, South Korea, Argentina, and Singapore) resulted in

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those countries having successfully adopted modem management techniques and new technologies, occupying prominent niches in the world economic system, and even positioning themselves in role as capital exporters. As pointed out by (BALASUBRAMAYAM V.N., 2001), several developments in the global economy since the decade of the eighties have softened opposition to FDI and rekindled faith in its ability to promote development. Indeed, suspicion and distrust of foreign firms seems to have yielded place to a newfound faith in their ability to promote growth and development. A number of factors have influenced this change in attitudes, including increased familiarity with the operations of MNCs, reduced flows of alternative sources of finance such as bank credit and foreign aid and the demonstrable success of several developing countries with FDI. In the last decade of the 20'*' century, the numbers of parent companies more than doubled (increasing from 36,600 to 63,312), and the network of foreign affiliates expanded almost fivefold (from 174, 900 to 821, 818). (WORLD INVESTMENT REPORT, 2001). On the other hand, RUGMAN (2002) shows how most globalization activity is, in fact, based within the triad of Europe, Japan and the U.S.; empirical evidence reveals that most MNCs operate in a regional/triad basis rather than globally. Among 20 "global" MNCs studied, only six actually operate across all three parts of the triad. The other MNCs are biregional or home-triad oriented. FDI is largely intra-firm and industry, and that the key driver is regional and local based economic activity, not a global free-for-all. Small and medium companies have recently increased their presence in the world of innovations, but only MNCs have sufficient capacity to put inventions to industrial use, as well as organize their sale and advertising. For this reason, MNCs not only develop technical innovations of their own, but also purchase them from small firms (GUBAIDULLINA F., 2003, ). In order to enhance their competitive edge, MNCs (Microsoft, Motorola, GM, GE, Samsung, IBM, P&G, Nokia, etc.) set up research centers in countries with a qualified workforce. (WORLD INVESTMENT REPORT, 2001). Transfers of technology and know-how are developing through supply linkages between foreign affiliates of MNCs and local firms. Describing benefits of supply linkages, (SAUVANT K.P., 2001) is concerned that promoting linkages is potentially a win-win-win proposition. Obviously, foreign affiliates may accrue benefits by using local suppliers to reduce costs, increase flexibility and expand sales. Outsourcing and sub-contracting raise the need for inter-firm linkages. In fact, supply chain management has become critical for the competitiveness of many firms. Local

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firms can benefit by upgrading their technology, productivity and ability to compete internationally. For developing countries, the formation of backward linkages, through which foreign affiliates purchase parts, components or services through various forms of outsourcing or subcontracting arrangements, assumes particular importance. However, the extent to which foreign affiliates forge linkages with domestic suppliers (as opposed to, say, using imports) is determined by the cost-benefit ratio of such efforts, as well as by differences in firm-level perceptions and strategies. The most important factors are related to corporate strategy and the availability of supply capacity. A lack of efficient domestic suppliers is a common obstacle to the creation of linkages, particularly in developing countries. The policy makers in host countries therefore have an important role to play in influencing the willingness of foreign affiliates to use local suppliers. As laid out in more detail in the (World Investment Report, 2001), linkage promotion policies need to be consistent with and embedded in a broad range of policies that support enterprise development and FDI promotion. The starting point for an effective linkage programme is a clear vision of how FDI fits into the overall development strategy. The vision must be based on a clear understanding of the strengths and weaknesses of the host economy. A linkage programme should, in particular, address the competitive needs of domestic enterprises and the implications these have for policies, private and public support institutions and support measures (including skills- and technology-upgrading). Moreover, it is essential for any programme to seek close collaboration with the private sector, both foreign affiliates and domestic suppliers, in design and implementation. Linkage programmes can only work if they are networking effectively with efficient intermediate institutions providing support in skill building, technology development, logistics and finance.

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3. Internationalization of Russia Internationalization of capital, especially in the form of FDI, is an important aspect of globalization. Having peaked in 2000 at $1,364 billion, the world FDI volume almost halved in 2001 to $745.5 billion and continued its fall in 2002 by another 22.2 per cent to $580.3 billion. More than three-quarters ($1.0 trillion) of global inflows went to developed countries. Inflows to Central and Eastern Europe increased by 9 per cent (to $27 billion, representing 2 per cent of world inflows). The existing trend of inflow concentration in countries with unified business regulations generates additional problems for other nations in need of investment. In view of the contraction of global FDI volumes after 2000, they must on the one hand spend more of an effort luring investment, while on the other maximizing the benefits they receive from the MNC affiliates already operating in the region^ Russia's integration into the world economy is set to take place in a situation in which its own structural economic transformations are moving at a creeping pace, and sound economic regulations are yet to be put in place. Until recently, Russia has been exporting capital; before 2001, its annual capital flight figures hovered at between $20 billion and $25 billion (BEA, 2001, pp. 18-19).^ The Economist Intelligence Unit (EIU) predicts an imminent reversal of the downward inflow trends. In 2003, the global FDI volume is expected to grow by 27 per cent to $655 billion, and in 2004 by almost the same proportion (to $834 biUion). The top 20 recipients will include China, Mexico, Brazil, Russia, and India (taken together, they accumulate around 44 per cent of the FDI going to developing countries). An increase in FDI flows alone can boost the attractiveness of the Russian economy by stimulating structural reforms. A combination of such developments as divestiture of state properties, raised business activity, political reforms, and a stable political and economic forecast will give further impetus to this process. Although Russia is open to foreign capital imports (FDI), neither new economic mechanisms that have been in place for more than a decade, nor the economic growth continuing for the last four years made FDI a critical factor in Russia's development (fig. HI). There is no doubt that MNCs have been held back by political and economic instability in target nations, 1 Vedomosti (2003), 23 March. 2 Statistics on FDI come from two sources: •) balance of payment results, and b) Goscomstat's data on the amount of ruble and hard-currency investments by enterprises. Although, obtained by the Goscomstat's method, FDI figures exceed those calculated by the Central Bank by 1.5 to two times, the difference between their data on the accumulated investment volumes is less striking.

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but in the 1990s, many countries did succeed in attracting large volumes of investments from developed economies. By the volumes of FDI received, Russia ranks low among the third dozen recipient countries, after Poland, Hungary, and the Czech Republic. The Central Bank of Russia estimates net FDI (after deduction of the outflow) received in 2002 at $2.6 billion. According to EIU, Russia's current accumulated per capita FDI ($160) is 21 times less than that of the Czech Republic, and 18 times below that of Poland. 21000 19000 + 17000 i 15000 + 13000 + 11000 9000

ly/su--—

44,6

-40 -30

^ 1 2 0 , 2 - -20 - 10 -0

i Foreign investments total, USD million •Share of direct foreign investments, % Fig. HI. Attracted Foreign Investments (with the Ruble Proportion of the Investments in USD Million, in Percent) However, that modest result appears even more insignificant if one compares its size against that of recipient nations' economies (including developing nations. Central and East European nations, and a majority of FSU countries). In 1998, Russia's share of global accumulated FDI stood at 0.3 per cent, compared to 3.8 per cent in Brazil, 6.4 per cent in China, and 21.4 per cent in the USA (BEA, 2001, p. 45). Between 1992 and 1999, the total FDI volume received by Russia amounted to $17.7 billion or $120.6 per citizen, compared to $1,343 in Estonia, $847 in Latvia, $474.6 in Azerbaijan, and $419.5 in Kazakhstan. One can safely say that FDI from MNCs have not become and will hardly become the main source of investment in the modernization of the Russian economy. In the 1990s, the bulk of investment came from Russian enterprises' own funds. In 1999, the share of loans in the aggregate investments in fixed assets in Russia amounted to merely 4.3 per cent. FDFs portion in the aggregate capital accumulation is also insignificant (around

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one per cent of GDP).^ The share of FDI in the structure of foreign investment has decreased (Fig. H2). 100% Si Other investments

80% 60%

• Portfolio investments i l Direct investments

20% 0% 1999

2000

2001

2002

Fig. H2. Structure of Attracted Foreign Investments (with the Ruble Portion of the Investments in USD Million, in Percent) Taking into account that Russian companies have only restricted access to external financial markets, foreign portfolio investments (or investments in the form of trade credits and loans from international organizations) can hardly produce a radical change in the current investment situation. Portfolio and debt capital, attracted between 1995 and 1998, brought negative consequences and thus confirmed the advantages of direct investments as more resistant to negative changes. The key motive for investing in Russia remains access to the internal consumer market debt servicing and to natural resources (in the first place, to hydrocarbon fuel fields). For that reason, the bulk of FDI coming to Russia (around 40 per cent) can be accounted for in the fuel-and-energy and food industries. At the same time, investments in the processing industries and infrastructure sector, essential for long-term growth of the Russian economy, remain extremely insignificant. As noted in (BEA, 2001, p.l5.), Russia has already lost two chances to attract large FDI volumes during the previous peaks of inflows into developing countries: during the period of voucher privatization (when shares could not be sold to strategic investors), and in the post-crisis period when government took no special measures to lure investments. Russia may also be unable to capitalize on the new investment boom as well for radically changing the existing situation. ^ Notably, statistics do not capture MNC activities separately; however, taking into account that investments mostly come from MNCs, we shall conventionally surmise that the FDI statistics reflect MNC activities in Russia.

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This brings us to raise the following questions: Does Russia actually need FDI to insure economic growth, and what potential does it have for involving foreign capital into its economy transformation? Past experiences show that the Russian public is not aware of the importance of FDI and views MNCs as a threat to Russian businesses. Russian industries show unequal distribution of resources and investment needs. One may split Russian industries into three sectors with partially isolated financial flows (BEA, 2000, p. 19): export oriented industries; the defense complex and science, financed by the budget; and civil non-raw material industries, whose top managers (prime beneficiaries of privatization) used to block investment flows from MNCs. Meanwhile, the arrival of MNCs and FDI could be especially beneficial for the Russian economy with its outdated technologies in most industries and the low competitiveness of its products in the world markets. At a time when the world economy is slowing down, Russia shows growth, although that growth still needs stability. In 2002, the Russian economy demonstrated extremely controversial trends in development. On the one hand, GDP grew 4.2 per cent and manufacturing output by 3.8 per cent; infiation fell to 15 per cent; capital fiight contracted drastically; the external turnover reached $151.8 billion; and the black ink of the external trade balance amounted to $59.8 billion, significantly beating all forecasts. On the other hand, Russia escaped stagnation exclusively due to an improved situation in a number of raw material markets and the global steel market. However, its large-scale raw-material exports should not be taken as a sign that Russia will never be able to enjoy post-industrial growth and take part in the globalization process. Another positive factor for the Russian economy is a change in the motivation of economic agents. Statistics show a contraction of the share of non-market settlements, especially with respect to natural monopolies (ANALYTICHESKY VESTNIK, 2003). Overall growth between 1999 and 2002 amounted to 20 per cent; precrisis living standards and financial stability were restored. However, that growth was achieved due to high oil prices and the weak post-crisis ruble, which made it impossible to address new and old post-perestroika social and economic problems. One of them is the low global competitiveness of the Russian economy as a whole, undermining long-term growth potential. The raw materials sector continues to dominate the country's industrial structure (in 2002, its share amounted to 30 percent), exports (54 per cent), and budget revenues (32 per cent of the consolidated budget and 54 per cent of the federal budget).

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100% mother investments

80% 60%

•Portfolio investments

40%

•Direct investments

20% 0% 1999

2000

2001

2002

Source: Estimations: Rossijskij statisticheskij edzegodnik - 1998, p. 760; Rossijskij statisticheskij edzegodnik- 2000, p. 105, 249, 594; Rossijskij statisticheskij edzegodnik - 2002, : 313, 33L Fig. H3. Companies with Foreign Participation (C fp) in Russia The existing growth mechanism, based on the flow of resources along technological chains from the raw materials sector to the investment complex, is unstable. For example, the 2002 contraction of internal investments in the oil industry resulted in a fall in demand for mechanical engineering products and a slump in mechanical engineering in the second half of the year. At the same time, there are signs of improvement in the investment climate in Russia. A number of recognized international rating agencies have improved Russia's credit ratings, and capital flight from the country has substantially subsided (by Central Bank's estimates, the flight of capital from the private sector fell from $11.8 billion in January-September 2001 to $3 billion in the first nine months of 2002). Investors, active in the enclave part of the general legal space of the national economic regime is maximally protected from poorly predictable changes in economic conditions by special legal provisions and/or special agreements with authorities, based on laws and regulatory acts granting them certain taxation, customs, and administrative concessions (e.g., the fuel industry). At the same time, there are foreign companies in Russia with their own technologies and know-how that produce competitive goods and intend to reasonably expand their production. As noted in (BEA, 2001, p.55), enterprises created on FDI funds have appreciably higher technology levels. For example, their output per worker is double that seen across Russia. At the end of 2000, the workforce of enterprises and organizations with foreign investments amounted to around

H. Internationalization of Russian Regions

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2.5 per cent of the total Russian workforce, while their share of output represented 13 per cent of the country's GDP. 60

^

50

39^ ^

^

^

^ ^

--VSI' _

39,7

40 30 17,8 17,8

20

^ • - ; ^ - V6,ji^

10

- -^°'^

5":7a—•""•"^7.2 1998

1999

•manufacturing total •X — incl. food industry

2000

2001 "HDI • incl. fuel industry ^ ^ O " ^ trade and catering

Fig. H4. Companies with Foreign Participation (C fp) in Russia The fuel and food industries account, respectively, for 18.3 per cent and 19.8 per cent of total accumulated FDI in Russia. At some periods, those industries had absolute dominance in the inflows structure. In 1998, for example, the food industry accounted for 35.5 percent of the total FDI, and in 1999, the fuel industry received almost 29 percent of the total. As of 2000, by-industry distribution of FDI posted some changes (see figure H4). The fuel industry's share substantially contracted, while those of trade and catering went up. Moreover, investments in mechanical engineering and metalworking almost doubled, and the shares of transport and telecommunications grew as well, possibly signifying a growing interest in long-term infrastructure projects.

4. Differentiations and Internationaiization of Russian Regions Thus, the first decade of Russia's openness to the rest of the world produced a clear by-industry differentiation of FDI, including differentiation among RF regions by volumes of inflows, as well as by basic social and economic indices.

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"152,9"

1,972

^^'^^^

I

Per capita GRP('000 Investments in fixed rubles) capital ('000 rubles) I Minimum value

0,899-3,063— 1

Average salary. COOOh rubles)

1

Minimum food basket, ('000 rubles)

W Maximum value

Source: RF Ministry of Economic Development Fig. H5. Interregional Contrasts (2002) Apart from that, the interregional difference by registered unemployment levels amounted to a factor of 20, and by per capita incomes and minimum living costs to a factor of 15."^ A majority of Russian regions currently have no capacity to substantially increase their economic potential, expand respective regional budget revenue bases, and consequently to provide better living standards. Notably, the dominance of the raw material sector in budget revenues and exports may drastically exacerbate disproportion in regional budget potentials and require further centralization of funds, thereby undermining financial independence of regions in the longer term. In addition, strong dependence of the country's economy on the situation in the raw materials sector makes the risk of a general meltdown in the national finance unacceptably high. Interregional differentiation is also evident in the field of investments. In 1999, six leading regions accounted for 73 per cent of all accumulated FDI. During the last 12 years, foreign company affiliates were concentrated exclusively in Moscow, Moscow Oblast, and two oil-producing regions, Sakhalin and Tyumen Oblasts. The unequal distribution of foreign investments by industries and regions reflects the weakness of the existing policy of luring FDI to Russia. The state provides no stimuli or conditions to attract inflows to other industries and significantly undermines the chances of the majority of regions to tap foreign investments for boosting their own economic growth (see Appendix: table HI). 4 Izvestia (2003), 2 June.

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Russian regions show strong differentiation by such critical investment climate parameters as investment potential and investment risks.^ Investment risk is the main factor of investment climate instability in Russian regions. Recent years saw the diminishing importance of financial, economic, and political risks, while that of "subjective factor" risks (criminal, and, especially, social risks) has increased. Just as before the 1998 meltdown, investors view regions as sources of qualified labor and as consumer markets. Investors continue to attach great importance to infrastructure and production potentials, although that of the latter has somewhat diminished. A rating survey of large company managers from 2001 showed that investors do not pay much attention to the innovation potential of a region (presumably, they rely on their own tried technologies instead of investing in the local stagnating scientific and technical capacities). This survey destroyed the myth of the attractiveness of Russian natural resources for the investor. All more or less efficient resource enterprises/fields have already been divided, and access to them for new investors is extremely difficult. Currently, the most important factor for potential investors is the local legislation risk. The federal-level investment legislation has been more or less finalized, while that on the regional level is still being developed at a continuously increasing pace. The problem is not only that Russian regions show increasing divergence in local investment laws, but also that in many Russian Federation entities, investors simply get lost in the intricate and controversial local laws, which may be interpreted differently by investors and local authorities. One can point out several Russian regions with a potential for investment growth in the European part and in the Ural: • • • • •

Northwest Region led by St. Petersburg, Central Region led by Moscow and Moscow Oblast, Volga Region (Samara and Saratov Oblasts), South Russia Region (Krasnodar Territory and Rostov Oblast), and Ural (Sverdlovsk and Chelyabinsk Oblasts).

^ The first investment rating of Russian regions was made by Expert-Region Consulting Agency. Using international experiences, they developed a substantially original technique combining statistical and expert-appraisal approaches. In contrast to all previous regional studies of that sort, they assessed the investment climate in each of the 89 Russian regions separately. They used over 100 statistical regional development indices for 1994-2000 (RF Goscomstat data) and analyzed around 1000 federal and regional standard acts on investment activity regulation.

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The analysis shows uneven by-regional distribution of operating joint ventures in Russia outside Moscow. In 1989, St. Petersburg (then, Leningrad) hosted 7.14 per cent of all Russian joint ventures, in 1995 11.3 per cent. On average, the 10 largest Russian regions make up around 70 per cent of all operating joint ventures, with megalopolises (Moscow and, to a lesser degree, St. Petersburg) taking the lead as financial centers. There are also a number of port or "entrance" (borderline) regions: St. Petersburg and Karelia bordering with Scandinavia in the Northwest; Krasnodar and Rostov serving as the gate between the Black Sea region and the center of Russia; and Khabarovsk and Primorsky Territories in the Far East linking Russia to China and Northeast Asia (mostly, Japan and Korea). In 2002, the investment climate in regions located between Moscow and St. Petersburg (Moscow and Leningrad Oblasts) appreciably improved. The adjoining Yaroslavl and Novgorod Oblasts belong to the Russian regions with minimum investment risks. They may be suitable for hosting projects which, for various reasons like high land rent, bureaucratic delays, strict environmental requirements, etc., may be unfeasible or difficult to develop in large megalopolises or surrounding regions. They adjoin to Tver and Vologda Oblasts with high investment ratings. This leads to the conclusion (EXPERT, 2002, p. 98) that a lucrative investment nucleus is being formed along the trunk road E95 as its axis, continuing into Vladimir and Nizhni Novgorod Oblasts, Chuvash Republic and Tatarstan, and reaching farther to the east. These appear to be the most attractive Russian regions with strong investment potential. A survey held among 50 European companies (AREND R., 2000) operating in Russia showed that the critical factor for locating a business is the size of the market. This explains the high concentration of MNCs in megalopolises and the low share of exports in their sales, because they are focused mostly around Russian consumers. Export orientation is characteristic of raw material companies only. By 2000, the number of regions with local laws aimed at creating propitious conditions for FDI inflow in place increased from five to 45. This trend reflects the growing awareness by regional authorities of the importance of FDI as economic development instruments, as well as their readiness to conduct proactive FDI luring policies. At the same time, Russian regions achieved a high degree of unification of local laws supporting domestic and foreign investors based on homogeneous principles and a standard set of measures and tools for stimulating investment. Unfortunately, foreign companies are subject to Russian economic regulations which, judging by various survey results and numerous facts of tax dodging by local enterprises, are far from being optimal. At the same time, regional authorities can offer the following types of concessions to investors:

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• temporary complete or partial exemption from taxes due to the regional budget; • deferment or installment of tax payments to the regional budget; • granting investment tax loans; • granting budget loans or lax loans (credits); and • extending regional administrations' guarantees and warranties to investors. However, past experiences seem not to confirm the efficiency of the tools above. The main conditions for creating a positive investment environment should be the equitable treatment of all investors in similar situations and unrestricted competition. The most important factors for investors are reliable legal guarantees and dispute resolution arrangements that provide for fair protection of their ownership rights in Russian regions as well for stable legal regulation of their activities. The absence of stable legal regulations poses the highest investment risk, and by dealing with that obstacle, regional authorities could substantially boost their regions' attractiveness. In particular, they must provide for efficient implementation of bankruptcy laws that firmly tie ownership status to the financial situation of a given company, thus stimulating the attraction of lucrative foreign partners.

5. Competitive Advantages in Northwest Russia Differentiation of Russian regions by investment attractiveness and investment accumulated is a reflection of the country's poorly developed infrastructure, which isolates outlying inland regions from external markets and scares away potential industrial investors. Despite the significant and variegated differences among Russian regions, however, there are a number of territories with distinct geographical and competitive advantages. These are littoral territories with seaports. Russia has only three macroregions claiming the role of the country's "outlets": the Northwest Region, Southern Region (Azov and Black Sea territories), and the Far East^. So far, only St. Petersburg and the Northwest have availed due to their proximity to the EC and the natural sea outlets in full. The Northwest macro-region^ directly connects the most populated and economically de-

^ The Far East Region cannot make use of its sea-outlet potential due to administrative problems, and Kaliningrad is still entangled in political skullduggery. '^ The Northwest Federal District includes 11 regions (RF entities): Republic of Karelia, Republic of Komi, Arkhangelsk Oblast, Nenetsk Autonomous District,

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veloped Russian regions with Europe. Historically, it has served as the base for exploring the entire Russian Arctic coasts, the economic importance of which is increasingly rising. The Northwest Region is of particular EC interest, largely because it lets through numerous EC's trade cargo flows. However, an asymmetry between Russian and European interests exists. While the EC pursues clearly political goals in its relations with Russia and the Northwest Region, Russia's interests lie primarily in the economic dimension. In the future, sustainable economic growth will level that asymmetry to a degree. Special arrangements are already in place to involve Russian regions in crossborder and international cooperation. Nevertheless, in some aspects, the asymmetry may deepen in such domains as living standards, contractual discipline, and business practices. The Northwest's share of the Russian territory, population, and basic socio-economic indices is nine to ten per cent. Apart from the strengths of the region, which include rich human and other resources (a wide variety of minerals, timber, oil, gas, fish reserves), as well as high urbanization levels, one should not forget its weaknesses, which given sufficient effort can be transformed into strengths. For example, the Northwest Region has low population densities in locations rich in natural resources. These are Nenetzk Autonomous District and the Republics of Komi and Karelia. Their developed infrastructure shows a strong degree of degradation, and the interregional cooperation remains in a rudimentary stage. Official statistics show practically no traces of interregional (to say nothing of intra-sectoral) exchange. Northwest regions specialize in the following economic sectors: • • • • • • •

Republic of Karelia - timber and metallurgy; Republic of Komi - oil, gas, timber, and power production; Arkhangelsk Oblast - timber and mechanical engineering; Nenetzk Autonomous District - oil and gas; Vologda Oblast - non-ferrous metallurgy and chemistry; Murmansk Oblast - metal working, power production, and fishery; Leningrad Oblast - petrochemical industry, power production, and timber; • Novgorod Oblast - chemistry and food production; • Pskov Oblast - timber, food production, and mechanical engineering; and • Kaliningrad Oblast - fishery and mechanical engineering.

Vologda Oblast, Kaliningrad Oblast, Leningrad Oblast, Murmansk Oblast, Novgorod Oblast, Pskov Oblast, and the City of St.Petersburg.

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St. Petersburg is a multifunctional city with a multifunctional economy. Socio-economic differentiation among Northwest regions is also very high. The numbers of economically active in the population may differ by a factor of 100, the manufacturing output by a factor of 20, etc. St. Petersburg is the indisputable leader with half of the total population and businesses. Of the top 15 Northwest companies with the largest sales volumes, five are located in St. Petersburg^ and three in the Republic of Komi. St. Petersburg, hosting affiliates of large international companies like IKEA, BBH (Harwall Group, PRIPPS), Heineken, Carlsberg, Siemens, Knauff, ABB, and Philip Morris, is the undisputed leader of the region. Recent statistics show a slowdown in the city's economic growth, manifested among other things by falling direct foreign investment rates and diminishing numbers of foreign visitors crossing northwestern borders. This contraction of capital and human inflows may be caused by the lack of unoccupied land sites with adequate engineering infrastructure in the city as well as by local regulatory hurdles. Apart from Vologda and Leningrad Oblasts, other highly industrialized regions are the Republic of Komi, Murmansk Oblast, and Arkhangelsk Oblast. They have impressive natural resource based growth potential, which is currently underutilized due to infrastructure development and resource-transportation challenges. Another group of Northwest regions includes the Republic of Karelia, as well as Novgorod, Pskov, and Kaliningrad Oblasts, whose growth potential stems from joint borders allowing for short resource/commodity delivery and exchange times. For over a decade, regional specialization that can be used for further development of cooperation among northwest regions and with the external world has been emerging. A study of the main clusters of economic activities, their structure and competitiveness revealed a new emerging cluster: that of ICT.^

^ Sevemaya Verf (shipbuilding), Lenenergo (power production), Petro (Tobacco), Baltika Brewery (food and beverages), Baltiyski Zavod (shipbuilding). Source: Expert (2001), ^ Emerging Clusters of the Northem Dimension. Competitive Analysis of Northwest Russia - A Preliminary Study. ETLA. Helsinki. 2002.

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goods

Specialty inputs

- Inherited industrial and human capital

-Mobile and fixed communications -Data communications and Internet access

- R&D potential

Teclinology

Related industries

Telecommunication

- Education

N—H

- Telecommunication equipment

- Software - Networks

1

^

- Traditional media - Entertainment - Consumer electronics - Metalworking chemicals (plastic etc) - Electric energy

- Components and subassemblies Digital Content

- Hardware

Portals

_jt. Associated

services

- Consuling services - Distribution channels - Venture capital - Banking

-

IT Packaged software Project software System integration Information security

Consumers - Households - Companies - State and public organizations

Fig. H6. The Northwest ICT Cluster Chart In particular, it is noted that the Northwest's industrial and research capacity, currently used for import substitution, may under certain conditions obtain a competitive edge in the international market, considering its attractive workforce qualifications and cost. The region's best-known company located in St. Petersburg, Fort-Ross, confirms its high profile through active participation in international exhibitions (e.g., CeBIT). The Northwest's information industry is evidently influenced by that of neighboring Finland, which can present a best practices model for the Russian region. The success story of the new industry that has emerged based on purchased technology and favorable external conditions is not limited to that of Nokia alone. A new information technology cluster has formed around it and, in many respects, because of it. One of the factors behind Nokia's success is the use of outsourcing, which implies competence, trust, and contractual discipUne. Due to their geographic proximity, nearshore Northwest companies, along with Estonian software developers, may become the main partners Finnish companies in off-shore programming. The aggregate turnover of around 900 Finnish companies of that profile is es-

H. Internationalization of Russian Regions

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timated at EUR900 million, with EUR400 million falling on exports. Thus far, the participation of Russian programmers has been insignificant^^. The currently developing IT Cluster in the Northwest, as well as the industry as a whole, is facing a number of difficulties that may promote serious growth bottlenecks in a longer term. It was noted^^ that the IT industry is in the middle of a slump along with the rest of the world economy. In software development, however, the crisis is substantially less sizeable than across the sector. Despite growing unemployment among programmers and closures of software companies, there is a shortage of highly qualified specialists. Crisis-induced circumstances (the need to cut costs while simultaneously updating production capacities in order to boost competitive strength) increasingly force companies to outsource. The absolute indices of the outsourcing segment are growing with this trend poised to increase, confirmed in particular by financial results of the world's leading IT suppliers (EDS, IBM, and Keane). According to Forrester Research data, the numbers of offshore programmers is to grow from a present level of 360,000 to 100,000,000 over the next three years. IDC estimates predict that IT services will annually increase by 12.4 per cent, reaching a level of $626 billion by 2006. Market-Visio/EDS research agency maintains that software exports and development services is to increase from around $200 million in 2001 to $300 million (by some forecasts $350 million) in 2003. Outsourcing should account for about half of that amount, with experts putting the 2002 figure at $100 million. The most rapidly developing segment is the outsourcing of information systems including client-server applications, technical and emergency service applications, as well as call center applications.

^^ Quoted from an interview with Market-Visio's regional director in Vedomosti of 20/06/03. ^^ Second Intemational Forum "Software Outsourcing Summit" or SOS'2002), St. Petersburg, 6—7 June 2002. See: www.auriga.coin/company/SOS2_presentation.pdf.

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6. Outsourcing: Opportunities and Cliallenges Development of outsourcing depends on the demand from large companies seeking ways to reduce their outlays. With local companies still in the process of adapting themselves to a competitive market environment in the Russian market, such demand is practically non-existent. A long transition period of the Russian economy and slow adaptation of enterprises to market conditions are inevitable, given the extremely variegated types of horizontal-interaction behavior, cooperation, and subcontracting. There still exist companies, structured by the "natural economy" principle (like the absolute majority of manufacturing enterprises in the Soviet Union), that produce their own work stock (at foundry and forge shops), running their own repair and transport shops, etc. As a rule, their production capacities are worn down and underutilized; they badly in need of re-equipment, but their resources are insufficient to provide for the entire investment required. Companies, which have abandoned natural economy, cut down their production capacities, separate and sell blanking shops, and customize their auxiliary processes for their main production needs (Kirovsky Zavod and KAMAZ). They purchase certain parts from external suppliers in the form of ready-for-use assemblies. Seeking ways to survive, some companies solicit outside orders for their blanking shops (Petrozavodsk Paper Mill). Outsourcing (necessary to cut costs and improve the quality of production) is practiced by some companies (LOMO and Irbit Motor Factory) on an insignificant scale; steady outsourcing demand may emerge within Russian companies at a later stage of management systems' reform. The largest range of outsourcing services is currently provided in the IT sector followed by accounting and tax planning. One of the most popular types of outsourcing is IT-outsourcing, practiced by YUKOS Holding Company and IBS (a systems integrator company).i2 They commission entire projects or parts of projects with experts from other companies or free-lance progranmiers. However, even IToutsourcing has low circulation in Russia. ^^ The actual size of the Russian ^2 Outsourcing and offshore programming represent two different activities. Offshore programming is developing software for foreign customers (Offshore software development), while outsourcing includes both application service providing and IT infrastructure support, as well as working for the company on a contractual basis. 13 The size of the market is estimated between $300, 000-400, 000 and $80 million, with the most often provided figure of $30-40 million (as aggregate Russian outsourcing exports in 2001). Quoted from an interview with Yu. Amosov, vice-president of Port.ru Company.

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IT-outsourcing market is difficult to assess, both due to its traditional secrecy and because many large contracts are made abroad. In any case, Russian computer technology companies are evidently not yet prepared to operate as independent outsourcers for leading responsible customers. When working in the Russian market, flagship global corporations offering outsourcing services like IBM, Intel, SAP, Parametrics, and Firepond provide them through Russian partners.^"^ Internal IT divisions of Russian companies have weak management and, very often, very limited responsibility. However, as managers become aware of the critical importance of IT for business as a whole, they begin to become aware of the need for outsourcing services as well. Some estimates put various types of outsourcing services at 10 per cent of the overall Russian IT market. ^^ Notably^^, although large companies dominate on the Russian outsourcing consumption market today, the number of small businesses actively using outsourcing is increasingly growing. Interestingly, while large companies use comparatively small providers, small businesses tend to contract larger service providers. This may be explained by the fact that large companies choose to "attach" service providers to them with the intention of getting the best quality irrespective of price. Small businesses, on the contrary, prefer to buy standard services at the lowest possible prices. The former uses outsourcing in order to improve the quality of their products, services, or delivery, while the latter simply aims at cutting costs. Experts maintain that the lack of normal, standard business processes is practically the main reason many Russian companies shy away from outsourcing. Company managers believe that their own IT personnel is more aware of internal company structure, its peculiarities and needs. They may be right, because an external company may find it difficult to get its bearings in the chaos it confronts with a Russian company. Apart from that, outsourcing means opening access to the most treasured of all things, information. In the West, customer trust in the provider is sup14 Pricewaterhouse Coopers, practically swallowed the Russian LVS Company without any trace, while the alliance between Lanit and EDS Companies, as well as a less celebrated unification of R-Style and ICG (Intemational Computer Group), left the administrative structure and the "Russian image" of the domestic companies intact. The thing is that Pricewaterhouse Coopers operates by the same scenario throughout the world making the customer to adopt its own outlook and train the customer's personnel. EDS, on the contrary, prefers to spare the customer's efforts in the maximum possible way and solve its problems efficiently with taking into account all local specifics. 1^ http://eng.datafort.ru/content/rus/68/684-article.asp?pm= 1 &. 1^ Ibid, K. Radchenko, Director for Information Technology and Personnel at MVTs Severstal.

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ported by a generally accepted system of risk insurance and a system of international certificates like Web Trust, Sys Trust, etc. In Russia, such guarantees of customer trust have limited distribution. This means that unless businesses feel protected, the actual prospects of outsourcing in Russia will remain hazy.

Source: Ernst &, Young, presentation at Second Russia-USA Round Table on Information and Communication Technologies Fig. H7. IT Market Evolution in Russia and the World One should also be aware that the capacities for Russian outsourcing directly depend on the development levels of the entire domestic IT industry, which is not as yet clear. An analysis by UBS Warburg says that Russia's internal IT market grew from $2.5 billion in 2000 to $3.1 billion in 2001, while Digital Planet Agency puts overall spending on IT services in Russia at $10 billion. However, even this substantially higher figure represents a mere 0.4 per cent of the global market (the ST* position in the world). A survey of Russia's largest IT companies by Expert RA Rating Agency shows that the Russian IT industry is still in the process of formation. Analysts note the lack of transparency, sound organization or high competition levels. A substantial portion of profits by Russian IT companies falls on the sale of foreign-made completed parts. This means that in the near future, one can hardly expect to see capitalization of the Russian IT industry and arrival of large investments. The survey revealed that in 2002, the aggregate return of the 50 largest IT companies (without the resale of Western appliances) amounted to $2-2.2 billion. Together with the results by international companies operating in Russia, this puts the overall size of the market at around $4-4.5 billion (a 30 per cent growth from 2001). In the

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opinion of Expert RA, the main growth factors were government support and financial aid from the World Bank. Some programs for promoting the services of Russian programmers (mostly in St. Petersburg) are in place in the Baltic Sea Region.^^ The most profitable area in the industry is information technology services, accounting for 47 per cent of the market. Hardware producers hold 23 per cent, and software developers 12 per cent of the aggregate gains by the 50 largest companies. However, at present, Russia's share of the global IT market is insignificant, and there are no clear prospects for a radical change in this situation. At the same time, isolated success stories hold promise for the future. ^^ Teleconununication services can boost growth of production chains. For example, when a MNC establishes its affiliate in Estonia and sales offices in Russia, it will require telecommunication channels to manage the deliveries, thus increasing provider and telecommunication operator traffic. This will push up electronic equipment assembly capacities as well as the output of cables, metals, and construction services further down the road ^^. Ongoing economic growth in Russia and the emerging sprouts of market economy should inspire hope. In a situation, in which government revenues and economic stability completely depend on external economic developments (oil price fluctuations), however, another crisis may already be lurking in the near future. Thus the idea of setting the bearings of the Russian economy in hightech production instead of in the sale of raw materials is the focus of attention yet again. In order to transform Russia from a raw material producing appendage into a developed high-tech economy, the government needs to provide a propitious investment climate and train experts capable of handling inflows. At present, the prospects for large private direct investments in Russian high-tech companies do not appear very realistic. On the other hand, it is evident that neither Russia as a whole, nor its Northwest Regions can grow in isolation from the global economy. A ^^ Mind Match Program in Denmark (2001), Russia ICT Connector in Finland (2003), and a program by Intel for providing support to small IT businesses. ^^ For example, the absorption of Exteria Company by EPAM Systems (2002). After the merger, Exteria became a leading (commissioned) software developer in the FSU countries. EMAP Systems was established in 1993 with its main office in Princeton (New Jersey) and the development center (around 300 personnel) in Minsk. Its customers are around 50 companies (ranging from newcomers to the market to Fortune 500 members) in 30 countries. Exteria was established in 1999 with the main office in Moscow (around 100 personnel); it serves domestic customers and the Russian offices of foreign corporations. ^^ Ekonomika i Vremia, N39.

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number of Russian regions have already adapted themselves to the new situation, with their companies participating in international cooperation. As for St. Petersburg, it is standing on the threshold of post-industrial development, having developed specific mechanisms of adaptation to the new socio-economic situation that radically differ from those adopted elsewhere in the country.

Appendix Table HI. Regions - Leaders by Accumulated FDI

Moscow Moscow region Sakhalin region St. Petersburg Krasnodar region Arkhangelsk region Krasnojarsk region Samara region Novosibirsk region Leningrad region Total

Total FDI 1993-1999

Total FDI 2000-2001

mln$

2000, 2001, 1999 mln. $ mln. $ 1472.8 1154.7 1 204.9 312.7 3

%

Investment potential rating

7758.5 1735.1

38.5 8.6

1311.2

6.5

246.1

374.6

1009.2 755.5

5.0 3.8

146.7 958.9

698.9

3.5

453.5

2000

Investment risk rating 1999

2000

1 3

1 6

1 10

71

64

70

69

114.1 793.4

2 12

2 10

2 18

11 6

1.4

1.4

51

43

71

62

2.3

14.6

0.8

6

6

75

74

441.6 436.1

2.2 2.2

59.6 151.8

117.6 89.1

6 19

7 18

15 62

23 58

406.7

2.0

205.5

238.2

22

29

17

30

15006.3

74.5

Source: Ekspert (2000), N40, pp. 84-87J6-79, 90; Regiony Rossii, Sotsialjnoekonomicheskie pokazateli (2002); Stat.sbomik, Goskomstat Rossii, pp. 823, 825

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References Analysis of Tendencies of Development of regions of Russia. Tipologija regionov, vyvody I predlodzenija (1996), TACIS Project. TACIS, Contract BIS/95/321/ 057. AREND, R. (2000), Prjamye investitsii v rossijskuju ekonomiku-stoit li ovchinka vydelki? in: Obzor rossijskoj ekonomiki. Ezhemesjachnyj bulletenj RECEP, 14 June. BALASUBRAMANYAM, V.N. (2001), Foreign Direct Investment in Developing Countries: Determinants and Impact, OECD Global Forum On International Investment "New Horizons and Policy Challenges for Foreign Direct Investment in the 21st Century", Mexico City, 26-27 November, http://www.oecd. org/dataoecd/53/20/2407305.pdf. DUDAREV, G., HERNESNIEMI, H. and FILLIPOV, P. (2002), Emerging Clusters of the Northern Dimension. Competitive Analysis of Northwest Russia, ETLA, Helsinki. DUNNING, J. H. (2000), A Rose by Any Other Name...? FDI Theory in Retrospect and Prospect Rose By Any Other Name ? http://copenhagen.jibs.net/LitReview/2000/2000_3_20.pdf. EKSPERT (2001), N41 (301), 5 November. EKSPERT (2002), N45 (352), 2 December. Emerging Clusters of the Northern Dimension. Competitive Analysis of Northwest Russia - A preliminary Study, ETLA, Helsinki, 2002. GRAHAM, Ed. M. (1995), Foreign Direct Investment in the World Economy, IMF Working Paper WP/95/59, Washington, D.C.: International Monetary Fund. Growth Reduce Poverty, CAERI Discussion paper, N.5., Cambridge. GUBAIDULLINA, F. (2003), Prjamye inostmnye investitcii, dejateljnost' TNK I globaliztcija, in: Mirovaja ekonomika i medzdunarodnye otnoshenija, N2, 4247. Razvitie ekonomiki Rossii:tendentsii I problemy (2003), Analiticheskij vestnik, Informatsionno-ananliticheskoe upravlenie apparata Gosudarstvennoj Dumy, N9,http://wbase.duma.gov.ru:8080/law?d&nd=981600006. IZVESTIA (2003), 02.06.03. KLEIN, M., AARON, C. and HADJIMICHAEL, B. (2001), Foreign Direct Investment And Poverty Reduction, OECD Global Forum On International Investment "New Horizons And Policy Challenges For Foreign Direct Investment In The 21st Century", Mexico City, 26-27 November 2001 http://www. oecd.org/dataoecd/24/60/2422017.pdf Kratkaja kharakteristika osnovnykh polodzenij programmy socialjno-ekonomicheskogo razvitija Rossijskoj Federatsii na srednesrochnuju perspectivu (20032005 gody). Obzor ekonomicheskoj politiki v Rossii za 1999 god (2000), Buro economicheskogo analiza, M.: TEIS. Politika privlechenija prjamykh inostrannykh investitsij v Rossijskuju ekonomiku (2001), BEA, TEIS, p.l5.

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ROEMER, M., and GUGERTY, M.K. (1997), Does Economic Growth Reduce Poverty, in: CAER I Discussion paper N. 5. Cambridge, MA.: Harvard Institute for International Development. RUGMAN, A. and VERBEKE, A. (2002), Regional Multinationals and Triad Strategy, http://www.aueb.gr/deos/EIB A2002.files/PAPERS/C 164.pdf. SAUVANT, K. P. (2001), Recent FDI Trends, Implications for Developing Countries and Policy Challenges, OECD Global Forum On International Investment "New Horizons And Policy Challenges For Foreign Direct Investment In The 21st Century", Mexico City, 26-27 November 2001 http://www. oecd.org/dataoecd/24/62/2421851 .pdf. VEDOMOSTI (2003), 23 March. WORLD BANK (2000c), World Development Report 2000/2001, Washington, D.C.: World Bank. WORLD ECONOMIC OUTLOOK (2000), Washington, D.C.: International Monetary Fund, May. WORLD INVESTMENT REPORT (2001), Promoting Linkages. UN N.Y. ZIMENKOV, R. (2003) Prjamye Inostannye investitsii inostrannykh kompanij v ekonomike SSHA, in: Investitsii v Rossii, N2, pp.22-30. http://www.credit.ru/article.php?story=2003033130861. http://www.minsvjaz.ru.

Comment on: Intemationalization of Russian Regions: Thie Roie of i\/INCs and Outsourcing with Respect to Domestic and Foreign Si\/IEs Christopher Schumann In this paper, the author deals with the role of foreign direct investments and multinational companies in the economic development of Russia. Specific attention is given to the effects on regions and local companies on the ICT sector in North-West Russia. Russia is presently in a phase of economic growth, but in order to assess if this gives way to long-lasting impulses for sustainable growth, one must be aware of the transmission mechanisms and effects for the regions. The role that foreign companies play in this context is important, and an analysis of these effects gives direct hints at the conception of policies for international trade and economic policy on the regional level with respect to foreign actors. The author first states that foreign direct investment is good for economic development due to transfer of technology and know-how. In the first chapter, she gives an eclectic overview of the literature on this topic and concludes that "negative effects are inconclusive but positive effects are overwhelming". Although this goes along with the mainstream of today's economists, a little more reflection on the possible negative effects would have been desirable, especially the belief that FDI helps to reduce poverty is questioned in the literature. Among others, Stiglitz (2000) expresses doubts the trickle-down of profits to poor local population. In the second chapter, the author emphasizes the importance of business regulations for FDI activities. She states, however, that the level of FDI per capita in Russia has been low in comparison to other transition countries. Until recently, Russia suffered from overall capital outflow rather than inflow because of significant capital flight. In an environment with contradictory regulations and general insecurity about continuity of policies, it is difficult to find foreign investors, especially in the case of Russia where even local businessmen preferred to invest abroad. Therefore, the call for business regulations that are in line with regulations in other countries that successfully attract FDI is convincing. Russia is extremely heterogeneous with respect to its economy. There are high differences in regional levels of GDP per capita, investments, salaries and living costs and FDI is attracted mainly by regions with a large extent of natural resources in the field of energy. Other regions have difficulty presenting themselves as interesting investment targets.

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In chapter 4, the author identifies a region that has the potential to become an economically successful region. The North-West region, with its capital in St. Petersburg, has several advantages. Due to its metropolis, it first of all has a consumer market of considerable size. Additionally, it has access to the Baltic Sea; its seaport can foster trade of the region with the Baltic neighbors as well as other foreign trade partners and transit trade is another platform for business. The author concludes that the North-West region is rich in human and in natural sources and has advantages vis-a-vis other Russian regions. Among the business sectors with high potential in the North-West, the author identifies a newly-emerging cluster: the ICT sector. Having the IT giant Finland next door can indeed provide additional impulses to the development of this branch in Russia. But a kind of spill-over can only be geared, if Russian enterprises prove to be reliable partners offering high quality in the field of hardware assembly and development as well as software programming. The author correctly states that Russian enterprises could profit from the outsourcing of Nokia and other foreign ICT companies. Chapter 5 is therefore devoted to outsourcing and its practice in Russia. Outsourcing is rather rarely used within Russian business life. The reason behind this is the principle that is left from Soviet times whereby enterprises wanted to keep all business activities under one roof. While in the area of socialism with the permanent threat of shortages it made sense to control as many vertical steps of a business production, it no longer does not seem up-to-date. Especially if companies want to introduce new technologies in the IT field for their production, it seems wise to make use of existing know-how outside the firm rather than building up new departments from scratch. Yet the author states that the precondition to make use of this procedure is to have the willingness to give away pieces of information to the enterprise carrying out the outsourcing activity. As long as this willingness is not present due to an old management ideology based on strict secrecy, this kind of business will stay underdeveloped in the region. The idea that there is a clear connection between the use of information technology and outsourcing is convincing: "As Russian managers become aware of the critical importance of IT for business as a whole, they begin to become aware of the need for outsourcing services as well." But in the end, the author suggests that the Russian industry is still at the beginning of the process of accepting new outsourcing concepts. In this paper, the author has presented many insights that Russia is confronted with in the context of the internationalization of its business. While regions with rich natural resources are attractive for national as well as international investors, other regions lag behind in economic development. While foreign direct investment and the involvement of MNC in Russia may give positive impulses for some regions, it remains unclear how the

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vast majority of the population should profit from it. After presenting the eclectic theory of FDI, the paper remains mostly on the descriptive level of analysis. Some of the expected positive effects for Russia and the NorthWest region seem to stem from the author's hope rather than from facts. In the context of the ICT business, it would be useful to more thoroughly compare the potential of the NW region with that of its Baltic neighbors. Estonian enterprises in particular have successfully offered their services for the outsourcing activities of Finish companies. Nevertheless, the author has convincingly elaborated on the role of outsourcing within Russia business life. It is clear that Russian industries should change their management strategies in this respect if Russia as a whole wants to improve its business position and offer good investment opportunities for foreign as well as national financial sources.

I. Do Export Processing Zones Attract FDI and its Benefits? Experience from China and Lessons for Russia 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. ImpUcations of the Chinese Experience for Russia

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References

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Comment on: Do Export Processing Zones Attract FDI and its Benefits? Thomas Gries

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1. Introduction The question posed by the title of this paper is of paramount importance to Russia, because Russia would like to increase the volume of foreign direct investment coming into its territory. In the case of China, which has experienced a huge volume of inward FDI since the early 1990s, the question can be answered quite simply but with qualifications. Export-processing zones (or, to use Chinese terminology, Special Economic Zones or SEZs) did succeed, during the decade of the 1980s, to bring into China a significant volume of foreign direct investment (FDI).* With this investment did come certain benefits. However, both greater volumes of investment and greater benefits followed when the special privileges accorded to foreign investors in SEZs were nullified by the Chinese government in 1991 via the opening all of China to foreign investment on essentially the same terms as were granted in the SEZs. This has led some observers to conclude that the SEZs were a failure in the sense that perhaps the benefits that almost unquestionably have been brought to China by foreign investment could have been accelerated had the 1991 liberalization occurred earlier and the period curtailed during which this investment was largely restricted to SEZs (and to SEZ-like zones; as we shall see, even during the 1980s, FDI was not limited to the formally-declared SEZs but extended to other areas to which SEZ-like privileges were extended to firms). Thus, the question posed by the title can be restated as follows: were the SEZs, and SEZ-like zones, a "building block" upon which the successful build-up of FDI during the 1990s and 2000s rested? Or, in the end, were the restrictions imposed on China outside the SEZs during the hey-day of the SEZs simply an obstacle that slowed China's economic progress? Finally and of course, a principal question for this article is can anything of relevance to Russia be gleaned from the Chinese experience. These questions of course are in a category that can never be answered definitively; after all, we will never know the "counterfactual", i.e., if things had been done differently in China during the 1980s - specifically, if China had pursued more liberal and open policies than it did - would the economic situation there be better than it is now? The answer is, we shall ^ What are identified in most countries as "export processing zones" were referred to in China as "Special Economic Zones". These zones were, in fact, meant to increase exports via selective deregulation of regulations and reduction of tariffs on imported intermediate goods that impeded establishment of export-related activity and thus correspond to what is elsewhere termed export-processing zones. However, the term "Special Economic Zone is used throughout this paper in conformance with the considerable literature that has been developed that is specific to China.

I. Do Export Processing Zones Attract FDI? 253 never know for sure. But, nonetheless, we can explore these questions with the hope that some insight can be gained, even if this insight might not in the end give a final answer to the questions that we pose. Moreover, this exploration can offer some insights as to what steps Russia might need to take in order to attract more FDI.

2. Some Background: the SEZs and the Opening of China to Foreign Investment during the 1980s It is useful to begin by examining the circumstances under which China, which prior to 1979 had been in effect fully closed to foreign direct investment, began to open itself to this investment in the 1980s. The process began with reforms first enacted during the late 1970s. One of these reforms was the passage in 1978 of the Law on Chinese-Foreign Joint Ventures. This law, in principle, allowed foreign investment anywhere in China, subject to government approval and tight conditions and regulation. The main objectives of the law were to bring to China technologies that, at the time, were lacking in the largely state-owned industrial sector and, also, to improve the quality of services in China. A parallel objective was to increase China's exports; in 1978, China's exports of manufactured goods were a scant portion of national product and, moreover, lack of foreign exchange was seen as a binding constraint on further development. The intent of the 1978 law does not seem to have been to open China to a flood of foreign investment but rather to encourage selective investment in sectors where Chinese firms were clearly deficient. Indeed, a main worry in 1978 was that foreign investment should not create too much competition for domestic firms, which of course at that time were almost all state-owned. Thus, China did implicitly restrict foreign investment on a sectoral basis; such investment was generally not sought in sectors where Chinese firms were already present even if, in many instance, these domestic, largely state-owned firms were not up to world standards in terms of product technology or efficiency. Alas, many if not most of the regulations and restrictions associated with this law were non-transparent, especially with respect to specifically what were the sectors in foreign investment was sought or, alternatively, officially discouraged (ROSEN, 1999). This was true even after the publication of implementing regulations for the law in 1983 and pubhcation of "clarifications" of these regulations in 1986 (as we shall see, the "clarifications" were actually a de facto liberalization of policy). It would not in fact be until 1995 that a comprehensive list of regulations and guidelines, including transparent sector-specific restrictions, for foreign investors would be published.

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However, it was quickly recognized that the 1978 law in itself not only would not open China to a flood of foreign investment but in fact was inadequate to enable much FDI at all, especially export-related FDI which in fact was sought (JIA, 1994). Thus, in 1979 a law enabling the Special Economic Zones in which foreign investors could operate export-oriented ventures free from much of the regulation then present in China was passed. The first such zones were established in 1980. The main advantages granted to exporters in these zones were access to imported raw materials and intermediate goods at world prices (World Bank, 1993) and availability of export credit that was then lacking in the domestic financial institutions. Thus, as a practical matter, in the early 1980s, to qualify for certain export-oriented privileges that were indeed desired by foreign investors seeking to invest in the manufacturing sector in China, this investment had to be placed in the SEZs. There were four such zones created in 1980. Three of these were in Guangdong Province, in the cities of Shantou, Shenzhen, and Zhuhai, and one was in Fujian Province in the city of Xiamen. In 1988, a fifth zone was established, on Hainan Island. In addition, in 1984, fourteen coastal cities were designated as "Economic and Technical Development Zones" (ETDZs). As such, these cities de facto became SEZs, as most of the privileges available to exporters operating in the SEZs became available to exporters operating in these designated cities as well. Importantly in what was to follow, all of these zones were in the coastal areas of China that for a variety of reasons were a priori the most attractive, when compared to other areas of the country, to foreign investors. For example, these areas had, relative to much of the rest of China at the time, a well-developed infrastructure, including access to deep-water port facilities and airports. The coastal areas tended to have well-developed human capital as well, e.g., virtually all persons in the cities of these areas were literate and numerate, and the region possessed a disproportionate number of China's university graduates (JIA, 1994, op. cit,). China thus avoided a problem associated with EPZs in many developing countries, where these zones have often been located in the least-developed regions of the countries. The number of zones created also doubtlessly worked to China's advantage by hastening the liberalization process in China from the mid1980s onward. This is because officials in the ETDZ cities soon found themselves in competition with each other, and with the SEZs, to attract foreign investors and, in this competition, no such official would seek to enforce restrictions that were not being enforced in other areas. The result was that regulation as actually applied in these areas tended to be more liberal than de jure regulation. Moreover, the success of these zones in at-

I. Do Export Processing Zones Attract FDI? 255 tracting FDI led to a number of other areas being accorded SEZ-like status, where this status was often granted by provincial governments not necessarily taking these actions with the permission of the central government (LARDY, 1994, 2002). By 1989 there could be identified something like 111 "zones", most of them in fact without official status, which operated under the pretty much the same rules as were applied in the SEZs (ROSEN, 1999, op, cit.) Most of these continued to be located in the coastal provinces. Even so, foreign investment in the SEZs and SEZ-equivalent areas built up quite slowly at first. The rate of FDI however picked up significantly following 1986, when requirements appearing in the 1978 law on foreign investment that operations in China with foreign investment be formed as joint ventures with local enterprises and that the heads of such operations be Chinese nationals were eased pursuant to the "clarification" of the 1983 regulations.^ Indeed, the results following 1986 were actually quite spectacular from the perspective of that time. FDI inflow in 1986 was close to $US1.9 billion whereas three years earlier it had been barely a third of this amount.^ FDI inflow then rose to more than $2.3 billion in 1987. Although these flows are but trickles when compared to the amounts that would be realized in the middle 1990s, by the standards of the middle 1980s, they were impressive. Between 1979 and 1991, about 43% of all FDI in China was placed in the Guangdong and Fujian provinces, where the SEZs were located. An additional 27% went to the coastal provinces containing ETDZs or, later, the unofficial SEZ-like zones noted above; thus, about 70% of FDI in China during this period went to the provinces in which the SEZs or SEZlike zones were located. How much of this investment was located in these zones, as opposed to areas in these provinces not designated as special zones, is not reflected in the official data, but it is almost certain that the vast majority of the FDI was actually in the zones. FDI in the SEZs and SEZ-like zones, moreover, almost surely included almost all manufacturing operations under foreign investment. By contrast, much of the FDI outside the SEZs in provinces other than the coastal provinces was in services sectors, often ones catering to tourists and other overseas visitors (e.g., hotels). ^ Following 1986, operations in China, including in SEZs, could be majority or 100% foreign-owned if either (1) 50% or more of the output was for export or (2) the operation was to produce technologically advance products, ones where incumbent Chinese firms lacked the relevant technology. ^ All figures for FDI flows are on a balance of payments basis, i.e., reflect actual realization of investment. Chinese authorities often cite figures for amounts of investment that are "contracted" (in effect approved by the government) and these figures have historically often been much higher than realized investment.

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With this investment did come certain benefits, e.g., new sources of employment in regions where unemployment or, more correctly, shadow unemployment, was doubtlessly quite high, and new sources of foreign exchange at a time when scarcity of foreign exchange was, as noted, a binding constraint on Chinese growth. However, the benefits were rather limited. For example, there were relatively few "linkages" established during the early years between foreign-invested operations in SEZs and SEZ-like zones and Chinese firms, e.g., few export-processing operations used Chinese firms to supply inputs for products to be exported. One result was that there was little technology transferred between these operations and local firms; a common channel by which technology transfer takes place is from a producer of final goods to supplier firms, but during the 1980s it was difficult for foreign-invested firms operating in limited zones in China to open this channel very wide."* Rather, something of a "dual" economy was evolving, such that firms in SEZs and SEZ-like areas operated largely separately and independently of other firms in the Chinese economy. But, of course, this was contrary one of the reasons why China had decided to open itself to foreign investment in the first place, to create technology transfer to laggard Chinese firms. The lack of technology transfer was in part due to the nature of foreign investment in the SEZs and SEZ-equivalent areas: Initially this investment was largely concentrated in relatively labor-intensive, technology nonintensive activities such as the cutting and sewing of clothing and other assembly operations.^ The main attraction of these areas, from the point of view of the foreign investor, was the ready availability of cheap but disciplined labor, rather than local non-labor inputs (CHEN and WONG, 1997). Thus, for example, in the case of operations in China in which Hong Kong light manufacturers had invested, the flow of product was of inputs of intermediate goods from Hong Kong to the Chinese affiliates, where final assembly took place. The Hong Kong firms and their affiliates rarely used inputs from Chinese sources. Where such inputs were used, these were of products where Chinese firms already had mastered the relevant technologies. For example, garment assembly operations in China did use cloth from Chinese suppliers as well as cloth made in Hong Kong. But in this sector there was little opportunity for transfer of new technology to Chi"* The terms "foreign-invested operation" and "foreign-invested firm" are used throughout this paper because local affiliates of foreign investors are still termed thusly in China, even if they are majority or wholly owned by the foreign investor; the terms reflect the fact that, at the outset, operations with foreign investment had to be in the form of joint ventures with locally controlled firms, a requirement that, as noted in the text, was eased in 1986. ^ This in fact seems to be the experience of many countries that have established EPZs; see Rhee, Katterbach and White (1990).

I. Do Export Processing Zones Attract FDI? 257 nese firms. (Or at least this is the view of many analysts; we re-examine this view in the following section.) Most of the early investment in SEZs and SEZ-like areas came from socalled "overseas Chinese", most especially those of Hong Kong, then not part of China. Indeed, doubtlessly one of the most successful of the SEZs was the one established in Shenzhen, a city immediately north of Hong Kong's "New Territory" region on the Chinese mainland. This and other SEZs in Guangdong province were, by 1990 if not earlier, acting virtually as extensions of Hong Kong's light manufacturing industries (CHEN and WONG, 1997, op. cit.). There is evidence that by the late 1980s, however, that Hong Kong investors were beginning to "fan out" and invest in Chinese provinces other than Guangdong, having already established a lightmanufacturing base in Guangdong (ZHANG and CHEN, 1997). Moreover, investment in Fujian Province, Shanghai, and other coastal areas began by the late 1980s to arrive from other "overseas Chinese" located in areas other than Hong Kong, including Taiwan and the southeast Asian nations. In late 1990, Chinese President Deng Xiao-peng visited several SEZs during his now-nearly legendary "trip to the South" following the Tiananmen Square incident, where he observed the employment and export activity that these zones had generated. He wondered aloud whether it continued to make sense for privileges extended to export-generating firms to be restricted to these zones. Why not, he rhetorically asked (or at least he supposedly asked; as noted, the particulars of this trip now are the stuff of near-legend and remarks that Deng supposedly made might never have been uttered at the time), end the restrictions such that foreign investors could locate manufacturing operations more or less where they might choose? Accordingly, in 1991, the restrictions limiting export-related privileges to firms located in SEZs were largely lifted, and other measures were taken to liberalize China's policy towards foreign direct investment. Importantly, by this time, in fact the special advantages accruing to firms in SEZs already were diminishing, largely as the result of reductions in tariffs China applied to imported goods. Moreover, as already noted, by that time, the advantages granted to operations in SEZs were being applied on a rather widespread basis in the unofficial zones throughout the coastal regions of China. Additionally, the terms actually applied to foreign investors in these zones were almost surely de facto more liberal than allowed by the official policies of the central government (although this is a hard proposition to test because, as already noted, the official policies were not fully transparent). The liberalization of 1991 thus probably should be seen almost as much a bringing into line of formal policy with policy as actually implemented as a change in policy.

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3. The 1991 Reforms and their Aftermath As is well known, after the liberalization of 1991, the flow of FDI into China increased very dramatically. Charts 1 and 2 indicate the flow and cumulative stock of foreign direct investment in China from 1980 until 2002. Chart 1: FDI flows to China 1980-2002

^30000

1 • 1

---.••••••III 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 year

Fig. II. FDI Flows to China 1980 - 2002 ($-US Millions) As noted earlier, there had been a significant surge in foreign direct investment following 1986, but then flows of FDI leveled off at something like $3 billion per year beginning in 1988 and grew quite slowly until 1991. This slow growth is often attributed to the Tiananmen incident in 1989 and the crackdown that followed this incident but it is not really clear form the FDI flow data that there was a trend break following 1989. But beginning in 1991, when the liberalizing measures took effect, foreign direct investment flows once again began to grow and indeed so at almost astounding rates. One consequence was that China became the largest recipient of FDI flows among developing nations and, furthermore, by 1995 had become the second largest recipient of this investment among all nations (the United States was in first place). The growth continued until about 1997, whereupon FDI flows into China fell somewhat during the next three years. But, by that time, the flows on an absolute scale were very high - in fact, substantially higher than to any other developing nation ~ such that China continued to be the largest developing country recipient of FDI even after the annual flow declined. And, of course, the stock of

I. Do Export Processing Zones Attract FDI? 259 FDI (a better measure of economic activity generated by foreign-invested firms than flow of FDI) continued to grow substantially. Perhaps anticipating China's entry into the World Trade Organization (WTO), FDI flow into China began once again to grow beginning in 2000 and this growth seems to have persisted through 2002, after this entry was completed. Impressively, and unlike the period of growth during the 1990s, this recent growth in FDI in China has been taking place at a time when total worldwide flows have been declining (UNCTAD 2002). Indeed, in 2002 and 2003, China has been the nation receiving the largest amounts of foreign direct investment, surpassing even the United States which held this position from the late 1980s until 2001. Chart 2: FDI Stocks in China 1980-2002

M

250000

»,»,M,M,M,w,M,w,M,B,B,B,B 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1999 2000 2001 2002

Fig. 12. FDI Stocks in China 1980 - 2002 ($-US Millions) With the passing of time, the sectoral mix of foreign direct investment began to shift such that, although such investment continued in lowertechnology, labor-intensive sectors, an increasing proportion of the new investment was in higher technology activities (LEMOINE, 2000). This resulted in both foreign-invested firms leading China into new export activity (e.g., in electronics and other goods embodying advanced technology) and these firms participating to a greater extent in the local economy. A consequence of the latter was that output from newly established foreign-invested operations shifted sometime in the middle 1990s from being primarily oriented towards export markets and more towards local markets. Even so, exports from foreign-invested enterprises continued to grow and, indeed, almost all growth of Chinese exports during the 1990s can be attributed to these enterprises (WEI, 1996; LEMOINE, 2000, op, ciu). Part of the reason for this doubtlessly is that China's regulatory framework, es-

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pecially as regards working of the financial system, worked so as to intermediate most domestic savings into the inefficient state-owned sector (LARDY, 1998). The result was that would-be local entrepreneurs were at a disadvantage relative to foreign-invested firms (HUANG, 2003). Thus, such entrepreneurs often teamed up with foreign investors, so that new ventures would be subject to the more favorable regulatory framework (HUANG, 2003, op, city One major consequence of the post-1991 developments in China is that total factor productivity in the Chinese coastal provinces, where FDI is concentrated, grew faster in this period than prior to the earlier period, and the difference in the two growth rates is statistically significant (GRAHAM and WADA, 2001). By contrast, there was no such acceleration in total factor productivity in the remaining provinces of China in the post-1991 period. This suggests that the jump in the growth of the total factor productivity in the coastal provinces is the consequence of technology transfer into the region by foreign-invested enterprises.^ Consistent with this, FDI is significant as a determinant of growth in the coastal provinces of China and, also, in a Mankiw-Romer-Weil version of the Solow growth model, the coastal provinces seem to be converging to a different, and faster, growth path than the remaining provinces (DAYAL-GULATI and HUSEIN, 2000). There is also evidence that FDI in the coastal provinces of China has boosted productivity in that region even in laborintensive operations, suggesting perhaps more significant technology transfer than normally thought to occur in such operations (LEMOINE, 2000, op, cit,). Thus, it would seem that one of the original goals of opening China to foreign investment, notably the upgrading of China's technological capabilities, has been fulfilled to some major degree since 1991, or at least so in the coastal provinces.

^ But it should be noted that Graham and Wada 2001 did not directly test for this; rather, they suggest that because the main thing that changed as between the coastal provinces and the rest of China was the large influx of FDI into the former area, this likely was the cause of the different performances in TFP growth.

I. Do Export Processing Zones Attract FDI? 261 Chart 3: Exports by Foreign Invested Enterprises (FiEs) and Total Chinese Exports, 1985-2002

I 200000 •exports by FIEs

1

D total Chinese exports

JUL

i

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

2002

Fig. 13. Exports by Foreign Direct Invested Enterprises (FIEs) and Total Chinese Exports, 1985 ~ 2002 ($-US Millions) Additionally, the goal of boosting exports has been furthered, perhaps to an extent that China's reformers would never have dreamed of achieving, during the post-1991 period. Chart 3 provides some evidence that foreigninvested firms have indeed created most if not all the growth in Chinese exports virtually since the first foreign investment in China took place. This point has been made by several authors (e.g., WEI, 1996, op, cit,) It has been noted, however, by one author (HUANG, 20003, op, cit,) that some of this growth might in fact have been achieved by domestically owned firms, particularly ones in China's emergent private sector, had these firms not in various ways been handicapped relative to foreigninvested firms. This last point is controversial and whether in fact it is true is one of those matters that, at the end of the day, remains unknowable. What does seem clear from Chart 3 is that there was no clear trend break in exports by foreign-invested enterprises following 1991. Rather, these exports grew at what would appear to be a steady rate from 1986 onward, with no acceleration in this rate evident following 1991. This brings us back to reconsideration of the earlier period.

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4. The Period of the SEZs Re-examined As noted in the introduction of this paper, a common view regarding the SEZs and the SEZ-like zones in China is that, if anything, the restrictions on FDI that existed in China at the time of the SEZs actually impeded Chinese development. It was only after many of the restrictions were lifted, or so goes this view, that large scale FDI entered into China, helping to launch an era of high growth.^ But an alternative point of view can be formulated: that the economic development that was registered during the 1990s in China came about as the result of, as it were, the maturation of a forest that was planted during the 1980s. Without the passage of a certain amount of gestation time, it can be argued, the trees of this newly planted forest could not have been expected to bear much fruit. In this view, the SEZs and the SEZ-like zones did not impede FDI and its benefits, but rather provided (not to overdo the metaphors!) a "greenhouse" environment in which the young plants could be nurtured. Moreover, in this latter view, the decade of the 1980s was a time when exactly how far the transitions that were first initiated in the late 1970s might proceed was highly uncertain. Many Chinese leaders during the 1980s, for example, remained unconvinced that the "reforms" of the late 1970s and early 1980s were in fact desirable. These "anti-reformist" leaders in particular worried that, if given extensive rights to operate in China, foreign firms might effectively annihilate the incumbent domestic, largely state-owned enterprises that then accounted for the vast majority of nonagricultural employment in China. At the same time, however, there was also consensus among the Chinese leadership, anti-reformist factions included, that China needed to increase its exports. Hence, initially, one motivation behind creation of the SEZs was to achieve the desired increase in exports but to keep output from foreign-invested enterprises (and other enterprises that might operate in these zones) from competing in the domestic market. This separation was not entirely successfully implemented, of course: By the end of the 1980s, as noted in the previous section, foreign-invested firms operating in the manufacturing sector were in fact were beginning to sell into the domestic Chinese market. By that time, however, official resistance to foreign participation in the domestic econ-

'^ I have not identified specific analysts holding this point of view. But, let's just note that this view is quite prevalent at certain international organizations, e.g., the World Bank. See, for example, Madani 1998, who somewhat softly states (page 1) "Not all export processing zones have served as engines of industrialization and growth...".

I. Do Export Processing Zones Attract FDI? 263 omy, following several years of positive experience with the SEZs, was beginning to attenuate. Nonetheless, in the early and middle 1980s, there was much resistance within the Chinese leadership to the liberalization of Chinese economic policies and no guarantee that this liberalization would continue, let alone be expanded. Indeed, even in the late 1980s, it was not a wholly unreasonable for reformers to fear that those liberalizing measures undertaken by China might be rolled back by conservative "hardliners". Given this, foreign investors were understandably skittish during the 1980s about locating major operations in China, for fear that a reversal of liberalization might take place or even that foreign-invested operations might be nationalized in the event that China reverted to a harder-line version of Communism. SEZs were of course places where the rules for foreign investors were relatively favorable. Indeed, because suspicion of foreign investors characterized a significant portion of the Chinese leadership, it was only because these zones were quite limited in number and scope that anti-reformist leaders in China could be persuaded to allow these zones to exist. Accordingly, the SEZs at that time arguably provided the only possible setting in which foreign investors could be comfortable with operating in China; after all, as recently as the late 1970s, China had been largely closed to foreign investment and in fact the country was seen by the outside world as a rather hostile place in which to attempt to do business. Thus, that the zones be conducted as limited experiments represented not only a compromise between reform-minded leaders of China and leaders opposed to the reforms but, arguably, even had reform-minded leaders pushed and achieved a wider opening of China at that time, foreign investors might have perceived China as being subject to too high a degree of risk to be willing to make significant investments there. Given all of this, it is important again to note that the amounts of FDI drawn to the SEZs and the SEZ-like zones after 1985 were, by the standards of the time, quite impressive. While more dramatic growth of FDI flows took place during the 1991-97 time frame (and additional growth has occurred after 2000), one might ask whether the later growth would have occurred at all without the earlier experience and the confidence that was gained both on the part of China's leadership and on the part of foreign investors during the earlier time. Moreover, the benefits brought by the existence of the SEZs, while these benefits were clearly much less than what was to come during the 1990s, were not insubstantial during the 1980s. The most significant benefits were registered in Guangdong Province. In fact, by 1990 Guangdong Province could, by a substantial margin, boast the highest per capita GDP in China. This was in large measure due to the success of foreign investment in the three SEZs and numerous smaller zones, both formal and in-

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formal, located in this province (ZHANG and KANG,1997, op. cit,). Furthermore, at least some of the benefits that are most often attributed to the liberalization of the early 1990s were in fact beginning to appear in Guangdong Province prior to these liberalizing measures taking effect. These included the emergence of foreign-invested firms in higher technology sectors than the textiles and apparel sector. For example, exports of electrical and electronic products from Guangdong were already close to $1.7 biUion in 1991, and these exports came from foreign-invested enterprises that were established before the reforms of that year. In fact, this investment took place after the 1986 "clarification" of the 1983 foreign investment regulations; as recently as 1987, Guangdong registered no exports at all of electrical or electronic goods. Thus, this sector underwent very rapid development in this province during 1987-1991. Furthermore, at least some linkages between foreign-invested firms and locally owned firms in this sector were in fact beginning to be established prior to 1991. It is also clear that certain incumbency advantages that were created by foreign investment during the 1980s in Guangdong and other provinces where SEZs and SEZ-like zones had been established persisted after the 1991 liberalization. Thus, foreign direct investment continued to flow into these zones (or to locations nearby the zones) even after foreign investors were allowed to place their investments outside these zones. Indeed, to this day, the vast majority of FDI in China continues to be located in the coastal provinces where the SEZs and ETDZs were initially established. In fact, a higher percentage of total FDI flows to China during the 1990s flowed into these provinces (about 83%) than during the 1980s (about 70%). Although the official data do not reveal whether these flows went into the areas formerly designated as SEZs or ETDZs, casual observation suggests that a great deal of new foreign-invested activity is located in or at least very near these areas. Shenzhen and Xiamen, for example, continue to attract new FDI (the author can attest to this because he has visited both places within the past eighteen months!). One reason for these revealed incumbency advantages doubtlessly is that, once a certain type of activity begins to cluster in a specific location, external scale economies are created that cause similar activities to be placed in the same general location. These scale economies in turn are the result of the creation of pools of specific resources, e.g., workers with specialized skills, local firms offering specialized services, etc.^ The point ^ The author can give an example of the latter from personal experience: on summer break while an undergraduate, I obtained temporary employment in a high technology firm located near San Francisco, Califomia, where I grew up. This firm had need for small quantities of metal parts that had to be machined to very high tolerances; without the parts, the end-products produced by the firm would

I. Do Export Processing Zones Attract FDI? 265 here is that these incumbency advantages seem to have been established during the period when foreign investment in China was largely restricted to the SEZs and that the 1991 liberalization did little to diminish these advantages. Indeed, as noted earlier, a principle factor favoring the SEZs, notably low or zero tariffs on imported inputs, had already been eroded before 1991; this erosion does not seem to have adversely affected the ability of the SEZ and SEZ-like zones to attract FDI, suggesting again that incumbency advantages persisted even after the initial advantages possessed by these areas ceased to be operative. Even given all of this, however, the case to be made in favor of the SEZs and SEZ-like zones being successful is a limited one. The essence of this case is two-fold. First, it must be argued that these zones created "greenhouses" in which incumbency advantages were created that were necessary for foreign investment to grow at the rates that occurred during the 1990s. But, while the facts seem to support this case (because, even after the advantages granted to the SEZs ended, FDI continued to come to these same areas), these same facts could support an alternative hypothesis: That the areas in which the SEZs were established were ones where location advantages favoring FDI already existed. Such advantages, as previously noted, include relatively well developed infrastructure plus availability of "human capital". Second, it must be argued that creation of these zones was a necessary step to draw FDI into these regions, i.e., that absent the SEZs, the FDI would not have come even after the liberalization of the early 1990s. The alternative hypothesis noted just above implies, however, that the regions in which the SEZs were located at least had latent location-specific advantages that would attract FDI, once a favorable policy environment was established. Indeed, there are those who believe that, had China liberalized its policies towards FDI at an earlier date without passing through the intermediate SEZ stage, the benefits of FDI in China would have arrived sooner than they did. The case that the zones were in fact necessary rests on the untested proposition that, in the absence of special zones, full-blown liberalization would not have been long tolerated by a Chinese leadership that included numerous skeptics of liberalization, such that an opening of not function, but the number of parts was too small to warrant in-house capacity to produce them (these end-products were high unit value electronics goods). The specific designs of the parts were changed often, such that large work-inprocess inventories were not practical. Thus, thefirmhad to be located very near supplier firms that could produce these parts in small production runs on short notice. The Silicon Valley area south of San Francisco was the only place in the entire United States where there existed a cluster of such supplier firms, and the existence of these supplierfirmswas a major reason why quite a large number of otherfirmsproducing high technology goods were located in this area.

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China to foreign investment would not have been seen as credible, or at least would have been seen as very risky business, by foreign investors. Which of the two hypotheses, (1) that SEZs were a necessary intermediate step between China being closed to FDI and China being open, or (2) that the era of the SEZs represented an unnecessary and ultimately unproductive side trip on China's path to development, is correct? I would submit that rigorous testing of these two hypotheses is, alas, not possible. We simply do not know what would have happened had the reformist faction in China been bolder and, say, put into place the liberalization of 1991 six years earlier. Would this have led to a surge of FDI and economic growth, or would this have played into the hands of conservative "hardliners" in the leadership who then would have moved successfully to squelch the reform effort? In the end, we just don't know. Whichever the two hypotheses one accepts regarding China's experience, it is quite clear that by 1990 or so the SEZs and other zones had outlived their usefulness. Thus, one analyst from China (LONG, 2001) argues persuasively that restrictions and conditions put on foreign investors at that time were not serving long run developmental interests of China but, rather, were counterproductive. Another analyst (LUO, 2003), looking at the issue from quite a different perspective, arrives at a similar conclusion: he notes that performance of subsidiaries of foreign investors in China has tended, ceteris paribus, to be weaker where regulatory interference has been higher. By both effectively ending the differential treatment accorded to foreign investors operating in the SEZs and SEZ-like zones in 1991 so as to extend equivalent treatment to foreign-invested firms operating anywhere in China and further reducing the regulatory burden under which these firms operated, Deng Xiaopeng thus did create a new environment in China that enabled a faster pace of development. The case for the SEZs ultimately rests on the notion that, even if the need for these changes had become clear by 1991, ten or even five years earlier the benefits of deregulation of FDI were not apparent to the Chinese leadership. The utility of the SEZs, viewed with perspective, was to demonstrate that these benefits indeed did exist.

5. Implications of the Chinese Experience for Russia The main question to which this article seeks an answer is whether the Chinese experience with export processing zones as a vehicle to attract FDI has any relevance for Russia. There are of course some parallels between Russia and China. Both are very large countries that have in recent years rejected or largely rejected the precepts of communist economic thinking.

I. Do Export Processing Zones Attract FDI? 267 But the differences between the two countries are profound and perhaps more pronounced than the similarities. And these differences affect greatly the issue of what lessons Russia might be able to draw from the Chinese experience. The differences begin with physical ones. In particular, China is, relative to its physical size, rather poorly endowed with natural resources but has extremely abundant labor, most of whom live in densely populated regions within a large temperate climatic zone of the country. There are almost equally large regions of China, located mostly to the north and west, where the climate is intemperate and the population density low, but over half of the land of China is densely populated, and this is a very large area. Russia is, by contrast, very richly endowed with natural resources, but most of the nation is subject to harsh climatic conditions and thus most of the land is sparsely populated; and, although there are heavily populated regions of Russia, as a percent of the total land, these are scant when compared with China. An immediate consequence is that, while foreign direct investment to produce labor-intensive export products has flowed readily into China and indeed has served as a foundation of much of the economic growth that has occurred there, it is not clear that Russia has a latent comparative advantage for this type of product. Rather, Russia's comparative advantage is likely to lie elsewhere, in natural resource intensive products (or the export of the resources themselves), and in certain skill or knowledge-intensive activity. Beyond this, there is a huge difference in the way the two countries have over the past two decades or so pursued poUcy reform. China's approach, as is apparent from the earlier sections of this article, has been to introduce reform gradually and incrementally. The resulting rather slow evolution away from totalitarianism has in fact enabled China to remain "communist" in name and to retain the Communist Party as the only political party in the country. Russia, or rather what then was still the Soviet Union, by contrast took the "cold turkey" approach of rejection of communism and dissolution of what had been in effect a highly centralized empire such that the former non-Russian Soviet republics became independent sovereign states. Russia, the core of the old Soviet Union, then then attempted to adopt a capitalist economic system and a democratic political system, with the consequence that both political and economic power were decentralized. Thus, there was a rapid diffusion of power away from Moscow towards the far-flung regional capitals of Russia and from the central government to local governments and non-governmental entities. This transformation was boosted by privatization of state assets; it is well recognized that, during this process, needed to accomplish the transition from communism to capitalism, the process became corrupted. One consequence is that many state assets fell into the control of senior local and regional officials or into the hands of criminal organizations that were heav-

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ily entwined with the government on all levels, i.e., central, regional, and local. By contrast, as already noted, the Chinese experience was for decentralization to proceed very gradually. The SEZs in China represented in many ways test cases for such decentralization; the big job for the SEZs, in the early days at least, was to convince foreign investors that, once inside the SEZs, their operations would be insulated from what then were seen as hostile policies of the central government. This implied that, for the zones to be effective, the central government could not interfere too much in the operation of the zones and that liberalizing measures initiated by local governments would not be rescinded by the central government. An underlying (and as it proved, correct) assumption was that at least certain local governments were more inclined to welcome foreign investors than the central government. Importantly, also, these local governments were relatively free of corruption. The challenge for Russia in establishing effective EPZs (or special economic zones of any sort) is, however, likely to be the reverse of this: to convince foreign investors that, once inside such zones, they would be protected from the caprices of local governments or criminal organizations that might operate in symbiosis with local governments. It is difficult to envisage this protection being achieved without a demonstrably strong role of the central government acting under a commitment that that the zones be enforced as "corruption-free" (or, at minimum, "reduced corruption") areas. Does Chinese experience help in any of this? I would submit that there are some aspects of Chinese experience that, in spite of the point made in the paragraph just above, do offer some practical lessons for Russia. Perhaps the most important is that special zones, if they are to draw foreign investors, must be established in locales already possessed with attributes sufficiently attractive to foreign investors that these investors might be expected to come to those locales were government policy to be conducive to foreign direct investment (which, as we have noted, was not the case in China when the SEZs were first implemented). As already noted, this was in fact done in China; the EPZs were located in coastal areas and indeed mostly in close proximity to port cities that were a priori the areas most attractive to foreign investors. These also were areas where the physical infrastructure was in relatively good shape and where human capital (meaning, mostly, well-educated workers) was abundant. Human capital indeed is a strength of Russia, but it is concentrated in a relatively few locations. These are the places where foreign investors are most likely to locate in Russia. In many cases, however, in order for the latent advantage created by the concentration of human capital to be realized, significant upgrading of infrastructure will be necessary. Moreover,

I. Do Export Processing Zones Attract FDI? 269 the main requirement to be met would be that special economic zones be heavily insulated from crime and corruption. The major reason why foreign investors, according to a number of polls conducted by western business consulting groups, have been reluctant to come to Russia has the level of corruption and crime. The example of Vladivostok comes to mind. This city and the region around it possesses an adequate supply of human capital to support foreign investment and, moreover, the region is located quite near areas of burgeoning economic activity located both in China and South Korea. Moreover, linkages between these areas are already being established, and foreign investors are playing a large role in this. For example, a new special economic zone has been created near Incheon, Korea, where foreign investors are establishing operations to link up with other operations of these same investors located in China, especially in and around the city of Shanghai.^ The region of Vladivostok is located in this same region and thus is favorably situated to link into the economic growth that is taking place only a short distance to the south. Indeed, that Vladivostok is on Russian soil adds some attractive features, e.g., access to the energy and other natural resources of the Russian Far East, that are not necessarily available to foreign investors operating in China and Korea. But for this linkage to happen, Vladivostok would have to be able to offer some things to foreign investors that are not now available. Better infrastructure is one of these. Foreign investors who link operations in Incheon and Shanghai, for example, benefit from huge new airports with state-of-the art air cargo facilities, something that Vladivostok does not have at present time. Even more, foreign investors would need demonstrably effective guarantees that their operations would not be molested by criminal organizations or "shaken down" by local officials seeking side payments as a condition for continuation of permission to operate. To achieve this, a special export zone in or near Vladivostok, with access to upgraded air cargo facilities, might prove to be very effective. Such a zone in Vladivostok or, indeed, anywhere in Russia, to be successful, must not be perceived as threatening to local interests (most especially, local business entrepreneurs) but rather a venture that is of potential benefit to these interests. Does the Chinese experience offer any lessons on how to overcome a potential fear of local interests that special economic zones and the foreign investors that come to these zones might throw local ^ On this, see "US Companies Build Free Economic Zones", in Korea International Trade Organization, New York Office, Bridging the Pacific, issue 29, December, 2003.

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business into bankruptcy? In fact, it does. The main special interests in China that perceived a threat from foreign investment were the very large state-controlled firms. Thus, a key factor in the success of the SEZs was that foreign investors were, as the result of early decisions, encouraged only to the extent that their activities did not directly compete with existing state-owned enterprises (SOEs) in China. The main rationale was to protect the SOEs from what was feared to be potentially ruinous competition from foreign-owned enterprises. But a main consequence was to create new sectors in China that were largely insulated from the way in which business had been run in China and, simultaneously, were not threatening to the existing establishment. Thus, Chinese SOE managers (who most often were also officials in the Communist Party and hence were closely intertwined with local political figures) faced little incentive to subvert or co-opt the operations of foreign-controlled firms, as the latter did not threaten their own activities. Instead, over time, at least some of these managers and officials learned that the foreign-controlled operations could be rather like the mythical goose that laid the golden egg where, in this case, the golden egg took the form of subcontracting and other cooperative relationships with the foreigners. Moreover, these managers and officials for the most part learned that such geese do not respond well to being squeezed for their eggs, or at least not to being squeezed too hard. Thus, the "gold" to the incumbent firms of China resulting from extensive "export platform" foreign investment has not, by and large, come from trying to appropriate the profits of these firms by means legal and extralegal, but by selling to them intermediate products that can be made locally and incorporated into the exported goods. The main function, in the end, of the special zones in China was to create confidence and credibility in the eyes of foreign investors that China was a good place to invest, i.e., that foreign investors could earn adequate returns there at acceptable levels of risk. Indeed, once this credibility and confidence was established, the need for special zones largely disappeared, and the zones were effectively dismantled. Likewise, the biggest need in Russia today with respect to foreign investment is to establish a level of credibility such that foreign investors can be confident about investing there and earning adequate returns on the investment. Russia does not lack the attributes sought by foreign investors; it has, for example, a welleducated population, an adequate infrastructure (albeit that major improvements are needed), and abundant natural resources, and the potential market in Russia for just about any good or service that might be produced there is large. But the element of credibility is lacking and the main role that special zones might play is to build this credibility so that foreigners would develop the confidence to make those investments in Russia that Russia does need.

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References CHEN, E.K.Y., and WONG, T.Y.C. (1997) "Hong Kong: Foreign Direct Investment and Trade Linkages in Manufacturing", in DOBSON, W. and YUE, C.S., editors. Multinationals and East Asian Integration, Ottawa: International Development Research Centre. DAYAL-GULATI, A., and HUSAIN, A. M. (2000) "Centripetal Forces in China's Economic Take-off, IMF Working Paper WP/00/86, available at http://www.imf.org/extemal/pubs/cat/longres.cfm?sk=3582.0. DONGES, J.B., and WIENERS, J. (1994) "Foreign Investment in the Transformation Process in Eastern Europe", The International Trade Journal, 8, 2, pp. 163-192. GRAHAM, E.M., and WADA, E. (2001), "Foreign Direct Investment in China: Effects on Growth and Economic Performance", Washington, DC: Institute for International Economics, Working Paper 01-3; available at http://www.iie. com/publications/wp/2001/01 -3 .pdf. HUANG, Y. (2003) Selling China: Foreign Direct Investment During the Reform Era, Cambridge, UK: The Cambridge University Press. JIA, W. (1994) Chinese Foreign Investment Laws and Policies: Evolution and Transformation, Westport, Connecticut: Quorum Books. LEMOINE, F. (2000) "FDI and Opening up the Chinese Economy", Paris, France, Centre d'Etudes Prospectives et d'Information Internationale, Working Paper 2000-11, 2000, available at: http://www.cepii.fr/anglaisgraph/workpap/pdf/ 2000/wpOO-ll.pdf. LONG, G. (2001) "Negative Impact of Performance Requirements by the Central Government and by Provincial Governments on Foreign Direct Investors", paper presented at the APEC Investment Symposium, Xiamen, Fujian, China, September 9-10. LARDY, N. R. (2002) Integrating China into the Global Economy, Washington, DC: The Brookings Institution. LARDY, N. R. (1998) China's Unfinished Economic Revolution, Washington, DC: The Brookings Institution. LARDY, N. R. (1994) China in the World Economy, Washington, DC: The Institute for International Economics. LUO, Y. (2003) "Market-seeking MNEs in an Emerging Market: How ParentSubsidiary Links Shape Overseas Success", Journal of International Business Studies, 34, pp. 290-309. MADANI, D. (1998) "Export Processing Zones", Washington, DC: The World Bank, PREM Notes Economic Policy, no. 11. RHEE, Y.W., KATTERBACK, K., and WHITE, J. (1990), "Free Trade Zones in Export Strategies", Washington, DC: World Bank, Industry Series Paper 36. ROSEN, D.H. (1999) Behind the Open Door: Foreign Enterprises in the Chinese Marketplace, Washington, DC: Institute for International Economics. United Nations Conference on Trade and Development (UNCTAD) (2003) World Investment Directory: Russian Federation, Geneva: United Nations. United Nations Conference on Trade and Development (UNCTAD) (2002) World Investment Report 2002, Geneva: United Nations.

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WEI, S.J. (1996) "Foreign Direct Investment in China: Sources and Consequences", in Takatoshi Ito and Anne Krueger, editors, Financial Deregulation and Integration in East Asia, Chicago: University of Chicago Press. World Bank (2001) "Export Processing Zones in Sub-Saharan Africa", Washington, DC: The World Bank, Economic and Social Policy Findings 193. World Bank (1993), "Development Brief Number 23: East Asia's Export Push", Washington, DC: The World Bank. ZHANG, Z. and KANG, C. (1997), "China: A Rapidly Emerging LightManufacturing Base in Guangdong Province", in DOBSON, W. and YUE, C.S., editors. Multinationals and East Asian Integration

Comment on: Do Export Processing Zones Attract FDI and its Benefits? Experience from China and Lessons for Russia Thomas Gries The paper by Edward M. Graham analyzes the role of SEZ in China and the contribution of these zones to the Chinese economic miracle. After this analysis, the Chinese experiences are compared with the role and functions of FDI in Russia, and the conditions for potential benefits from SEZ are discussed. The major conclusions drawn for Chinese FDI are: • Overseas Chinese played a major role for FDI to China. • At the beginning when China was just a location for cheap labor intensive assembly processes, FDI in SEZ started with few spill-over effects for regional development. • Moreover, as SEZ were located in regions with relatively good infrastructure and certain human capital, FDI led to clusters of activities and external scale economies. Advantages of agglomerations increased after moving towards more sophisticated goods. • The created incumbency advantages of FDI persisted even after foreign investors were allowed to place their investments outside SEZ. Regional development experienced significant gains from inflowing FDI and a regional export lead development. • After the more general liberalization in the 90s, two hypothesis concerning SEZ have been discussed: (1) SEZ were a necessary intermediate step between China being closed to FDI and China being open, or (2) the era of SEZ represented an unnecessary and ultimately unproductive side trip on China's path to development. • Whichever of the two hypotheses is correct, it is quite clear that by 1990, the SEZ had outlived their usefulness. But, starting with SEZ 15 years before was a consistent logical step considering the political conditions of that period. The Chinese leaders could experience the power of efficient international market oriented activities without losing control over the economy as a whole. The ongoing control of the majority of the economy by the communist party avoided a counterrevolution. "The case for SEZ ultimately rests on the notion that even if the need for these changes had become clear in 1991, ten or even five years earUer the benefits of deregulation of FDI were not apparent to the Chinese leadership."

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The major conclusions concerning the role and functions of FDI to Russia are: • While China clearly had comparative advantages in labor intensive production processes, Russia's comparative advantages are not that clear. • The manner by which reforms were introduced and the implications of the reform strategies are very different. While in China reforms were a means of regional emancipation and a chance for a gradual decentralization to develop local growth potentials, in Russia many state assets fell under the control of senior local and regional officials or into the hands of criminal organizations heavily entwined within the government on all levels. • Even if the de jure legislation was more liberal in Russia, the de facto reliability of the legal system in Russia is still deterring investors. • While local governments were relatively free from corruption in China, the situation in Russia seems different. The challenge for Russia in establishing effective economic zones of any sort is to convince foreign investors that once inside such zones, they would be protected from the caprices of local government and/or criminal organizations. Foreign investors must be convinced that the SEZ is in fact a corruption free zone. These major conclusions, which are carefully developed and discussed, summarize the most important facts and effects of Chinese and Russian FDI. I very much agree on all of these appraisals. Therefore, I would like to focus on three aspects in more detail: First, FDI play a positive role, but they are not the only factor for development. This general empirical view coincides with my own findings based on a theoretical approach on FDI and endogenous catching up.^^ In this semi endogenous model of growth and development, it can be demonstrated that domestic factors determine whether or not a dynamic endogenous process of upgrading and catching up takes place, and the end results on economy can be determined. Domestic factors, in particular domestic human capital, are the dominant determinants of the countries' economic prospects. FDI cannot overcome fundamental domestic deficiencies. FDI and the resulting technology inflows and technological spillover effects can, on the other hand, accelerate the speed of upgrading of the local economy. Once regional centres of rapid development boosted by FDI are identified, we can switch to ideas coming from "The New Regional Economics". As this literature suggests, such areas of rapid growth turn into centers of agglomeration. When domestic conditions are sufficient, SEZ and inflowing FDI define zones of accelerated growth and development and finally regional agglomerations. Therefore, SEZ may define the re10 See Gries (2002).

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gions of agglomeration and rapid development and thereby the future regional structure of a country rather than being the dominant determinant for the overall success of a growth and development process. Second, a stepwise opening for international capital inflows was a reasonable strategy for China. Considering the political conditions in China, the cautious and gradual opening-up policy was a reasonable strategy to modernize the Chinese economy. The following figure shows that not only the volume of FDI activities increased tremendously over time, but the kind of FDI cooperation changed significantly as well. While joint ventures dominated at the beginning, in the later years ownership became more important. In order to control the situation, the Chinese government acted very deliberately even with respect to the type of cooperation. The visible success of each step, the strategy of limiting reforms to SEZ and the slow and controlled changes prevented a thread of counterrevolution. Moreover, concentrating FDI to SEZ and thereby boosting regional agglomerations may have proven more successful at creating an open-door policy than some country-wide spread of FDI without agglomerating effects. The acceptance of opening up and market orientation within the communist party may have thereby increased. Third, SEZ eased the problem of de jure and de facto legislation. Even in terms of the problem of rent seeking and corruption, the gradual introduction of SEZ may have had positive effects on local administration: 1. The "limited capitalist experiment" led to a very close look of the top political leaders on everything that happened in these few zones. Local administration was under very strict peer control by the central authorities. Because the zones and what happened were under special control and observation, local authorities did not dare exploit foreign investors; corruption was restricted. 2. There was competition among the different zones for attracting FDI. This competition helped not only to get rid of corruption, but also made it easier for foreign investors to solve problems with local governments. The introduction of capitalist structures in Russia led almost overnight to an archaic idea of capitalism. Namely, "the central idea of capitalism is making profits and the invisible hand will do the rest at leading the economy to wealth and prosperity". In this archaic-style capitalism, the individual strategy is to maximize rents in whatever "market or bargaining position". Therefore not only owners of regular goods maximized profits, but the monopolists of public administrative goods, services and information did so as well. As these activities were regarded as part of the game, this behavior could not be brought under control easily. Additionally, not only domestic individuals and firms were affected by rent-seeking behavior, foreign investors also had to cope with this problem. Therefore, even if the de jure legislation is quite liberal today in Russia, the de facto reliability of

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legislation does not seem to be continuously reliable. Today rent seeking behavior in the administration is a number one obstacle for FDI in Russia. Therefore, SEZ in Russia will only make sense if the problem of corruption is dealt with.

References Gries, T. (2002),Catching-up, Falling-behind, and the Role of FDI - a Model of Endogenous Growth and Development, South African Journal of Economics, Vol. 70:4, 2002.

J. The Baltic Sea Regional Integration and International Trade: A Gravity Model Approach Tiiu Paas 1. Introduction

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

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3. Specifications of Gravity Equations for Exploring Regional Integration in Trade

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3.1. Gravity Equation and Data 281 3.2. Exploring Deviations from the Traditional Gravitational Forces Explaining Bilateral Trade Flows of the Countries 282 4. Modeling International Trade Flows in the Context of EU Eastward Enlargement 285 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 andCC12 5. Trade Integration in the Baltic Sea Region (BSR)

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5.1. Modeling Bilateral Trade Flows of the BSR Countries

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5.2. The BSR Role in the Baltic States' Trade Relations

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6. Conclusions

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Appendix

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References

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

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1. Introduction The main feature characterizing recent European integration processes is integration of national economies with different historical backgrounds and structures in the context of EU eastward enlargement. The eastward enlargement of the EU poses a major challenge for both the so-called old member countries (EU15) and the candidate countries (CC12) in order to adjust with all economic, social and political changes. The most expedient economic factor in pushing economies into integration is international trade. International trade flows are often considered to be indicators of links between the economic centres of the region, thus representing links between economic and spatial concepts. Previous studies have shown that the gravity equation is the most successful model for explaining regional trade patterns, which incorporates theoretical and empirical advantages related to it (see Baldwin 1994; Sen and Smith, 1995, Eichengreen and Irvin, 1998; Feenstra, 1998; Estevadeordal, et al 2002a and b). This paper aims at exploring international trade flows of the countries that are involved in the EU eastward enlargement process using a gravity model-based approach. The regional integration effects are handled as the deviations from the volume of trade predicted by the baseline gravity model, which expresses the impact of traditional gravitational forces like the size of economy, level of economic development and distance. Attention is given to analysing differences in behaviour of bilateral trade flows of two groups of countries, the EU15 and CC12. The EU eastward enlargement candidate countries (CC12) are forming two groups: 1) the Luxembourg group of candidate countries (formed in 1997): Poland, the Czech Republic, Hungary, Estonia, Slovenia, Cyprus, and 2) the Helsinki group of candidate countries (formed in 1999): Latvia, Lithuania, Bulgaria, Romania, Slovakia and Malta. The first round of eastward enlargement in 2004 involves ten candidate countries out of twelve. Bulgaria and Romania will have a chance to join during the next round of enlargement. This paper is divided into four main parts. Section 2 views theoretical foundations of using gravity equations for exploring international trade flows. In section 3, the main specifications of the gravity equations are presented. Section 4 explains the main empirical results obtained by using the gravity approach for exploring bilateral trade flows of the two groups of countries, the EU15 and CC12. Attention is paid to defining possible regional clusters that influence bilateral trade relations of the countries. In section 5, bilateral trade flows within the Baltic Sea region (BSR) countries are analyzed, emphasizing the BSR role in the Baltic States' trade integration. The empirical part of the paper draws mainly on IMF trade statistics and data of the World Bank and the Baltic States' statistical offices.

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2. Theoretical Foundations for Using Gravity IVIodels in Studying International Trade Flows From a methodological point of view, gravity theory can be considered a relational theory which describes the degree of spatial interaction between two or more points in a manner analogous to physical phenomena. As early as the middle of the nineteenth century, H.C. Carey (Principles of Social Science, 1858-1859) observed the presence of gravitational force in social phenomena, stating that the force was in direct ratio to mass and inverse to distance (Isard, 1960 pp. 498-500). Gravity theory has primarily been centered in those fields in which distance plays a significant role. Gravity theory has proven to be useful in describing social phenomena in space such as population migration, flow of goods, money, and information, traffic movement and tourist travel. The gravity model is a mathematical model based on analogy with Newton's gravitational law which has been used to account for aggregate human behaviour related to spatial interaction. Newton's law states that the attraction force between two bodies is directly related to their size and inversely related to the distance between them. Thus, interaction (/„) between entities / and 7 is a function of repulsive forces (/?.) at / and attractive forces (A) at 7, and an inverse function of distance (or friction) (D.) between / and ^ ^f(R,,A.)

(1)

In the gravity equation used for exploring international trade flows, the interaction volume (/) is represented by the trade flows from the country / to the country 7. R. is a parameter representing factors which are associated with "leaving" /, for instance, the population numbers and/or the GDP of the exporting country /. A. is a parameter representing attractive factors related to the importing country / In the case of bilateral trade relations the export of the country / equals the import of the country 7. D is the distance between the trading countries / and 7. The gravity model of international trade was developed independently by Jan Tinbergen (1962) and Pentti Poyhonen (1963). In this basic form of the gravity model, the amount of trade between two countries is assumed to be increasing in their sizes, as measured by their national incomes, and decreasing in the cost of transport between them, as measured the distance between their economic centres. Following this work, Hans Linnemann (1966) included population as an additional measure of the country's size. This model is sometimes called "the augmented gravity model" (Cheng and Wall, 2002). It is also common to specify the augmented gravity

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model using per capita income (or per capita GDP). Population expresses the size of a country as well as the size of its economy. Per capita income expresses the level of economic development. Thus, the size of the economy and the level of economic development are the main attractive forces or pull factors of bilateral trade flows. The main push factor is the distance between the trading partner's countries. These pull and push factors are the traditional gravitational forces that influence bilateral trade flows. The theoretical considerations for using gravity models to explore international trade flows have been widely discussed and developed (Anderson, 1979; Bergstrand, 1985, 1989 and 1990; Deadorff, 1984, 1995 and 1998; Evenett and Keller, 1998 and 2002; Anderson and Wincoop, 2001; Harrigan, 2001; Hanson and Xiang, 2002). The use of gravity equations is widespread despite the fact that they have, until recently, tended to lack strong theoretical bases. Thanks to various modelling refinements and their application to debates about theoretical foundation of the gravity equation, this model has established itself as a serious empirical tool for exploring regional trade patterns. It is noteworthy to mention that the gravity equations built for exploring international trade flows fit the data remarkably well. Evenett and Keller (2002), among with Deardorff (1998), evaluate the usefulness of gravity models also in testing alternative theoretical models of trade. The gravity model has been widely used as a model for estimating the impact of a variety of policy issues, including regional trading groups, currency unions, political blocks, various trade distortions and agreements, border region activities and historical linkages. Owing to comparative advantages, habits, tastes, infrastructure and technology, regions with common border and/or similar historical background may be natural trade partners. Borders often tend to be formed around areas and populations that are relatively homogenous, and in which the regional economies are linked. The associated regions may create common rules to protect themselves from external shocks. Growing empirical literature finds that historical linkages are important determinants of international trade flows (Frankel, Stein and Wei, 1995; Frankel, 1997; Eichengreen and Inrwin, 1998). Lagged bilateral trade flows are significant in determining current trade in a large cross-section of countries, after controlling for traditional gravitational forces. This means that past trade linkages adjust slowly to new conditions. The current EU members have already created a well-integrated market among themselves, and they are maintaining stronger trade links with each other than with the countries that will join later. This fact must also be taken into consideration when analysing the EU eastward enlargement processes. In conclusion, based on continuing discussions and some uncertainty about the foundations of the gravity model, one can summarize that the

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theoretical considerations of the gravity models are based on 1) microeconomic foundations, 2) regional science and new economic geography and 3) trade theories. These theoretical foundations are acceptable when exploring the current intemational trade pattern of the countries that are involved in the EU eastward enlargement, which has been formed as a consequence of the recent decade of transition and European integration processes. Gravity model based estimation provides a useful framework for assessing the impact of regionalism on the level and direction of trade.

3. Specifications of Gravity Equations for Exploring Regional Integration in Trade 3.1. Gravity Equation and Data The basic gravity equation estimated in the paper consists of the main pull and push factors (gravitational forces) influencing bilateral trade flows: lnY.=B^+Bjln(POP).+B;n(POP)j+B;n(GDPpc).+BJGDPPpc). '+B;n(DISTANCE)..+u.

(2)

where • Y.. - export from country / to country j (or import from country j to country /); • (POP), and (POP) - populations of the exporting (/) and importing (j) countries, respectively (or home (/) and host (j) countries); • (GDPpc). and (GDPpc). - gross domestic product per capita of the exporting (/) and importing (j) countries, respectively; • (DISTANCE).- the distance in kilometres between the countries / andy (the flight distance between the capitals of the countries); • w„ - error term. The main pull factors for developing bilateral trade flows are the size of economy and the level of economic development of the trading partners. The size of economy is expressed by the population numbers and the level of economic development by the GDP per capita. The main push factor is the distance between the trading countries, which expresses not only transportation costs but also other possible conditions that may influence their bilateral trade relations (cultural traditions, common or similar language, etc). Several authors have discussed how to use the GDP data for estimating gravity equations and whether one should use GDP(PPP) (PPP - Purchasing Parity Power) or GDP(MER) (MER - Market Exchange Rate) (see also Gros and Consiarz, 1996; Baldwin 1994 and 1997; Comett and

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Iversen 1998; Iversen, 1998). Gros and Consiarz do not recommend one use PPP-converted GDP for estimating gravity equations. Instead, estimates of a country's trade potential should be made on the basis of the international value of goods and services it produces, not how well off its inhabitants are (Gros and Consiarz, 1996, pp. 715). Iversen argues that the proper measure of the transition economies' incomes (GDP(MER) or GDP(PPP)) lies somewhere between the two approaches, and it is impossible to settle this matter on a purely theoretical basis (Iversen, 1998, p. 273). ). Previous results of modelling bilateral trade flows between the countries of the Baltic Sea Region using the data of the year 1998 show that the statistical estimators are best in the equations with GDP(PPP) (Paas, 2001 and 2002). For estimating gravity equations of the countries involved in the EU eastward enlargement process (EU15 and CC12), the following data sources are used: 1) Export and import data of the IMF on EU15 and CC12 (IMF, Direction of Trade Statistics Yearbook 2001; Foreign Trade. Estonia, Latvia, Lithuania, Central Statistical Bureau of Latvia, 2001); 2) Population and GDP (PPP) data of the World Bank (http://www.worldbank. org/data/databytopic/GDP.html); 3) A matrix of distances between the capitals of the countries (www.indo.com/distance).

3.2. Exploring Deviations from the Traditional Gravitational Forces Explaining Bilateral Trade Flows of the Countries In addition to the traditional gravitational forces influencing bilateral trade flows, there are also some factors that create resistance to trade and affect the degree of trade intensity, for instance, various regional agreements and institutions that support trade relations. Also the historical background of the trading partners leaves, through their historical ties, an imprint on their current trade relations. In the gravity models, all these considerations and policies are modeled as deviations from the traditional gravitational forces, and, in the case of regional integration, they are captured by regional dummy variables. The gravity equation with dummies: lnY.=B^+Bjln(POP).+B;n(POP).+B;n(GDPpc).+B/GDPpc). + BJin(DISTANCE).r¥ DUMMIES+u..

(3)

Analyzing the bilateral trade flows between the countries that are involved in the EU eastward enlargement (EU15 and CC12) and in order to test the evidence of possible regional clusters and/or other conditions influencing bilateral trade relations, the following dummies are used in the gravity equation (table Jl).

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The aim of including the border dummy into the gravity equation is to test the hypothesis that borders significantly influence trade flows within the countries involved in the EU eastward enlargement. The reasons behind the border effect often remain unknown. Researchers have not been able to determine whether the border effect is the result of trade agreements or barriers, past linkages, or perhaps natural as the result of comparative advantage or tastes. The European integration process provides an interesting opportunity to examine this evidence. The emphasis is first of all laid on studying integration of the border countries with different historical and political background and past economic linkages. These differences are explained by separation of some border countries into two world economic and political systems after the Second World War and the Iron Curtain. The East-West dummy enables us to examine whether the countries with different levels of economic development and that are involved in the EU eastward enlargement are actively using the new challenges for expanding their markets and for establishing new business contacts. The West-West dummy enables us to test the hypothesis that the past trade linkages between the EU15 countries are still significant in determining current trade relations after some years of intensive transition processes in the CEE and Baltic countries. The CEFTA dummy is used in order to study the effect of the Central European Free Trade Area on the EU eastward enlargement. Are the CEFTA countries estabUshing a special cluster within EU15+CC12? How are East-East trade relations adjusting to the EU enlargement? According to Katarzyna Zukrowska (2001, p. 227-237), CEFTA is a unique form of regional trade liberalization among the post-socialist states. CEFTA is proved to be a route to the EU for the countries that have joined European integration processes later and are delayed in their transformation. Based on this, it is possible to suppose that CEFTA has played the most significant role in the internal reintegration processes.

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Table Jl. Dummies of the Gravity Equation (3) Dummy

Explanation

Border dummy

Designating that trading partners have a common border (land border). Designating that trade flows occur between current EU members (Western partner) and candidate (Eastern partner) countries. Designating trade flows between EU-15 countries. Designating that trading partners are the CEFTA countries (the Czech Republic, Bulgaria, Hungary, Romania, Slovakia and Slovenia). This dummy mainly expresses East-East trade relations within the countries involved in EU eastward enlargement. Designating that trading partners are the Baltic Sea region countries that are involved in EU eastward enlargement (Denmark, Finland, Germany, Sweden, Poland, Estonia, Latvia and Lithuania).

East-West dummy

West-West dummy CEFTA dummy

BSR dummy

The BSR dummy is used in order to test the hypothesis that the countries around the Baltic Sea are forming a special regional cluster that supports their economic integration. The countries around the Baltic Sea have some cultural similarities and historical linkages. At the same time, due to their different political and economical background, this region is nonhomogenous, consisting of countries with different levels of economic development. The Second World War and the Iron Curtain separated the two world systems and broke the traditional economic and political relations between the Baltic Sea region countries, which had already been established during the Middle Ages (Hanseatic League). Economic co-operation between the Baltic Sea region countries was practically stopped until the end of the 1980s. Political changes that have taken place during the recent decade have significantly influenced the economic cooperation of the countries around the Baltic Sea. The integration of the Baltic Sea region countries into the EU has more than twenty-five years of history starting from January 1, 1973 when Denmark became a member of the EU. The collapse of the Berlin Wall and German unification moved the EU border to the east, and Germany became the biggest Baltic Sea region country. After several years of negotiations and preparations, Sweden and Finland joined the EU in January 1, 1995. This marked the next stage of EU enlargement (the northern enlargement). Since 1997 when Estonia was nominated as EU candidate

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country, the Baltic Sea region countries have been involved in the next stage of EU enlargement, eastward enlargement. In conclusion, using various dummies, we try to test the role of regionalism in the EU eastward enlargement, paying specific attention to studying possible regional clusters of countries that influence integration processes in international trade.

4. Modeling International Trade Flows in the Context of EU Eastward Enlargement 4.1. The Specifications of the Gravity Equations The experiences of previous studies, which have shown that the gravity model is a successful model for explaining regional trade patterns, encourage us to use this model for studying trade integration in the context of the EU eastward enlargement. The following prepositions lie at the centre of this study: 1) The bilateral trade flows between the countries that are involved in the EU eastward enlargement adhere to traditional gravitational rules. The baseline gravity model expresses the impact of traditional gravitational forces like the size of economy, level of economic development and distance on the international trade flows. 2) It is possible to capture deviations from the trade flows explained by the baseline gravity models using dummy variables. There is evidence of regionalism in the eastward enlargement processes, which will be explained by including regional dummies into the gravity equation. 3) There are statistically significant behavioural differences between the bilateral trade flows of the EU15 and CC12. In order to test these propositions, four specifications of the gravity equations are estimated using data of EU15 and CC12 of the year 2000 (table J2). All estimators are the White heteroskedasticity-consistent covariance estimators. Estimation results are presented in Appendix 1, and the explanation of variables included in the specifications of the gravity equations are presented in the appendix 2.

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Table J2. The Gravity Models for Exploring Trade Flows of EU15 and CC12 Model

Explanation

Model 1. Basic gravity equation, EU15+CC12.

The gravity equation includes basic variables that characterize the size of economy and level of economic development as pull factors and distance between the trading partners as a push factor which influences bilateral trade flows (equation (2))

Model 2. Gravity equation with dummies, EU15+CC12.

The gravity equation includes basic variables and dummies that characterize the possible influence of regionalism on bilateral trade flows (BSR, Border, West-West trade relations, EastWest and CEFTA dummies) (equation (3).

Model 3. EU-15

The gravity equation (3) estimated for EU-15.

ModeU. CC-12.

The gravity equation (3) estimated for CC-12.

4.2. The Estimation Results of the l\/lodel 1 and IVIodel 2 The estimation results of the basic gravity equation (2) without dummies allow us to conclude that the behaviour of bilateral trade flows in the countries involved in the EU enlargement (EU15 H-CC12) is in accordance with the basic gravitational rules. In order to test whether the increase in /?^ owing to the inclusion of dummies in the gravity model, is statistically significant or not, the F-test is used. Testing this by means of the F-test is exactly the same as testing whether the coefficients for the dummies are equal to zero or not. The estimated equation (2) (Model 1) is treated as a restricted equation and the estimated equation (3) (Model 2) as an unrestricted equation. According to the test results, the estimated equation (3) is statistically better than the equation (2), which was estimated without dummies (Appendix 1). Hence, including dummies that explore possible effects of regionalism on international trade flows into the gravity equation improves the explanatory power of the gravity model to a statistically significant degree. The coefficient of the border dummy in Model 2 is statistically significant, and it indicates that bilateral trade flows between the border countries are 1.6 times larger (exp (0.458)) than trade flows between other countries {ceteris paribus). The statistically significant coefficient of the East-West dummy is negative at a 0.05 level of significance, which suggests that

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East-West trade flows are on average only about 0.8 times as large as other trade flows are under the ceteris paribus conditions (exp(-0.213)). Thus, the preposition that both groups of countries, EU15 and CC12, which are involved in the EU eastward enlargement are already actively using all new challenges for expanding their markets, was not accepted. The coefficient of the West-West dummy indicates that bilateral trade flows between the current EU members countries are on average 1.4 times larger (exp(0.337)) than trade flows between other countries {ceteris paribus) involved in the EU enlargement. Thus, the past trade linkages between the EU15 countries are still significant in determining current trade relations after some years of the intensive transition and integration processes. The coefficient of the CEFTA dummy is statistically insignificant. We cannot prove the statement that CEFTA is having a remarkable effect on international trade flows in the context of EU eastward enlargement. This has primarily had an effect on the internal reintegration processes of the CEFTA countries. The statistically significant coefficient of the Baltic Sea region dummy is 0.862. This suggests that the Baltic Sea Region countries' bilateral trade flows are on average 2.4 times larger than trade flows outside the region after controlling for the size of economy, the level of economic development, distance and other dummies. In conclusion, the BSR bias is the largest. The Baltic Sea region as a non-homogenous region expresses the positive impact of synergetic effects on integration processes of countries with different economic levels and political background. The BSR supports the adjustment processes with EU eastward enlargement of both the EU15 and CC12.

4.3. Behavior Differences between the Trade Flows of EU15 andCC12 The sample of data characterizing bilateral trade flows of the countries that are involved in the EU eastward enlargement processes comprises the datasets of two groups of countries, EU15 and CC12. In order to test the assumption that the trade flows of the two groups of countries behave in a similar fashion, Chow test statistics were used. This allowed us to compare the regression coefficients' stability of the estimated gravity equations (3). For comparing the regression coefficients' stability, three gravity equations are estimated: a) EU15+CC12 (Model 2,), b) EU15 (Model 3,), and c) CC12(Model4). The estimation results allow us to conclude that the assumption about the occurrence of behavioural differences between the bilateral trade flows

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of EU15 and CC12 can be accepted. Thus, we reject the hypothesis about the stabiUty of the estimated gravity equations' parameters. The elasticity of bilateral trade flows with respect to per capita GDP is higher than the elasticity with respect to the size of population of exporting and importing countries in both the EU15 and CC12. But there are differences between the EU 15 and CC12 in elasticity coefficients with respect to exporting and importing countries per capita GDP as an indicator of economic development level. The exporting countries' per capita GDP has the most significant positive impact on bilateral trade flows of EU15. We can see that with a 1% increase in the exporting country per capita GDP, the bilateral trade flows on average increase by about 1.6% on the ceteris paribus conditions (Appendix 1). In the case of importing countries the respective coefficient of elasticity is only about 0.3%. In the case of the candidate countries, these differences between the coefficients of elasticity with respect to exporting and importing countries per capita GDP are smaller: the respective elasticises are 1.4% and 0.7%. The size of the population of trading partner countries has almost the same impact on bilateral trade flows in the case of both exporting and importing EU15 countries (the respective coefficients of elasticity are 0.97% and 0.91%). The elasticity coefficients of CC12 trade flows regarding exporting and importing countries' size are different: 0.72% and 0.53%, respectively. The candidate countries are more sensitive to the size of exporting than of importing countries' economy. Comparing the modelling results presented (see appendix 1), it is possible to summarize that the negative impact of distance on bilateral trade flows is more significant in the case of the candidate than the EU current member countries, the respective elasticises are -1.5% and -0.9%. During the transition processes, the candidate countries have primarily developed trade relations with nearby countries, also using possibilities of crossborder cooperation and regional integration with the countries that have cultural similarities. The EU15 countries have statistically significant BSR and border countries' biases (respectively about 1.8 and 1.5; •=0.05). In the case of CC12 countries the BSR and border dummies are statistically significant only at the level of significance of 0.1. Thus, the evidence of cross-border trade relations and Baltic Sea regional cooperation is stronger in the current EU members than for candidate countries.

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5. Trade Integration in tlie Baltic Sea Region (BSR) 5.1. IVIodeling Bilateral Trade Flows of the BSR Countries The gravity equations estimated in the previous section of the paper allowed us to conclude that there is a regional cluster of the BSR countries that supports development of bilateral trade flows between the countries that are involved in the EU eastward enlargement processes. In this part of the paper we will test whether 1) the behaviour of bilateral trade flows within the BSR adheres to normal gravitational rules like the bilateral trade flows of EU15 and CC12; 2) there are past trade linkages between the industrialized countries of the region in determining current trade relations after some years of intensive transition processes in the Baltic States, Poland and Russia (tested by the Models 5 and 6); 3) there are past linkages between the transitional countries (Estonia, Latvia, Lithuania, Poland and Russia) of the region after some years of intensive European integration within the EU enlargement preparation processes (tested by the Model 5); 4) the BSR countries with different level of economic development and political background (industrialized and transitional countries of the region) are actively using new challenges for expanding their markets and for establishing new business contacts (tested by the Model 6). Table J3 presents the specifications of the BSR gravity equations (Models 5 and 6). These models are estimated using data of ten BSR countries (including also Norway and Russia) in the year 2000 (see Appendix 1). Table J3. The Gravity Models for Exploring Trade Flows between the BSR Counties Model

Explanation

Model 5. East-East trade relations.

The gravity equation (3) includes the East-East (BSR) and West-West (BSR) dummies.

Model 6. East-West trade relations.

The gravity equation (3) includes the East-West (BSR) and West-West (BSR) dummies.

There is no sense in including both pull factors (the exporting and importing countries' size of population and per capita GDP) in the BSR gravity equation due to evidence of strong multicoUinearity in the regression model. There is a statistically high positive correlation between the per capita GDP and dummies designating affiliation of the countries to the groups of developed and transitional countries. Thus, we only include the size of population of the exporting and importing countries in the gravity

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equation, which is the most significant pull factor of bilateral trade flows. The push factor is the distance between the capitals of the BSR countries. The estimation results correspond to the statement that the BSR trade flows behave in accordance with the rules of gravitation having the size of economy as the main pull factor. The elasticity is the highest with respect to distance, with the respective coefficient of elasticity being -1.3%. The impact of distance is as expected negative. The BSR countries are developing cross-border cooperation and having bilateral trade relations mostly with the nearby countries. The statistically significant coefficient of the East-West dummy (Model 6) is positive contrary to the respective coefficients in the Model 2 (EU15+CC12) (appendix 1). That enables us to conclude that BSR countries with different levels of economic development are more actively using the new challenges for expanding their markets and for establishing new business contacts than the countries involved in the EU eastward enlargement outside the BSR. The coefficient of West-West dummy is also statistically significant and positive. Thus, the past trade linkages between the developed BSR countries are significant in determining current trade relations after some years of the intensive transition and integration processes. Estimating the BSR gravity equation with the East-East dummy instead of the East-West dummy (Model 5), we proved the statement that the trade relationship between the transitional countries of the region are weakly developed compared with West-West and East-West trade relations. This empirical result is in contrast to the proposition about positive impact of lagged trade relations on the current trade flows of the BSR transitional countries. In conclusion, the past trade linkages have a significant positive impact on the current bilateral trade flows of the BSR countries only within the countries with high levels of economic development. The role of the EastWest trade relations is more remarkable within the BSR than within the EU15+CC12.

5.2. The BSR Role in the Baltic States' Trade Relations The three Baltic States - Estonia, Latvia and Lithuania - shared a rather similar history during Soviet occupation. Accordingly, following the 1991 breakup of the Soviet Union, each country faced similar initial conditions prior to embarking on their respective transitional paths toward building market economies. The Baltic countries, as small countries, were more affected by the collapse of trade than other economies in transition. In spite of being relatively reformist within the FSU, the Baltic States inherited

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more distorted economies than for instance Poland and Hungary, which already had applied some market elements during the previous decade. Almost the only sphere in which the Baltic States had more favorable initial conditions than the CEE countries was in regard to foreign debt, since Russia took over all of the foreign assets and liabilities of the FSU. Compared with many other former Soviet republics, the transition processes of the Baltic States were characterized by success. They implemented a comparatively liberal foreign trade regime. The Estonian foreign trade policy has been the most liberal. Estonia introduced a foreign trade system without tariffs and quantitative restrictions. Lithuania introduced a relatively extensive system of trade barriers. Latvia has been somewhere in between Estonia and Lithuania. The agreements between the Baltic States and the EU came into force on January 1, 1995. These agreements are in accordance with the WTO and the General Agreement on Tariffs and Trade (GATT) and regulate the free movement of goods, services, capital and labor. Similar agreements have been entered into between the Baltic States and the European Free Trade Association, which came into force at the beginning of 1998. The Free Trade Agreement for agricultural goods between the Baltic States was enacted on January 1, 1997. BSR trade integration is most remarkable for the three Baltic States among the countries around the Baltic Sea (table J4). Table J4. The Baltic States' Exports and Imports by Groups of Countries in 2000 (Share in %) The group of countries BSR EU CIS EFTA

Estonia

Export 74.8 68.5 9.6 3,2

Import 64.4 56.1 17.8 2.0

Lithuania

Latvia

Export 54.9 50.9 21.9 2.6

Import 65.0 38.0 39.1 1.6

Export 55.9 47.9 16.3 2.5

Import 60.2 43.3 31.7 1.8

Source: Foreign Trade 2000, Estonia, Latvia, Lithuania, Statistical bulletin, Central statistical Bureau of Latvia, Riga, 2001 The main trading partners for the Baltic States are capital-abundant countries around the Baltic Sea region, such as Germany, Sweden, and Finland (figure Jl).

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Dim port 2000 HExport 2000

/ , y y .<*•' x..-^*

.e>^^

<"'^ rJ^^

^""^
^'

'^^

./\j\/'y '^'^

^"

Fig. Jl. The BSR Share in Export and Import of the Countries around the Baltic Sea in 2000 (%) Due to the remarkable amount of foreign direct investment coming from the capital-abundant BSR countries to the Baltic States and due to close trade relations within the countries of the region, the Baltic States succeeded in restructuring their economies and in reorienting their FSU- and CIS-based trade relations to those with the EU comparatively quickly. In conclusion, it is difficult to overestimate the role of the BSR in the reintegration processes of the Baltic States into Europe. Hopefully, the Baltic States as the only former Soviet republics among the EU accession countries provide an interesting case for generalizing transition, EU eastward enlargement and regional integration processes and for developing a new field of economics, the economics of transition and integration. In real terms, the influence of the Baltic economies on the EU eastward enlargement cannot be significant, as the Baltic markets are very small in comparison with the markets of the current EU member states as well as the other candidate countries. The population of the Baltic States is only about 2 % of that of EU15 and about 7 % of the CC.

6. Conclusions Despite the continuing discussions about the foundations of the gravity equation, we can summarize that the theoretical considerations which are mostly based on microeconomic foundations, trade theories and new economic geography are also applicable when analysing possible consequences of regional integration in the context of EU eastward enlargement. The regional integration effects as the deviations from the volume of trade

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predicted by the baseline gravity model, which expresses the impact of traditional gravitational forces like size of economy, level of economic development and distance, are captured by regional dummy variables. The behaviour of bilateral trade flows between the countries involved in EU eastward enlargement (EU15 and CC12) as well as the EU current member countries (the West-West trade relations) and the candidate countries (the East-East trade relations) is in accordance with the rules of gravitation, having statistically significant spatial biases. The East-East trade relations are less developed than the West-West relations (the determination coefficients of the Models 4 and 3 are 0.730 and 0.875, respectively). The regional integration effects are captured by the following statistically significant dummies (at the 5% level of significance) 1) the Baltic Sea region dummy (the BSR bias is 2.4); 2) the border countries' dummy (the border bias is 1.6); 3) the West-West trade relations dummy (the West-West bias is 1.4), and 4) the East-West trade relations dummy (the East-West bias is 0.8). Thus, the Baltic Sea region bias is the largest. In the context of EU eastward enlargement, past trade linkages play a more significant role in the case of the EU15 than CC12. Past trade linkages of the current EU15 adjust comparatively slowly to the new conditions. That also partly explains why the East-West trade flows are on average only about 0.8 times as large as other trade flows under the ceteris paribus conditions (Model 2). The CC12 countries are more actively looking for new challenges as opposed to the EU15 countries. The effect of CEFTA on EU eastward enlargement is mostly expressed through the support of the candidate countries internal reintegration processes, not through the support of East-East trade relations. Analyzing the stability of regression coefficients of the gravity equations estimated separately for EU15 and CC12, we can conclude that there are statistically significant behavioural differences between the bilateral trade flows of these two groups of countries. These differences could be summarized as follows: 1. The negative impact of distance on bilateral trade flows is more significant in the case of the candidate than the EU15 countries, the respective elasticises are -1.5% and -0.9%. Thus, the candidate countries are primarily developing trade relations with the nearby countries using possibilities of cross-border cooperation and regional integration with the countries that have cultural similarities. 2. The current EU15 countries' bilateral trade flows have the highest elasticity with the respect to the exporting country's per capita GDP, also having significant differences between the elasticises with respect to exporting and importing countries' per capita GDPs (1.6% and 0.3%, respectively). In the case of theCC12, the differences between the coeffi-

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cients of elasticity with respect to exporting and importing countries per capita GDP are remarkably smaller (1.4% and 0.7%). 3. The size of the population of trading partner countries has almost the same impact on bilateral trade flows in the case of both exporting and importing EU15 countries, the respective coefficients of elasticity being 0.97% and 0.91%. The CC12 trade relations are more sensitive to the size of exporting than to the size of importing countries' economy (the respective elasticities being 0.72% and 0.53%). 4. Evidence of cross-border trade relations and Baltic Sea regional cooperation is stronger in the current EU15 members than in the transitional countries. The share of the BSR countries' export and import flows in the trade flows of the EU15 and CC12 varies depending on their population size, location, level of infrastructure and other factors. The BSR role in developing bilateral trade relations in the context of EU eastward enlargement is as a rule more remarkable in the case of small than large EU member states and candidate countries. The estimation results correspond to the statement that the BSR trade flows behave in accordance with the rules of gravitation having the size of economy as the main traditional pull factor. Elasticity is the highest with respect to distance, the respective coefficient of elasticity is -1.3%. The BSR countries are developing cross-border cooperation and having bilateral trade relations first of all with the nearby countries. The BSR developed and transitional countries are more actively using the new challenges for expanding their markets and for establishing new business contacts than the countries involved in the EU eastward enlargement outside the region. This fact is confirmed by the statistically significant positive coefficient of the East-West dummy in the BSR gravity equations (Model6) contrary to the respective coefficients in the Model 2 (EU15+CC12). The countries around the Baltic Sea benefit from the integration due to the synergetic effect of non-homogenous entities - the countries on different economic levels and with different historical ties. The BSR supports the adjustment processes with the EU eastward enlargement of both the EU15 and CC12. The integration within the BSR has played a significant role in supporting the adjustment processes of the transitional countries of the region and in making the economies of these countries competitive to follow the requirements of EU enlargement processes. The integration processes within the BSR have been of particular importance for the Baltic States.

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Appendix Table J5. The Specifications and Estimators of the Gravity Equations Based on Data of the Countries Involved into EU Eastward Enlargement (Data of 2000) Model 1 EU15+ CC12

Model 2 EU15+ CC12

Model 3 EU15

Model 4 CC12

Model 5 BSR(EastEast)

Model 6 BSR(EastWest)

Constant

-28.749 (0.000)

-27.389 (0.000)

-22.824 (0.000)

7368 (0.000)

8.411 (0.000)

Ln(GDPpc)i (P) Ln (GDPpc)^ (P) Ln(POP)i (P) Ln(POP). (P) Ln (DIST) (P) Border (p) East-West (P) West-West (P) CEFTA (P) BSR (P) WestWest(BSR) (P) East-East (BSR) (p) EastWest(BSR) (P) N R^

1.625 (0.000)

1.477 (0.000)

1.633 (0.000)

-11.515 (0.000) 1.424 (0.000)

-

-

1.006 (0.000)

0.942 (0.000)

0.662 (0.014)

-

-

0.963 (0.000) 0.932 (0.000) -1.199 (0.000)

0.945 (0.000) 0.913 (0.000)

0.316 (0.000) 0.972 (0.000) 0.909 (0.000) -0.925 (0.000)

0.702 (0.000) 0.546 (0.000) -1.318 (0.000)

0.702 (0.000) 0.546 (0.000)

-0.955 (0.000)

0.723 (0.000) 0.529 (0.000) -1.512 (0.000)

-1.318 (0.000)

-

0.457 (0.002)

0.387 (0.019)

0.689 (0.068)

-

-

-

-0213 (0.042)

-

-

-

-

-

0.337 (0.022)

-

-

-

-

-

-0.111 (0.524) 0.862 (0.000)

-

-

-

-

0.572 (0.007)

0.777 (0.059)

-

-

3.171 (0.000)

2.128 (0.000)

Variables

R' P

-

-1.043 (0.000) 1.043 (0.000) 702

702

210

132

90

90

0.864

0.878 0.877 0.000

0.879

0.745 0.730 0.000

0.842

0.842

0.833 0.000

0.833 0.000

0.863 0.000

0.875 0.000

Model 1. The gravity equation includes basic variables that characterize the size of economy and level of economic development as pull factors and distance between the trading partners as a push factor which influence bilateral trade flows (basic variables).

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Table J5 (continued): Model 2. The gravity equation includes basic variables and dummies (Nordic countries. Border countries, East-West trade flows. West-West trade flows, CEFTA countries, BSR countries) Model 3. The gravity equation estimated for EU15. Model 4. The gravity equation estimated for CC12. Model 5. The gravity equation estimated for BSR countries, includes East-East (BSR) dummy. Model 6. The gravity equation estimated for BSR countries, includes East-West (BSR) dummy.

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Table J6. Variables of the Gravity Models Specifications Presented in the Appendix 1 Explanations (GDPpc).

Per capita GDP (PPP) of exporting (home) country.

(GDPpc).

Per capita GDP (PPP) of importing (hoste) country.

(POP)j

Population of exporting (home) country.

(POP)

Variables Population of importing (host) country.

(DIST)

Distance between the home (i) and host (j) countries.

BSR

Baltic Sea region dummy (=1, if trading partners' countries are the BSR countries; =0, if other trade relations). The Baltic Sea region countries that are involved in the EU eastward enlargement are: Denmark, Finland, Estonia, Germany, Latvia, Lithuania, Poland and Sweden.

Border

Border countries dummy (= 1, if trading partners' countries have common border; =0, if other countries).

East-West

East-West dummy (=1, if trade flows are between the EU15 and CC12 countries; =0, if other trade relations).

West-West

West-West dummy (=1, if trade flows are between the EU15 countries; =0, if other trade relations).

CEFTA

CEFTA countries dummy (=1, if trading partners' countries are the CEFTA countries; =0, if other trade relations). CEFTA countries are: Czech Republic, Hungary, Slovakia, Slovenia, Bulgaria, and Romania.

West-West(BSR)

West-West(BSR) (=1, if trading partners' countries are the BSR industriaUzed countries Denmark, Finland, Germany, Norway and Sweden;; =0, if other trade relations).

East-West(BSR)

East-West dummy (= 1, if trade flows are between the BSR transitional (Estonia, Latvia, Lithuania, Poland, Russia) and industrialized (Denmark, Finland, Germany, Norway, Sweden) countries; =0, if other trade relations).

East-East (BSR)

East-East (BSR) dummy (=1, if trading partners' countries are the BSR transitional countries Estonia, Latvia, Lithuania, Poland and Russia; =0, if other trade relations).

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References ANDERSON, JAMES E. (1979), A Theoretical Foundation for the Gravity Equation, American Economic Review, Vol. 69 (1), pp. 106-116. ANDERSON, JAMES E., VAN WINCOOP, ERIK (2001), Gravity with Gravitas: A Solution to the Border Puzzle, NBER Working Paper, No 8079, Cambridge Mass.: National Bureau of Economic Research. BALDWIN, RICHARD E. (1994), Towards an Integrated Europe" Centre for Economic Policy Research. BALDWIN, RICHARD E. (1997), Comment on Gros and Gonciards, European Journal of Political Economy, Vol. 13, pp.187-188. BERGSTRAND, JEFFREY H. (1985), The Gravity Equation in International Trade Some Microeconomic Foundations and Empirical Evidence, Review of Economics and Statistics, Vol.67, pp.474-481. BERGSTRAND, JEFFREY H. (1989), The Generalized Gravity Equation, Monopolistic Competition, and the Factor-Proportions Theory in International Trade, Review of Economics and Statistics, Vol.71, pp.143-153. BERGSTRAND, JEFFREY .H. (1990), The Hecksher-Ohlin-Samuelson Model, the Linder Hypothesis, and the Determinants of Bilateral Intra-Industry Trade, The Economic Journal, Vol. 100, pp. 1216-1229. CHENG I-HUI,. WALL, HOWARD J. (2002), Controlling for Heteogeneity in Gravity Models of Trade, Federal Reserve Bank of St. Louis Working Paper, No 1999-OlOC, St. Louis, p. 33. CORNETT, ANDREAS P. (2002), Integration and Reintegration in the Baltic Sea Region: A Tentative Assessment, Papers of the 7th Nordic-Baltic Conference in Regional Science, Ystad, Sweden. CORNETT ANDREAS P., IVERSEN, SOREN P. (1998), The Baltic State in an European and Baltic Perspective: Trade and Transition in the Baltic Rim, Materials of the Conference "Global-Local Interplay in the Baltic Sea Region, Pamu, Estonia October 1-4. DEADORFF ALAN V. (1984), Testing Trade Theories and Predicting Trade Flows, Handbook of International Economics, Volume 1, Amsterdam: NorthHolland. DEADORFF ALAN V. (1995), Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World? NBER Working Paper, No 5377, Cambridge Mass.: National Bureau of Economic Research. DEADORFF ALAN V. (1998), Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World, J.A. Frankel, (ed.) The Regionalization of the World Economy, The University of Chicago Press, Chicago, London, pp. 731. ESTEVADEORDAL ANTONI, FRANTZ BRIAN, TAYLOR ALAN M. (2002a), The Rise and Fall of World Trade, 1870-1939, NBER Working Paper, No 9318, Cambridge Mass.: National Bureau of Economic Research, p. 33. ESTEVADEORDAL, ANTONY, TAYLOR ALAN M. (2002b), A Gentry of Missing Trade? American Economic Review, XCII, pp. 383-393.

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EICHENGREEN BARRY, IRWIN DOUGLAS (1998), The Role of History in Bilateral Trade flows, in J. Frankel (ed.) The Regionalization of the World Economy, The University of Chicago Press, Chicago, London, pp.33-64. Estonia and European Union. Statistical Office of Estonia, Tallinn, 2000. EVENETT SIMON J., KELLER WOLFGANG (1998), On Theories Explaining the Success of the Gravity Equation, NBER Working Paper, No W6529, Cambridge Mass.: National Bureau of Economic Research. EVENETT SIMON J., KELLER WOLFGANG (2002), On Theories Explaining the Success of the Gravity Equation, Journal of Political Economy, 110, pp. 281-316. FEENSTRA, ROBERT C. (1998), Integration of Trade and Disintegration of Production in the Global Economy, Journal of Economic Perspectives, XII, pp.31-50. FRANKEL JEFFREY, STEIN ERNESTO, WEI SHANG-JIN (1995), Trading Blocks and the Americas: The Natural, the Unnatural, and the Super-natural, Journal of Development Economics, Vol. 47, pp. 61-95. FRANKEL JEFFREY (1997), Regional Trading Blocks, Institute for International Economics, Washington DC. FRANKEL JEFFREY (ed) (1998), The Regionalization of the World Economy, The University of Chicago Press, Chicago, London. FEENSTRA, ROBERT C. (1998), Integration of Trade and Disintegration of Production in the Global Economy, Journal of Economic Perspectives XII, pp.3150. Foreign Trade 2000. Estonia, Latvia, Lithuania. Statistical bulletin, Riga, 2001. FUJITA M., KRUGMAN P., VENABLES A. J. (1999), The Spatial Economy. Cities, Regions and International Trade, Cambridge: MIT, p. 367. GROS DANIEL, GONCIARZ ANDRZEJ (1996), A Note on the Trade Potential of Central and Eastern Europe, European Journal of Political Economy, Vol.12, 1996, pp. 709-721. HANSON, GORDON H., CHONG XIANG (2002), The Home Market Effect and Bilateral Trade Patterns, NBER Working Papers, No w9076, Cambridge Mass.: National Bureau of Economic Research, July. HARRIGAN, JAMES (2001), Speciahzation and the Volume of Trade: Do the Data Obey the Laws?, NBER Working Paper, No 8675, Cambridge Mass.: National Bureau of Economic Research. International Monetary Fund, Direction of Trade Statistics Yearbook, 2001. ISARD, WILLIAM (1960) Methods of Regional Analysis: An Introduction to Regional Science, New York, NY: John Wiley and Sons. IVERSEN, SOREN P. (1998), The Czech Republic's Reintegration in The European Division of Labour. A Gravity Model Analysis. Proceedings of the Conference "Business and Economic Development in Central and Eastern Europe: Implications for Economic Integration into Wider Europe, Brno, pp.257-280. LINNEMANN, HANS (1966), An Econometric Study of International Trade Flows, Amsterdam: North-Holland Publishing Company. MCCALLUM, J. (1995) National Borders Matter: Canada_U.S.regional TradePatterns, American Economic Review, June, 85(3), pp.615-623.

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Ministry of Foreign Affairs of Latvia. Bilateral Agreements. http://www.am.gov.lv/, 2003. Ministry of Foreign Affairs of Lithuania. Cooperation with international economic organisation, http://www.urm.lt/, 2003 Ministry of Foreign Affairs of Lithuania. Foreign Trade Policy http://www.urm.lt. PAAS, TIIU (2001), Modeling International Trade Flows of the Baltic Sea Region Countries, Global Business & Economics Review - Anthology 2001, Selected Papers of Business and Economics Society International, Worcester, USA, pp.607-618. PAAS, TIIU (2002), Gravity Approach for Exploring Baltic Sea Regional Integration in the Field of International Trade, HWWA Discussion Paper, No 180, Hamburg: Hamburg Institute of International Economics. POYHONEN, PENTTY (1963), Tentative Model for the Volume of Trade between Countries, Weltwirtschaftlishes Archiv, 90, pp.91-113. SEN, A., SMITH T.E. (1995), Gravity Models of Spatial Interaction Behaviour, Springer Verlag. TINBERGEN, JAN (1962), Shaping the World Economy, New York: Twentieth Century Fund. ZUKROWSKA KATARZYNA (2001), CEFTA: Training for Integration. Sheila Page (ed). Regions and Development: Politics, Security and Economics, European Association of Development Research and Training Institutes, Geneva, pp. 227-238. World Development Indicators, CD-ROM, World Bank, 2000.

Comment on: The Baltic Sea Regional Integration and Intemational Trade: A Gravity l\/lodel Approach Natalja von Westemhagen (Bundesbank)^ After a decade of transition, the transition countries of the Baltic Sea region were remarkably swift in embracing reforms and in approaching EU accession. Their EU membership poses a number of challenges due to the integration of economies with different historical backgrounds and economic structures. Intemational trade is a strong link, which induces the integration process between two blocks of countries, current EU members and the EU accession countries. The author investigates the role of the Baltic Sea region in the EU eastward enlargement process focusing on trade linkages both between these two blocks of countries and within the countries of the same block and draws special attention to the impact of regional integration effects on trade relations. To address these issues the author applies the gravity model approach, which has been broadly used in the literature to estimate trade potential between groups of countries distinguished by different economic, cultural and political conditions (for more detailed theoretical foundations for gravity model see e.g. GROS/DAUTREBANDE (1992)). The base specification of the gravity model consists of the main pull and push factors. Main pull factors include population, which proxies the size of the economy and gross domestic product per capita of home and host countries, which proxies the level of economic development. Distance between both trading home and host countries belongs to the main push factors. Possible regional integration effects are captured through different dummy variables, which reflect trade links between EU member countries and EU accession countries, between EU member countries taken as a separate group, between the CEFTA countries reflecting trade links between EU accession countries, between the trading partners of the Baltic Sea region involved in EU eastward enlargement process. The main finding of the paper is that the fact that countries belonging to the Baltic Sea region is a strong factor which induces integration process within countries with different economic and political backgrounds and spurs the EU eastward enlargement process. Nevertheless, there is evi^ Declaimer: the comment represents the authors' personal opinion and do not necessarily reflect the views of the Deutsche Bundesbank or its staff.

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dence that EU candidate countries which belong to the Baltic Sea region still have some potential for developing trade relations with current EU member states. Additionally, there is evidence that due to role of the past trade linkages the trade relations between the transition countries of the region are weaker than the trade relations between the EU member countries and the EU candidate and EU member countries. Therefore, the transition and the EU member countries of the Baltic Sea region use the challenges of integration more actively than the countries outside of the region. One could introduce some more intuition on the popularity of the Baltic Sea region for EU member countries and EU candidate countries over time in order to compare the popularity of the Baltic Sea region for these group of countries over time and consider the popularity of particular countries within the Baltic sea region over time. However, the main comments refer to the empirical analysis of the model. One of the relevant conmients refers to the country sample in the gravity model for the Baltic Sea region. Incorporating such a large country as Russia into the Baltic Sea region, for example, could lead to estimation results biased towards Russia. One possibility is to control with a dummy variable for Russia or alternatively carry out an estimation without Russia. Although gravity models are used in order to predict the potential in trade relations between countries with different economic, political and cultural backgrounds, the cross-section estimation of exogenous variables with high variability can nevertheless be an obstacle to a precise prediction (see DEARDORFF (1995). Considering a panel data-set with the historical data could possibly improve both the explanatory power and predictive power of the model. Strong economic growth, which the transition countries of the Baltic Sea region have experienced after the Russian crisis, led to a considerable inflow of foreign capital. Therefore, one could also extend the actual analysis for the transition countries of the Baltic Sea region - which is at present in the framework of the gravity model for trade - to investigate the role of foreign direct investment and bank lending for the Baltic Sea region with respect to the EU enlargement (see SCHIPKE et. al. (2004). In the end, one would expect some policy options reflecting the main findings in the paper on the popularity of the Baltic Sea region for the EU eastward enlargement and on incentives for the transition countries of the Baltic Sea region to develop their future trade relationships. One could address the question of whether rapid integration of the transition countries of the Baltic Sea region also bears some risks and what could be a suitable strategy from the stability point of view.

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References Gros, D., Dautrebande, B. (1992), International Trade of Former Republics in the Long Run: An Analysis Based on the "Gravity" Approach. CEPS Working Document No. 71, Brussels. Deardorff, A.V. (1995): Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World? NBER Working Paper No. 5377, Cambridge. Schipke, A., Beddies, C, George S.M., Sheridan, N. (2004), Capital Markets and Financial Intermediation in the Baltics, IMF Occasional Paper No. 228.

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

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

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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

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Comment on: Russia's Foreign Economic Relations and Regional Integration in CIS Countries: Theory, Problems and Options Grigori Feiguine

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1. Introduction The modem tendencies of global economic development demonstrate the rapid increase of world trade, inter-regional, inter-firm trade and global capital transfers. The global industrialization upswing, international division of labor expansion, and foreign trade growth stimulate the integration of developing countries into the system of global economic relations. The process of globalization accelerates within countries the coordination process of economic, political and social activities, and cultural rapprochement. Uneven development, environmental degradation in certain regions of the world, and the destruction of national identity are all considered negative consequences of this process. Developed countries encourage these consequences through rising profit levels. The problem of transitional countries entering the world economy is dependant on the price competitiveness of finished products, export dynamics characterized by export quota value and the common culture level of the country. The use of intemational norms of economic relations and participation in global economic cooperation are related to the essential factors of a country's integration into the world economy. The main conditions for this process are the privatization of state enterprises, the creation of market institutions, price liberalization, and economic opening-up of the national economy. Economic opening-up plays a key role in economic integration into the world economy. It includes foreign trade and currency liberalization, the foundation of a new system of intemational relations, creation of the state regulation mechanism of economic cooperation and participation in the work of intemational organizations. Trade liberalization affects the growth of faster countries. On average, trade can be a powerful force for poverty reduction, especially over longer time-horizons where the cumulative effects of growth on incomes of the poor are larger. Estimates suggest that after controlling for other determinants of growth, countries that fully liberalized trade and investment in finance and telecommunications grew an average of 1.5 percentage points faster than other countries over the past decade (GLOBAL ECONOMIC PROSPECTS, 2003). The degree of development of foreign economic relations is estimated through the level of foreign trade of goods and services, capital export, import, intemational labor migration and the economic integration progress. Globalization is accompanied with regionalization of economic activity. It includes the isolation of separate groups of countries and the foundation of regional unions. This process, on the one hand, stimulates economic integration and on the other, impedes the globalization process by increasing the isolation of regional groups, contradictions and competitiveness among individual countries. Integration into the global economic system of coop-

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eration is based on the use of advantages in the international division of labor and progress in foreign economic relations. There has been discussion about the analysis of regional development dependent on foreign capital and convergence, openness to international trade and internal integration and the consequences of regional integration. Taking into consideration the relation between foreign direct investment (FDI) and convergence among regional inflows, it is suggested that capital inflow is expected to boost growth in recipient countries (DE MELLO, 1999). The geographical proximity of a country to Western Europe and forthcoming preparations for EU accession have affected capital flows and the subsequent flow of goods during the process of integration of Central European economies into the world economy (KAMINSKI, 2001). The theory of growth and related empirical research confirms further integration of accession countries into the EU and the Euro area (TUMPELGUGERELL, MOOSLECHNER, 2003). While EU membership would bring benefits for accession countries, it is somewhat doubtful to what extent this provides benefits to the EU or to exposed member states (WELFENS, 1999). Empirical assessments of Russia confirm strong negative correlation between openness to international trade and internal integration within Russia (BERKOWITZ, DEJONG, 2002). The regional integration process includes both the micro and macrolevels. Microlevel integration is conducted by the organization of direct economic relations. Macrolevel integration is based on the coordination of country aims of social economic development. Policy coordination between the two levels is directed towards the maximization of the integration effect. The pace of East European integration is affected by economic, political, and social divergence as well as by the progress of transformational reform in transitional countries.

2. Russia's Foreign Economic Relations: Policy Performance and Development Perspectives The shift in the Russian Federation's territorial frontiers from the borders of the former USSR is the distinguishing feature of the present geopolitical state. After the collapse of the Soviet Union in 1991 and the emergence of new sovereign states in the western, northern and eastern areas of Russia, the need for a legal and economic basis of cooperation with neighboring countries has appeared. Further opening-up is planned for the Russian economy. Russia ranks 136 among 156 countries in the assessment of the annual Index of Economic Freedom provided by Heritage FoundationAVallStreet Journal's

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analyses in 2002 (HOLMES, JONSON, KIRKPATRICK, 2002). Economists draw attention to a correlation between the level of economic freedom and state welfare. The total value of circulated goods and services through trade turnover made up 40% of Russian GDP in 2000. This was 6 times higher in comparison to the average world international quota in 1995, which equaled 43% (OBOLENSKIY, 2000). Economic opening-up and high FDI inflow into countries encourage the transition process to a market economy. Thirty to fifty percent of national income is dependent on the level of foreign economic cooperation in developed countries. The present state of the world economy is characterized by a slowing down in growth rates. The world growth rate is estimated at 1.7% in the World Report "World Economic Development and Perspectives in 2003" (UNCTAD, 2003). The foreign direct investment inflow into developed countries decreased to $540 billion (one-third of FDI inflow in 2000). The international trade rate increased to 2% in 2002 in comparison with a decline in the previous year. Changes in world economic competition affect the restriction of world demand for raw material resources. Different approaches to the role of globalization and integration in the country's economic development exist. Some scientists point to the negative consequences of these processes, including uneven and unfair distribution of common goods among countries and regions. The intensification of a country's interdependence decreases the traditional mechanism of state regulation. The distinguishing feature of Russia's foreign economic policy is overcoming differences in the level of economic development with developed countries. Based on the geopolitical situation and foreign political interests, the priority of the expansion of foreign economic relations with CIS and reasonable cooperation with other regions should be mentioned. In accordance with official data of the State Customs Committee of the Russian Federation, cumulative trade turnover in Russia was equal to $126 billion with non-NIS and $25.8 billion with CIS in 2002. Non-NIS's share makes up 83% in cumulative trade turnover (including 85.3% for exports and 77.8% for imports). The Russian trade balance with non-NIS makes up $54.4 billion (BIKI, 2002, NO 20). EU-15 is most certainly a region of priority for Russian foreign economic interests. A stable system of legal and economic contracts as well as gas and oil pipelines exists and functions well within this region. Mutual cooperation between the EU and the Russian Federation is encouraged by the development of scientific and technological research. The export of fuel and power resources dominates the trade balance of the Russian Federation to Western Europe. The share of cumulative trade turnover of Russia with that of EU member countries made up 36.6% in 2002 (36.7% in 2001), in comparison to CIS countries -

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17% (18.2%), APEC - 16.4% (16.1%), and Central and East Europe 12.9% (13.8%). The share of EU exports made up 35% of Russian exports, while that of Central European, Eastern European countries and CIS exports was 15% in 2002.

MERCOSUR 1%

JAPAN

CHINA

SOUTH KOREA 1%

HOIS

1

• EC DCEE

ASEAN ^^'^^^ 1%

DNAFTA • MERCOSUR HJAPAN

^^.^THEREST 20% ^CIS 15%

• CHINA • SOUTH KOREA •ASEAN

• THE REST

1

Source: Customs Statistics of Russian Federation. Fig. Kl. The Share of Regional Unions in Russian Export in 2002 (in Percent) The Russian Federation provides development of long-term foreign economic relations with market economies. The main Russian trading partners are pointed out in the Table Kl. The export share to the Federal Republic of Germany, Italy, USA, Great Britain, and Poland decreased in Russia's cumulative trade turnover in 2002 in comparison with the previous year. The favorable export growth tendencies are a result of the combination of internal and external factors. They are characterized by the decrease of internal demand for the basic items of commodity export. The outpaced production growth in the key export oriented sectors stimulates the formation of commodity surplus. The balance of Russia's current account is positive with FDI inflows making up $3.3 billion. The share of industrial goods to the total commodity export equals 25% and the export share of high technologies to industrial goods amounts to 16% (WORLD DEVELOPMENT REPORT, 2002). The export volume amounted to 10% of GDP in purchasing power parity (PPP) in 2001. The backwardness of Russia's transport infrastructure impedes export growth.

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Table Kl. The Main Russian Trading Partners in 2002

Federal Republic of Germany Italy Netherlands China Ukraine Total 5 countries Belarus Switzerland USA Great Britain Poland Total 10 countries

The cumulative turnover (biUion $)

Per cent to the total export

Share change to 2001 (percent)

14.6

7.6

-1.6

9.6 8.3 9.2 9.0

7.0 6.8 6.4 5.5 33.3 5.5 5.1 3.7 3.5 3.5 54.6

-0.4 2.1 0.8 0.2 1.1 0.1 2.8 -0.5 -0.7 -0.7 2.1

9.8 6.0 6.9 4.9 5.0

Source: Customs Statistics of Russian Federation.

The improvement of foreign trade conditions resulting in the growth of physical deliveries of goods to 10.1% in Russia in 2002 has also been mentioned. Despite these positive tendencies, the deterioration of value added products must not be overlooked. Their share decreased from 2223% in 1999 to 19% in the cumulative export volume of Russia in 2002. The relationship of Russian commodity exports to GDP amounted to 32% in 2002 in comparison with 33% in 2001. The specific weight of the Russian Federation in the world trade pattern of export made up 1.7% in 2002. Despite the insignificant role of the Russian economy in world trade, it is becoming increasingly integrated into the global economy and is considered to be part of it. There is a continued natural export predominance from Russia to developed countries. The insufficient level of diversification of foreign deliveries commodity classification impedes the flexibility of export relations in world markets and causes a dependence on changes in world competition. Russia's position appears worse when viewed in relation to comparisons based on the Growth Competitive Index (GCI). This index shows the degree of effective resources used in various countries. Russia moved from 46th place in 1998 to 58th place in 2002 from 80 countries in the world with favorable economic growth perspectives and high GCI value. The share of Russian machines and equipment in the world machine technical product export is estimated to be about 0.3%. The value indicators of this market segment are considered lower in comparison to that of developed countries. The volume of highly competitive Russian technical machine products in the world market makes up $3 billion, while special technical deliveries inside the CIS are not included (BFCI, 2003, NO 12). The low

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level of global competitiveness in the Russian economy demonstrates the necessity of special governmental policies stimulating future scientific development. Russia does not use its comparative advantages - including geographical location, big stocks of natural resources, and an excess of cheap labor (despite its low productivity level) - efficiently. There is a marked increase in natural and fuel specialization in the trade export structure. As a result, undertrading tendencies take place within Russia, which means the existence of a disparity between the geographical distribution of commodities and the real economic potential with trading partners. The export share of the Federal Republic of Germany, Italy, USA, Great Britain, and Poland decreased in Russia's cumulative trade turnover for 2002 in comparison with that from the previous year. Fuel and natural resource exports comprise 56.4% of the cumulative volume of Russian exports to non-NIS, whereby metal and manufactured products exports increased to 1.1% and chemical products export decreased. Russia's import growth rate from Germany exceeds its export growth rate to the Russian Federation. Russia exports the following products to the Federal Republic of Germany: fuel and power resources, chemical semi-finished goods, components of machines, and electrical engineering products. Russia also encourages the development of mutually beneficial cooperation with Italy. Fuel and natural resource exports make up 70% of its total exports from Russia. Areas of concentration for mutual interest are: machinery, power/energy, transport, and the agrarian-industrial complex. Accession to NATO on the part of Baltic and Central Eastern European countries has brought about a change in the geopolitical situation in Westem Europe. The fulfillment of the conditions outlined in the Maastricht Treaty on the part of new EU member countries will result in convergence of their main macroeconomic indicators to the level of successful EU countries. Two basic stages in the development of trade relations between Russia and the USA can be seen. It is marked by a period of high growth rates of mutual trade at the beginning and decreasing rates at the end of the 20th century. The USA's cumulative trade turnover with Russia decreased to $300 million in 2002 in comparison to the previous year. The United States trade balance with Russia is positive and is equivalent to $1.1 billion. The share of Russia's fuel, natural resources and goods makes up about 90% of this total value (BFCI, 2003, NO 76). The USA makes use of special protective mechanisms in the form of tariff restrictions on ferrous, textile goods, mineral fertilizers and so on. The most debated questions relate to the most favorable regime foundation for foreign economic relations and the elimination of trade barriers between these two countries.

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The Russian share of US exports in 2001 was equal to 0.4% while its share of imports was 0.5%. The share of the manufacturing industry exceeds 80%, with machinery and equipment transport facilities making up 55% of US exports compared to 34% of Russian exports. WTO data on Russian and US indicators depict the predominant position of the United States in both world exports and imports (table K2). The benefits of overcoming Russian economic and political isolation from Asian Pacific countries can be seen in the existence of enormous economic potential and the absence of a rational mechanism for its profitable use. The share of Asia-Pacific Economic Forum (APEC) countries amounted to 21.3% of Russian export and 18% of import in 2000. See fig. K2. Table K2. Dynamics of World Economic Indicators in 2001 (in Percent) USA Russian Federation Share of world exports 12 1.7 Share of world imports 18 0.8 Share of world exports of ma17 0.3 chines and equipment Source: Bulletin of Foreign Commercial Information (2003), Russian Trade with the USA: Structure and Tendencies, NO 76, 8 July, p.2. Based on data from the Chief Customs Administration of the Chinese People's Republic, the cumulative trade turnover between China and Russia amounted to $10.86 biUion in 2002. This was an increase of 17% in comparison with the same period in 2001. Russia's export share to China reached 7.2% while imports were 3.1%. The development of energy machine building, telecommunication equipment production, and joint forestry resources exploitation are considered some of the areas with the most potential for joint Russian-Chinese cooperation. Small Chinese intermediaries are the main operators in the Russian timber market. They often violate currency, customs and migration legislation in Russia. The Central Bank of Russia and the Bank of China have signed joint agreements on economic cooperation preventing illegal asset laundering received from criminal activities, financed terrorism and currency control.

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25000 -1

20000 -I -Trade Turnover

15000

- Export

10000

- Import

5000 0

I

1

I

I

I

I

I

1

1

1992 1993 1994 1995 1996 1997 1998 1999 2000

Source: Customs Statistics of Foreign Trade of Russian Federation(2001), Moscow, Fig. K2. Russian Foreign Trade with APEC (Million US-Dollar) In accordance with data from the Ministry of Economic Development, Russian trade turnover with Japan decreased in 2002 compared to 2001. Cumulative trade turnover between Russia and Japan reached $4.1 billion in 2002, with semi-finished products and natural resources dominating Russian exports. The share of non-ferrous and precious metals was 40%, sea products 27%, timber 15% and mineral fuel 10% (BFCI, 2003, NO 25). Automobiles, road-building equipment, metal processing equipment, communication equipment, and electrical products prevailed as Japan's major imports to Russia. The development of the fuel processing branch suggests areas of top priority for future mutual cooperation. The rapid growth of Asian NIC's promotes the reorientation of Russian economic policy toward the enlargement of mutually profitable cooperation. The Republic of Korea is the 15th largest trading partner of the Russian Federation. The share of Korean trade turnover amounted to 3.7% of the cumulative trade turnover of the country in 2000. Russia and the Republic of Korea stimulate the development of mutual economic cooperation by attracting foreign direct investment (FDI); the cumulative FDI volume into Russia reached $269.6 million (157 projects), with the majority of projects concentrated in the Far East. The Russian government has displayed a foreign policy concept in which the expansion of economic cooperation with Central and South American countries is marked by participation in international organizations. The development of Russian-Latin American economic relations encountered two periods at the end of the 20th century. The first period lasted from 1990 to 1996 and was characterized by a low level of cooperation with Western countries on the part of Russia. The second period from 1996 to the present depicts the improvement of mutually beneficial cooperation.

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Transition countries also experienced growth in both exports (9%) and imports (11%) in 2002. This trade volume increase was the result of FDI inflows and a rise in internal demand. Russia's foreign economic relations and CIS development were characterized by an unstable and inadequate character in the 90s. The collapse of traditional economic ties, diverse levels of economic development, the low level of production competitiveness, the absence of efficient specialization, and the use of trade restrictions by some CIS countries impeded the integration process. Eastern European countries were focused on trade cooperation with developed countries. Foreign investors penetrated CIS markets and attempted to make use of the extraction of natural resources. A tendency of trade turnover slow down among all CIS can be seen through 2000. Factors relating to improvement in the world economy, overcoming of the world monetary crisis, territorial proximity, and the search for suppliers both promoted and stimulated a rise in trade in 2002. Unbalanced Russian trade turnover with CIS (share of the net trade balance in the cumulative turnover) offers greater evidence of rising unbalance in the period from 1995 to 2002. The specific level of trade turnover with the CIS started decreasing after 1998. CIS's share in Russian trade turnover declined from 60% in the 1990s to 17% in 2002 (see fig. K3). The share of CIS exports to Russian exports of machines, equipment and transportation products equaled 1:5. The specific weight of the cumulative export volume of energy resources increased for CIS countries. This was the result of business activity stimulation and the reduction of unpaid debts on earlier shipments of mineral fuel. The decrease in the specific share of Russian imports can be explained by an improvement in the internal economic situation both inside the country and abroad.

30-1

252015105n-

•

•—.

•

•

U 1

1995

"•

•

1996

_

•"-.^.....^

•

1997

I

1998

•

The unballanced coefficient 1

M

Specific weight of CIS in Russian turnover

'

I

1999

•

•

2000

2001

I

.

B

— I

1

11

2002

Source: Data of Russia's Balance of Payment. Fig, K3. The Trade Dynamics of Russia and the CIS (in Percent) In the 21st Century, Russia could take its role as a country with an average level of economic development, having huge natural resources, a suf-

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ficiently high level of education amongst the population, and good scientific potential (KUDROV, 2000). The future of Russian foreign economic relations should be based on its cooperation in the immediate tasks of the EC, APEC, MERCOSOUR, NAFTA, ASEAN, CIS and other subregional groups. In order to become more integrated in the global economy, it is important to facilitate Russian participation in the work of international organizations as well as future WTO accession. The regulation of the problem of foreign debt is considered one of the important factors of Russia's stable position among leading world countries. The main areas causing problems concerning foreign debt solution are: intergovernmental negotiations on the terms of credit payments, the reduction of the value of promissory notes with partial payments in the secondary market, reorientation of state policy on public loans, and the strengthening of exports.

3. Political and Economic Issues of CIS Development The distinguishing feature in the second half of the 20th century was the development of new tendencies in the process of internationalization, marked by the realization of integration on the part of the European Economic Community (1957). Economic integration involves the process of economic interaction and interdependence among countries, accompanied by an organization of individual countries into groups with an economic rapprochement of main macroeconomic indicators. This process occurred through the formation of foreign economic treaties regulated by the activity of international agencies. Regional economic integration causes the abolishment of restrictions on the trade of goods and services of member countries as well as other activities that promote citizen welfare. The main levels of economic integration include the following: - a free-trade area providing for the abolishment of tariffs among member countries; - customs union prompting the establishment of common external tariffs; - a common market abolishing restrictions on the mobility of production factors; - and complete economic integration accompanied by common fiscal and monetary policies. From a theoretical point of view, regional integration provides for the creation of trade, resulting in the shifting of resources from the least to the most efficient producers. Trade diversion also results in discrimination against outside producers to less efficient producers within the country or group of countries. The dynamic effect of integration brings with it market

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growth, as companies achieve economies of scale. Moreover, efficiency increases because of competition (DANIELS, RADEBAUGH, 1995). Deep integration is accompanied by the accumulation of factors of production, macroeconomic stabilization, and institutional improvement (DENISUK, 2002). The transition to a market economy will be facilitated by the existence of a fixed exchange rate, providing an anchor for the new price structure (WILLIAMSON, 1991). Y. Tiberg and A. Phillip substantiate the concept of managed integration, suggesting the inevitability of creating an economic and political union with subnational structures. The analysis of these approaches confirms that there is an absence of a common standpoint on the role on integration in a country's economic progress. The creation of the Commonwealth of Independent States (CIS) began in 1991. A Charter drawn up by the Council of the Heads of State was signed by representatives of 12 governments in 1993, which formed the foundation of an economic union to ensure consistency in integration. Seventy-seven bilateral and multilateral economic agreements were signed, although only 44 treaties are actually in force. An agreement on the Foundation of a Common Agrarian Market was signed at the CIS summit in Moldova in 1997. This organization seeks to stimulate the free transfer of agricultural production, food, scientific and technical products, technologies and services. Economic expediency, common history, and a social-cultural basis form the foundation of the CIS regional integration process. CIS countries make up 16.3% of the world's territory, 5% of the world population, 25% of the reserves of natural resources, 10% of industrial output, 12% of scientific and technological potential, and 10% of resource saving goods (ZIYDULLOW, 2002). The destruction of traditional economic ties, an elimination of a common sales market, and the reduction of investment and consumer demand were typical features of the social-economic situation in 12 former Soviet Union Republics throughout the 1990s. Different types of models for economic development include the market economy model, dominated planned economy model, and an oligarchic model (typical of some CIS countries). Distinctions in economic development as well as motivational aims of state participation in the union impede the integration process. Some countries pursue policies primarily to bolster their own economic and political interests, while others seek to solve internal problems of providing security or becoming regional leaders in some respect. The unification process is affected by existing international threats and the necessity for coordinating joint efforts through a renewed treaty for collective security in the CIS. While one may suppose that the integrity of the CIS has been undermined and is forming instead subregional groups of countries, other scien-

K. Russia's Foreign Economic Relations and Regional Integration

317

tists foresee a new stage of integration and further prospects for CIS development. The process of CIS integration is centered on developments in political relations as well as market reforms (KRYLATYACH/STROKOVA, 2003). The theory of anchor integration separation is aimed at creating attractive conditions for joining the union countries. The anchor demonstrates the highest level of stability and the unification process is started around the center (TIMCHENKO, 2002). The absence of deep regional integration within the CIS is the basic cause of perspective developments in bilateral economic cooperation among countries (KOROLEV, 2003). CIS economic development between 1992 and 2000 showed predominantly negative tendencies characterized by a slowdown in the main macroeconomic indicators. The volume of industrial production dropped on average by 34%, agricultural production 26%, fixed capital investment 63%, and cargo carriages by 74% (KOROLEV, 2003). The physical volume of GDP index increased in all CIS countries in 2001, but was lower than its 1991 level (see fig. K4).


Average throughout the CIS

•o

,o "co 0

E o

Q w (li

2

O

Source: Data of Interstate Committee of CIS. Fig. K4. Physical Volume Dynamics of Gross Domestic Product Index in Fixed Prices in 2001 (1991=100%) There is also a marked reduction in gross capital accumulation throughout the CIS. A decrease in gross savings, disproportion of income distribution and inconsistent financial policy in investment creation are basic causes of unfavorable economic development in the majority of Eastern European countries. Tendencies toward an uneven capital distribution and a reduction in fixed capital investment started improving in the CIS at the beginning of the 21st century (see table K3). Fixed capital investment in 2003 was as follows: $54.8 billion in Russia (79.4% from total investment volume in CIS), $5 billion in the Ukraine

318

OlgaNosova

(7.2%), $2.1 billion in Belarus (3%), $5.3 billion in Kazakhstan (7.7%), and $1.2 billion in Azerbaijan (1.7%) (KOMAROV, 2003, P.75). Insufficient investment levels demonstrate the potential need for additional capital in all CIS countries. According to scientific estimates, the necessary capital volume for the CIS is $90 billion including Russia, which alone is estimated to need $70 billion. There were marked tendencies of a rise in industrial production in all post-socialist countries in 2001. Shares in metallurgy, fuel and energy increased in the cumulative volume of CIS production. The machinery and equipment industry, metal processing as well as chemical and fuel chemical branches suffered decreases (see fig. K5). Table K3. Fixed Capital Investment in the CIS between 1995-2001 1995 1996 1997 1998 Investment index in the whole (% to 36 30 29 28 1991) Investment in the whole (billion dol- 73.2 90.3 88.3 61.4 lars) Source: Data of Interstate Committee of CIS.

1999

2000

2001

29

34

37

43

54.1

69

A policy of export growth is concentrated in areas of resource production, including the fuel-energy and mineral-resources branches. Growth in manufacturing products causes changes in processing goods. The speed of growth for finished products affects the rate of recession for processing goods production. There is a clear need for attracting external financial sources for the acceleration of economic growth. The majority of countries use an export restriction regime in the form of licenses, permissions, and duties. Expert estimations assume that about 40% of CIS trade belongs to non-free trade commodities. The assessment of mutual trade share dynamics in cumulative trade turnover demonstrates the decrease of mutual trade within the CIS from 1998 to 2002 (see fig. K6). Russian economic losses due to oil and gas duty free export could exceed $3 billion per year in the event that a free trade area be founded (CHEKLINA, 12).

K. Russia's Foreign Economic Relations and Regional Integration

319

Source: Data of Interstate Committee of CIS. Fig. K5. Dynamics in the Industrial Production Volume Index in 2001 (1991=100%)

50-1 40-

• —

m—

• "

30-

A

#

• A

20-

^*v

-^

Export

—•—Import

— ^

10n -

1

1994

1995

1996

1997

1998

1999 2000

1

2001

1

2002

Source: Data of Interstate State Committee of CIS. Fig. K6. Share of the Mutual Trade in the Cumulative Trade Turnover in the CIS (in Percent) Russian shares of interregional CIS exports as well as the corresponding shares of the other remaining 11 CIS members and the CIS as a whole decreased between 1990 and 2001 (see fig. K7). This is partially the result of a reduction in the share of finished products, especially machines and transport facilities as well as an increase in the share of basic resources. This tends to support the claims of an aggravated process of economic unification and an increase in the prevalence of

320

Olga Nosova

CIS isolation. The achievement of CIS monetary stabilization provides for a reduction in currency fluctuations, with public revenues being formed through tax proceeds.

S Russia a The Rest 11 Countries DCIS in the Whole

.pll.flh.rin.Fll 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: Data of Interstate Committee of CIS. Fig. K7. The Share of Interregional Export of the CIS in Total Export Volume (in Percent) The inefficient functioning of economic structures, a decrease in the number of sectors with added value, low product competitiveness, and a reduced volume of mutual interregional trade are typical characteristics of CIS development. An assessment of the development of political and economic results of CIS integration shows the slow pace of convergence. A rise in country's divergence continues to grow and influences reintegration tendencies in Eastern Europe. There has been no real improvement in objective conditions of deep CIS integration. Inconsistent CIS policy, opened regionalism, the domination of individual countries, and opportunistic behavior continuously push states to search for new forms of cooperation and integration in the world economy through the formation of subregional unions or bilateral cooperation agreements.

4. Regional Economic Integration in CIS: Problems and Development Prospects Different political alliances and subregional unions have appeared in the post-socialist territory of the former Soviet Union. The uneven and unbalanced development of the integration process within CIS countries, and diverse speeds of political, economic, social and cultural convergence are the basic causes of regional agreements among small groups of states. The

K. Russia's Foreign Economic Relations and Regional Integration

321

goal of state integration remains the creation of a free-trade area. There is an absence of a common customs tariff among states. A look at the different levels of economic integration demonstrates the continued dominance of EuroAsES and USER within the CIS (see table K4). EuroAsES's role within the CIS is the largest of all subregional unions, and its members support a free trade regime. Economic relations within the union are centered around their regional market, and a common unified tariff rate exists for a majority of commodity items. A common customs area continues to be a goal of the EuroAsES. The USER development is directed at the creation of a common market which includes not only the free movement of goods and services, but factors of production as well. The circulation of only the Russian ruble set from January 2005, and a common currency planned for January 2008. GUUAM activity is directed at strengthening foreign economic relations among its regional members. The Ukraine conducts the independent foreign economic policy of "European choice". CAA pursues the creation of a freetrade area and the protection of its member countries against "trade wars". Table K4. The Macroeconomic Indicators of Regional Unions in the CIS in 2000 (CIS=100%) Regional Unions

Population

EuroAsES' USER' GUUAM' CAA'

Industrial Production

64.6

Gross Domestic Product 78.0

55.4 32.3 17.9

71.3 20.1 12.7

71.8

Agricultural Production 63.0

Retail Trade Turnover 79.4

67.0 26.9 11.4

55.4 35.9 20.4

74.7 19.9 13.5

^^ EuroAsES (Euro Asian Economic Association) was formed in 1996. Belarus, Kazakhstan, Kyrgyzia, and Russia are members of the Customs union. Tadzhikistan joined EuroAsES in 1999. ^^ USER includes the union of Belarus and Russia, and its treaty was signed in 1999. ^^ GUUAM is an informal union of Georgia, Ukraine, Uzbekistan, Azerbaijan, and Moldova. ^'^ CAA (Central Asian Economic Association) was founded in 1994 and is comprised of Kazakhstan, Kyrgyzia, Uzbekistan with the goal of a common economic territory. Tadzikistan joined the CAA in 1998. Source: Ziyadullaev N.S. (2002)^The CIS: The Way to the 3rd Millennium (Problems of Development and Perspectives of the Commonwealth Consolidation), Moscow: ISPI RAN. Proper functioning of subregional unions requires a mutually beneficial, multilevel system of integration. There are different speeds of integration,

322

Olga Nosova

necessitating an optimal combination of various forms of cooperation, coordination, and interdependence among the countries involved. The success of regional integration within the CIS on a whole is based on the completeness and effectiveness of subregional integration. Subregional unions should pursue more active integration processes and stimulate complete convergence within CIS. The treaty on a common economic area was adopted by the heads of four CIS states in September 2003: the Russian Federation, the Ukraine, Kazakhstan, and Byelorussia. The treaty is directed at improving foreign economic relations, making better trade regimes, providing for the implementation of international legislation, promoting the process of integration among the CIS countries, and stimulating economic growth.

5. Policy Conclusions An examination of the development of Russian foreign economic relations demonstrates the need for deeper integration into the world economy. The policy of economic opening up is related to the objective regularity of social development throughout the world. The enlargement of Russian foreign economic relations should be directed at undertaking the following policy measures: - decreasing the predominance of fuel and power specialization in foreign trade; - elaborating on a foreign trade mechanism for decreasing undertrading tendencies, disparities of geographical distribution and real economic needs; - increasing Russia's share of exports in world commodities. A look at the economic and political process of integration within the CIS underscores the necessity of setting priorities for future prospects of the union. The elaboration of a joint program of coordination within CIS and subregional unions will be directed at eliminating technical barriers, trade limitations and quantitative restrictions. The main areas for strengthening the CIS are as follows: - reducing the effects of disintegration of world market fluctuations on CIS development; - stimulating the predominance of integration tendencies; - increasing the intercomplementarity and interchangeability features of cooperation; - improving the subregional system of interstate regulation;

K. Russia's Foreign Economic Relations and Regional Integration

323

eliminating national divergences in resource supply, discrepancies of economic potential, and differences in market reform models; and expanding on the creation of a common market that includes the formation of a common free trade area, the elimination of trade barriers and the unification of customs tariffs.

324

Olga Nosova

Appendix

^

00

s

(N

t •a

S

II

s ?

(^

*53

S

cn

2

•Si

r-

(N

CO

o

^

a

CO

B o

O

CO

8

Table K5. The Main Macroeconomic Indicators in the Fixed Prices in the Whole in CIS (1991=100) p CM " ^

(NJ . S (N

8|8

i

0\

8;

a OS OS

8^

I

S

O

K. Russia's Foreign Economic Relations and Regional Integration

325

Table K6. CIS Trade Balance in 2001 (Million Dollar) Countries

Total

CIS

Other Countries

Azerbaijan

883

-222

1105

Annenia

-535

-129

-406

Belarus

-621

-1134

513

Georgia

-364

-107

-257

Kazakhstan

2284

-674

2958

Kyrgyzia

9

-89

98

Moldova

-327

7

-334

57670

3345

54325

Tadzikistan

-36

-326

290

Ukraine

490

-4156

4646

Russia

Source: Data of the Interstate Statistic Committee, Table K7. Real Disposable Population Incomes in the CIS (1991=100%) 1995

1996

1997

1998

1999

2000

2001

Azerbaijan Armenia Belarus Kazakhstan Kyrgyzia Moldova

Countries

30 20 64 12

45 24 76

52 26 92

64 31 89

68 35 106

73 37 134

Russia Tadzikistan Ukraine

59 10 35

36 24 75 11 15 18 58

15 17

11 29

-

-

-

-

-

15 17

16

16

17

19

61 12 31

15 51 14 30

Source: Data of the Interstate Statistic Committee,

-

-

-

44

48 13 30

51 12

13 28

32

326

Olga Nosova

Table K8. Legal Foreign Working Labor Force in the CIS in 1999 (People's Quantity) Countries

Russia

Belarus

Kazakhstan

Moldova

Ukraine

Total Including Arrived People from CIS Russia Azerbaijan Armenia Belarus Georgia Kazakhstan Kyrgyzia

211361 94722

2198 2047

11887

326 18

2783 565

-

70 5 113

625 13

12

-

-

1 2

260 30 134 47 29 7

Moldova Tadzikistan Turkmenistan Uzbekistan Ukraine From other Foreign Countries

2826 5167 2 5214 1662 549 8619 4135 281 3411 62856 116639

1009

9

18 6

12

-

-

24

10

-

1 5 1 1821 151

8

42 273 10878

-

3 308

3 46 2 4 4

2218

Source: Data of the Interstate Statistic Committee.

References BERKOWITZ, D., DEJONG, D., (2002), Integration: An Empirical Assessment of Russia, William Davidson Working Paper, NO 488. BULLETIN of Foreign Commercial Information (2003), About Russia' Trade Economic Relations with Japan, NO 25,4 March, p.2-3. BULLETIN of Foreign Commercial Information (2002), Foreign Trade in Russia in 2002, NO 20, 20 February, 1-2. BULLETIN of Foreign Commercial Information (2003), The Global Competitive Report, NO 12, 1 February, p.l, 4, 5, 16. BULLETIN of Foreign Commercial Information (2003), Russian Trade with the USA: Structure and Tendencies, NO 76, 8 July, p.2. CHEKLINA, T.(2003), Russia's Trade Economic Relations with CIS, Bulletin of Foreign Commercial Information, NO 48, 26 April, p.l 1-14. CUSTOMS Statistics of Foreign Trade of Russian Federation(2001), Moscow. DANIALS, J.D, RADEBAUGH, L.H. (1995), International Business: Environments and Operations, seventh edition, Addison Wesley Publishing Company. DE MELLO, L. R.Jr. (1999), Foreign Direct Investment led Growth: Evidence from Time Series and Panel Data, Oxford Economic Papers, NO 51, 133-151.

K. Russia's Foreign Economic Relations and Regional Integration

327

DENISUK, B. (2002), At the European Interests Periphery. Ukrainian Regional Integration Challenges in the Context of European Choice, Policy and Hour, NO 9, 21-37. HOLMES, K.R, JONSON, B.T, KIRKPATRICK, M. (2002), 2002 Index of Economic Freedom, The WallSteet Journal, Washington DC, New York. GLOBAL Economic Prospects 2004 - Realizing the Development Promise of the Doha Agenda, (2003), World Bank. KAMINSKI, B. (2001), How Accession to the European Union Has Affected the External Trade and Foreign Direct Investment in Central European Economies, WPS 2578, World Bank. KOROLEV, M. (2003), Social Economic Situation in Commonwealth Independent States in 1992-2002, The Bulletin of Foreign Commercial Information, NO 48, 1-4. KRYLATYACH, Z., STROKOVA 0.( 2003), Regional Trade Agreements in the Framework of WTO and Agrarian Market in CIS, World Economy and International Relations, NO 3,49-55. KOMAROV, V. (2003), Investment in CIS, Ukrainian Economy, NO 2, 74-81. KUDROV, V. (2000), Russia's Place in the World Economy in the Beginning of XXI-th Century, World Economy and International Relations, No 5, 75-83. TIMCHENKO, S. (2002), To the Question of Reintegration Postsocialist Space, Bulletin of Moscow University, NO 6, 113-120. TUMPEL-GUGERELL, G. and MOOSLECHNER, P., eds. (2003), Economic Convergence and Divergence in Europe. Growth and Regional Development in an Enlarged European Union, Austria: Oesterreichische Nationalbank. WELFENS, P.J.J. (1999), EU Eastern Enlargement and the Russian Transformation Crisis, New York: Springer. WILLIAMSON, J.(1991), The Economic Opening of Eastern Europe, Institute for International Economics, Washington DC, May. WORLD Development Report (2002), Building Institutions for Markets, World Bank, Oxford University Press. ZIYADULLOW, N.S. (2002), The CIS: The Way to the 3-rd Millennium. (Problems of Development and Perspectives of the Commonwealth Consolidation), Moscow: ISPI RAN.

Comment on: Russia's Foreign Economic Relations and Regional Integration in CIS Countries: Theory, Problems and Options Grigori Feiguine The present article discusses two issues. The first issue deals with analysis of Russian foreign trade following the collapse of the Soviet Union in 1991. The author gives a detailed analysis of Russian foreign trade, shows the main trends of its development and gives a detailed account of changes that happened in the past 2-3 years. The analysis also discusses Russia's main trading partners, and several indicators describing the relationship between Russia and various trading partners are evaluated. The author further outlines key factors which over the long-run may strengthen Russia's position in foreign trade. The second issue Nosova touches upon is the exploration of economic and trade relations among countries of the former Soviet Union. The author gives an account of main trends of economic development in CIS countries after 1991 and a detailed characterization of their economic relationships with each other. She then proceeds by offering a brief analysis of integrated formations on the territories of CIS countries. The objectives of these formations are outlined, and their role in integration of CIS as a whole is noted. To conclude, the author points to factors that strengthen integration within CIS. This article gives a detailed overview of the issues mentioned above. Assertion of several theoretical propositions is richly supported with empirical material. While the strong points of the article should undoubtedly be noted, the issues below are open for discussion.

1. Conceptual Foundations of Empirical Studies In the beginning of the article, Nosova notes that global integration is one of the main trends in development of modem economy. Globalization suggests a substantial growth in volume of international trading and investment and implies an increased degree of integration within the regions. Furthermore, the author points to specifics of integration within countries with a transitional economy into world economy. Thus, unalienable elements of this process are privatization of government enterprises, liberalization of prices and creation of market institutes.

Comment on: Russia's Foreign Economic Relations

329

The author mentions several theoretical studies on issues of globalization, regionalization, and integration. Meanwhile, a single theoretical basis for empirical analysis is worthy of attention. In this regard the following problems are of interest: interconnections between transformation and integration; wealth effects caused by liberalization of foreign trade; parity of concepts of inter-industrial and intra-industrial trade and the role of the last in the process of globalization. The author makes references to some works on integration in general and European integration in particular. Meanwhile, it would be interesting to see a more detailed and systematic description of conditions and strong points of integration. A single theoretical base for this study would have allowed for the systemization of results and the checking of theoretical propositions in practice.

2. The Problem of Comparative Empirical Analysis and Benchmarking The second part of this work gives a large amount of empirical information on content and structure of Russian foreign trade. Thus, data are provided about the balance of Russian foreign trade; information about regional structure of the economy in 2002 is also presented. Moreover, we are given statistical evidence characterizing economic relationships of Russia with its main trading partners. Nevertheless, assessment of this data remains problematic. Can we speak of predominantly positive or negative tendencies in development? Possibly for clarification of these tendencies, it would be worthwhile to consider regional and industrial composition of Russian foreign trade for a more prolonged period, such as starting from 1992 to present. For empirical confirmation of such assessments, a comparative analysis of Russian trade with foreign countries may be of interest. But there lies another problem: what should we choose as a standard measurement? Such a standard can be chosen among the more successful countries with a transitional economy, such as the Czech Republic, Poland, and Hungary. Also worthy of attention is a comparison of Russian trade statistics with that of CIS and Baltic countries. Such comparative analyses can give answers to the question of what extent Russia lags behind or surpasses countries that are involved in solving largely similar problems of transformation to a market economy.

330

Grigori Feiguine

3. Questionability of Certain Assertions Some assertions made by the author in this article are open for debate. Nosova claims, for example, that Russia is not using its endogenous competitive advantages. This claim needs correction. In ratings of competitiveness, Russia traditionally takes one of the last places. Relatively low salaries in Russian and consequently low labor costs are not competitive advantages as Russia substantially lags behind industrial countries in labor productivity. The modem stmcture of Russian foreign trade is defined on one hand by its richness in natural resources, and on the other by its inability to export the final product - at least to developed nations - due to uncompetitive state of its processing equipment. The author should therefore clarify the specific competitive advantages and means of their exploitation. The author makes a proposition based on the type of economy CIS countries have: market, planned or oligarchic. This proposition is questionable. Economic organizations of CIS countries are specific. This is determined to a large extent by their cultural traditions. Economic systems of CIS countries are not identical to that of the former USSR or other socialist countries. Therefore, use of the term 'planned economy' is hardly accurate in reference to CIS countries.

4. One-Sided Nature of Conclusions Conclusions of this article touch upon only one aspect, i.e. economic and trade relations among CIS countries. Yet this work has sufficient empirical data to reach conclusions about another aspect, development prospects of Russian foreign trade. It is necessary to note the role trade with CIS countries will play in Russian foreign trade, and also the place integration takes and will take in Russian extemal economic policy. Despite certain critical points, the article by Professor O. Nosova, "Russia's Foreign Economic and Regional Integration in CIS Countries: Theory, Problems and Options," presents an overall meaningful exploration into the current state of the Russian economy in intemational trade, as well as modem integration processes among the CIS. The empirical value of this article also lies in the fact that it uses the most up-to-date statistical data, helping to uncover the most relevant trends. It is also worth mentioning the author's practical observations and some recommendations. While analyzing regional stmcture of Russian foreign trade, she points to the necessity of developing trade relations with various regions, including developing countries. The latter is very important be-

Comment on: Russia's Foreign Economic Relations

331

cause in markets of developing countries, the lack of competitiveness of Russian economy is less apparent as in trade relations with industrialized nations. Thus, development of foreign trade with developing nations may be construed as one of the ways to achieve diversification within the Russian economy in the future. The author also notes that one of the instruments for strengthening the Russian economy in international trade lies with a solution to the problem of external debt. This observation is accurate, since presence of a clear and precise mechanism regulating management of external debt would entirely eliminate another potential default as occurred in 1998. Additionally, such a mechanism would allow Russia to be granted most favored nation status by industrialized countries. Nosova points to the main factors that hinder integration within the CIS (inefficiencies of economic structures, economic decline in processing industry, shrinkage in volumes of trade operations among CIS countries) and illustrates possibilities to eliminate them. Her proposition about the necessity of accepting an intergovernmental program for creating a single trading zone deserves special attention, as this would eliminate any kind of trading barriers and unify customs tariffs. It is noteworthy that this exact goal is on the agenda of current meetings among leaders of CIS countries. Thus, Nosova's recommendations certainly have practical value and should be taken into consideration by leaders of Russia and those throughout the CIS.

List of Figures

Fig. Al. Effect of the Boom on the Labour Market

13

Fig. A2. Resource Movement Effect of the Boom on the Commodity Market Fig. A3. Spending Effect of the Boom on the Commodity Market

14 15

Fig. A4. Russian Federation: Unemployment as Percent of Total Labour Force, 1989-1998

20

Fig. A5. Domestic Oil Market, Price Differentiation and Exports

22

Fig. A6. Long-Term Development of Oil Price (1860-2002)

24

Fig. A7. Russian Federation: Real Exchange Rate

27

Fig. A8. Real Exchange Rate Developments of Belarus, Russia and Ukraine Fig. A9. Real Exchange Rate Developments of Selected Transition

28

Countries

29

Fig. A10. Real Exchange Rate Developments in Bulgaria and Romania.. 30 Fig. A l l . Ratio of Oil Price to Natural Gas Price in Russia

31

Fig. A12. Russian Federation: Gross Fixed Investment

34

Fig. A13. Russian Federation: Gross Fixed Investment in Prices of 1995

34

Fig. A14. Russian Federation: Gross Fixed Investment, Annual Growth. 35 Fig. A15. Russian Federation: Investment in Basic Funds

35

Fig. A16. Russian Federation: Investment in Fuel

36

Fig. A17. Russian Federation: Structure of Investment in Fuel Industries

36

334 List of Figures Fig. A18. Russian Federation: Oil Export Price to Domestic Oil Price Ratio

37

Fig. A19. Russia: Real Oil Price Index

37

Fig. A20. Current Account as Percent of GDP

38

Fig. A21. Russian Federation: Fuel Production

38

Fig. A22. Russian Federation: Fuel Production

39

Fig. A23. Russian Federation: Industrial Employment

39

Fig. A24. Russian Federation: Employment in Mining, Quarrying and Energy Industry 40 Fig. A25. Russian Federation: Shares of Mining, Quarrying and Energy Industrial Employment 40 Fig. A26. Russian Federation Shares of Mining, Quarrying and Energy Industrial Output 41 Fig. A27. Russian Federation: Mining, Quarrying and Energy Industry Output 41 Fig. A28. Russian Federation: Employment in Mining, Quarrying and Energy Industry

42

Fig. A29. "Dutch Disease": The "Present Benefits - Future Losses" Tradeoff

47

Fig. CI. Weighting Scheme of Official Consumer Price Index in Russia 76 Fig. C2. Weighting Scheme of Core Inflation with Different Re-Weighting Methods Fig. C3. CPI and CPI ex in Russia from January 1997 to December 2002

78

Fig. C4. CPI and Trimmed Mean Measure from January 1997 to December 2002

79

77

List of Figures

335

Fig. C5. CPI and Edgeworth Index from January 1997 to December 2002

80

Fig. C6. CPI and Core Inflation Measure based on p* Approach for Russia from January 1997 to December 2002

82

Fig. C7. All Russian Core Inflation Approaches from January 1997 to April 2003 Fig. Dl. Russian Public and Corporate Foreign Debt Fig. D2. Exchange Rate Development Ruble/US-Dollar for Selected Periods (Daily Data) Fig. D3. Decision-Making by the Russian Central Bank, Competition and Efficiency in the Russian Banking System

85 96

103 107

Fig. D4. Money Supply Aggregates 1999-2003

109

Fig. D5. Selected Interest Rates 2000-2004

Ill

Fig. Fl. Energy Consumption and Technical Energy Saving Potential in the Russian Economy in 2002

167

Fig. F2. Contracting Scheme

170

Fig. Gl. Growth of Output and Disposable Income

189

Fig. G2. Imports Increased on Back of Stable Real Effective Exchange Rate

189

Fig. G3. Labor Productivity and Output

192

Fig. G4. Output, Labor and Capital in Russia from 1960 - 2003

194

Fig. G5. High Growth Rates May be Secured only by Rise in Productivity

195

Fig. G6. Domestic Exports by Commodity Groups

200

Fig. G7. Breakdown of Domestic Exports by Commodity Groups

201

Fig. G8. Real Investments and Effective Exchange Rate

203

336 List of Figures Fig. G9. Nominal Interest Rates

203

Fig. GIO. Real Interest Rates

204

Fig. G i l . Current Account and Economic Growth

205

Fig. G12. Transformation of Growth Mechanism has Begun in Mid 2002

208

Fig. G13. Productivity Starting to Grow on the Back of a Stronger Ruble

208

Fig. G14. Market Exchange Rate versus PPP: International Comparisons

210

Fig. G15. Private Debt Grows on the Back of Decreasing Sovereign Debt

215

Fig. G16. The Share of Dollar Deposits is Falling

216

Fig. HI. Attracted Foreign Investments

227

Fig. H2. Structure of Attracted Foreign Investments

228

Fig. H3. Companies with Foreign Participation in Russia

230

Fig. H4. Companies with Foreign Participation in Russia

231

Fig. H5. Interregional Contrasts (2002)

232

Fig. H6. The Northwest ICT Cluster Chart

238

Fig. H7. IT Market Evolution in Russia and the World

242

Fig. II. FDI Flows to China 1980 - 2002

258

Fig. 12. FDI Stocks in China 1980 - 2002

259

Fig. 13. Exports by Foreign Direct Invested Enterprises (FIEs) and Total Chinese Exports, 1985 - 2002 261 Fig. Jl. The BSR Share in Export and Import of the Countries around the Baltic Sea in 2000 292

List of Figures

337

Fig. Kl. The Share of Regional Unions in Russian Export in 2002

309

Fig. K2. Russian Foreign Trade with APEC

313

Fig. K3. The Trade Dynamics of Russia and the CIS

314

Fig. K4. Physical Volume Dynamics of Gross Domestic Product Index in Fixed Prices in 2001 Fig. K5. Dynamics in the Industrial Production Volume Index

317 319

Fig. K6. Share of the Mutual Trade in the Cumulative Trade Turnover in the CIS 319 Fig. K7. The Share of Interregional Export of the CIS in Total Export Volume 320

List of Tables Table Al. Net Exporters and Net Importers of Different Groups of Merchandise Goods 1991-2000

43

Table CI. Frequency of Trim within the Trimmed Mean Measure of Core Inflation

78

Table C2. Core Inflation for the first four Months of 2003

84

Table Dl. Loans and Deposits with Credit Institutions

94

Table D2. Exchange Rate Regime in Russia, China and South Korea on Basis of Daily Data Table El. Obligations and Expenditures of the World Bank/ International Development Agency Related to Assistance to Russia

127

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

128

Table E3. EU-Russia Foreign Trade, 1996-2002

140

Table Gl. Services Grew Faster than GDP in 2002

190

Table G2. Gross and Net Exports of Selected Countries

197

100

Table G3. Accumulated FDI per Capita in Selected Transition Countries, 1990-2001

198

Table G4. FDI Receipts by Sector

198

Table G5. Assets of the Largest Banks

216

Table HI. Regions - Leaders by Accumulated FDI

244

Table Jl. Dummies of the Gravity Equation (3)

284

Table J2. The Gravity Models for Exploring Trade Flows of EU15 and CC12

286

340 List of Tables Table J3. The Gravity Models for Exploring Trade Flows between the BSR Counties

289

Table J4. The Baltic States' Exports and Imports by Groups of Countries in 2000

291

Table J5. The Specifications and Estimators of the Gravity Equations Based on Data of the Countries Involved into EU Eastward Enlargement 295 Table J6. Variables of the Gravity Models Specifications Presented in the Appendix 1

297

Table Kl. The Main Russian Trading Partners in 2002

310

Table K2. Dynamics of World Economic Indicators in 2001

312

Table K3. Fixed Capital Investment in the CIS between 1995-2001

318

Table K4. The Macroeconomic Indicators of Regional Unions in the CIS in 2000 Table K5. The Main Macroeconomic Indicators in the Fixed Prices

321

in the Whole in CIS

324

Table K6. CIS Trade Balance in 2001

325

Table K7. Real Disposable Population Incomes in the CIS

325

Table K8. Legal Foreign Working Labor Force in the CIS in 1999

326

List of Contributors Irina Eliseeva, University of Economics and Finance, St. Petersburg, Russia

Petra Opitz, Deutsche Energie-Agentur, BerUn, Germany

Cathleen Faber, University of Potsdam, Germany

Tiiu Paas, University of Tartu, Estonia

Jose Fajgenbaum, IMF, Washington, D.C., USA

Peter Palinkas, DGII; European Parliament, Luxembourg

Grigori Feiguine, St. Petersburg State University of Economics and Finance, Russia

ChristofRuehl, The World Bank Russia Country Office, Moscow, Russia

Evgeny Gavrilenkov, Bureau of Economic Analysis, Troika Dialog, Moscow, Russia

Christopher Schumann, European Institute for International Economic Relations (EIIW), University of Wuppertal, Germany

Edward M. Graham, HE - Institute for International Economics, Washington, D.C., USA

Hans-Gerhard Strobe, University of Potsdam, Germany

Thomas Gries, University of Paderbom, Germany

Paul J.J. Welfens, European Institute for International Economic Relations (EIIW), University of Wuppertal, Germany

Ruslan Grinberg, Russian Academy of Sciences, Moscow, Russia

Natalja von Westemhagen, Deutsche Bundesbank, Frankfurt/M., Germany

Albrecht Kauffmann, European Institute for International Economic Relations (EIIW), University of Potsdam, Germany

RalfWiegert, European Institute for International Economic Relations (EIIW), University of Potsdam, Germany

Olga Nosova, National Technical University Kharkov, Ukraine

Audrey P. Zaostrovtsev, State University of Economics and Finance, St. Petersburg, Russia

Nina Oding, Leontief Centre St. Petersburg, Russia