OREANDA-NEWS. October 18, 2010. In the publication Hard Landing 2: Central and Eastern Europe facing the debt crisis we attempt to assess this risk on the basis of current indices reflecting the state of national economies, including data on the condition of public finances, which are of particular importance, reported the press-centre of PwC.

The conclusions drawn from the report unequivocally indicate that countries in Central and Eastern Europe must be prepared for a long period of reduced economic growth, which may be accompanied by considerable fluctuations in the financial markets. There is no doubt that better times will return in the end, although at this moment it is hard to determine when this is going to happen. The best way of surviving this difficult period is to pursue a prudent economic policy and implement vigorous structural reforms.

Although it appears that the most acute phase of the global financial crisis is behind us, its consequences will affect the economies of Central and Eastern Europe for a long time. Our region was affected by the crisis in a particularly severe way – some countries came close to bankruptcy, whilst others had to tighten their belts considerably to avoid this fate. Lower economic activity was directly translated into reduced tax revenues, and in many cases it was very difficult to cut budget expenditures without dramatic consequences for the economy and society. Therefore, certain countries in the region may now be threatened by a debt crisis, similar to the one observed in Western Europe, which may in turn lead to further financial destabilisation.

Vulnerability of the country to the debt crisis
Strengths:
Good growth prospects
Accumulated reserves from the pre-crisis period
Moderate foreign debt
Low public debt
Weaknesses:
Structural weaknesses in the banking system
Excessive dependence on exports of energy resources
General assessment of the economic situation

Russia, as with other countries of the region, was severely affected by the global crisis. The rapid GDP growth rate of 6-8% in the pre-crisis period rapidly changed into a -8% fall in 2009.

Despite this deep shock, Russia – in contrast to the vast majority of the CEE countries – was in a relatively comfortable position. A policy of running huge budget surpluses and accumulating foreign exchange reserves before the crisis, rather than spending windfall profits from oil and gas exports, allowed the government to react to the recession with a massive stimulus package. The package included large-scale support for Russian banks and private entities facing large, unhedged foreign exchange exposure. While some inflationary effects of such a move are quite possible in the longer term, the good state of the Russian budget before the crisis meant that the risk of excessive debt build-up could be avoided.

Thanks to higher oil prices, and a policy of stimulating demand and supporting banks and firms, the Russian economy is steadily recovering from the decline in output. The expected growth rate in 2010 is 3.7%, with continuing growth forecast for 2011. However, if the global economy is hit by a new recession, and oil prices fall once again, the possibilities of using a policy of stimulating demand will be much more limited than in 2009.

The massive amounts of money injected into the Russian economy under the government stimulus package were not neutral to the fiscal system. The public sector deficit deteriorated considerably to -8.8% of GDP in 2009, whilst in the pre-crisis years it had recorded surpluses of 5-8% of GDP. Although the price that the Russian government paid to defend the economy against the crisis was quite high, the country’s fiscal system is well positioned to recover fairly quickly if oil prices remain at the current level or increase. In the coming years the public sector deficit is expected to fall below -2% of GDP.

Russia’s public debt remains at a low level of 7.3% of GDP, which poses no major threat to the country in the short term. In the longer run, however, profound structural reforms are needed in order to ensure a sustainable model of public finance less dependent on the fluctuation of oil prices.

Russia was the only CEE country to be running a current account surplus both before and during the crisis. Nevertheless, the surplus was significantly reduced during the global crisis, falling from 6.2% of GDP in 2008 to 3.6% in 2009. Such a result is not a surprise taking into account the scale of the demand stimulus administered by the government in 2009. In the coming years the current account surplus is likely to increase once again.

For the time being, foreign debt in Russia is not an area of major concern, as it represents less than 40% of GDP (far below the CEE average) mainly in long-term credits. The situation is even less risky due to the central bank’s large foreign exchange reserves. The foreign exchange reserves are 7 times bigger than the cumulative total of the current account balance and short-term debt.

The ruble weakened seriously during the first wave of the crisis. Prior to the crisis a strong ruble created the backboneof the macroeconomic stability of the country. As oil prices increased, expectations for the ruble appreciation were strong. This situation encouraged financial markets and borrowers to take one-way bets on the ruble, which led to very large capital inflows. When the crisis broke, the large scale of liabilities left Russia vulnerable to the reversal of capital flows.

Albeit that the weak ruble helped the economy to deal with the crisis, its impact was reduced due to the structure of Russian foreign trade flows (exports dominated by raw materials). At the same time, however, weakening of the ruble may have quite a strong inflationary impact.

Constraints on foreign business are being abolished and the regulatory environment has improved recently. However, several branches of economy remain closed to foreign investment. As part of government’s plans to simplify the process by which investors can gain access to them, a law rendering more moderate the existing restrictions for foreign investment in Russia’s strategic sectors and mineral resources is expected to be adopted.

The Russian investment policy includes tax reliefs, minimised administrative barriers and founding of private-public partnerships. The government is planning to provide financing for infrastructure projects to promote investment and to simplify the formalities to be complied with by foreign investment. Among the introduced improvements for investors, Russia has adopted the lowest corporate tax rate of any G8 or BRIC country, amended the laws to allow build-operate-transfer (BOT) projects, and created a framework allowing foreign investment in strategic areas. The combination of a continuing upward trend in oil and commodity prices, tight monetary policy and balanced governmental support of core enterprises is fuelling a gradual recovery of the Russian economy, which creates new possibilities for foreign investors in 2010 and future years.

Significant changes to tax legislation effective as of 2009:
the profits tax rate decreased from 24% to 20% as of 1 January 2009;
the one-off deduction rate increased to 30% of the acquisition cost of fixed assets – for assets with useful life of 3-20 years; for other fixed assets it remains at 10%;
certain types of R&D expenses are deductible with a 1.5 multiple.

Significant changes effective as of 2010:
as of 1 January 2010, the Unified Social Tax (UST) was replaced with Social Insurance Contributions; the assessment rate is flat and stands at 26% for the year 2010 (which corresponds to the maximum UST rate) and the ceiling for calculating contributions is set at RUB 415,000 (approx. USD 13,833) per annum; a single tax base is established for contributions to all funds; starting from 2011, the overall assessment rate will reach 34%, and the ceiling will be adjusted accordingly to the annual inflation index.

Indicators of vulnerability, 2009
With promising results for 2010 and favourable forecasts for 2011, Russia is well-positioned to reverse the declining trend in its economy. The main challenge for encouraging further economic growth would be to improve the investment climate in Russia.

The main challenge for encouraging further economic growth would be to improve the investment climate in Russia. Economic policy should encompass structural reforms in the public sector, changes in the pension or healthcare systems, and liberalising reforms in the markets for goods, services and production factors. Albeit that no serious risk exists either in the area of public debt or external debt, the situation for the country is not totally comfortable. On the one hand, in order to avoid serious financial turbulence, the Russian banking system should be strengthened. The banking sector is still vulnerable to any major shock that may come from the global markets. Strengthened supervision from the central bank (the first steps in this area have already been made), as well as increased transparency, which would build wider confidence in the Russian banking system, are necessary to secure long-term sustainable growth.

On the other hand, the financial stance of Russia remains vitally dependent on the situation in the global oil market. Therefore, any reversal of the recovery of demand and prices for oil may have a serious impact on the economy.

Peter Gerendasi, Country Managing Partner, PwC Russia, said:
"Russia has managed to start recovering quite successfully from the crisis and preserved macroeconomic stability despite being hit quite hard. Due to the strong governmental support the Russian economy has been steadily improving since the end of 2009. The investment climate is becoming more favourable for foreign investors attracting funds to major economic sectors. What is more Russia has chosen a new model of economic growth based on innovation and development. One of the top priorities is the stimulation of innovations aimed at modernizing the economy and getting rid of commodity dependence. The Government has approved the plan of measures to stimulate innovative activities of enterprises aimed at technological development of the companies and creation of the stimulus towards innovation in the state sector. A lot has already been done to move the process forward and many different projects focusing on the modernization of Russia and making it more open to the investors are underway."