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Friday, July 25, 2008

Economic Stormclouds over Russia

The International Herald Tribune reports:

Fears are growing that Russia's oil and gas fueled economy is running too hot — and about to boil over in the kind of mess that has scalded smaller East European neighbors.

Some of the most vehement warnings have been coming from the normally bland Finance Minister Alexei Kudrin, who saysgross domestic product is growing too fast and any ill-conceived stimulus measures such proposed tax cuts will lead to intolerable inflation and a sudden stall in growth.

Kudrin startled audience at a recent tax conference when he compared the issue to nuclear war. Cut taxes, Kudrin warned, and Russia won't maintain its thousands of atomic warheads. "The 33 percent share of the budget spent on defense and security is our guarantee that there won't be a nuclear war," the minister said.

His opponents, including Economic Development Minister Elvira Nabiullina, are clamoring for the sharp tax cut to wean Russia off its addiction to imports, which are growing at an annual rate of over 40 percent.

The government is walking a tightrope. With all the government and private sector spending, inflation is reeling out of control — food prices are soaring at an annual rate of 25 percent — and threatens to submerge hundreds of thousands of people below the poverty line.

Dollars are flooding in thanks to record-high oil prices, and the country's rising middle class is on an unprecedented spending binge thanks to accessible bank loans. The government, in the meantime, is hustling to modernize exhausted infrastructure, pumping up the economy even more.

Kudrin's sensationalist remark about Russia's nukes comes at a time when the nation's economy is bucking recessionary trends around the globe. GDP growth, fueled by the rising price of Russia's mainstays, natural gas and oil, was 8.1 percent last year and 8.7 percent year-on-year in the first quarter of 2008.

"Russia's economy is overheated at the moment," said Eric Berglof, chief economist at the European Bank for Reconstruction and Development. "The growth rate is too high — two to three percentage points above potential."

An economy overheats when its capacity to produce cannot keep up with rising demand. A World Bank report issued in June lists seven signs — ranging from infrastructure constraints to accelerating property prices.

"The government has failed to address bottlenecks in the economy, to implement necessary infrastructure projects that would improve the power system, railroads, agriculture, or alleviate the traffic jams in Moscow," Berglof said.

But if the government throws too much money at resolving these problems, the risk is that the cash injection will only further fuel inflation, economists say.

During the waning months of his presidency last year, Vladimir Putin approved a number of big projects as part of a pre-election spending spree. As a result, state spending jumped 37 percent last year, and 70 percent in the fourth quarter alone. Putin's favored candidate, Dmitry Medvedev, was elected president and Putin is now Prime Minister.

Russia's consumer price index has climbed 9.1 percent from the start of the year to July 14, according to the state statistics agency — three percentage points higher than in the same period last year and outpacing the Central Bank's forecast of 10.5 percent for 2008. On an annual basis, prices soared above 15 percent.

As prices rise, workers demand higher pay, creating an inflationary spiral. And as food prices rise, poorer people spend more on necessities. FBK International, a consultancy, has forecast that the number of Russians living in poverty could increase this year for the first time since 2000 — by 1.1 million people to a total 20 million.

"Inflation needs to be cooled down sooner rather than later. If it is not dealt with early, the consequence will be ... a greater fall in the growth rate, as we see in Estonia and Latvia right now," said Anders Aslund, senior fellow at the Peterson Institute for International Economics in Washington, referring to the two Baltic states whose economies overheated and are now seeing a sharp decline in growth.

Tax-cut supporters insist that reducing the value-added tax from 18 to 12 percent will provide manufacturers the necessary respite to rejuvenate output. Also, by jump-starting manufacturing and small and medium businesses, tax-cut advocates also hope to diversify the economy, which is highly dependent on oil and gas.

Not so, countered Kudrin. The VAT accounts for one-third of federal budget revenues. Cutting it will not help economic restructuring, as badly as Russia needs it.

Concerns over Russia's economy coincide with the approaching 10th anniversary of the 1998 financial crisis, when the country defaulted on domestic debt and devalued the currency, causing a shock wave on international markets. Millions of Russians lost their savings.

Economists stress there is no chance of a repeat crisis. Russia has wisely used the oil windfall to tuck away hundreds of billions of dollars in strategic reserves and sovereign wealth funds — "rainy day" funds that it can use as a buffer against any short-term shock such as a precipitous drop in oil prices.

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