**COUNTRY COMMERCIAL GUIDE--RUSSIANFEDERATION**

**FISCAL YEAR  2000**

 

 

**II.  ECONOMIC TRENDS AND OUTLOOK**

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**Major Trends And Outlook**

 

Russia’s 1998 economic crisis,sparked by spillovereffects of the East Asian crisis, low oilprices and a fundamental fiscal imbalance, led to aloss of confidence in Russia's economy.  Investors withdrew from government securities,driving yields to unsustainable highs and puttingsignificant pressure on the ruble.  When a $4.2 billion IMF tranchedisbursed inJuly 1998 failed to restore marketconfidence, investors continued to leave, placingadditional pressure on the ruble and Russia's foreign exchangereserves.  On August 17, 1998,Russia became the first country in modern times to announce a restructuring ofits domestic governmentsecurities.  Simultaneously, theCentral Bank declared a moratorium on certain loan repayments, imposed new capital controls and widened theruble exchange rate band (originallyset at R6.0-6.2/$ to R6.0-9.5/$).

 

The ruble quickly hit, then broke through theupper limit of the new wider band.  Facing dwindling reserves and continued pressure, the Central Bank switched to a policy of a"managed float."  Theruble ended the year near R2l.1/$ and has been relatively stable in 1999, buoyed by stronger energy prices and more stringent foreignexchange controls.  As of July 8,1999, the ruble was trading near R24.4/$.  

 

In 1998, Russia's banking sector suffereda systemic collapse.  Large banks were heavily invested in domestic government securities. Many were also active in the equity market, which plummeted. Many large Russian banks wereactive in forward foreign exchange markets and were left insolvent by the devaluation.  The payments system ground to ahalt, many banks defaulted on external borrowings (including Eurobonds) and large numbers of depositors were unable to access their funds.  TheCentral Bank has since succeededin resuscitating the payments system.  Depositors in some institutions wereable to recover a portion of their funds from aCentral Bankprogram to transfer small accounts to state-owned Sberbank. Progress towards closing or restructuring insolvent banks has been slow.

 

A devaluation-triggered inflationary spikefollowed the August crisis, with monthly inflation hitting 41.5% in September 1998. Yearly inflation for 1998 was 84.3%, but inflationhas decelerated in 1999. Predicted inflation for 1999, according to IMF and WorldBank figures, will be approximately 30%.

Monthly inflation in May 1999 was 2.2%, down fromApril 1999 rate of 3%, but still up significantlyfrom the .5% monthly inflation registered in May1998 and running at 116%year-on-year.

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Tight monetary policy after the crisis allowed the Central Bank to prevent inflation fromspinning out of control.  However,the Russian economy has been slowto recover.  In 1998, GDP contractedby 5.2% and was down 4%in the first quarter of 1999. Although industrial production also fell by 5.2% in 1998, a modest recovery began atthe end of the year.  Industrial productionhas risen moderately in 1999,with preliminary figures showing April output up 1.5% year-on-year, onpace toward a 3.5% annual rate.

 

Currently, the Russiangovernment does not haveaccess to capital markets, either domestic or international, as a result of itsrestructuring of domestic debt and its announced intention to seekrestructuring of a portion of its external debt.  This, combined with the lack of an IMF program, has forcedthe Government to get serious about addressing Russia'spersistent fiscal imbalance.  Inthe first quarter of 1999, the federal budget showed a primary surplus (beforedebt servicing) of 1.2%of GDP, compared to a primary surplus of .2% for the first quarter of1998.  Encouragingly,progress has been made on both revenues and expenditures.  Revenuesgrew from 10.6% of GDP in the first quarter of 1998 to 11% of GDP in the firstquarter of 1999.  Non-interest expenditures fell from 10.3% of GDPin the first quarter of 1998 to 9.8% of GDP in the first quarter of 1999.  In light of this performance, the IMFand World Bank are expected to approve 1999 programs in the summer and todisburse funds if Russian performance meets program standards.

 

## Balance ofPayments

 

Russia's balance-of-paymentsdynamics have changed markedlysince 1998.  Exportsand imports have dropped in dollar terms. Exports fell from $18.5 billion in the firstquarter of 1998 to$15.6 billion in the firstquarter of 1999.  Imports collapsed following devaluation, from $18.3 billion in the first quarter of 1998to $9.4 billion in the first quarter of 1999.  Accordingly, the trade surplus has risen from $200 million in the first quarter of last year to $6.2 billionin the first quarter of 1999. Exports are expected to grow in the second quarter of 1999, due tostronger prices for energy (whichin the first quarter of 1999 accounted for 40percent of Russia'sexport revenue) as well as greater competitiveness of otherexports.  Recovery in imports will be constrained by current low real income levels and thehigher competitiveness of lower-priced, domestically-producedimport substitutes.

 

The crisis has also curbed investment.  Annual foreign direct investment into Russia fell from $4 billionin 1997 to $2.2 billion in 1998. Portfolio investment fell even more sharply, from $17.3 billion in 1997to $8 billion in 1998.  Investment is not expected to recover in 1999.  Russia's official external debt is currently$152.4 billion.  The Government hasannounced that itcannot meet its 1999 external debt payments of $17.2 billion. Instead, the1999 budget envisions paymentsof $9 billion.  Russia has missed scheduled payments on its rescheduled London and ParisClub debts, although creditors to datehave opted not to declare Russia in officialdefault.  As of July, 1999, theGovernment has continued to meet scheduled payments on its Eurobonds (total parvalue S15.9 billion) and debts to international financial institutions.  The Government has tapped Central Bank foreign exchange reserves to meet external debt payments,with the Bank granting roughly $7.1 billion in such financing from August 1998 to May 1999.

 

**PrincipalGrowth Sectors******

 

Domestic production received a boost from the devaluation,which priced many importsout of the market.  Domesticproducers have picked up some of the slack.  Sectors that have experienced growth include chemicals,forestry, pulp and paper, food processing (more than 10 percent production increasefrom 1998 to 1999) and to a lesserextent, machine building, non-ferrous metals, construction materials, glass and porcelain.

 

However, many Russian firms remainhampered by lack of working capital, impeding their ability to raiseoutput to fully capitalize on theirrelative price advantage following the devaluation.  Lower real incomes have alsoconstrained demand.  Preliminary data showed average dollarwages of $59.7/month at the end of May 1999, compared with $134.4/month at the end of 1998.  A sustained increase in domestic demand is unlikelyto comein the absence of a recovery inreal incomes.

 

Exporters who arepaid in dollars but whose costs are ruble-denominated also received a boost fromdevaluation.  This is especiallytrue of energy producers, whohave also benefited from rising world oil prices.  The price of Brent crude had risen 50 percent during the first halfof 1999, providing a significant boost to both production volumes andrevenues.  Exportersin other sectors, including chemicals, non-ferrousmetals (especially aluminum) and minerals, fertilizer and paper,have also registered production increases.

 

**Regional Perspectives**

 

While Moscow and St. Petersburg are the most affluent and concentratedmarkets, especially in the consumer sector, business in Russia is expandinginto the regions.  Highlighted below are snapshots of Moscow, Russia’s wealthiest city; St. Petersburg, theheart of northwest Russia; the industrialized areas of the Urals and West Siberia;and the Russian Far East, Russia’s window to the East Asian and trans-Pacificeconomy.

 

**Moscow andEnvirons:**

 

The 10 million people in Moscow City proper and another 6.5million in surrounding Moscow Oblast make up over ten percent of Russia’s totalpopulation and is the largest and wealthiest metropolitan consumer market.  Moscow is Russia’s undisputed politicaland financial center, home to a large percentage of its nascent middle class,and is the city in Russia with the most diverse economy, and most moderntransport and communication services and other commercial infrastructure.  The Moscow Oblast Customs Departmentprocesses fully one-third of Russia's total trade turnover.  Communications and road modernizationhave been top priorities of the city and oblast administrations and areproceeding apace despite the country’s broader economic downturn in 1998.  The number of cars on Moscow streetshas more than quadrupled during the past decade.  Despite a heavy bureaucracy, the city has taken advantage ofits position as Russia’s financial capital and transportation nexus to foster agrowing foreign business community. Costs for business services, while the highest in Russia, have fallenmarginally since autumn 1998.

 

Moscow Oblast offers a unique mix of opportunities to localcompanies and foreign investors. Although the oblast surrounds the capital, it generally does not haveprices, rent or production costs as high as those found in the city itself, yetis nearby enough to benefit from the capital’s economic vitality,infrastructure and large market. In both Moscow City and Moscow Oblast, companies generally do not facethe liquidity problems endemic in other Russian regions.

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**St. Petersburg and Northwest Russia**:

 

St. Petersburg is Russia’s second largest city and thefourth largest in Europe, with a population of five million.  The surrounding Leningrad Oblast addsanother 1.8 million.  St. Petersburgis a major financial, commercial, and industrial center, and a key educationaland research hub.  Its factoriesproduce everything from heavy machinery and electronics to consumer goods, andits ports and rail links comprise a major transportation center, tying Russiato Scandinavia and the rest of Europe. Combined, St. Petersburg and Leningrad Oblast form a substantial marketfor consumer and industrial goods.

 

During the last three years, Northwest Russia has attractedmore foreign investment than any other area of Russia save for Moscow, and hasdistinguished itself by the progressive outlook of its political and economicleaders.  Novgorod Oblast was thefirst region in NW Russia to adopt a foreign investment law, providing up to100 percent local tax holidays for incoming investors.  In 1997, it won the American Chamber ofCommerce in Russia’s “Region of the Year Award.”  Leningrad Oblast has the highest per capita investment inthe country, and the U.S. ranks as the largest investor in both St. Petersburgand Leningrad Oblast.  Currently,over 200 U.S. companies are operating in Northwest Russia.

 

In1996, St. Petersburg raised $300 million through a Eurobond program.  Despite the crisis, the city has beenable to make interest payments on the bonds (although a new issue planned for 1999 has beenpostponed).  Leningrad Oblast,which obtained syndicated bank financing,has not defaulted on its loans, although it has been delinquent in makingpayments.

 

With their proximity to European cargo routes, St.Petersburg and Leningrad Oblast are a natural transportation hub.  The Port of St. Petersburg is Russia'slargest commercial seaport by volume, and handles over a third of Russia'simports.  Although the economiccrisis only resulted in a slight 3 percent decline in traffic at the port in1998, this figure was nearly 10 percent below the expected turnover for theyear.  Commercial seaports are also located in Murmansk, Kaliningrad, andArkhangelsk, and several cargo port projects are being developed in LeningradOblast.  Presently, Russian ports are generally notsufficiently equipped to provide modern services, and commercial opportunities exist for U.S.firms in modernizing port handling facilities, developing modern freightforwarding systems and constructing cargo-processing terminals in the ports.

 

St. Petersburg isalso enjoying significant growth in other transport facilities.  Capacity at Pulkovo-2 is being taxedwith increasing passenger traffic, and a feasibility study estimates that thenumber of passengers will increase from 1.45 million in 1998 to 3.66 million by2008.  In response, the EBRD hasapproved a loan for construction of Pulkovo-3, a new international passengerterminal.  The Pulkovo-3 programenvisions airport, runway, and infrastructure development, and longer-termdevelopment of the surrounding area, including the construction of a hotel,business-centers, warehousing, and other related projects.  A new cargo airport in Vyborg on theRussian-Finnish border is also under consideration.  The St. Petersburg area also has an extensive rail networkconnecting it to Western Europe, Moscow, and other Russian regions.

 

Accordingto UNESCO, St. Petersburg is the only Russian city  rankedamong the world’s top 10 cities in "tourismappeal."  Despite a stillunderdeveloped tourism infrastructure, over two million foreign tourists willvisit St. Petersburg in 1999 (downslightly from 1998 dueto the economic crisis and the Kosovo conflict). Tourism is expected to grow 6-9 percent annually over the next fiveyears, creating a burden on the city's hotels, which are booked during thesummer.  Moreover, St. Petersburg has few mid-range hotels,and is in need of international-standard3-star hotels.  The city is seeking to cultivate joint ventures with foreigninvestors and hotel chains and to conclude management contracts withinternational chains that can invest in hotel renovation.

 

Outsideof the St. Petersburg-Leningrad Oblast metropolitan area, Northwest Russiaoffers many commercial opportunities. As in therest of Russia, the weaker ruble has stimulateddomestic production in the northwest. Small investments can bring substantial returns and help build a base inRussia, since these areas have a number of underutilized enterprises with goodequipment and an educated workforce. Murmansk Oblast, above the Arctic Circle, has abundant mineral, oil and gas deposits, as well as establishedmining, metallurgy, and fishing industries.  Neighboring Arkhangelsk’s largest investment is Conoco’sPolar Lights project, providing a market for petroleum processing products andservices.  Pskov, which links St.Petersburg and Northwest Russia with Kiev and Southern Russia, offersopportunities in agriculture,food processing, and tourism.  Karelia’s main sectors arelogging, wood processing, and pulp and paper, as 85 percent of the territory iscovered by state forest stock. Vologda also holds opportunities inforest products as well as chemicals.

 

Themarket in Northwest Russia is generally receptive to U.S.- manufacturedgoods.  However, U.S. new-to-marketexporters should note that a number of European firms, primarily fromScandinavia and Germany, have already established their distribution networksin Northwest Russia and pose significant competition in many industries.  In most cases, the primary competitivefactors to be considered are pricing/financing, terms of delivery, adaptabilityof the product, and a well-established representation or distributor network.

 

# The Ural Mountains and Western Siberia:

 

CentralRussia’s Urals and Western Siberia territoriescover an area larger than the United States east of the Mississippi, and arehome to over 40 million people. They are some of Russia’s most resource-rich regions, with minerals,fossil fuels and vast forests. During the Soviet period, the Urals region was a leading center of heavyindustry (metallurgy and machine building), as well as defense and aerospaceplants.  Today, those industriesremain concentrated in Chelyabinsk, Perm and Sverdlovsk Oblasts.  In Western Siberia, Tyumen Oblast is known for its prolific gas and oil reserves.

 

Inaddition to fossil fuels and heavy industry, the telecommunications and foodprocessing industries offer opportunities for American firms.  The telecom infrastructure around urbancenters has developed rapidly over the past four years.  Local landline services areconcentrating on data communications and digital switching upgrades.  Cellular Tel services are now available in most of theregion's major cities.  Food processing also has been expanding, particularly sincelast year's ruble devaluation has priced most imported foodstuffs out of thismarket.  The region is home to over6,000 food processing firms, manyof which seek imported processing and packing production lines to meet theincreasing demand for high quality, competitively priced foodstuffs. 

 

Russia'snationwide financial crisishasaffected the Urals and Western Siberia in much the same way as other parts of the country.  Low world oil prices into early1999 and U.S.antidumping actionagainst Russian steel exacerbated economic difficulties in this region.  At the same time, its marketablenatural resources and industrial capacity with export potential promise that it should be one of thefirst areas of the country after Moscow to recover economically.   

 

SverdlovskOblast (4.6 millionresidents) is one of Russia’s most urbanized areas.  Its capital, Yekaterinburg (1.6 million inhabitants), isRussia’s third or fourth largest city. Sverdlovsk Oblast has the largest GDP of any oblast in the Urals,producing 5 percent of Russia’s industrial output and ranking second only toMoscow Oblast in that category.  Ferrous metallurgy and machine buildingform a large chunk of Sverdlovsk’s economy, much of itdefense-related.  Services have grown to 40 percent ofregional GDP.  Yekaterinburg is a major road and rail transport hubs, with regularair service to several Europeancities.  Its banking infrastructureis the best in the Urals, with 31 banks and 17 branches of commercial banksfrom other regions.  In 1997,Sverdlovsk became the fourth oblast in Russia to receive an internationalcredit rating.  Sverdlovsk Oblastleads the Urals in attractinginvestment, and several large U.S. firms havesubstantial investments here.  The oblast’s top exports are steel, copper, chemicals, aluminum,titanium and radioisotopes. According to oblast statistics, 1998 trade was valued at $2.9 billion,of which trade withthe United States totaled $400 million. Non-ferrous metallurgy remains a growth sector, and the world’ssecond-largest titanium producer (VSMPO, a supplier to Boeing and other multinationalfirms) is found here. 

 

PermOblast Heavy industry, primarily metallurgy and machine building are still a large sector of the economy of Perm Oblast (3.1million residents).  Much of this industry is defense-related, andproduction of aircraft engines, Proton rockets and space control systemscontinues.  Perm produces 30percent of Russia’s paper and 98 percent of its potassium-based fertilizers.  The oblast is also a regional centerfor electricitygeneration.  The oblast capital,the city of Perm (population 1.2 million) is a major river port (on the Kama,with access to the Volga),has two airports and is situatedon the Trans-Siberian railway.  In1998, Perm's foreign trade was valued at $1.5 billion, including $87 millionwith the U.S.  The oblast’s 1998 imports were valuedat $300 million.  Perm's topexports are refined oil and petrochemical products, fertilizers and metals.  Perm has over 100 known deposits of oiland gas and two oil refineries. Annual extraction exceeds 9 million metric tons of oil and 500 millioncubic meters of gas.  Fifty percentof Russia’s magnesium, 98 percent of its potassium and most of its titanium orecome from Perm.

 

ChelyabinskOblast (population3.6 million) ranks fifth in Russia in industrial output.  Oblast officials estimate 1998 foreigntrade turnover at $2.3 billion, including $350 million with the United States.  Ferrous metallurgy and machine buildingplay a key role in the oblast’s economy. Metals account for 85 percent of the oblast’s exports and over 40percent of total output.  Theoblast is rich in iron ore, copper, bauxite and gold.  It is situated along the Trans-Siberian railway.  Over 70 percent of its exports offerrous metals come from the giant Magnitogorsk Metallurgical Works.  

 

TyumenOblast (population3 million) is Russia’s third largest oblast in terms of territory, and includestwo autonomous districts, Khanty-Mansiysk and Yamalo-Nenets.  Tyumen is rich in oil and gas: its combined output ofboth exceeds 7 percent of Russia’s GDP (including over 90 percent of Russia’snatural gas and 60 percent of its oil).  GAZPROMdominates the gas industry in Yamalo-Nenets, while LUKOIL, YUKOS, Sibneft and Tyumen Oil Company are the oil leaders inKhanty-Mansiysk.  Southern TyumenOblast is predominantly agricultural. Several U.S. and European firms have established joint ventures in theregion for production and sale of crude oil.  Tyumen is an important electric power producer, accountingfor 7 percent of Russia’s electricity. It also produces a third of Russia’s automobile batteries.  The oblast has drawn up plans forrevitalization of the Tobolsk petrochemical plant and creation of a newoil-producing center in the Uvatskiy area. 

 

**The Russian Far East:**

 

Separated fromthe world market for most of its history, the Russian Far East (RFE) is only today becoming a full participant ininternational trade.  This presentsboth unique opportunities and challenges for U.S. exporters.  The RFEmarket has four time zones, 6.2 million squarekilometers (two-thirds the size of the continental U.S.), a population of 8 million, and ten cities with over 100,000 people.

 

The 1998devaluation of the ruble has been the key recent economic event in the rapidlychanging resource-based economy of the Russian Far East.  The markedly weakened ruble has mademany Russian Far East (RFE) industries newly competitive in world markets.  Though the decline of the ruble hasbeen bad news for many U.S. exporters (particularly food exporters), it hascreated new opportunities for U.S. equipment exporters as Russian factorymanagers try to retool aging facilities in order to step up production.  Though the regional economy is stillvery depressed, pockets of recovery are visible in the wood processing, foodprocessing, and fishing sectors.

 

U.S. companiesface considerable obstacles to business in the Russian Far East, as elsewhere in Russia. Obstacles unique to the RFE include remoteness and isolation from the rest of Russia; lack of frequent,reliable flights and transport; comparative lackof sophistication and international experience of many RFE business andgovernment leaders; inadequacy and continued deterioration ofinfrastructure, including transport, heat, telecommunications, water,electricity, medical services, and housing; and regional travelrestrictions, often holdovers from the Sovietperiod.

 

After fouryears of growth, U.S. exports to the region declined in 1998, as U.S. foodsales (mainly chicken and meat) fell in favor of local Russian production.  However, we have witnessed morerequests from suddenly competitive local Russian manufacturers for industrialequipment. 

 

Exports to the Russian FarEast (millions USD)

 

                                    1994      1995      1996      1997      1998

                  U.S. Exports      227    372   425    470   270

                  World Exports      650   1748      1683      2100      1500

 

The numberof U.S. firms active in the market is climbing: 

 

                  Region          #Firms      1997      1998      1999  

                  Primorsky               30      36      45          

                  Sakhalin                25      26      34    

                  Khabarovsk              30      27      35    

                  Magadan                 5?      13      14    

                  Kamchatka               5?      12      10    

                  Amurskaya                ?     5     3     

                  Yakutsk                    ?     4     1

                  Total                  95      123      142

 

Whiledifficult to estimate precisely, existing and potential U.S. investment in theregion is substantial. 

 

U.S. investment in the RFE(millions USD)

                  Sector                  Existing    L/T Potential

                  Oil and gas                 500         35,000

                  Mining                    10            270

                  Ports                     5            220

                  Fishing                    4            100

                  Forestry                  44             10

                  Environmental            25             15

                  Food processing          40             15

                  Retail                     3              0

                  Real estate                     2                0

               Total                   633        35,630

 

As shown by thetable above, though U.S. activity in other extractive sectors is substantial,the chief U.S. business interests in the RFE are the Sakhalin offshore oil andgas projects (which could bring $35 billion in investment over the comingdecades -- six times the sum of cumulative U.S. investment in Russia to date).

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