III. ECONOMIC TRENDS AND OUTLOOK Major Trends and Outlook Russia is in the midst of an unprecedented transition from a centrally-planned to a market economy. Similarly, Russian foreign trade, formerly concentrated in the other republics of the former Soviet Union, is in the process of integration into the world economy on a market basis. GDP: Real GDP fell by 13% in 1991, 19% in 1992 and another 12% in 1993 on a year-on-year basis. Real GDP for the first quarter of 1994 declined 17% from the same period in 1993. Industrial output declined by 18% in 1992, 16% in 1993, and (preliminarily) 25% in the first quarter of 1994 over the same period in 1993, largely as a result of the decline of the enormous military industrial complex of the former Soviet Union. However, production of consumer durables including automobiles and appliances as well as food processing is increasing. In 1993, transport was down by 25 percent from the previous year's volume, construction materials by 15 percent, and agriculture by 4 percent. Oil extraction and natural gas production fell slightly. The service sector of the economy, as recorded in official statistics, grew almost 45 percent in 1993 over 1992, to 42 percent of total GDP. Official unemployment remained below 1 million in 1993, while unofficial unemployment was estimated at 5 million; the government has forecast 7 million unemployed, or about 10% of the working population, by the end of 1994; independent estimates predict a jobless rate as high as 15%. Disposable Income: Real disposable income increased by 10% in 1993, and Russians hold an estimated $10 billion in foreign currency cash. With the sharp rise in consumer purchasing power, Russians spent a lower proportion of their income for foodstuffs and essentials. Recorded consumer sales increased by 2% and real savings began to grow after a prolonged fall. Despite the increase in consumer saving, recorded capital investment declined by 15 percent totalling barely half the level recorded in 1991. With the development of a market economy there has been an increasing differentiation of income levels. Foreign direct investment remains below $1 billion annually. Monetary Policy: Monetary policy turned highly inflationary in 1992 with excessive ruble emissions from the Central Bank of Russia (CBR) and its counterparts in the other CIS republics. In mid-1993 Russia abolished the ruble zone, forcing other republics to issue their own currencies, and began to restrict state credits to domestic enterprises. The CBR implemented real positive interest rates in late-1993. As a result of these steps inflation declined from a peak of 2500% for 1992 to 900% for 1993. The monthly inflation rate was down to 15% by the end of 1993 and fell further to about 10% monthly during the first quarter of 1994. Government Spending: After the dissolution of the Soviet Union, Russia slashed defense spending and began to cut investment and domestic and foreign subsidies. Total government spending in 1993 equalled 35 percent of GDP with a consolidated budget deficit equal to 8 percent of GDP, a sharp improvement over the 18 percent of GDP deficit in 1992. The 1994 budget, which as of mid-June had not received final parliamentary approval, included a projected deficit of 70 trillion rubles, equal to 9.6% of GDP. Financing of the deficit is accomplished primarily by borrowing from the Central Bank. A domestic market for Treasury bills began operating in 1993 and is increasingly active. Taxation: Under the current taxation system introduced in 1991, revenue is collected mostly at the federal government and is divided between the federal and regional governments. In practice this division is the result of an ad hoc bargaining process. A proposed new tax law aims to augment regional revenue to match increased responsibilities. Corporate profit taxes are the GOR's primary source of revenue, representing almost 40 percent of 1993 revenues. The corporate profit tax rate, formerly 32%, has now been divided into a federal and regional portion with ceilings of 13% and 25%, respectively. A value-added-tax was introduced at 28% in 1992 and cut to 20% (with a 3% surtax) in 1993. VAT receipts represented 25 percent of 1993 government revenues. The decline in industrial production and the illiquidity of large sectors of the economy have sharply reduced the tax base, and a significant proportion of taxes and trade duties goes unpaid. IMF Membership: Russia became a member of the International Monetary Fund in mid-1992 and made a first credit tranche drawing of $1 billion in August of that year. In 1993, based upon limits on credit expansion and the budget deficit, the IMF approved a $1.5 billion drawing under the new Systemic Transformation Facility. Russia did not meet its third quarter targets as a result of credits issued for the harvest and for winter provisioning of the Russian northern territories. Renewed stabilization policies were implemented during the fall, opening the way for a second $1.5 billion STF tranche which was approved in April 1994. Russia and the IMF are negotiating a $4 billion upper credit tranche standby program. Exchange Rate: Russia implemented a unified exchange rate regime in mid-1992 and the ruble is now traded daily against the dollar and other major currencies at the Moscow Interbank Currency Exchange (MICEX) and in an interbank market. A number of other exchanges have opened throughout the country. The ruble has depreciated steadily against the dollar during 1994 at about the same rate as inflation. Sharply increased CBR gold and hard currency reserves totalled $4.4 billion at the end of 1993. The CBR intervenes directly on the MICEX and through commercial banks to influence the ruble exchange rate. The CBR annual discount rate, peaking at 210% (annual, non- compounded) in 1993, was gradually reduced to 185% by the beginning of June 1994 as inflation subsided. Rates remain well above the rate of inflation. Exporters are required to exchange 50 percent of hard currency earnings for rubles. The CBR estimates capital flight during 1992-93 to have totalled $10-15 billion. In an effort to stem further capital flight Russia in January 1994 introduced a currency monitoring system requiring exporters to maintain with commercial banks a "passbook" of all foreign currency transactions. These can be checked against commercial contracts and Customs declarations. Laws, Regulations, Decrees: Russia in March 1993 passed a bankruptcy law prepared with the assistance of the American Bar Association, but the law has been applied only in a handful of cases to date. During early 1994 the government was preparing parallel regulations for resolving inter- enterprise arrears, estimated at $8 billion, and winding up unprofitable enterprises. A presidential decree of May 23 ordered state enterprises to settle their inter-enterprise debt and instructed the government to establish a system of promissory notes to handle any remaining debt. Another presidential decree on the same date threatened unprofitable and corrupt state enterprises with direct state control or liquidation. An antimonopoly law passed December 1993 requires semiannual review of industry prices and gives the Antimonopoly Committee extensive authority in promoting competition. Russia passed a Law on the Protection of Shareholders in October 1993 and is preparing a brokerage law facilitating trading of shares through licensed brokers. Russia has not yet passed a corporation law. World Bank Activity: Russia joined the World Bank in June 1992 and received approval of a $600 million rehabilitation loan for financing critical imports in August 1992. Further loans totalling over $1 billion were approved in 1992 and 1993 for employment services and social protection, privatization, oil sector rehabilitation, and highway maintenance. In May 1994 the World Bank began negotiations on five further loans totalling $1.7 billion for developing financial institutions, land use/registration and agricultural reform, industrial restructuring, and environmental protection in the oil sector. Assistance Programs: The international program of technical and humanitarian assistance, begun in 1992, became increasingly active in 1993. The United States is the largest source of technical assistance and funding. The Group of Seven in 1993 established a Support Implementation Group (SIG) in Moscow and opened its office in 1994. The IMF, World Bank and European Bank for Reconstruction and Development (EBRD), which opened offices in Moscow in 1992, have active technical assistance programs and provide funding in various areas. The International Finance Corporation has focused its assistance activities on the privatization program. The European Community has mobilized an assistance program, and individual countries have established bilateral arrangements. Principal Growth Sectors The Russian economy has highly uneven growth across sectors. Although the Russian government is attempting to channel investment funds into high prestige, capital-intensive sectors such as aerospace, shipbuilding, oil and gas, and telecommunications, the most powerful force shaping the economy is increasingly consumer demand. An early area of growth in consumer demand is in low-cost subsistence products: food and clothing. During its first stages, this demand led to surges in imports (such as candy bars, ice cream, foreign clothing). Now, this consumer demand is stimulating domestic production, which in turn leads to demand for raw materials (such as imported foodstuffs) and capital equipment (food processing machinery). A second area of growth is in higher cost consumer products: homes, home appliance, and home electronics. This, in turn, creates demand for building materials, construction equipment, and manufacturing equipment. Government Role in the Economy Roughly 85 percent of wholesale and retail prices had been liberalized by the end of 1992. Together with a virtually unrestricted import regime, price liberalization ended shortages of consumer goods. During 1993 prices in remaining major sectors - energy, rail transportation and housing - were decontrolled, although much housing stock has yet to be privatized. Energy prices remain controlled at the wholesale level, with domestic prices substantially below international levels. By mid-1994 Russia had liberalized domestic trade and dismantled virtually all non-tariff restrictions on foreign trade. Centralized (subsidized state) imports were phased out in 1994, as was the system of quotas and licensing for exports except for a few commodities involving international commitments. In mid-1992 Russia applied to begin the process of accession to GATT and passed an international-standard Customs Code and Tariff Law in 1993. Import tariffs rose from zero to an average 7-8% in 1993; a tariff averaging 15% was introduced in July 1994. Massive privatization began in 1992. A voucher was issued to each Russian citizen. By mid-1994 two-thirds of enterprises slated for share sales have been placed on a corporate, or joint-stock basis, and half of the total have been privatized; 70% of small enterprises have been privatized. An estimated 70% of the work force now earns a living outside the state sector. Through mid-1994 shares were sold according to one of three variants. The two most popular of these allowed managers and employees to receive 25% of shares free, with rights to purchase an additional 15%; or to purchase 51% at a discount. In either case, another 20-30% usually was reserved for the federal, regional or local government, and the remainder were auctioned to investors. Foreign investors were able to purchase shares by buying vouchers. Voucher privatization is slated to end in June 1994 and will be replaced by a system in which the government will sell off many of the remaining enterprises for cash and restrict the extent of ownership by managers and employees. Urban residents are being allowed to purchase their residences for nominal fees, and a September 1993 decree permitted sale of agricultural land among Russian citizens. The December 1993 Constitution guaranteed the right to own private property. The government presidium in May adopted a draft land law which would prohibit foreigners from owning land but allow them to lease it up to 99 years. The draft law also strictly controls land use and limits the amount of land an individual may own. The number of registered commercial banks is now over 2,000 and continues to grow. About one third of the banks derive from the specialized banks of the late Soviet era; the rest have been created de novo. Many were founded by enterprises as an expedient way to draw directed CBR credits, and the enterprises remain the sole large depositor and borrower for many of the banks. The very large banks are widely held, although the state, through the CBR of Russia or the State Committee on Management of Property still retains significant equity interest in the former specialist banks (such as Agropromstroybank and Promstroybank). By law, the CBR holds a major share in Vneshtorgbank (Foreign Trade Bank) and a controlling interest in Sberbank (National Savings Bank). Balance of Payments Situation Russia's trade with all countries except the Commonwealth of Independent States, or former USSR minus the three Baltic republics, totalled $43.7 billion in exports, $27 billion in registered imports, and an estimated $6 billion in unregistered imports in 1993, leaving a positive balance of about $11 billion. Total trade turnover for the first quarter of 1994 fell by 6% from the level of the same quarter in 1993 to $13 billion. The chief cause of the fall was a sharp drop in imports; exports continued to grow steadily. Russia assumed 61% of the Soviet Union's debt in 1991 and subsequently assumed most of the other republics' share in return for the republics relinquishing claims on Soviet foreign assets. Total foreign debt stands at over $80 billion, $45 billion of which is owed to the Paris Club, $26 to the London Club, and the remainder to other countries and suppliers. Debt service obligations totalled nearly $32 billion in 1993. An April 1993 agreement with Paris Club creditors rescheduled $14.5 billion of Russia's official bilateral payments falling due in 1993. Negotiations with London Club creditors to reschedule commercial bank credits resulted in agreement in principle but stalled in late 1993 over the issue of Russia's refusal to waive sovereign immunity. Pending conclusion of an agreement, the Russian government is setting aside money in the budget for debt servicing payments to the banks. A further $21 billion in debt service falls due in 1994. The Paris Club in June 1994 agreed to reschedule $7 billion of this over a fifteen-year period, with a three-year grace period. Russia has proposed formation of a creditors club for rescheduling uninsured supplier credits. The Duma in 1994 set an overall ceiling on Russia's foreign debt at $100 billion. The Vneshekonombank (VEB, or the Bank for Foreign Economic Relations) of the USSR had repaid half of its debt to enterprises and private individuals by mid-1994 and was reorganizing to resume operations. The Russian government says that Russia is owed $140 billion by other countries. Russian officials acknowledge that much of this lending by the Soviet Union will never be repaid. Russia expects to receive $1.5 billion from its debtors in 1994, primarily in payments in kind. Under intergovernmental agreements Russia continues to lend to some developing countries, although in April 1993 it ceased granting "technical" loans to fellow CIS republics and instead offered government credits tied to debt repayment. However, Russia continues to supply large amounts of energy to the CIS at a discount. According to data from the State Statistics Committee, Russia in 1993 had a $15 billion positive balance of payments in the current operations account. This was due primarily to the large trade surplus; Russia had a negative balance of $500 million in services and of $4.2 billion in capital and financial operations. There was a net inflow of $500 million in foreign investment. Russian Balance of Payments (billions of US dollars) FIRST HALF TOTAL (1) 1993 1993 --------------------------------------------------------- Balance of trade 5.9 13.8 exports 20.9 43.0 imports -13.7 -27.0 humanity/technical assistance -1.3 -2.2 Goods and services -.2 -.5 exports 1.6 4.1 imports -1.8 -4.6 Net interest .6 -1.6 receipts 2.1 3.9 payments -1.5 -5.5 Transfers and remittances 1.4 3.4 to Russia 1.6 4.3 from Russia -.2 -.9 ----- ----- Current Account Total 7.7 15.1 Direct Investment .4 .4 to Russia 1.0 1.7 from Russia -.6 -1.3 Portfolio investments .5 .1 to Russia .7 .4 from Russia -.2 -.3 Other investments .1 -3.8 medium/long-term loans to Russia 3.2 5.1 repaym. of principal (scheduled) -5.7 -13.0 foreign credits extended by Russia -.8 .1 interest on principal (scheduled) 6.7 11.0 other capital (commercial bank assets/liabilities, etc.) -3.5 -7.0 Deferred and rescheduled payments on interest and principal 6.1 15.5 Deferred and rescheduled income on interest and principal -8.2 -16.4 Capital/financial operations -1.3 -4.2 Reserves -2.3 -3.3 Errors and omissions (includes capital flight) -4.1 -7.6 General Balance 0.0 0.0 (1) This information is from the State Statistical Committee and follows an official Russian format. The IMF has produced somewhat different figures in a standardized format. Governments and enterprises in the Commonwealth of Independent States (the former Soviet Union minus the Baltic republics) owe Russia 2.3 trillion rubles (about $1.15 billion as of the preparation of this document). Russia expects to receive repayment of a portion of this debt in the form of transfers of ownership rights on selected pieces or property. Resolution of payment and accounting problems between state enterprises is a high priority. In addition, CIS enterprises and organizations owed Russia 3.5 trillion rubles for direct supplies at the end of 1993, 1.5 trillion rubles of which was for fuel and energy. Trade and Investment Barriers -ownership and jurisdictional disputes; -financial illiquidity of a majority of Russian firms; -lack of a normal commercial market; -absence of a commercial legal framework; -high cost and general difficulty of doing business; -severe infrastructure problems (telecom, roads, banking system, ports, etc. -payments arrears and frozen accounts; -frequent changes in government and firm personnel; -high taxes which frequently change; -frequent changes in the import and export regime; -lack of systematic and accessible credit information; -mounting crime and corruption. Labor Force The Russian labor force of 72 million workers is undergoing tremendous changes. Although well-educated and skilled, the Russian labor force is inflexible and mismatched to the rapidly changing needs of the Russian economy. For example, Russia has a large surplus of scientists, and the largest portion of the work-force continues to work in obsolete Soviet-era industries. Official unemployment, although increasing, remains low at less than 1.5 percent. (Unemployment is highest among women and young people.) However, millions of Russian workers are underemployed. As many as six million workers were temporarily furloughed in the past year. Many Russian workers compensate by working other part-time jobs. In February 1994, the average wage was 145,000 rubles. Workers in the energy and banking sectors received the highest wages. Workers in agriculture, science and health were among the lowest paid. Nearly all Russian workers are members of trade unions. However, western-style trade unions are active in only a small number of sectors. There continues to be a large number of strikes and other labor unrest in Russia, but most of this takes place in the state-dominated heavy industries. Major Local and Third Country Competitors in Specific Sectors The major local and third country competitors for U.S. companies in the telecommunications, healthcare, oil and gas equipment and computer sectors are as follows: Telecommunications Local: Rostelecom Third country: Germany, Belgium, France Oil Equipment Local: Lukoil, Yukos, Rosneft Third country: France, Norway, Britain Gas Equipment Local: Gazprom Third country: Italy, Germany, France Healthcare Local: Medtekhnika Third country: Germany, Japan Computers Local: IVK, Meriset Third country: Korea, Singapore Infrastructure Situation re: Goods/Services Distribution Although Russia boasts of an extensive transportation infrastructure built during the Communist era, its communications infrastructure leaves much to be desired. During the Communist era, Russia invested heavily in building transportation infrastructure: roads, railways, airports, and ports. During later years, the government had difficulty maintaining many of these facilities. In the breakup of the Soviet Union, Russia lost a number of key ports, which has led to overcrowding at the St. Petersburg port. Some western companies are finding it easier to ship goods to Helsinki and then transport them into Russia by truck. In addition, SeaLand Service operates a container service out of the Far East port of Vostochniy to Moscow, with onward links to Western Europe. The Russian government is today seeking Western assistance to repair and upgrade many major transportation and communications facilities. Despite expected large Russian investments in fiber optic lines, weak communications infrastructure (phone and postal services in particular) will complicate goods distribution for years to come. Major Infrastructure Projects Underway o Oil and Gas: The Marathon, McDermott, Mitsui, Mitsubishi and Shell Sakhalin II consortium will develop large oil and gas fields offshore Sakhalin Island in a $10 billion project. o Oil and Gas: Texaco is involved in a $2.5 billion greenfield oil exploration project in the Timan Pechora region of the Komi republic. o Civil Aviation: Russian manufacturers are using Western engines and avionics to bring the Russian civil fleet up to world standards. o Civil Shipbuilding and Harbor Modernization: Russia is seeking to modernize the St. Petersburg, Vladivostok, and other ports. Russian shipyards are building oil tankers, fishing trawlers, cargo ships, and pleasure craft. o Housing: The Russian defense sector is beginning to address Russia's severe housing shortages, particularly the needs of retired military officers and troops. Russian defense firms are producing homes, apartment buildings, internal equipment (e.g. boilers), and appliances. o Defense Conversion: The Russian government is attempting to turn Russian defense firms into the major suppliers of Russian consumer and industrial goods. The Russian defense sector has been producing nearly all of Russia's televisions, video cassette recorders, and cameras, plus most washing machines and vacuum cleaners. o Telecommunications 50 by 50 Project: U.S. West is involved in a $40 million upgrade of Russian telecommunications that involves 50,000 kilometers of fiber and microwave lines and 50 digital exchanges in 50 Russian cities. o Global Navigation System: Russian firms are working on a satellite system to improve aircraft navigation across Asia. o Proposed US-Russia Space Station: Russian firms are preparing to work with U.S. partners on a joint space station.