Zaks Investment Advisory Service

The “R” in BRIC

At the end of last year, we devoted several programs to China. China’s economy is the largest of the four emerging economies comprising the group that Goldman Sachs gracefully dubbed BRIC. However, all of the countries in this group deserve our attention: both their economies and stock markets have grown rapidly in recent years. All investors should have an idea about what kinds of investment opportunities these markets present. I would remind you that BRIC is an acronym for Brazil, Russia, India and China. Let us take a look at the “R” – Russia. I am sure that my listeners have a very good idea about what is happening in Russia, primarily on the political and cultural scenes, but not necessarily on its economic and financial ones. We, for our part, will try to look at Russia from the investors’ standpoint.

Russia’s economy has undergone cardinal changes over the past 16 years. Its history may be roughly split into two periods: before the 1998 financial crisis, and after. The first period was highlighted by a hard-fought transition to a market system and by privatization, which also created a class of so-called “oligarchs.” The economy contracted each year between 1990 and 1997 (it stopped shrinking in 1997). The 1998 financial crisis, which badly impacted many people who deposited their money with private banks, produced one positive result: the ruble, which had until then been supported at an unrealistically high level, was devalued by a factor of about three. The results became apparent almost immediately: prices on many imported products became prohibitively expensive and Russia’s industry began to produce local substitutes. The economy was already growing by 1999, and growing pretty fast.

I’d like to make the following observation: despite all the problems with initial privatization efforts, the country managed to transform itself into something resembling a market economy. And, as experience shows, a bad market economy is still better than any type of planned one. I understand perfectly well that from an ethical point of view, what happened – the fact that many ended up without a kopeck to their name while others pilfered billions – was awful. But this transition presented an opportunity for the economy to grow. Many of you probably remember what the Soviet economy looked like in the late ‘80s: empty store shelves and lines. And it was already impossible to get out of that situation while staying within the framework of the old planned system: Andropov, the old KGB hand, tried to make the economy function by force, but it did not work. Dislocations within the economy were such that it became impossible to improve things through additional planning. On the other hand, a quasi-market economy of the ‘90s was capable of redistributing resources, and of applying them more rationally and efficiently.

Although the 1998 financial crisis did temporarily affect Russia’s real economy, (the GDP that year fell by about four percent), it also, and more importantly, created an additional stimulus for subsequent growth. The ruble’s devaluation helped to accelerate the growth process: the economy grew by three percent in 1999, and in 2000 – by six percent.

The second positive development was marked by a growth in the price of oil and other natural resources: gas, metals, etc. From 1998 to the start of 2008, oil prices grew almost tenfold. The value of Russia’s exported oil in 2007, according to some very rough estimates, was about $150 billion. A part of this money ended up in the Swiss bank accounts of the oligarchs and, in the opinion of many experts, the Kremlin leadership. But a part of it did manage to seep into the economy. For Russia,, this represents big money. It makes its way into the economy in two ways: first, companies that export natural resources invest a part of their proceeds into production and infrastructure development (both physical and financial), which helps them run their business. Second, trying to diversify their sources of income, they also buy up and invest in other companies. In turn, the government then makes big money by levying taxes on these companies, a part of which goes to higher pensions and other payments, which improves the population’s purchasing power and thus develops the economy. A part of the money received by the state is then spent on infrastructure improvements. On the other hand, of course, a part is also wasted on senseless projects, but this happens in every country. In either case, a growth in the price of exported commodities supports the Russian economy.

Thirdly, president Putin has adopted several measures that have significantly helped the economy. The principal one was a simplified tax code and a flat 13-percent income tax rate. This resulted in many enterprises moving from the gray economy into the legal one and starting to officially pay their taxes. And while the tax rate was reduced in percentage terms, the actual amount of money received by the state grew sharply. Instead of spending money and time on thinking up unproductive schemes to avoid paying taxes, many enterprises started focusing on doing business.

How much has the Russian economy grown? I can offer you the following comparison: in 1995 (and ’95 was one of the worst years, when the economy had just begun to climb out of its transition crisis) in purchasing power parity terms, the gross product of a Russian citizen was 19 percent that a US resident. In 2006, it was about 26 percent. In other words, the purchasing power of the average person living in Russia in ’95 was five times smaller than the purchasing power of the average American, while now it is 3.6 times smaller. This is significant growth.

On the other hand, serious negative tendencies have emerged in recent years, ones like the nationalization of enterprises, the creation of monopolies, and the growth of bureaucracy and, correspondingly, corruption. But we will have to talk about these things in our next program. This was Sergey Zaks. Thank you for your attention and until next time.