200708 Russia A Regional Leader Once Again.pdf

This article, Russia – A Regional Leader Once Again? (Brien Desilets, August 2007), reviews Russia’s post-1998 recovery and its resurgence as both an economic and political power under Vladimir Putin, buoyed by rising oil prices and fiscal discipline. It compares Russia’s economic growth, inflation, debt, consumption, employment, investment, and banking sector reforms with those of other former Soviet Union (FSU) states, highlighting that while Russia stabilized inflation, reduced debt, and built a stabilization fund, many smaller FSU countries—such as Armenia, Azerbaijan, and the Baltic states—achieved stronger growth and lower inflation. Russia’s recovery was also marked by declining reliance on foreign currency deposits and an improved current account, though much of its progress was tied to high oil revenues. Econometric analysis shows that Russia’s GDP growth has a stronger positive influence on FSU economies than U.S. or EU growth, confirming its role as the region’s economic hub. The article concludes that while Russia lacks clear comparative advantages in economic management compared to some peers, it remains the gateway to the West for the FSU, with its fortunes closely tied to oil prices and external economic conditions

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RUSSIA – A REGIONAL LEADE
R ONCE AGAIN?
Brien Desilets
August 2007

Russia is back. After recovering from the 1998 financial crisis and benefiting
from seven years of management under the no-nonsense Vladimir Putin and four years of
double-digit oil price growth, Russia is back on its feet. It now is even reclaiming its
political clout, standing up to the US on defense issues in Europe.

Russia is different. While there has been some talk of a new Cold War, this
rhetoric has not found roots. Russia is ready to play. It has accumulated a massive
stabilization fund from its oil revenues and is planning to invest this money in the world’s
government bond markets and/or its own stock market. It is supporting its companies in
overseas ventures and working with companies investing in Russia. Even where conflicts
arise, such as with British Petroleum’s operations, Russia is articulating and publicizing
its objections and concerns. The result is a more understanding private sector and a more
understanding global community.

With the rise of Russia’s economy and status, now seems a perfect time to take a
step back and review the recent economic history of Russia and the other former Soviet
countries. In doing so, we can determine how well Russia has managed its economy.
We can answer questions such as: Have the other countries of the former Soviet Union
(FSU) benefited from their split with Russia? With Russia’s economy and status now on
the rise again, would the other FSU countries benefit from casting their lots with Russia
again?

To measure Russia’s success, I will analyze the main economic performance
indicators for Russia and its FSU peers. The indicators are not available for all countries
but they are available for the majority of countries. Data for Turkmenistan, Tajikistan
and Uzbekistan is not available for most indicators. I will concentrate on the countries
for which data is available. First I will look at the most important indicators, Economic
Growth and Inflation. Then, I will examine the Domestic Indicators of Government
Expenditure, Government Debt, Private Consumption, Employment, Investment and
Interest Rates and Banking. I will also review the External Indicators, starting with the
Current Account, moving on to Transfers specifically, then Foreign Direct Investment,
Exceptional Financing and Exchange Rates. In Section II, I develop a model that
measures the effect of Russia’s real GDP growth rate on the real GDP growth rates of the
other FSU countries. Section III concludes.

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I. ECONOMIC PERFORMANCE

ECONOMIC GROWTH AND INFLATION
1


Economic Growth
All of the FSU countries experienced negative economic growth in 1992-1993.
Beginning in 1994, some countries rebounded to positive economic growth. Other
countries took more time to recover. Armenia was the first country to recover,
experiencing positive economic growth in 1994 and thereafter. Georgia, Estonia and
Lithuania followed quickly, with sustained positive economic growth beginning in 1995.
Ukraine was the slowest to recover, experiencing negative economic growth until 1999.

Russia’s own path was wobbly. It hit bottom in 1992 with real GDP growth of -
14.5 percent. Improving to -8.7 percent in 1993, it stumbled again in 1994 to -12.8
percent. It finally reached positive economic growth in 1997 at 1.4 percent. Then came
the 1998 crisis and with it a return to negative economic growth at -5.3 percent.

Russia rebounded quickly from the 1998 crisis with 6.3 percent growth in 1999
and 10.1 percent growth in 2000, settling at around 5 percent in 2001-2002. In recent
years, 2003-2006, Russia’s growth has been pushed to capacity at 6.5-7.5 percent, aided
by the increase in oil prices and the economic activity spurred by increased oil revenues.

In general, Russia has not outpaced its FSU neighbors. In fact, only Ukraine,
Moldova and Kyrgyzstan have experienced growth lower than Russia’s in the past two
years. Meanwhile, Armenia, Azerbaijan, Tajikistan, Estonia, Latvia and Kazakstan all
are now experiencing double-digit economic growth.


1
All data from IMF IFS unless otherwise noted.
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REAL GDP GROWTH RATES, 2001-2006
-5
0
5
10
15
20
25
30
35
2001 2002 2003 2004 2005 2006
Armenia Azerbaijan Belarus
Georgia Kazakstan Kyrgyzstan
Moldova Russia Tajikistan
Ukraine Uzbekistan Estonia
Lativa Lithuania


Inflation

After experiencing some of the worst inflation in 1992, Russia quickly tightened
the reins of monetary policy and inflation decreased in 1993-1997. Other countries lost
control of inflation. Georgia experienced inflation of more than 22,000 percent in 1994.
After Georgia, Ukraine and Armenia stood out with inflation rates near 5,000 percent in
1993 and 1994 respectively. By 1995, inflation rates in all countries included in my
analysis were below 1,000 percent (data is unavailable for Tajikistan, Turkmenistan and
Uzbekistan). By 1997, the situation had normalized somewhat with inflation below 100
percent in all countries and below 25 percent in most countries.

Then came the crisis in Russia. Inflation soared from just under 12 percent in
1997 to more than 84 percent in 1998. To the surprise of many, Russia recovered quite
quickly from the 1998 crisis. Inflation was down to a little more than 20 percent in 2000
and continued to drop to below 11 percent in 2004.

Recently, many of the FSU countries have experienced inflation lower than
Russia, which reduced its inflation rate from 20.2 in 2001 to 10.9 in 2005 and back up
again to 12.7 in 2006. Belarus reduced inflation to below 20 percent only in 2004.
Inflation in Moldova and Ukraine overtook inflation in Russia in 2005, but by less than 1
percent. Inflation in Ukraine dropped back below Russia in 2006 at 9.1 but Moldova
stayed higher than Russia at 11.6.

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Of the countries with lower inflation than Russia, m
ost notable is Armenia which
reduced its 5,000 percent inflation rate of 1994 to an average rate of 3.2 in 2001-2006.
Lithuania and Estonia’s inflation rates have been on the rise during the past few years but
both are still under 5 percent. Kyrgyzstan also has been on the rise and surpassed 5
percent at 5.6 percent in 2006. Kazakstan has been increasing steadily since 2002 and
reached 8.6 in 2006. Georgia and Azerbaijan are also on the rise, heading for 10 percent.



FSU Inflation, 2001-2006
-2
-1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
202001 2002 2003 2004 2005 2006
% Change
Armenia Azerbaijan Estonia
Georgia Kazakstan Kyrgyzstan
Latvia Lithuania Moldova
Ukraine Russia
Source: IFS, Russian data from Rosstat/UNECE


GDP and Inflation

The plot below shows inflation and real GDP growth rates for the FSU countries
for 2001-2006. Belarus was excluded because its inflation rates of 61.1 percent in 2001,
42.5 percent in 2002 and 28.4 percent in 2003 are outliers and make it difficult to analyze
the data for the other countries. Its other data points are included which is why there are
some data points on the plot that do not belong to any country rectangle.

What does the scatter plot tell us? It tells us exactly what I have said already, that
most FSU countries have outperformed Russia in terms of real GDP growth and inflation.
The smaller countries of the Baltics and Caucasus appear to the bottom, right corner of
the plot. This is because they have achieved both lower inflation and higher growth than
Russia in the past 5 years. Russia lies in the opposite corner of the plot toward the upper
left, with high inflation and relatively low real economic growth. Kyrgyzstan occupies
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the stagnation position in the lower left corner with low
economic growth and low
inflation.

Of the countries included in the plot, Ukraine has had the most volatile experience
during the past few years (hence it occupies the largest area of the plot), with economic
growth ranging from 2.6 to 12.1 percent and inflation from 0.8 to 13.5 percent. These
ranges have not come in ordered pairs, either. Ukraine experienced its highest inflation
of 13.5 in 2005, when its real economic growth was only 2.6 percent. Moldova has had a
similar though less volatile experience. The countries to the bottom right of the plot have
achieved higher real GDP growth with lower rates of inflation than Russia, Ukraine,
Moldova and Kyrgyzstan.


DOMESTIC INDICATORS

Government Expenditure

In terms of government expenditures as a percentage of GDP , the FSU countries
have grouped themselves into two roughly defined teams. The dividing line between the
two teams is 14 percent of GDP. Above this line lies Russia, the Baltic countries,
Moldova and Kyrgyzstan. Below this line lies the Caucasus countries, Kazakstan and
Ukraine. I can think of no explanation for this grouping and it is not geographically
logical.
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The lowest level of governm
ent expenditure as a percentage of GDP in Russia
was in 1999 at 14.6 percent. It rose to 17.7 percent in 2002 and since then has hovered
between 16.6 and 17.6 percent of GDP. Government expenditures in the other FSU
countries for which data is available are mostly stable or decreasing and all have been
under 20 percent of GDP since 2004.

GOVERNMENT EXPENDITURE AS A PERCENTAGE OF
GDP
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Armenia Azerbaijan Georgia
Kazakstan Kyrgyzstan Moldova
Russia Ukraine Estonia
Latvia Lithuania


Government Debt

During 1994-2000, Russia maintained one of the highest debt levels among the
FSU countries (data is unavailable for Belarus, Tajikistan, Turkmenistan and
Uzbekistan), peaking at 27.6 percent in 1998. In the aftermath of the 1998 crisis and as
revenues have increased with the rising price of oil, Russia (along with Kazakstan) has
improved its net debt position, reaching -6.4 percent of GDP in 2005.

Ukraine, Georgia and Moldova have maintained debt levels similar to Russia,
following basically the same pattern over the past 10 years. The Baltic countries,
Armenia and Azerbaijan have maintained much lower debt le vels over the same period,
staying in the range of +/- 4 percent of GDP. Kazakstan, also benefiting from rising oil
prices since 2000, improved its net debt position from 1.7 percent of GDP in 1999 to -
13.5 percent of GDP in 2005.

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CENTRAL GOVT NET DEBT AS A PERCENT OF GDP
-15
-10
-5
0
5
10
15
20
25
30
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Armenia Azerbaijan Estonia
Georgia Kazakstan Kyrgyzstan
Latvia Lithuania Moldova
Ukraine Russia


Private Consumption

Russia has the lowest level of consumption as a percentage of GDP compared to
the other FSU countries (data is unavailable for Belarus, Tajikistan, Turkmenistan and
Uzbekistan). After peaking at 57.5 percent in 1998, it dropped to 46.2 percent in 2000
then steadied at approximately 50 percent in 2001-2006. Estonia has followed a similar
consumption pattern, hovering around 55 percent of GDP. Armenia has shown a notable
and steady decrease in consumption as a percentage of GDP from more than 100 percent
in 1995-1998 to less than 75 percent in 2006. Azerbaijan also has decreased steadily
from one of the highest percentages at more than 90 in 1996 to the lowest at
approximately 40 percent in 2005. Both of these changes are due mostly to increases in
GDP rather than decreases in consumption. Nominal consumption grew by an average of
12 percent in Armenia and 10 percent in Azerbaijan in 1996-2006. Moldova and
Kyrgyzstan show notable increases from 82.0 and 67.5 percent in 2002 to 91.6 and 85.2
percent in 2005, respectively. Consumption in mo st other countries for which data is
available is fairly steady.


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CONSUMPTION AS A PERCENTAGE OF GDP
40
45
50
55
60
65
70
75
80
85
90
95
100
105
110
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Armenia Azerbaijan
Georgia Kazakstan
Kyrgyzstan Moldova
Russia Ukraine
Estonia Latvia
Lihi


Employment

To compare levels of employment, I use employment as a percentage of
population for the FSU countries for which data is available (data is unavailable for
Tajikistan, Turkmenistan and Uzbekistan). I use this measure of employment to
overcome differences in labor force definitions and other reporting techniques.

In terms of employment, Russia has performed better than many other FSU
countries. Beginning at 43.6 percent of the population in 1994, employment dipped to
40.6 percent of the population in 1997 and has been on the rise ever since, reaching 46.2
percent in 2004. Russia’s major net oil exporting partner in the FSU, Kazakstan, has
exhibited a similar employment pattern, beginning at 41.0 percent in 1994, dipping to
40.0 percent in 1998 then increasing to 48.9 percent in 2005. This may indicate that
much of the employment is as a result of the growth in the oil price. This could be a
direct result, with the oil and related service sectors employing more people as business
increases, or it could be an indirect result, with the government hiring more people with
extra tax revenues from oil operations. There is some evidence of the latter in the
government expenditure as a percentage of GDP data. This indicator was at its lowest for
Russia and Kazakstan in 1999 then rose for both of them for the next two years, in Russia
for the next three. (The world oil price was at its lowest price in 1998, then rose nearly
45 percent in 1999 and more than 58 percent in 2000 before falling 16 percent in 2001.)

On the other hand, Ukraine and Estonia also exhibit similar patterns, dipping in
1999 then rising again. This trend could be the result of structural reforms, with the
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public sector shedding employment and the private sector later picking it up. It could
also be an aftershock of
the 1998 crisis. More research is required to identify the actual
trend. Of the countries for which data is available, Kyrgyzstan has performed worst with
employment as a percentage of population falling from 14.4 percent in 1996 to 9.5
percent in 2005.


EMPLOYMENT AS A PERCENTAGE OF POPULATION
30
35
40
45
50
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Armenia Azerbaijan Belarus Georgia
Kazakstan Moldova Russia Ukraine
Estonia Latvia Lithuania


Investment

Russia has one of the worst records in terms of investment among FSU countries.
Recently, only Moldova and Kyrgyzstan have performed worse. From 10-11 percent of
GDP in 1997-1998, levels of investment in Russia have risen to 23-25 percent of GDP in
2003-2005. Azerbaijan leads the pack of countries for which data is available with levels
of investment reaching higher than 65 percent of GDP in 2003-2004. Estonia is notable
for its steady increase in investment beginning at approximately 25 percent of GDP in
1998 and reaching more than 40 percent of GDP in 2005. Most other countries show a
steady increase since 2001. Kyrgyzstan is notable for its relatively flat level of
investment which has hovered between 16-17.5 percent since 2000.

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GROSS FIXED CAPITAL FORMATION AS A
PERCENTAGE OF GDP
10.00
15.00
20.00
25.00
30.00
35.00
40.00
45.00
50.00
55.00
60.00
65.00
70.00
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Armenia Azerbaijan Georgia
Kazakstan Kyrgyzstan Moldova
Russia Ukraine Estonia
Latvia Lithuania


Interest Rates and Banking

To measure interest rates in the FSU countries, I rely on the IMF series Deposit
Rate because it offers the most complete series. According to this data, interest rates in
nearly all FSU countries have stabilized recently, coming down from the crisis days of
the early transition and the aftermath of the 1998 Russia crisis (data is unavailable for
Kazakstan, Turkmenistan and Uzbekistan). Nearly all countries now have rates below 10
percent and stable, thereby facilitating financial sector development and investment. In
Russia, the deposit rate decreased generally (not always steadily) from its high of 17.1
percent (annual average) in 1998 to 4.1 percent in 2006.

Much more important than interest rates in a transition economy is the level of
financial sector development. In this regard, Russia has recently passed a milestone. In
2002, the amount of ruble deposits surpassed the amount of foreign currency deposits
(FCD). This shows a new level of confidence in the ruble and, by proxy, in the overall
monetary, fiscal and economic management of the country and the country’s banking
sector.

Not only have ruble deposits overtaken FCDs but FCDs are waning in importance
as a percentage of M2. FCDs peaked in 1998 at 30.2 percent of M2. Then, as Russia
rebounded quickly from the 1998 crisis, FCDs decreased steadily to 24.5 percent in 2001.
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After rising slightly to 25.4 percent in 2002, they decreased dram
atically in 2003-2006.
In 2006, they stood at their lowest level, at 11.4 percent of M2
2
.

The increase in ruble deposits over FCDs during a period of falling interest rates
may be confusing at first. According to portfolio allocation theory, savers seek the
highest returns on their savings so put their money into the assets with the highest yield.
So, why would savers choose to increase their ruble deposits in the face of decreasing
interest rates? The answer is quite simple: the exchange rate. In an economy with a high
degree of foreign currency penetration and a low degree of confidence in the domestic
currency, the exchange rate matters much more than the domestic interest rate. In 2002,
ruble deposits surpassed FCDs. In 2003, the price of a dollar decreased for the first time
in post-crisis Russia. It continued to decrease for the following three years. Smart
Russian consumers were transferring their dollar assets to ruble assets as the ruble
appreciated against the dollar.

DEPOSIT RATES, 1997-2006
0
5
10
15
20
25
30
35
40
45
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Armenia
Azerbaijan
Belarus
Georgia
Kyrgyzstan
Moldova
Russia
Tajikistan
Ukraine
Estonia
Latvia
Lithuania



2
Deposits data from Bank of Russia.
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MONETARY BASE & DEPOSITS, 1995-2006
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
BILLIONS OF RUBLES
Monetary Base
Demand Deposits
Time, Savings, For Curr. Deposits
For. Curr. Deposits
Source: Central Bank of Russia


FOREIGN CURRENCY DEPOSITS AS % OF M2
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: Central Bank of Russia

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EXTERNAL INDICATORS

Current Account

Russia has perform
ed better than any other FSU country in terms of its Current
Account balance as a percentage of GDP (data is unavailable for Belarus, Tajikistan,
Turkmenistan and Uzbekistan). It experienced its worst years in 1997-1998 when its
Current Account roughly balanced. The Current Account peaked in 2000 at 18.0 percent
of GDP and has since hovered around 10 percent of GDP. Ukraine has had a similar
experience to Russia, coming out of deficit in 1999 and remaining positive since then.
Kazakstan pulled itself out of deficit in 2000 but then went negative again until
resurfacing in 2004. The other countries are much smaller so naturally have to rely more
on imports. They seem to have experienced a generally similar trend, with large deficits
in 1996-1998 then rising during the 1998-2002 period to near or above -10 percent of
GDP. Some of them steadied there but others have increased their deficits recently,
notably the Baltic countries.

Most FSU countries maintain significant trade ties to Russia. For the period
2001-2006, exports to Russia amounted to approximately 15-30 percent of GDP for
Belarus and Moldova, 5-10 percent of GDP for Kazakstan, Kyrgyzstan and Ukraine and
0-5 percent of GDP for the Baltic and Caucasus countries. In terms of imports, Russia
was the source for imports totaling approximately 25-45 percent of GDP for Belarus and
10-20 percent of GDP for Estonia (which surpassed 20 percent at 22.8 percent in 2002),
Kazakstan, Lithuania, Moldova and Ukraine. The Caucasus countries import
approximately 2 percent of GDP from Russia. Kyrgyzstan is notable for its increase
during the period, from 4.0 percent in 2001 to 5.9 percent in 2005. Data is unavailable
for Tajiksitan, Turkmenistan and Uzbekistan.
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CURRENT ACCOUNT BALANCE AS A PERCENTAGE
OF GDP
-35
-30
-25
-20
-15
-10
-5
0
5
10
15
20
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Armenia Azerbaijan
Georgia Kazakstan
Kyrgyzstan Moldova
Russia Ukraine
Estonia Latvia
Lithuania


Transfers

In terms of Current Transfers (IMF definition), Russia ranks the lowest of the
FSU countries. The countries with the largest am ount of transfers as a percentage of
GDP are Armenia, Moldova and, just recently, Kyrgyzstan.

Armenia has a large diaspora population and has received large sums of transfers
since its independence. It may be surprising for some people that these transfers come
mainly from Russia. In 2005, Armenia’s net transfers (including official transfers)
totaled 174.5 billion dram, or 7.78 percent of GDP. Russia accounted for 81.3 percent of
those transfers, up from 74.2 percent in 2004
3
. According to a 2005 survey
4
, in 2002,
most remittances to Armenia came from Russia (68 percent), followed by the US/Canada
(17 percent), Europe (9 percent) and other CIS countries (4 percent).

Since transfers to Moldova have experienced rapid growth since 1998, it is
plausible that they also come from Russia and are related to developments in the oil and
gas sectors. The same could be true for Kyrgyzstan.

The issue of transfers raises another point for Russia and its neighbors. Russia
still is a regional hub for labor migration. This is supported by the fact that it has run one
of the highest levels of employment (as a percentage of population) among the FSU


3
Central Bank of Armenia.
4
Banaian and Roberts 2005.
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countries. Thousands if not millions of workers from
the FSU countries participate in the
Russian labor market formally and informally. The remittances they send home and the
cash they carry home contribute a substantial amount to their native economies.

CURRENT TRANSFERS AS A PERCENTAGE OF GDP
0
5
10
15
20
25
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Armenia Azerbaijan Belarus Georgia
Kazakstan Kyrgyzstan Moldova Russia
Ukraine Estonia Latvia Lithuania


Foreign Direct Investment

Russia has not been a leader among the FSU countries in attracting FDI. Among
the countries for which data is available, only Georgia, Belarus and Ukraine have
attracted less FDI than Russia (data is unavailable for Tajikistan, Turkmenistan and
Uzbekistan). FDI in Russia has not been negligible, however, and has reached 20-22
percent of GDP in recent years, from levels near 0 in 1997-1999. Azerbaijan, Kazakstan
and Estonia top the list for attracting FDI. For Azerbaijan and Kazakstan, though, the
FDI has come in a spurt since 1999-2000, surely related to oil sector investment, and
already has waned. Estonia’s FDI has been increasing steadily since 1997 and in 2006
reached 100 percent of GDP. This level of FDI is no doubt one of the benefits of EU
membership combined with sound economic management.

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FOREIGN DIRECT INVESTMENT AS A PERCENTAGE
OF GDP
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Armenia Azerbaijan Belarus
Georgia Kazakstan Kyrgyzstan
Moldova Russia Ukraine
Estonia Latvia Lithuania


Exchange Rates

Many of the FSU countries’ exchange rates exhibit similar movements over the
years. There even seems to be a core grouping of countries. Changes in the exchange
rates of Kazakstan, Georgia and Belarus show consistently high correlations with those of
Russia. Ukraine showed a high correlation with Russia in the 1997-2006 period overall
but its correlation rate dropped to close to 0 for the 2001-2006 period. Armenia and
Azerbaijan’s exchange rates seem to be moving closer to Russia’s in recent years. Their
correlation rates with Russia are 34 and 32 percent respectively for the 1997-2006 period
and 71 and 72 percent respectively for the 2001-2006 period.

In terms of volatility, the standard deviation of Russia’s exchange rate for the
overall 1997-2006 period is more than 50 percent where its standard deviation in the
2001-2006 period is only 5 percent. The only countries in which volatility increased in
2001-2006 over 1997-2006 were Latvia and Lithuania.

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ANNUAL PERCENT CHANGE IN EXCHANGE RATES,
2001-2006
-20
-15
-10
-5
0
5
10
15
20
25
30
35
40
45
50
55
60
2001
2002
2003
2004
2005
2006
% CHANGE
Armenia Azerbaijan Belarus
Georgia Kazakstan Kyrgyzstan
Moldova Russia Tajikistan
Ukraine Estonia Latvia
Lithuania


CORRELATIONS IN EXCHANGE RATE
GROWTH RATES 97-06 01-06
Russia 1.00 Russia 1.00
Moldova 0.95 Kazakstan 0.97
Georgia 0.94 Georgia 0.91
Ukraine 0.93 Tajikistan 0.90
Kyrgyzstan 0.90 Belarus 0.73
Kazakstan 0.87 Azerbaijan 0.72
Belarus 0.84 Armenia 0.71
Tajikistan 0.45 Moldova 0.63
Armenia 0.34 Latvia 0.35
Lithuania 0.34 Estonia 0.30
Azerbaijan 0.32 Kyrgyzstan 0.28
Estonia 0.23 Lithuania 0.11
Latvia 0.04 Ukraine -0.02


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II. MODEL

I seek a m
odel that explains the real GDP growth for the years 2001-2006 in all of
the countries of the FSU except Russia, using real GDP growth in Russia as an
explanatory variable. The countries for which I have data are Armenia, Azerbaijan,
Belarus, Estonia, Georgia, Kazakstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Russia,
Tajikistan, Ukraine and Uzbekistan.

First, I test the effect of Russia on the other countries using a simple linear
regression model. In the model, real GDP growth rates in the countries listed above
constitute the dependent variable and Russia’s real GDP growth rate is the only
independent variable. This model yields an R
2
of 88.6 percent. The coefficient for
Russia’s growth rate is 1.31 and its t value is 21.70, significant at almost 99 percent.

Parameter Estimates
Variable DF Parameter
Estimate
Standard
Error
t Value Pr > |t|
RUSRGDPGR 1 1.31237 0.06049

You may note that Russia’s economic expansion of the past few years is not an
isolated incident. It is part of a wider, global economic expansion which itself is the main
cause of the rise in oil prices that has so benefited Russia. So, perhaps the growth rates of
other countries in the world would prove just as reliable as Russia in predicting the FSU
countries’ growth rates.
I test this hypothesis and find it to be untrue. US real growth is a significant
explanatory variable on its own. However, it is not as strong as Russian real growth. The
R
2
for a model with the US real growth rate as the only explanatory variable is 77.8
percent (77.6 percent adjusted) and its t value is 14.8, still significant but not as
significant as Russian growth. When Russian growth and US growth are both included,
US growth proves insignificant. Similarly, the growth rate for the EU15 is significant on
its own but insignificant when included with Russian growth. The R
2
for the EU15
growth rate is 81.0 percent (80.2 percent adjusted) and its t value is 14.81. So, Russian
real GDP growth proves to be the best explanatory variable for the FSU countries.

It turns out that growth rates in the US and Europe explain Russian growth itself
better than they explain the FSU countries’ growth rates. Setting Russian real GDP
growth as the dependent variable and the US real growth rate as the explanatory variable
yields an R
2
above 91 percent and a t value above 25. For Europe, the R2 is above 88
percent and the t value also above 25. These findings support the view that Russia is the
regional economic leader. More importantly, especially in light of some of the recent
political events, it indicates that Russia is the gateway to the West for the FSU. It is
dependent on US and European growth and the FSU is, in turn, dependent upon Russian
growth. Russia is in fact more dependent on US and European growth than its FSU
neighbors are on it (and the US and Europe for that matter).
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Returning to the model using Russian growth to explain the FSU countries’
growth rates, I expand the m
odel to test for individual country effects. I use a one-way,
fixed effects panel regression model. In my first estimation, I use only the real growth
rate of Russia as an explanatory variable. The R
2
for this model is 95.29 percent and the t
value for Russia’s real GDP growth rate is 2.54, significant only at low levels: 85-90
percent.

Several other independent variables prove highly insignificant in explaining real
GDP growth rates. These include investment, FDI, the US interest rate, transfers, deposit
rates, the Current Account balance and lagged real GDP growth rates. The only other
variable that proves significant is inflation. I add inflation to the model and it is
significant at the 85-90 percent level with a t value of -2.16 and an estimate of -0.089.
The R
2
for this model is 95.7 percent.

The fact that inflation carries a negative coefficient reaffirms my earlier statement
that the successful developing economies of the FSU experience both higher growth and
lower inflation. Each 1 percent increase in inflation is associated with a decrease in GDP
growth of nearly 9 percent.

It is interesting to analyze the country effects parameters, though most of them are
insignificant even at the 90 percent level. Armenia, Azerbaijan and Kazakstan have the
highest t values so it can be inferred that their governments are best at managing their
economies, at least in terms of growth. For Azerbaijan and Kazakstan, however, their
recent growth is due mainly to the increases in world oil prices, a factor largely outside
their control. The table below shows the growth rates, parameter estimates and t values
for the countries included in the estimation.

Parameter Estimates
Variable DF Estimate SE t Value Pr > |t|
Cross-sectional Effects
Armenia 1 8.88 1.81 4.90 <.0001
Azerbaijan 1 6.97 1.89 3.68 0.00
Belarus 1 6.54 2.21 2.96 0.00
Estonia 1 5.04 1.82 2.78 0.01
Georgia 1 4.08 1.86 2.20 0.03
Kazakstan 1 7.21 1.85 3.91 0.00
Kyrgyzstan 1 0.16 1.82 0.09 0.93
Latvia 1 5.12 1.82 2.81 0.01
Lithuania 1 3.92 1.80 2.17 0.03
Moldova 1 3.66 1.88 1.94 0.06
Ukraine 1 4.50 1.86 2.42 0.02
Independent Variables
Inflation 1 -0.09 0.04 -2.16 0.04
RUSRGDPGR 1 0.62 0.26 2.42 0.02


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Avg. Real GDP
Growth
Country-effect
Parameter Estimate
t value of
Parameter Estimate Azerbaijan 12.74 Armenia 8.88 4.90
Armenia 11.20 Kazakstan 7.21 Kazakstan 3.91
Kazakstan 10.27 Azerbaijan 6.97 3.68
Lativa 7.90 Belarus 6.54 2.96
Estonia 7.79 Latvia 5.12 2.81
Ukraine 7.42 Estonia 5.04 2.78
Belarus 7.22 Ukraine 4.50 2.42
Lithuania 7.06 Georgia 4.08 2.20
Georgia 6.47 Lithuania 3.92 2.17
Moldova 6.26 Moldova 3.66 1.94
Kyrgyzstan 4.08 Kyrgyzstan 0.16 0.09

I now switch from the one-way fixed effects panel regression to a least squares
dummy model so I can remove insignificant country effects. Since Azerbaijan and Kazakstan both have benefited from their oil resources, I add an oil dummy variable to
the model. This proves significant. I begin removing the other country effects that are
less significant until I come up with a best fit model. The best model was one that
included the real GDP growth rate for Russia, the dummy variable for oil and country
dummy variables for Armenia and Kyrgyzstan. These are the outlier countries for the
sample that I have. Armenia has performed exceptionally well and Kyrgyzstan
exceptionally poorly. The parameter estimates for this model are displayed in the table below.
Parameter Estimates
Label DF Parameter
Estimate
Standard
Error
t Value Pr > |t|
RUSRGDPGR 1 1.23064 0.05239 23.49 <.0001
ARM 1 4.82005 0.92398 5.22 <.0001
KGZ 1 -3.99661 0.92398 -4.33 <.0001
Oil 1 2.79158 0.74347 3.75 0.0004

The R
2
for this model is 94.51 percent, the adjusted R
2
is 94.14. The F value is
253.93. The most significant variable is the Russian real GDP growth rate. It is
significant at nearly 99 percent. The other variables are significant at only the 90-95
percent level. This is acceptable given the limited number of observations (63 total
observations for 11 countries and 6 years).
III. CONCLUSION

The main conclusion I draw from reviewing the experiences of the FSU countries
in managing their own economies is that Russia does not enjoy a comparative advantage
in economic management relative to most other FSU countries. Most of the recent
improvements in Russia’s economy have come from a source largely outside of its
control: the world price for oil.
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On the positiv
e side, Russia did save its oil revenues and has created a
stabilization fund with them. It also paid down its debt and net debt as a percentage of
GDP was -6.44 percent in 2005. However, it rose to more than 5 percent of GDP in 2006
and may be on the rise again.

Another positive note is the employment situation in Russia. In the past few
years, Russia has had one of the highest employment rates of the FSU. Evidence from
remittances to Armenia and other countries indicates that Russia is a regional labor hub,
providing opportunities for neighboring countries. However, the increase in employment
rates has paralleled increases in oil prices so much of this employment may disappear
quickly with a decrease in the oil price. Evidence from government expenditure data
indicates that much of this employment may also be public sector employment,
contributing little to productivity.

The improvements in the financial sector and the increase in ruble deposits over
foreign currency deposits is a major milestone in Russia’s recovery and development as a
capitalist system. Its recovery from the 1998 crisis was impressive. If it can continue to
decrease inflation and maintain a sound financial sector, its currency may grow in
importance not only in its own country but also throughout the region.

The countries with clear comparative advantages in economic management are
Armenia and Estonia. I would suggest that the region should outsource its economic
management to these two countries, but no doubt some of their success is owed to the
fact that these distinct nations are proudly managing their own economies and not
economies they view as foreign. It is important to note, however, that even these two
countries that have benefited most from independence are still very much tied to Russia.
Remember that transfers from Russia account for 6.3 percent of GDP in Armenia and are
on the rise. In terms of trade as a percent of GDP, Estonia is the second highest importer
of Russian goods among FSU countries at an average of 17.2 percent of GDP in 2001-
2005. So, it can hardly be said that these countries have cut their ties with Russia.

Depending on the indicators used, those countries that seem closest to Russia or
most likely to benefit from a closer union with it are Ukraine, Belarus, Moldova,
Kazakstan and Kyrgyzstan. Only time will tell what relationship these and the other FSU
countries will have with Russia in the future.

My econometric study shows that economic growth in Russia still has a
significant positive effect on economic growth in the FSU countries. This is not
surprising given the economic connections in terms of trade, employment, remittances
and other activities not discussed in this article. Additio nally, the study showed that
Russia’s effect on the FSU countries was stronger than that of the US and Europe. The
US and Europe have a strong positive effect on Russia’s growth and Russia in turn
contributes to economic growth in the FSU countries. Russia is the gateway to the West
for the FSU countries, a fact that should perhaps be more carefully noted in current
political affairs.
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References

Banaian, King and Bryan Roberts. 2005. Remittan
ces in Armenia: Size, Impacts and
Measures to Enhance Their Contribution to Development. Working Paper 05/01, January
2005. Washington, DC: Armenia International Policy Research Group.

Berengaut, Julian and Katrin Elborgh-Woytek. 2005. “Who Is Still Haunted by the
Specter of Communism? Explaining Relative Output Contractions Under Transition”
IMF Working Paper 05/68. April 2005. Washington, DC: International Monetary Fund.

Shiells, Clinton, Marco Pani and Etibar Jafarov. 2005. “Is Russia Still Driving Regional
Economic Growth?” IMF Working Paper 05/192. September 2005. Washington, DC:
International Monetary Fund.