The evident slowing of the Russian economy has raised questions about available options to revive growth.

Investment boomed from 1999 to 2000, expanding from 9.3 percent to 17.7 percent. This was seen as the main impetus for increased productivity and a future recovery of GDP. However, data on fourth-quarter 2000 and first-quarter 2001 suggests that this view may be too optimistic.

The recent decline in investment coincided with a fall in GDP, which proves that the government’s economic policy in 2000, aimed at providing the real sector with greater liquidity, was unsuccessful.

The Russian economy seems unable to allocate the large balance-of-payments surplus for investment, and the increase in the monetary supply merely resulted in appreciation of the real exchange rate.

The inability to absorb financial resources has very much to do with the poor leverage of investment growth.

In 2000, banking loans comprised only 3 percent of investment. The short maturity of banking liabilities (90 percent are less than one year) is not the only constraint in terms of issuing long-term loans, and there seem to be no options to deal with this problem, at least in the near future.

Foreign borrowing is not possible, and an increase in deposits will require faster growth in real incomes and greater trust in the banking sector.

Another weakness is the low capitalization of Russian banks – total banking capital amounted to 4 percent of GDP as of the end of 2000. Furthermore, at the end of the first quarter in 2001, eight of Russia’s top 20 banks showed a year-on-year deterioration of their capital-adequacy ratios, and five of these banks operated with this ratio close to the 10 percent minimum set by the Central Bank of Russia.

Foreign investment provided no support; in 2000, Russia attracted only $10 billion in foreign investment. Foreign direct investment inflows to Russia totalled only $4 billion, or 1 percent of global foreign direct investment, in 2000. Also, this capital mainly targeted sectors with short production cycles.

Russian producers financed investment mainly from internal resources. Oil companies and Gazprom contributed half (some $10 billion) of industrial investment in 2000.

The poor leverage of investment growth suggests a strong correlation with the health of Russian enterprises, and therefore seems problematic. While the 1998 ruble devaluation made the industrial sector competitive on a price basis, this advantage is now exhausted as a result of high inflation.

Data for 2000 indicates a substantial increase in prices for natural gas (26 percent) and gasoline (38 percent) and a 43 percent rise in electricity costs. These tariff hikes in fact acted as a way for natural monopolies to preserve their revenues by placing the burden of real appreciation on other sectors of the economy. This resulted in declining net margins throughout the non-export manufacturing sector.

Expectations are also crucial in terms of investment growth, particularly regarding tax reform. In this respect, the government’s inability to reach an agreement on the restructuring of Paris Club debt is a worrying sign, as it increases the risk that the tax burden will not be reduced in upcoming years due to the need to honor foreign-debt payments.

At the same time, the approval of amendments to the profit-tax law allowing for an accelerated depreciation scheme (favorable for non-export manufacturing) is a positive development. However, this is probably not sufficient to convince enterprises to invest more. Rather, they are waiting for further confirmation that the easing of the tax burden is not temporary, as well as proof of the government’s ability to implement structural measures, such as a new Land Code.

An important indicator of companies’ willingness to invest is the scale of capital flight. Despite its growth to some $26 billion in 2000, capital flight fell to 25 percent of exports, from 30 percent in 1999.

Data for the first quarter in 2001 suggests that it remains unchanged compared to first-quarter 2000 at some $7 billion, or 27 percent of exports. Expectations of a continuing increase in tariffs create incentives to keep more money abroad.

Should capital flight increase in second-quarter 2001, this should be interpreted as a sign not to expect a substantial increase in investment this year.

In conclusion, Russia seems to be the victim of a vicious cycle in which economic slowdown provokes a decline in investment, which in turn leads to slower GDP growth.

Two major goals should be set in order to break this relationship.

Institutional weakness, mainly the banking sector’s inability to provide long-term resources, should be addressed.

To preserve the competitiveness of domestic production, control over tariff hikes is crucial. In addition, the government has little time remaining, as once it has begun, deterioration of investment perceptions is extremely hard to reverse.

Alfa Bank