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April 15, 2008

It's Not All About High Oil Prices, by Yaroslav Lissovolik

The key economic priority in Russia is to maintain the high economic growth rates that it has achieved over the past eight years, and recent growth performance has certainly been encouraging. There are reasons to believe that this growth will remain high despite further shocks from global financial turbulence.

This is due to the shift in the country's development from fragmentation to integration. The repatriation of capital and labour resources, the decrease in the size of the shadow economy and the country's increased role in the global economy are prominent examples of the country's integration, all of which played a major role in its post-1998 growth performance. This "integration theory" challenges the traditional view that high oil prices were the predominant reason for the country's economic expansion.

In the early to mid-1990s, one of the explanations advanced for the precipitous decline in gross domestic product was "disorganization" — a concept pioneered by Olivier Blanchard, economics professor at the Massachusetts Institute of Technology — characterized by a fragmentation of nonmarket production links between enterprises. This resulted in an economic system that was dubbed the "virtual economy" and characterized by supply disruption, nonpayments and barter.

After the 1998 crisis, disorganization increasingly gave way to economic integration characterized by the formation of market-based links between interdependent enterprises. Apart from the economic integration effect at the micro level of individual companies, we also observed this across the country's regions after years of widespread regional protectionism and trade barriers. The creation of a unified economic space free of trade barriers was another key factor that fuelled the country's economic growth. Interregional trade as a share of total production in goods such as sugar and gasoline — which was previously subjected to regional protectionism — increased by three to four times from 1995 to 2006.

At the macro level, the integration process was driven by the incorporation of sizeable chunks of the shadow economy into the official sector and the return of flight capital and migrant workers. With respect to capital flows, the massive influx of foreign direct investment was to a major degree driven by the return of capital that left the country back in the 1990s. The share of FDI coming to Russia from places like Cyprus, the Virgin Islands, Luxembourg — believed to harbour the bulk of the country's capital flight — has been as high as 40 percent.

Another trend, though less pronounced, is the return of "human capital" that had left the country in the 1990s. This process is particularly important for growth and productivity in the services sector, most notably in IT and financial services. Russia is the second-largest recipient of migrant workers in the world, most of whom are coming from the counties of the Commonwealth of Independent States. Indeed, if there is any progress in economic integration between Russia and the CIS, it is in the labour market.

The integration of parts of the "grey economy" into the official sector saw major advances in the past eight years, although there is still a lot more work that needs to be done in this area. The move in 2001 to lower the income tax to a 13 percent flat rate was one of the key factors in raising tax compliance and allowing for a growing share of financial transactions to be brought into the official sector. Overall, according to our estimates, the share of the shadow economy declined from close to 50 percent of GDP in the mid-1990s to roughly 25 percent of GDP now.

Finally, the country's integration into the world economy has increased in the past four years, as evidenced by the significant rise in the ratio of FDI to GDP. There is significant potential to increase global economic integration, most notably with respect to the country's accession to the World Trade Organization. Russia is the only major economy that is outside of this organization.

India and China also have a strong "integration potential." This is based on the world's largest diasporas that serve as a source of capital and human capital inflows. Indeed, nearly 50 percent of China's FDI inflows are believed to come from Chinese companies located abroad. Furthermore, China's economic growth in the past decade received a boost from the integration of Hong Kong and Macao.

Economic miracles, such as in China, Ireland and South Korea, are also frequently rooted in these countries' past underperformance, which often leads to higher than expected economic growth. This process was also based in part on the shift from economic fragmentation to integration. The dynamism of these economic miracles is often linked to the release of the "unobserved reserve" — the reduction in the shadow economy or the inflow of capital and labour resources made accessible from abroad.

Integration played a significant role in Russia's economic growth over the past eight years. In this context, the role that high oil prices played in the country's expansion, although important, should not be exaggerated.

First, it is important to note that the country has largely avoided the resource curse that has historically affected economies heavily dependent on the export of natural resources. The creation of the stabilization fund has helped Russia avoid the resource curse by following a policy of fiscal discipline; the government did not give in to the temptation to spend money from the stabilization fund on populist social programs. This fiscal policy was made possible by social and political integration characterized by popular support for the government's economic course.

Second, there are significant hidden reserves that could fuel continued growth due to the return of capital and labour from abroad, the decrease of the shadow economy and Russia's increased role n the global economy.

Admittedly, this upside can be exploited to the fullest only if macroeconomic stability and structural policies lead to further economic integration.

The Moscow Times



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