TCS Daily

Oil, Money and Confidence

By Pavel Kohout - August 5, 2005 12:00 AM

Russia is generally associated with bad news rather than good. After all, it's perhaps the only country in the world to have a whole ministry dedicated to emergency situations. However, Russia is not only the Yukos scandal, Chechen terrorists or Kursk (the lost nuclear submarine), so I thought it high time to deliver some underreported good news.

Take the economy, for starters. Russia has experienced 5.1% GDP growth during the first quarter of 2005. This is a formidable figure even by the measures of New Europe. Only the Baltic countries and Slovakia (all relatively tiny) leave Russia behind. Thanks to stabilization of the ruble exchange rate, dollar-denominated GDP has grown at a fascinating pace. In 1999, the whole Russian economy produced only $195 billion of value added. In 2003 the figure was more than twice that: $432 billion. In 2005, the IMF expects the Russian economy to be worth $755 billion in current prices, making it the 10th biggest economy in the world.

Remember, nominal dollar GDP reflects both improvement of living standards and development of local currency vs. the dollar. Viewed from that perspective, both living standards and perception of the ruble have improved significantly.

One might object that Russia is little more than an oil-fueled economy with little ability to add value. This was true during the 1990s, but things are gradually changing. Ten or even five years ago, Russia's economy was totally dependent on oil, with other industries in ruins and banks that were a joke.

While oil is still very important, Russia has become a paragon of sound public finance thanks to the awesome windfall from commodity markets. No, it's not that the government is spending money like a drunken sailor, thereby pushing consumption and fueling the economy. The government realizes that oil prices might fall. So, it is borrowing from Norway's fiscal playbook. It formed an Oil Fund in 2004. Although it is too early to judge, this step alone is worth praising.

Russia's currency, the ruble, is still "soft," with relatively high inflation and limited convertibility. Yet it has been gaining in popularity and enjoys growing confidence among the public. It can be shown that ruble bank deposits by households have steadily grown over recent years, while total value of foreign currency deposits has stagnated.


Source: Central Bank of Russia

And this isn't because Russians still keep the bulk of their savings in mattresses. People are no longer afraid to engage in long-term commitments with banks. The chart below shows the volume of demand deposits - the shortest financial instrument available - versus long term deposits maturing in one year or later.

Hardly any other indicator better shows improving confidence in the banking sector. In 1999, one year after the financial crisis, cash was king and people held most of their deposits in short instruments. Demand deposits were almost eight times more valuable than long-term deposits; now, the ratio has nearly reversed. Deposits with maturities over three years, very rare a few years ago, are relatively common now, making up more than one tenth of deposits.

Banking reform made progress in 2003 and 2004. In 2004, the central bank and government launched a state insurance program for household deposits as a primary element of reform. The Economist's Intelligence Unit considers other key reforms as new standards of accounting, disclosure requirements, bank monitoring, procedures for bank resolution, and the protection of creditor rights. This is no Potemkin village, these are serious reforms.

As banks have access to long-term money on the side of deposits, they are able to lend more aggressively. One of the reasons why the financial crisis was so brief was that Russia was not a credit-based economy, thus little credit turned sour. The banking market was almost a greenfield as recently as 2000. This is no longer true. State-of-the-art payment systems have been introduced. Elderly people in Moscow, for example, began receiving their pensions via cards in 2003. Similarly, modern credit scoring systems have been introduced to avoid creation of a huge bulk of bad debt.

The credit boom does not involve banks only. Russian capital markets are known mostly because of the infamous Yukos story, but few people know Russia also has a booming corporate bond market. Just see With risk spreads at their all-time lows, credit is cheap and potential investors have lots of capital to allocate. Goodbye central planning, hello free markets.

The credit boom also explains why there is relatively high inflation (13.3% in June 2005). According to quantitative theory of money, Russia simply cannot have low inflation while growing so rapidly. In this case, inflation is not an indicator of sloppy monetary policy (and yes, Russia did have disastrous monetary policy, especially in the first half of 1990s) but an inevitable phenomenon at this stage of development.

Non-oil industries have not yet even remotely recovered from the fall of the Soviet economy. However, in the conditions of basic macroeconomic stability, working banks and capital markets, Russia's human capital - of which she has plenty - will inevitably form new, prosperous ventures in industry, services, you name it. Yes, there are still serious issues to overcome: low life expectancy, HIV prevalence and environmental hazards, but the grim picture of a helpless post-Soviet economy is changing rapidly. Russia is an emerging economy to be reckoned with.


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