Doc. 11026
18 September 2006


Europe’s interest in the continued economic development of Russia

Report
Committee on Economic Affairs and Development
Rapporteur: Mr Kimmo Sasi, Finland, Group of the European People’s Party


Summary

The Russian Federation – the largest and most populous country in the Council of Europe with immense resources – has struggled hard to stabilise its economic and political system since the early 1990s. Its development efforts, undertaken while gradually embracing European democratic values and a market-oriented economy, have been tested through a series of difficulties, particularly during the August 1998 financial crisis. Whilst continued reforms have brought a widely appreciated macroeconomic and political stability, high growth, better living standards and confidence in the future, many development challenges remain in order for Russia to fully exploit its potential.

The report reviews Russia’s economic progress in recent years and highlights problem areas which call for priority action by the Russian authorities. It calls for closer strategic co-operation between Russia and other European countries around shared values and mutual interests in fostering more harmonious development through improved governance across all the country’s sectors and regions.

The major short- to medium-term development objectives should include strengthening the rule of law, streamlining the regulatory system, improving administration, halting the demographic decline, promoting human development, modernising the economy, clarifying the role of state within it, and stimulating economic activity in the Siberian and Far Eastern regions. Additional revenues accumulated through trade in Russia’s natural resources should serve to underpin structural reforms and provide the basis for future quality growth.

A.Draft resolution

1.       Endowed with immense human, natural and economic resources, the largest and most populous country in the Council of Europe, the Russian Federation has come a long difficult way in its efforts to stabilise its economic and political system since the early 1990s. It is also the country that has faced the biggest development challenges in gradually embracing European democratic values and a market-oriented economy.

2.       In the last seven years, the Russian Federation has succeeded where many thought that it would not. The profound shake up of its economy during the August 1998 financial crisis led to a rebound in the country’s competitiveness through a devaluation of the rouble, tighter budget discipline, a restructuring of foreign debt and improved supervision of the banks. It also ensured renewed support for reforms that resulted in a macroeconomic and political stability, as well as vivid growth, rising living standards, new wealth and confidence. However, significant income disparities, wide gaps in regional development and a continuing lack of diversification represent serious obstacles to lasting economic growth in the country.

3.       The rapidly expanding Russian economy faces a series of short- and medium-term development challenges. These include a need to maintain macroeconomic and political stability, make more effective use of resources, continue reform policies and pursue the overall modernisation of the economy. There is also a pressing necessity to strengthen the rule of law, streamline the regulatory system, curb inflation, better define ‘strategic’ sectors, improve the administration, enhance policy transparency, especially as regards forthcoming regulatory changes, and ensure an impartial implementation of the taxation system.

4.       The Parliamentary Assembly believes that Russia’s chairmanship of the G8 group of countries in 2006 and of the Council of Europe’s Committee of Ministers from mid-May to mid-November 2006 is a good opportunity for Russia to demonstrate its commitment to structural, judicial and democratic reforms, as well as human development and strategic co-operation with other European countries on a wide array of issues.

5.       The aspiration for ‘Europe without dividing lines’ highlights the wish of European countries to seek greater unity based on shared values, justice, solidarity, security and mutual interests. Sustaining strong economic growth in the Russian Federation, as has been the case in the last seven years, and fostering good governance across all sectors and regions of the country is paramount for the harmonious development and prosperity not only of Russia but also all Europe.

6.       Further integration of the Russian Federation into the European and global economy is assisted by its deepening partnership with the European Union. The parties’ agreement to set up four ‘common spaces’ provides a comprehensive framework for action, including through the ‘Common Economic Area’ aimed at putting in place conditions for increased and diversified mutual trade and investment, and the ‘Common Space of Freedom, Security and Justice’ structured to tackle, amongst other problems, organised and cross-border crime. While welcoming recent steps of the parties to facilitate free movement of people, the Assembly hopes that the forthcoming re-negotiation of the Partnership and Co-operation Agreement in 2007 will give yet more concrete content to the four common spaces.

7.       The current demographic situation in Russia has been acknowledged as a major weakness and indeed a threat to the country’s lasting growth and development. Westward emigration and ‘brain-drain’, very low birth rates combined with high abortion and death rates due to inadequate healthcare, various diseases, accidents and unhealthy lifestyles have caused an alarming decline of the Russian population with rapidly eroding manpower and led to a mounting need for immigration of qualified labour. This calls for immediate remedial measures in the areas of healthcare, education, family planning, employment policies and migration control.

8.       Sound management of regional economies (with varying levels of resources, specialisation, development and autonomy) is key to fostering balanced economic growth and the country’s territorial integrity. Stabilising the demographic balance, tackling more flexibly the problem of illegal working migrants and ensuring a more even spread of the population across the country’s territory is vital for stimulating economic activity beyond the central and western areas. The Siberian and Far East districts that account for three-fourths of the country’s territory and nearly all of the country’s natural resources should receive a fair share of income from the exploitation of their natural resources and use it for the development of regional infrastructure and social welfare networks.

9.       Unique and diverse cultural heritage and natural sites across Russia offer remarkable opportunities for developing tourism in a balanced manner. This would not only contribute to regional development but also help preserve the integrity of the national heritage. Measures should be taken to stimulate cultural tourism and ecotourism, drawing on the experience of other countries. In this context the Assembly welcomes the planned creation, by the Council of Europe, of the European Centre of Inter-regional and cross-border Co-operation in St. Petersburg for dialogue between the regions of the Russian Federation and other European countries in the economic and cultural domains.

10.       The European Union has been a staunch promoter of Russia’s accession to the World Trade Organisation (WTO). There is indeed a substantial body of opinion that WTO membership will galvanise domestic reform and improve the investment climate in Russia, leading to considerable medium-term gains to the Russian economy and welfare increases to virtually all Russian households. It is important however that the Russian government should act early to anticipate and mitigate any adverse short-term effects of adjustment to global competition on the most vulnerable domestic industries (such as food, chemical, pharmaceutical and microbiological production, engine manufacturing and farming equipment), companies and certain layers of the population, as well as take measures to strengthen the competitiveness of domestic enterprises.

11.       The Assembly hopes that the remaining negotiation difficulties (concerning subsidies to agriculture, the protection of intellectual property rights, the opening of the service and aviation sectors, and dual energy pricing), notably with the United States, will be resolved by the end of 2006 thus clearing the way for Russia’s membership in the WTO. At the same time, it calls on the Russian authorities to abstain from unilateral trade-blocking measures that have been used on several occasions, lately with regard to Georgia and Moldova concerning wine imports.

12.       Russia’s good economic record, unprecedented macroeconomic stability and a strong budgetary surplus have been achieved in the context of a highly favourable external environment with high demand and rising prices for Russia’s main exports – natural resources. In fact, over 75% of all Russian exports and much of the industrial growth rely on the exploitation of these resources, in particular fuels, non-ferrous metals and forestry. However, this unique competitive advantage needs to be consolidated through investment in the development of more diversified and higher value-added production. This also offers excellent opportunities to make progress on structural reforms, designed among other things to stimulate the expansion of the service and retail trade sectors, and to carry out vital but costly upgrades in infrastructure. There is a huge potential for growth in the transport sector, which is also crucial for more harmonious regional and national development, and a need for specific measures to support the growth of small and medium sized enterprises.

13.       Fair competition – as between big and small or medium sized enterprises, domestic and foreign companies – is paramount for a healthy economy in Russia that favours social and economic cohesion, is fully interconnected with global markets and flexible enough to resist external shocks such as those due to swings in commodity prices or volatility of financial markets. The roles of the state and of the natural (‘strategic’) monopolies in the economy need to be clarified and the powers of independent regulators should be reinforced for the benefit of both domestic and foreign investors.

14.       Better protection and enforcement of intellectual property rights is necessary to ensure a smooth integration of the Russian economy into the multilateral trading system, to attract more venture capital and modern technologies – from both domestic and foreign sources – into Russian research centres and industries, to incite innovation, to assert fair competition and to fight counterfeiting.

15.       Net capital outflows from the Russian Federation, having peaked in 2003-2004, declined considerably in 2005 showing increased investor confidence in Russian economy. Efforts should now be made to allow for the repatriation of transferred capital (estimated at about US$ 348 billion over 1996-2006). Towards this end, there is a need to clarify the relationship between the state and business, especially in sectors deemed strategic (energy, aerospace, etc.); strengthen the effective protection of ownership rights and minority shareholders; continue streamlining corporate taxation and regulations; and implement the International Financial Reporting Standards on the widest possible scale.

16.       Energy resources are the heart of Russia’s economy and its trade relationship with other European countries. Their sales (in value terms) constitute 64% of the country’s exports which are essentially Europe-oriented and growing. This illustrates the extent of complementary interests in the energy sector and the legitimate expectations on both sides. As Europeans increasingly rely on Russian energy supplies, Russian companies need more foreign investment and technologies to develop new oil and gas fields, especially in the Arctic regions, to minimise losses incurred through oil spills and gas leaks, and to enhance their capacity for exploiting existing wells more fully, expanding pipeline networks and building up processing industries, notably for petroleum products and liquefied natural gas.

17.       It is in Russia’s long-term interest to ensure reliable energy supply in Europe. There is therefore a pressing need to minimise risks associated with capital-intensive investment in energy production and networks, and to facilitate cross-border flows. Although the views of the EU and Russia differ as to the means for achieving shared goals, maximum efforts should made to reach a compromise leading to an agreement on Russia’s ratification of the Energy Charter Treaty and related Protocol on Transit. Dual energy pricing (or rather under-pricing) and abundant domestic energy resources should not be used as a pretext for the continuing waste of energy. No other country in Europe stands to benefit as much as the Russian Federation from efforts to enhance energy efficiency. It is important that the country be able to expand its energy production, including through nuclear power plants, and stabilise its domestic energy consumption through more efficient use of energy.

18.       The Assembly sees a need for continued improvements in the use of substantial revenues from energy resources (‘petro-dollars’), particularly those accumulated in the Oil Stabilisation Fund, in order to harness inflation pressures, implement the four national development priorities (the modernization of agriculture, education, healthcare and housing) and fight poverty; to enhance energy efficiency and reliability of the power supply in order to avoid power outages (such as a major blackout in and around Moscow in spring 2005); and to liberalise gradually domestic energy prices. There are also serious environmental concerns associated with the routing of certain pipeline projects, such as the planned North European gas pipeline across the Baltic seabed and the Sakhalin-2 project.

19.       The Assembly recalls its Resolution 1455 (2005) on the honouring of obligations and commitments by the Russian Federation, in which it signaled its concern over a series of measures meant to reinforce the “vertical of power” that may undermine the system of checks and balances, restrict political competition, tame the independence and impartiality of the judiciary, and muzzle the media. Moreover, the Assembly denounced the rise of oligarchic control over many of Russia’s economic assets and resources, and the alleged corruption of some governors. The still prevalent perception of endemic corruption in the public sector continues to harm the country’s image and deter investors. The Assembly welcomes the participation of the Russian Federation in the work of the Council of Europe’s Select Committee of Experts on the Evaluation of Anti-Money Laundering Measures – MONEYVAL – and hopes that the country will soon join the Group of States against Corruption – GRECO.

20.       The Assembly therefore proposes that the competent Russian authorities:

20.1.       take steps to clarify the role of the state in the economy and the relationship between the state and businesses, especially with regard to sectors considered as strategic;

20.2.       strengthen the powers of independent market regulators;

20.3.       ensure effective protection of private ownership and intellectual property rights;

20.4.       introduce legislative measures designed to better regulate lobbying activities and strengthen corporate ethics and liability, notably inspired by Parliamentary Assembly Resolution 1392 (2004) on corporate ethics in Europe, and the revised OECD Principles of Corporate Governance;

20.5.       accelerate judicial and administrative reforms and ensure a more effective enforcement of existing laws across the country’s territory and all levels of executive power;

20.6.       continue streamlining corporate taxation and regulation, especially with a view to alleviating the administrative burden on small and medium sized enterprises;

20.7.       improve the customs administration;

20.8.       accede to the Civil Law Convention on Corruption (CETS No. 174), the Convention on Laundering, Search, Seizure and Confiscation of the Proceeds from Crime and on the Financing of Terrorism (CETS No. 198), the Convention on Cybercrime (CETS No. 185), the Convention on Insider Trading (CETS No. 130), the Convention on Action against Trafficking in Human Beings (CETS No. 197), the revised European Code of Social Security (CETS No. 139) and the European Convention on the Legal Status of the Migrant Workers (CETS No. 93);

20.9.       ratify the Criminal Law Convention on Corruption (CETS No. 173) and the revised European Social Charter (CETS No. 163);

20.10.       consider appropriate domestic measures to tackle corruption on the ‘supply’ side;

20.11.       link measures for the modernization of healthcare, education, family planning, social security, housing, employment policies, migration control and agriculture with adequate financial resources and relevant structural reforms;

20.12.       encourage regional and local authorities to use a greater share of tax income from the exploitation of natural resources for improving local infrastructure;

20.13.       provide a stable and transparent legal framework for public-private partnerships and foreign participation in concession agreements, in particular with a view to realising large projects for the development of infrastructure at national and regional levels and the exploitation of natural resources;

20.14.       enhance policy and project co-operation with the European Bank for Reconstruction and Development in the field of energy efficiency;

20.15.       use the energy dialogue with the European Union to achieve progress on the ratification of the Energy Charter Treaty and the finalisation of the related Protocol on Transit;

20.16.       invest more in the development of alternative energy sources and energy efficiency;

20.17.       resolve current trade-blocking disputes with neighbouring countries;

20.18.       strengthen financing mechanisms for private farming and rural development.

21.       The Assembly also calls on the Council of Europe member states to:

21.1.       further facilitate the integration of the Russian Federation into the WTO and the country’s closer partnership with the European Union, in particular with regard to energy co-operation and the free movement of persons;

21.2.       ensure a rapid pace of negotiations between the European Union and the Russian Federation on the renewal of their Partnership and Cooperation Agreement and seek thereby to fix specific goals and implementation timetables;

21.3.       assist the Russian authorities in the reform of the country’s public administration and in enhancing the good governance capacity of state institutions;

21.4.       pursue investment opportunities in the Russian Federation beyond the natural resources sector;

21.5.       encourage investment in favour of sustainable tourism in Russia and development projects in Siberia and the Far East;

21.6.       offer their know-how and technologies to joint projects on energy efficiency, industrial innovation, tourism development, healthcare improvements and migration control;

21.7.       strengthen co-operation with the Russian Federation in the banking sector in order to reinforce bank supervision mechanisms, diversify retail banking and enhance the transparency of book-keeping;

21.8.       enhance partnership arrangements between universities and research initutions, especially through student exchange and scholar visit programmes.

B.        Explanatory memorandum by Mr Sasi, Rapporteur

Table of contents

I.       Introduction

II.       Recent economic developments

i.        Trade - Exports

ii.        Energy / Raw Materials Sector

iii.        Trade – Imports

iv.        Industrial Sector

v.       Other sectors

vi.        Investment climate

vii.       Russia and the WTO

III.       Challenges and opportunities to sustained growth and government action

IV.       Further required reforms and Europe’s role

i.       New Economic Programme for the period 2006-2008

ii.        Europe’s contribution sought

I.       Introduction

1.       Russia is by far the largest and most populous member state of the Council of Europe, with immense human, natural and economic resources. At the same time it is the country that has faced the perhaps biggest development challenges over the last fifteen years spent in transition from a centrally planned to a market oriented economy. Our Assembly has closely followed Russia’s transformation process over this period, not least through its annual debates on the work of the European Bank for Reconstruction and Development and a number of reports specifically dedicated to Russia1. The present report2 aims to appraise Russia’s major ongoing reform efforts, macroeconomic performance and the tasks that lie ahead.

2.       Europe has a vital interest in the continued economic development of Russia, as the country’s economic growth has raised the prospect of greater prosperity for ever wider parts of the population and given rise to more wealth - fostering trade and other exchanges with neighbouring and other countries. Obstacles to further rapid growth remain, however, in the form of an insufficiently diversified economy (heavily geared towards raw materials such as oil and gas); an incomplete development of the services sector; regional disparities; democratic decline; a still considerable capital outflow and continued barriers to investment.

3.       Your Rapporteur believes that the economic reform process in Russia can regain new momentum via the enactment of transparent and clear legislation making for predictable conditions in economic life; the strong protection of property rights and investment favouring a renewed influx of foreign capital, including into the productive sector; harmonisation of domestic rules and standards with those at European and world levels; and a determined fight against economic crime. Russia’s membership in the Council of Europe and a proper implementation of the 1997 Russia-EU Partnership and Cooperation Agreement are essential for the realisation of these reforms, as is the country’s entrance to the World Trade Organisation (WTO), where every effort must be made to ensure that this can take place as soon as possible.

4.        “I cannot forecast to you the action of Russia. It is a riddle wrapped in a mystery inside an enigma” is a famous remark made over half a century ago by Sir Winston Churchill. Russia has changed tremendously in the meantime, but even today Russia remains for many Europeans an enigmatic country. This is perhaps not so surprising given the number of critical news reports appearing in international media, while positive developments often go unnoticed. Working in and with Russia is often portrayed as a risky undertaking, but one purpose of this report is also to show that immense opportunities and rewards lie ahead for forward-looking entrepreneurs and investors, and that these often more than outweigh any risks that a still rapidly changing and challenging economic environment and a different business culture may hold in store. II

II.       Recent economic developments

5.       Russia has come a long way in its efforts to stabilise its economy since the early 1990s. It reined in inflation (from over 2500% in 1992 and 215% in 1994 to 11% in 1997); gradually consolidated its budget, taxation system and institutional framework; enacted stronger regulations in the banking sector while ensuring the extension of, and improved access to, credit facilities, with this in turn fostering dynamism in the financial sector, stimulating investment flows and trade; and making labour markets more responsive to market signals. Even the August 1998 financial crisis in Russia in retrospect turned out to have been less disruptive than many people thought at the time. Instead, the Russian government’s and the Russian central bank’s anti-crisis programme, assisted by the IMF, led to a rebound in the country’s competitiveness through a depreciation of the rouble3, tighter budget discipline, a restructuring of foreign debt and an improved supervision of banks. It also ensured somewhat renewed popular support for reforms, as arrears in salaries, pensions and social assistance were cleared.

6.       Since 1999, Russia’s economic performance has been striking. Its recovery from the August 1998 crisis was rapid and durable. In the last seven years, economic growth averaged 6.7% per annum; in 2003 and 2004, growth was recorded at, respectively, 7.3% and 7.2%, and the current data (6.4%) for 2005 suggests that the official forecast of 5.7% has been surpassed (see the table below). The official target of doubling Russia’s GDP between 2003 and 2010 may therefore be within reach. In 2002, the European Union and the United States accorded Russia a market economy status and the country has since made substantial progress towards accession to the WTO. The World Bank has recently reclassified Russia as an upper middle income country.

7.       While the initial effects of devaluation and the subsequent rise in world oil prices have each played an important role, Russia’s success has been underpinned by rather stable macroeconomic management, prudent fiscal policies and a notable growth in productivity. As a result, Russia’s public finances are solid: there has been a large surplus in the federal budget for six consecutive years, public debt is low, foreign currency and gold reserves are record high (over US$ 277 billion in August 2006 - they are the world’s 3rd biggest reserves4) and the national currency is accordingly strong, while debt has dropped to 9% of GDP (from 93% in 1999), even as GDP per head of population has increased substantially (from US$ 2116 in 2001 to US$ 4065 in 2004 and about US$ 5126 in 2005). The rapidly expanding lending to private clients has radically boosted Russian Banks’ profits which nearly doubled from early 2005 to early 2006. Unusually high growth rates (+37% in 2005) were also observed in the country’s pharmaceutical market.

Table 1: Basic economic indicators of Russia

 

1998

1999

2000

2001

2002

2003

2004

2005

Real GDP growth, %

-5.3

6.3

10.0

5.1

4.7

7.3

7.2

6.4

Gross fixed capital formation growth, %

-12.4

6.3

18.1

10.3

3.0

12.5

11.2

10.7

CPI inflation (Dec. /Dec.)

84.5

36.6

20.1

18.8

15.1

12.0

11.7

10.9

Exchange rate (Rouble/USD, average)

9.7

24.6

28.1

29.2

31.4

29.5

28.6

28.8

Unemployment (ILO definition, annual average, percentage of labour force)

11.9

12.9

10.5

9.0

8.1

8.6

8.2

7.6

Exports of goods (USD billion)

74.4

75.6

105.0

101.9

107.3

135.9

183.5

243.6

Imports of goods (USD billion)

58.0

39.5

44.9

53.8

61.0

75.4

96.3

125.3

Current account: USD billion

0.2

24.6

46.8

33.9

29.1

35.9

60.1

84.2

% of GDP

0.1

12.6

18.0

11.1

9.0

8.2

10.3

11.2

Budget balance (general government, % of GDP)

-5.3

-0.5

3.5

3.1

0.3

1.1

5.0

7.7

Central Bank: gross foreign exchange reserves (USD billion, end of period)

12.2

12.5

28.0

36.6

47.8

76.9

124.5

137

Source: Goskomstat, Central Bank of Russia, Ministry of Finance, Ministry of Economic Development and Trade, Economic Expert Group, OECD calculations.

8.       Global financial markets continue to express confidence in Russia, with Moody’s, Fitch and Standard & Poor’s having awarded investment grade status to the country’s debt (Baa2 by Moody’s and BBB by the other two agencies). In May 2006, Moody’s went even further by according ‘A’ class ratings to four Russian companies (Transneft, Gazprom, RZhD and Sovkomflot) ranking them higher than sovereign ceiling. Indeed, Russia repaid, ahead of schedule, its entire outstanding debt to the IMF (in January 2005) and the Paris Club of creditors (in August 2006). The abolition of restrictions for foreigners to own shares has brought huge capitalisation gains for large Russian enterprises, especially in the energy sector where, for instance, Gazprom’s (state-controlled gas company) market value soared from US$ 10 billion to US$ 250 billion in five years, enabling it to acquire parts of gas pipeline networks in neighbouring countries and to consider takeovers of western European energy companies. Furthermore, the liberalisation of currency transactions in July 2006 allowed the rouble to become fully convertible.

9.       Crucially, too, the standard of living has gradually risen across Russian society: inflation (6.2% in the first half of 2006) and unemployment have been significantly reduced, while real wages have grown by 82% (putting them 28% above pre-crisis levels), and the proportion of the population classed as ‘poor’ has fallen by a third (to about 18% in 2004). While many challenges remain, ordinary Russians now have increasing access to mortgages, bank loans, and credit cards. They traditionally save little, own their houses or apartments, pay low rates for utilities and are avid consumers of fashionable goods. Private consumption has increased strongly, but manageably, in recent years, at an annual average of 8%. Further gains in consumption and business activity are expected as a result of a cut in social taxes (from 35.6 % to 26%) and related changes to the pension system in 2005, as well as lower VAT (18% since 2004). Social benefits reform, aimed at the elimination of unfunded benefit entitlements, is another important element of the budgetary measures in 2005. A law on zero percent inheritance tax was signed in the second half of 2005.

10.       However wealth distribution in Russia remains highly uneven. Some 75% of the poorest in Russia live in peripheral or remote rural areas with worsening demographic prospects, including in some 50,000 so-called ‘dying’ villages. At the same time, rising prices for raw materials on global markets have increased the revenues of exporters and also personal fortunes, so that Russia is now estimated to have 26 ‘dollar billionaires’ (according to Forbes magazine 2005 list of the world’s wealthiest people) while Moscow alone has almost as many billionaires as New York. Russian tax authorities reported 80,000 millionaires (in dollars) resident in the country in 2004 (or one of 1800 citizens). Private sector experts consider these figures an understatement when taking likely tax evasion into account and believe the numbers to be anywhere between 300,000 and 400,000 (or one for every 350 to 475 citizens).

11.       Another problem is reversing capital flight. According to estimates by the Central Bank of Russia, net capital outflows from Russia’s banking sector exceeded US$ 10 billion in 2004, including US$ 7.8 billion from the private sector (which was four times more than in 2003 but which fell to zero in 2005), while capital outflow from the non-banking sector was US$ 11.5 billion (slightly down from US$ 12.2 billion in 2003) lowering to US$ 4.9 billion in 2005. At the same time, foreign direct investment – peaking at US$ 9.4 billion in 2004 and US$ 16.7 billion in 2005 – remains lower, in terms of FDI per capita, than in most other transition economies and inflationary pressures have been building up since the second half of 2004.

12.       The Fitch Ratings agency estimates capital outflows from Russia to have been US$ 100 billion for 2001-2004 (equivalent to 6% of GDP) and US$ 248 billion for 1996-2000 (or 9% of GDP), with a clear trend for larger volumes in both 2004 and 2003. Interestingly, the agency noted a tendency for private Russian banks and companies to replace this capital outflow by ever more – and cheaper – borrowing abroad. In 2004 alone, Russia’s external corporate debt grew from US$ 80 billion to US$ 106 billion. This could be interpreted as indicating a lack of confidence by the domestic corporate sector in the government’s macroeconomic policies, or in guarantees regarding the protection of ownership rights. Or it could be seen as a convenient way to avoid taxation and to share the domestic political risks with foreign creditors.

13.       In 2005, the Russian stock market ranked as the world’s best performer (up by 88%) after the moments of hesitation in 2004 in the light of the Yukos affair and more generally tense relations between the state and business. Moreover, big Russian companies raised € 4.1 billion through initial public offerings (IPOs) on the London Stock Exchange in 2005, while the launch of the Rosneft (state-controlled oil and gas giant that acquired Yuganskneftegaz, Yukos’ main production platform) IPO in July 2006 generated € 8 billion – the biggest ever for a Russian company. Smaller companies face a different situation, where limited access to finance and obstacles (such as red tape or corruption) constrain their development. Beyond the shining macroeconomic figures, the lack of diversification, aging infrastructure, growing regional divides and demographic decline are among the key economic weaknesses to be addressed in the medium term.

i.       Trade - Exports

14.       According to the WTO, Russia is now the world’s 13th biggest exporter with its share in global exports at 2.4%. Ever since 1999, Russian exports were roughly double imports in terms of value. Even though growth in consumption and domestic industrial investment has tended to suck in imports – in fact, import growth has repeatedly outstripped export growth in recent years – the overall trade balance has soared due to increased world prices for raw materials (and hence revenue from their exports which in 2005 grew by an impressive 34% in value terms but only 4% in volume terms). Domestic demand has gradually become a greater component of overall economic growth than exports – although it relies, of course, upon a strong export performance. It is therefore reasonable to suggest that, in the last five years, Russia has begun a process of transformation, which has already made it more interconnected – both economically and socially – with the outside world, particularly with its major trading partners,- the nations of Europe. This process seems set, not only to continue, but to gather pace.

15.       Two-thirds of Russia’s exports go to Europe – its top three markets in the region are the Netherlands, Germany and Italy – and consist overwhelmingly of raw materials. CIS countries absorb altogether over 16% of Russian exports, with a major share going to Belarus and Ukraine, especially in gas supplies (at least, in the case of Ukraine, up until the dispute in early 2006 between the two countries over the price of gas deliveries). Trade with China has been expanding in recent years but exports to that country have not yet reached the level of those to Russia’s main CIS partners.

Figure 2

Source: www.russiaexport.net

16.       Fuels, non-ferrous metals and forestry account for more than 75% of all Russian exports. These sectors have also represented 75% of Russia’s entire industrial growth over the last three years, and among them oil is by far the most important – representing 40% of all Russian exports and 45% of Russia’s industrial growth. Given that industry accounts for slightly less than half of Russian GDP, this means that increased oil production is responsible for a about a quarter of Russian growth in recent years. The share of oil revenue in the federal budget has doubled since the 1998 crisis from less than a fifth in 1998 to about two fifths in 2004. Exports of petroleum products grew considerably in 2005 (up by 5.3% in volume while crude oil export volumes shrank by 2% and gas export volumes expanded by 1%) and the share of energy (in value terms) reached 64% in the export structure.

Figure 3: Indicative Structure of Exports in 2005

Source: United Nations Trade and Statistics Database (COMTRADE)

17.       In an attempt to reduce the dependence of its budget on oil revenues, the Russian Government in 2004 created an oil stabilisation fund (OSF). This fund is meant to accumulate the oil revenues from exports attributable to Ural oil prices in excess of US$ 20 per barrel together with subsequent investment income from the fund’s resources. In addition, the fund received the unspent fiscal surpluses of 2003 and 2004. Withdrawals from the fund are meant to fill in gaps in the budget when global oil prices fall below US$ 20 per barrel and to repay foreign debt. Part of the resources so far accumulated in the fund already served to repay, in January 2005, the country’s entire outstanding debt to the IMF and also to reimburse US$ 19 billion to Paris Club creditors (which still leaves about US$ 80 billion in the fund by September 2006).

18.       The fund reserves were earmarked to close the gap in the pension fund for 2005 that appeared through the cuts in the unified social tax, to repay the total remaining debt of some US$ 22.2 billion (at end-2005) to the Paris Club in 2006, and to finance some of the four national priority projects in the fields of education, healthcare, agriculture and housing. We should also note that the fund has been instrumental in preserving macroeconomic stability by absorbing extra money flows and thus slowing their impact on inflation and the real exchange rate of the rouble.

ii.       Energy / Raw Materials Sector

19.       Russia’s rich natural resources are of fundamental importance to its economy and form one of its key competitive advantages. The production and processing of natural resources yield over 50% of the revenue to the consolidated national budget and overall mineral wealth output is very close to that of the US. It is thought that the country’s share in global reserves in natural resources amounts to 13-16% for oil, 32% for coal, 28% for gas, and from 10% to 36% for lead, zinc, cobalt, nickel, platinum, palladium, iron, silver and diamonds. Oil remains the lynchpin of Russia’s growth and is considered a strategic sector5. Although high oil prices on world markets, especially in 2004 and 2005, have been an extremely favourable external factor, production increases have also been significant. While total Russian export volumes have increased by 30% since the year 2000, the oil sector has increased volumes by 60%. The OECD estimates that even at 15 year-average oil price levels6, the Russian economy would still have been able to grow at 6.2% during 2003.

20.       These production increases have been made possible by aggressive extraction, mostly on the part of private Russian companies who have increased their investment levels in recent years to match those of the state sector, and have had access to state-held infrastructure such as pipelines. New investment and additional technology will be required if Russia is to continue to expand oil volumes, since much recent production has been based on fields that were already available, and many new prospects lie in technically challenging regions of the country. However, Russian companies are currently investing very little into the exploration and exploitation of new oil fields7 (including offshore ones) or in improved oil recovery techniques. There has, for instance, been a marked slowdown in the growth of oil output and investments since 2004 and this has translated into a more moderate GDP growth.

21.       To make the substantial investments that will be required, companies will need to feel very certain of their property rights – and they would need to be assisted by the reduction of the bureaucratic obstacles hampering new exploration efforts. The consensus view is that, to grow volumes significantly beyond 2008, Russia will need to invest in new pipeline capacity – and will need to bring on new fields by the end of the decade. Production Sharing Agreements, as first experimented in the Sakhalin-1 and Sakhalin-2 projects, could be further improved and more extensively used to involve not only foreign investors but also to give municipalities a stronger role in resource development and to benefit local infrastructure improvements.

22.       Gas is another important commodity (at about 12% of exports in 2004) that represents a great opportunity since, while its proven oil reserves are relatively low, Russia has the largest gas reserves in the world. There is also little risk of price competition or trade difficulties with OPEC. Demand for gas is constantly increasing – and will do so especially in Europe as North Sea stocks decline. Already, Russia supplies about 25% of Europe’s gas; Germany imports 40% of its gas from Russia and by 2010, Russia expects to be supplying 10% of the UK’s gas requirement, while some of the new member states of the EU and many other countries in central and eastern Europe are almost entirely dependent on Russian gas supplies. However, here too there are capacity questions. Despite the expertise of Gazprom (the main state company producing over 20% of the world’s natural gas) in gas extraction, export volumes have actually fallen in recent years, through a combination of over-regulation, monopoly control of pipelines, low use of new gas fields, underdeveloped liquefied natural gas capacity, and restraints similar to those that affect the development of the oil sector.

23.       In both of these sectors, European businesses could have an important role to play by investing more in the exploration and exploitation of new resources, as well as by participating in new pipeline projects and related industries. Russia has substantial holdings in pipeline facilities as well as gas and electric companies in eastern Europe, particularly in the Baltic States, and joint-venture projects in Russia are beginning to emerge. British Petroleum’s deal with TNK oil company led the way in 2003 (at US$ 6.75 billion, it was the largest foreign tie-up to date). Then, in September 2004, Total took a 25% stake in Novatek, the largest private gas producer, and ConocoPhillips bought a 7.6% stake in Lukoil, the leading oil and petroleum company in Russia. The German firm Eon has a small shareholding in Gazprom, and with another German firm, RWE, is thought to be interested in acquiring parts of Yukos. Both in terms of investment and technology, these developments are to be welcomed.

24.       Some eyebrows were raised, however, when in 2005 Eon and BASF struck a € 4 billion deal with Gazprom to build a 1200-kilometre North European gas pipeline under the Baltic Sea, without preceding consultation of neighbouring countries and despite an assessment showing that an overland link would have been cheaper. Up to 10% of the EU’s gas demand is expected to flow through this pipeline by 2012-2014 when it reaches maximum transportation capacity.

25.       European countries import increasing amounts of their energy resources from Russia. They are urging Russia to ratify the Energy Charter Treaty which offers a means to protect investments in the energy sector, encourages efficient energy use and facilitates transit of energy supplies across multiple national borders among 51 European and Asian countries that are parties to this agreement. This would allow liberalisation of access to pipelines and would slim the chances of unilateral suspension of energy supplies in a pricing dispute. Russian companies could in turn gain wider possibilities to operate in western European retail markets. While the Russian authorities have signalled their preparedness to enlarge foreign participation in the development of natural resources and willingness to obtain shares of the foreign downstream market, they also want to consolidate Russia’s control over pipelines and to expand oil and gas supplies to Asian countries where demand is soaring.

26.       Economists warn that the increasing centralisation of control over Russia’s energy sector by the government could reduce growth, as state-owned enterprises tend to perform less efficiently than privately owned companies. At the same time, in the electricity sector the transmission and distribution networks were successfully separated from production activities and a domestic wholesale market for electricity was established. Looking beyond the energy sector, Russia is now confronted with what is generally considered as self-inflicted damage to the investment climate due to the Yukos affair, especially the sale of the Yukanskneftegas branch of the company. This was perceived by foreign investors as a disguised re-nationalisation of a private oil and gas company. Important institutional investors in Russia, such as the EBRD, see rising uncertainties and risks regarding the protection of property rights and a lack of clarity about the role of the state in the economy.

27.       In January 2005 this Assembly adopted Resolution 1418 (2005) on “The circumstances surrounding the arrest and persecution of leading Yukos executives”8, in which it questioned the fairness, impartiality and objectivity of the judicial authorities. It also criticised various procedural shortcomings and the lack of transparency in the trial, in which the state’s action was seen as going beyond the mere pursuit of criminal justice over the tax claims so “as to weaken an outspoken political opponent, to intimidate other wealthy individuals and to regain control of strategic economic assets”. There were further concerns about alleged politically motivated, unjustified tax claims against the telecommunications provider VimpelCom9. Moreover, Russia’s top auditor then warned that other Russian companies could face court action over alleged dubious actions during the privatisation process in the 1990s, although those considered as loyal were likely to be spared.

28.       Energy security features prominently on the political agenda of Russia’s chairmanship of the G8 in 2006. The official Russian position, stating that “the globalisation of the energy sector makes energy security indivisible” and that shared interests “in the area of energy mean common responsibilities, risks and benefits” is reassuring. It also puts emphasis on “a world energy architecture that would help avoid conflicts and counterproductive competition for energy security”. The future will show if Russia and its key partners in energy matters can live up to expectations and high commitments.

29.       In addition to oil and gas resources, metals, chemicals and forestry count as main export commodities. Beyond them Russia has few other sectors that could offer possibilities for rapid and significant export growth (though there has been some recent expansion in its leading manufacturing sector – machine tools and equipment). In terms of finished goods, the competitive threat of China leaves little room for the development of cheap manufacturing. So far Russia has not developed an industrial base capable of competing in terms of highly-finished or technological goods and the quality of production remains a major development challenge. Russia has also yet to establish the trade agreements and alliances that would be needed to prevent and overcome any protectionist measures abroad. In the medium term, oil and gas – and commerce with Europe – will remain crucial. In the longer term perspective, Russia needs to export more value-added products. Europe’s support to Russia in this endeavour is crucial.

iii.       Trade – Imports

30.       Russia is the world’s 19th top importer. Its increased exports will be essential to balance ever-increasing imports (up by 28% in 2005) which have more than doubled since 1999, increasing by an average of 21% a year (well ahead of disposable incomes). Europe is by far the largest source of Russia’s imports: Germany is Russia’s top supplier, with a 14% share of business, up from 11.5% in 2000; Belarus, Ukraine, and China hold the next positions (China having increased its share from 2.8% in 2000 to 6.3% in 2004) or a 23% share of imports. Italy, France, Finland and Poland are the next largest European suppliers – all having increased their shares since 2000 and with a combined total of 14.5% in 2004. Given their shared history and culture, and Russia’s long-standing ties and existing infrastructure with eastern Europe in particular – and given that Russia’s population is concentrated in the west, European countries and Russia have an intrinsically strong trading relationship.

31.       Russian imports are principally made up of finished and manufactured goods. Machinery, electrical equipment and vehicles account for around 42% of imports; food, agricultural supplies and pharmaceuticals represent 20%, while chemicals and metals make up a further 25%. Within these statistics, the volume increases in consumer goods have been striking and highly beneficial for European firms. For instance, the value of domestic washing-machine imports has risen thirty-fold since 1999 with Italian products accounting for nearly half of that sector. Automobile imports have increased eight-fold over the same period, and Germany supplies more than half of these. And, again since 1999, Finland has increased the value of telephone sales to Russia by a factor of seven. Such dependence on imports could be lowered if domestic production capacity could be increased.

32.       The rising level of imports, while currently sustainable, could soon be a cause for concern. Russia’s present trade surplus, while healthy, is fragile. If oil prices were at their 15-year average level, the surplus would be cut to US$ 20 billion which, given present import trends and current estimated levels of capital flight, could quickly lead to a strong demand for foreign capital even though some useful reserves will have been accumulated in the oil stabilisation fund. Also, import demand has been stimulated by the strengthening of the Russian currency, leading to fears that the economy will be affected by ‘Dutch disease’, whereby the domestic economy is swamped by artificially-cheap imports. So far, this has not happened, in part because of the fiscal restraint that has been maintained by the Russian authorities. Instead, business has exploited its own previous inefficiency.

iv. Industrial Sector

33.       As a legacy of central planning, the industrial sector (which accounts for about 35% of Russia’s GDP) is still very much regionally concentrated, often in remote areas where operating costs are high, and is largely skewed towards heavy industry. With their windfall earnings from oil, large conglomerates have been able to buy badly-run businesses cheaply and generate huge productivity gains, by utilising neglected capacity, reducing headcount, and increasing hours worked per employee. These enterprises have much easier access to capital than their predecessors, and are run by a radically different breed of management.

34.       This has certainly helped to limit the damage to Russian industry – but there are drawbacks. Some estimates suggest that 20 conglomerates now control 70% of Russia’s GDP, and small-business surveys suggest that, ironically, fear of competitive pressure from such groups now outweighs fear of foreign competition. Direct foreign investment in Russian industry outside the energy sector – such as furniture making and trade by the IKEA company’s branch – remains something of a rarity. It hardly constitutes 1% of all FDI inflows.

Figure 5: Output share of integrated business groups and state-controlled monopolies

 

Share in industrial output, %

Share in output of goods and services, %

State controlled monopolies

13.9

10.5

    Electricity

7.7

3.3

    Gas

6.2

3.1

    Railway transport

 

2.1

    Pipeline transport

 

2.0

Integrated business groups

35.6

13.7

    LUKoil

7.6

2.9

    Alfa group – Renova

6.7

2.6

    Yukos

5.3

2.1

    Bazoviy Element - Sibneft

4.7

1.8

    Interros

3.8

1.5

    Surgutneftegaz

3.0

1.2

    Sistema

3.0

1.2

    Severstal

1.4

0.6

Others

50.5

75.8

35.       This consolidation of business has not yet substantially helped Russian industry to respond to consumer pressures. Fuels and energy still account for 20% of all industrial output, metallurgy for around 17%, food 15% and electricity 10% while high-tech and consumer goods make up a small part of the productive economy, restricting Russia’s potential not only for import substitution, but also export diversification.

36.       Smaller enterprises, which might be expected to adapt most quickly to a changing marketplace and consumer demand, remain weak and find it hard to get a foothold. They employ about 25% of Russia’s labour force, which is far below potential and the equivalent indicator in OECD countries, and face high administrative barriers that drain about 10% of their resources (compared with 3% in western Europe). Light industry, the most badly-hit part of the economy in 1998, still represents only 2% of GDP – and SMEs, the mainstay of many transition economies, are only about 15% of the economy (compared with 50% in advanced transition economies). Production of consumer goods would be a huge opportunity: the Boston Consulting Group estimates that a mid-sized firm that would make a 10% return on sales in Europe could expect to make 25% in Russia. European entrepreneurs should seize business opportunities in Russia whose untapped potential is huge.



37.       Nevertheless, the rise of the conglomerates has enabled Russia to combine rapid gains in efficiency with low levels of investment. Industrial investment has run at around 18% of GDP, which is lower than in eastern Europe and well below the OECD average of 22%. To maintain productivity gains and industrial growth over the medium term, Russia will need to increase investment rates – to move from passive to active restructuring - and there are early signs that this is happening (fixed investment grew by 12% in 2003 and by 11% in 2004 and in 2005). Unfortunately, however, the share of investment into the productive sector beyond the extraction of mineral resources is still very low. 77% of FDI inflows (that account for about 12% of Russia’s investment in fixed capital) concern manufacturing and the energy sector.

Figure 7: Importance of factors that increase competition for Russian industrial enterprises

(Percentage of surveyed enterprises that mention a factor)

 

1996

1997

1998

1999

2000

2001

2002

2003

Growth of volume of imported goods

31

23

28

8

9

14

23

30

Better quality of imports

7

9

11

7

14

10

18

20

Low prices of imports

17

14

18

5

9

12

12

24

Russian competitors keeping their prices constant

14

15

15

20

23

23

26

31

Entry of new Russian enterprises into market

18

25

25

26

34

36

44

42

Antimonopoly Service and Government activity

8

9

4

6

3

5

6

4

v.       Other sectors

38.       The services/retail trade sector has been transformed since 1990, when it was recorded at 36% of GDP – and as consumers become more affluent, demand will only increase. In 2005, it accounted for 60% of GDP, and although its significance is overstated in official statistics (because of ‘transfer holdings’ whereby oil production is accounted as a service), the World Bank and OECD have calculated that the sector is responsible for about one third of current GDP growth. In order to further consolidate growth Russia will need to develop its capacity in the services and advanced products sectors.

39. Given the propensity of Russians to spend, this sector should be a natural area of growth and in fact all of its sub-sectors have been doing well. Retail and catering, communications and transport have all been growing rapidly so that this sector even led the way in 2004. In fact, this sector offers the best immediate hope of driving domestic growth, since it is fast-moving, flexible and offers large-scale job creation. This is true both in areas that do not require high investment – such as retail and personal services, where deregulation and property rights protection will encourage further growth – and in high investment areas, such as e-commerce, railways, pipeline transport and aviation, as well as the use of water, land and forest resources. There are many opportunities for these businesses in a country of Russia’s size, with 142 million people spread over 11 time zones.

40.       Following a decade of decline in the 1990s as large state farms had to face resource constraints due to a substantial loss of governmental subsidies, Russian agriculture started to show signs of improvement. The introduction of market-oriented system has led to increased efficiency and a rebound in harvests for 2001-2004, especially in grain crops. Agriculture now accounts for about 5% of GDP, and the country has become a net exporter of wheat. Although large agricultural enterprises (i.e., former state collective farms with an average size of 5000 hectares) dominate production of most agricultural commodities in Russia, smaller private farms (of about 50 hectares) are rapidly gaining new market shares, especially for forage and vegetables10. Putting in place more favourable credit policies for the development of private farming would no doubt have a highly positive effect on both agriculture and overall rural development.

vi.       Investment climate

41.       Although European countries are leading investors in Russia (with over 74% of accumulated FDI), most investment comes from just two countries – the Netherlands and Cyprus that account for 60% of all FDI. While the importance of the Dutch investment position can be attributed in part to the country’s role as a financial centre, most investment from Cyprus probably consists of Russian offshore holdings reinvested in Russia. OECD evaluations for 2005 show that Russia’s FDI regulatory restrictiveness index is roughly double that of the OECD average, with highest overall barriers observed in insurance, electricity and air transport sectors.

42.       Judging from the FIAC (Foreign Investment Advisory Council) survey in 2005, the key obstacles to foreign investment in Russia are corruption, administrative hurdles and the selective interpretation and application of laws. The World Bank-EBRD Business Environment and Enterprise Performance Survey of 2005 singles out problems with corruption and labour regulations while noting some improvements in customs and trade-related regulations, as well as tax administration and licensing requirements. The most recent OECD investor survey on Russia recommends improving access to business-related information, promoting consultations with the business community on regulatory changes, and streamlining regulation, especially as regards land and property registration and work permits.

vii. Russia and the WTO

43.       Following China’s accession to the WTO in 2001, Russia is the largest economy seeking to join the organisation. Its accession could greatly benefit the WTO membership and of course also Russia itself. However, Russia’s candidacy has been somewhat contentious, whether in terms of its domestic economic policy or with regard to the WTO’s entry conditions demanded by some WTO members. Russia applied for WTO membership in 1993 and negotiations have since continued first on a multilateral (1995-2003) and then a bilateral (as from 2003) basis, with the EU and Russia concluding a milestone agreement on market access in May 2004. By the end of 2005, accession differences were resolved with trading partners representing nearly 87% of Russia’s foreign trade. Only three countries – Australia, Columbia and the US – still have to conclude bilateral agreements with Russia.

44.       The principal obstacles so far to Russia’s accession to the WTO – as they appear in bilateral negotiations with each WTO member – have been in the domain of intellectual property protection (due to law enforcement problems), customs formalities (notoriously complex and arbitrarily applied), subsidies and dual energy pricing. As far as the latter is concerned, the World Bank told the Rapporteur – during his fact-finding visit in Moscow in July 2005 – that gas prices for commercial users in Russia were already approaching a rational level (covering all costs, including return on investment), although still well below half of the average market price in western Europe and most of Asia. Remaining negotiation difficulties are with the United States over agricultural subsidies; intellectual property rights, where the US insists on better protection; trade in aircraft and services, where the US (and Switzerland) wants a greater market opening; and affiliates of foreign banks in Russia, where likewise the US insists on more openings but where Russia feels there should be more Russian oversight over their operations.

45.       Some economists fear that accession to the WTO might lead to a massive explosion of unemployment in Russia and render certain sectors of the economy (such as meat and milk production, the chemical and pharmaceutical industry, microbiological production, engine manufacturing, and the making of farming equipment) vulnerable, while others see considerable benefits from membership. It is worth noting in this context a recent IMF study entitled “Russia and the WTO: the ‘gravity’ of outsider status” (August 2004) which found that Russia’s exports to WTO members ‘underperformed’ its exports to other countries in the 1995-2002 period. At the same time, the analysis suggested tangible long-term gains for Russia (notably given the need to improve the quality of Russia’s processed and manufactured goods) from a WTO accession and highlighted the friction between the group of WTO members and those outside.

46.       World Bank studies11 suggest that WTO accession efforts could galvanise domestic reform and improve the investment climate, leading to considerable medium-term gains for Russia amounting to some US$19 billion (or roughly 3.3% of country’s GDP in 2004) and welfare increases to virtually all Russian households (by about 7% of the value of current consumption). The key factors for these yields are: market liberalisation and increased access for foreign investors to business services (especially in the telecommunications, banking, transportation and insurance sectors), the expected general halving of tariffs, a stronger legal position in dealing with anti-dumping measures12, as well as productivity gains and cost savings through increased competition and technology imports, and better resource allocation. These are expected to more than offset any losses in production resulting from the eventual elimination of subsidies for food production both at home and on world markets. Although rising energy prices for domestic users will gradually erode some of the competitive advantage Russian companies currently enjoy, they will also raise pressure for microeconomic and institutional reform, thus stimulating the domestic economy.

47.       The state-provided safety nets will be crucial in helping to mitigate any adverse short-term effects of adjustment on the most vulnerable in Russian society, while the transition periods negotiated (likely to be 3 to 7 years) will allow domestic industries to adjust to global competition. A more active participation by foreign investors can also be expected in infrastructure projects, provided the legal environment secures a fair, stable and transparent basis for the respect of long-term interests of both domestic and foreign investors.

III.       Challenges and opportunities to sustained growth and government action

48.       Although Russia now is in its seventh consecutive year of strong growth, the more recent past has seen a moderate slowdown in growth, whereas revenues from the energy sector in the medium term are expected to remain high and stable. This has led policy makers to fundamentally review current strategies for taxing, saving and using oil proceeds. There are increasing calls for a more dynamic use of oil wealth to underpin reforms, investment and growth, even though the particulars of the Oil Stabilisation Fund have yet to be agreed and specific proposals on additional spending formulated.

49.       Investment, especially in modern technologies, is a major challenge right across Russia’s economy and the economy itself is still far from being balanced. There is a wide range of factors that contribute to this situation, and which the Government has been addressing in various ways. A great deal of progress has been made, but risks and challenges remain. In addition to new laws on Special Economic Zones and Concessions, and new tax incentives, a recently established Investment Fund (endowed with US$ 2.5 billion in 2006 and at least the same amount in the next two years) aims to support infrastructure development, innovation systems and institutional reforms, notably through state guarantees and co-financing of selected projects. The value of these measures will be tested through their implementation which should be as transparent and impartial as possible. Incidentally, much of Russian companies’ borrowing abroad translates more into large dividend payouts (15-20% per annum is quite common) to domestic shareholders than toward financing new investment; such equations run counter the long-term interests of enterprises and need to be improved. Institutional investors, notably the EBRD13 (for which Russia is the biggest country of operations), have made a useful contribution to stimulating investment in high value-added sectors across the country.

50.       Political stability: In the aftermath of the 1998 crisis, and following a turbulent – often chaotic - decade, stability was the number one requirement for recovery. This was rapidly achieved, and since then has been consolidated. Federal inspectors have been appointed to each of Russia’s 89 regions, which have been regrouped into 7 federal districts. Conflicting laws and disputed jurisdictions have thereby been partly resolved, and central influence has been steadily extended. The federal administration has opened a host of regional offices, including 2,000 ‘public bureaus’ for citizens to file complaints or seek advice.

51.       New Russian legislation also abolishes popular election of regional governors, who instead henceforth are to be nominated by the President and then approved by local legislatures. The new laws further foresee the abolition of district parliamentary races, in that all parliamentary elections are to be via party lists. This has given rise to fears that, while overall order is improved in the country, democratic principles might be undermined in the name of stability, leading to an eroding long-term prosperity the way political instability once did. On the other hand the Rapporteur welcomes the recent improved co-operation between the President and the Parliament. Whereas political transformations may seem somewhat slow by western standards, a stronger participation of European businesses in the Russian economy, particularly in the real sector, would help to consolidate and advance vital reform.

52.       Financial uncertainty: Since 1998, when economic collapse brought on a currency devaluation, halts in debt payments and a series of bank bail-outs, fiscal prudence has been a great contributor to growth. From the year 2000, budgets have aimed for surplus based on conservative oil price assumptions. A strong federal treasury has been established, and has – by and large – resisted the temptation to erratically spend surpluses. Instead, debt has been repaid and currency reserves built up. Meanwhile government spending has been stabilised at about 34% as a proportion of GDP.

53.       This creates room for the ongoing programme of tax cuts, and has also had the effect of reviving private investment. Russian companies now increasingly borrow from international markets and foreign banks: their foreign debt exposure has increased by more than US$20 billion since 2000. As a result, Russian banks are now under competitive pressure to lend more to businesses, and increasingly also to consumers. The creation of an oil stabilisation fund in 2004 has been widely welcomed as a cushion insulating Russia against external shocks. Yet there is some concern that fiscal policy may be relaxed in a context of costly structural reforms and stagnant non-oil revenues.

54.       Taxation: In recent years, increased stability has enabled the government to undertake a thorough reform of the tax code, which was notoriously complex, widely evaded and placed a heavy burden on small enterprises. Sweeping reforms were notably launched after President Putin was elected in early 2000, leading to a simplified taxation system that is more fair, stable and predictable. A flat rate of personal income tax of 13% was introduced, the corporate tax rate lowered from 35 to 24%, basic value-added tax reduced from 20 to 18%, and a regional 5% sales tax abolished. Windfall taxes have also been applied to the resource sector, helping to shift the burden from other parts of the economy. Business taxes have thus fallen by some US$ 10 billion per year, and the transparency of the system has reduced the possibilities for tax-avoidance, bureaucratic harassment and corruption. The overall effect of these changes has been highly positive, although analysts warn that money should not be diverted from the stabilisation fund to fund tax-cuts, nor should taxes on the resource sector be pursued to the point of deterring future investment. The projected tax cuts were estimated by the IMF to cost the general government budget nearly 1.25% of GDP in 2005.

55.       Bureaucracy and over-regulation: The World Economic Forum’s global competitiveness rating puts Russia 75th of 117 countries in 2005, which shows continuing problems with its business environment and a slow pace in administrative reforms. Russia’s bureaucracy has doubled since the end of the Soviet era, and now has more than 1.2 million staff. There have been several attempts in recent years to slim it down, with limited success. There have been several rounds of deregulation also, reducing the number of licenses and inspections to which businesses – especially small businesses – are subjected. This myriad of regulation – and the corruption to which it so easily gives rise – has been a major obstacle to the development of small businesses; in some surveys, official regulation has been cited as a greater threat than foreign or domestic competition and corruption is seen as a major disincentive to foreign investment in Russia.

56.       The government has recently merged several ministries and separated legislative from enforcement agencies. During 2004, a government commission identified 5,000 bureaucratic functions, 1,000 of which are to be eliminated, the rest officially defined and codified. Large increases in the wages of public sector employees to match the remuneration levels in the private sector14 are to be followed by big cuts in the numbers employed (by at least 25% by 2010 according to the World Bank). The key challenge here will be, as in previous attempts, implementation. New laws of December 2005 and May 2006 on the creation of special economic zones for promoting research and development, industrial manufacturing and tourism and recreational activities aim not only to provide tax breaks and incentives but also to reduce bureaucratic hurdles.

57.       Law enforcement: To tackle inefficiency and corruption, all regional police chiefs and prosecutors are now centrally appointed, and most have been replaced or moved since 2000. But Russia’s judicial system is itself widely discredited, and this is yet another challenge for smaller businesses and entrepreneurs. Most Russians agree that any case that comes before the courts can be influenced by money, and the local law enforcement agencies are sometimes no better. It can therefore be difficult to enforce property rights, even when explicitly provided for in law. Though it happens less nowadays, it is still not unheard of for companies simply to be stolen – new owners, often with underworld and local government connections, simply impose themselves upon an enterprise, often with the intention of selling it on, and with complete disregard for the nominal owners. The government has made judicial reform a priority; already, in some regions, jury trials have been introduced. In the framework of negotiations for WTO membership, important steps are being taken to reinforce the police and customs capacity for detecting and preventing production and distribution of counterfeit goods, as well as enhancing the legal protection of intellectual property rights.

58.       Harnessing the influence of vested interest groups: Patronage networks stemming from the Soviet past, the sweeping privatisations of the early 1990s amid weak regulation, and often corrupt local elites have all combined to create formidable influence groups in modern Russia. They have accrued wealth and power, so that their influence is felt across industrial sectors, administrative regions and decision-making bodies. Separation of powers cannot be ensured or conflicts of interest excluded when top level officials sit on the governing boards of the main energy companies (such as Gazprom, Sibneft, Rosneft and others) or extraction and processing conglomerates that furnish the bulk of national budgetary resources.

59.       In its latest Resolution 1455 (2005)15 on the “Honouring of obligations and commitments by the Russian Federation”, the Assembly signalled its concern over a series of measures meant to reinforce “the vertical of power” that “may undermine the system of checks and balances”, “severely restrict political competition”, tame the independence and impartiality of the judiciary, and muzzle the media. It also denounced “obscure and irregular privatisations which resulted in an oligarchic control over many of Russia’s economic assets and resources, as well as allegations of corruption committed by some federal governors who were not accountable either to the federal authorities or to the people who elected them”.

60.       Your Rapporteur feels that, in addition to country-specific recommendations made earlier by the Assembly, the Russian authorities should ponder legislative steps for better regulating lobbying activities and strengthening corporate ethics, including along the lines of Assembly Resolution 1392 (2004) on “Corporate ethics in Europe” and the OECD Principles of Corporate Governance as revised in 2004.

61.       Banking reform: Because of past experience and widespread distrust of the system, 70% of Russians do not currently have a bank account (more than a third choose to keep their money at home, while others buy real estate, jewellery or antiques). Although banking reforms are progressing at a steady pace, Russians lack confidence in the robustness of private banks as demonstrated by a confidence-crisis in 2004. Bank deposit insurance is being introduced – though in a more diluted form than was originally intended – to help private banks compete, in particular against the huge state-owned Sberbank; further legislation is promised, to distinguish true retail banks from corporate-holding companies and to regulate the market. To build confidence in the sector as a whole, analysts are hoping to see increased access for foreign investment, a clear definition of the future of state-owned banks, and assurance that the implementation of deposit insurance will be fair and transparent. In addition, IMF experts stress the need to fully implement IAS accounting and strengthen creditor rights.

62.       Foreign investment & liberalisation: In recent years, Russia has legislated so as to encourage foreign trade and investment, both directly and indirectly. Along with a series of corporate governance laws and the simplification of the tax code (highly welcome to foreign firms, if not specifically designed for them), a new foreign exchange law has brought procedure more into line with OECD standards, and revised customs rules have speeded up clearance procedures. Anti-monopoly measures have also been introduced, and further liberalisation is promised in preparation for Russia’s entry to the WTO. There will, naturally enough, be close scrutiny of these in many key sectors, and particularly in the field of resources and utilities. In each case, there are significant questions as to what sort of marketplace will result.

63.       International economists point out that Russian policy would be more effective at stimulating the economy if it focussed on the overall context for doing business, particularly the issues suggested above, rather than by controlling and directing specific sectors. Following several years when FDI inflows were equivalent or lower than outflows, Russia became a net FDI importer in 2004. According to OECD studies16, FDI inflows to Russia stagnated in 2000-2002, then more than doubled in 2003 and in 2004, and slightly dipped in 2005 (although aggregate investment inflows increased from US$ 38 billion to 56 billion that year, mainly due to financial transactions and trade credits, which shows significant external borrowing by Russian banks and companies). Yet these sums are relatively modest as a share of total FDI circulating across the globe (US$ 900 billion) and are not commensurate with the economic potential Russia has. In fact, the accumulated FDI stock in Russia amounts to about 6.5% of GDP (or about five times less than the average of other transition economies in Europe) and is highly concentrated in just a few regions (notably, central and north-western areas that receive about half of all FDI).

64.       Regional development: Given the size of the country, Russia can be seen as a collection of regional economies with varying levels of resources, regional specialisation, development and autonomy17. Many of its economic problems are rooted at the regional level. Strengthening the rule of law and enhancing investment in the regions remains a major priority, not least as the best means to safeguard and foster the country’s territorial integrity. Development of the continental shelf could add a stimulus to economic development of coastal regions and port activities, especially in the Far East territories. Rising costs of land and property, and emerging shortages of qualified labour in central and north-western areas of the country now offer good opportunities for other regions to seek investment. However, regional authorities need to significantly improve access to business relevant information, facilitate administrative procedures and minimise perceived investment risks.

65.       The very uneven spread of the population across the country complicates prospects for lasting regional development. In fact, a quarter of Russia’s inhabitants live and work in the central-western areas (that represent less than 4% of the territory) and only 21% live in Siberian and Far East districts that account for 75% of the territory with nearly all of the country’s natural resources. Although about 73% of the population live in urban areas, there are very few dynamic urban centres and only two towns with over two million inhabitants (Moscow and St. Petersburg). The depopulation of certain regions is striking, such as in the southern Far East where there are 5 million people in the Russian regions bordering China and 110 million people in the three Chinese regions bordering Russia. Clearly, countering a ‘brain drain’ to the West of the country’s best and brightest, as well as expanding settlements in Siberia and the Far East, should be considered a high development priority.

66.       In preparing this report, the Rapporteur and the Committee on Economic Affairs and Development had the opportunity to visit Irkutsk. Situated to the north of Lake Baikal, the region is not only home to the country’s largest industrial complexes for fuel, energy, petrochemicals, metals and timber production but is also a major hub of trade routes (trading with around 70 countries) and a focal point for tourism. Large deposits of gold, rare metals, iron ore, mica, magnetite, talk, precious and semi-precious stones, other minerals and hydrocarbon resources combined with large scale power engineering (especially in hydro-energy) and machine building (such as for the extraction, electro-technical, chemical, hydraulic, aviation and defence industries) offer vast commercial opportunities for European companies.

67.       The world-famous Lake Baikal, unique for its size, age and purity, is the largest and the oldest (25 million years) freshwater lake on the planet with about 20% of the world’s drinking water and over a thousand unique species. The unspoilt beauty and calm of the local landscape is a real magnet for visitors. Additional investment in tourist facilities, services and promotion aimed at both domestic and foreign guests would definitely enhance social development. The Committee was reassured to learn that an important pipeline project would be modified to avoid any risk of spillages and hence pollution closes to sensitive environmental sites in a 40-kilometre zone around Lake Baikal.

68.       The Siberian Federal District, among the largest in Russia, covers a third of the country’s territory and is inhabited by only 20 million people (one seventh of country’s population). This region is unique in terms of its natural resources: it holds 77% of Russia’s oil, 85% of its gas, 80% of its coal, 70% of its copper, 68% of its nickel, 85% of its lead, 77% of its zinc, 82% of its molybdenum, 41% of its gold, 99% of its platinum group metals, and has 45% of the national hydro-power resources, 41% of the forest yield and 20% of the world’s fresh water reserves. However, its contribution to national GDP remains modest with only an 11.4% share, which needs to be enhanced through more affirmative development policies, especially by enhanced investment into processing industries, infrastructure and services.


69.       Kaliningrad (the Russian exclave on the Baltic Sea with a population of 950 000) is another region with a peculiar geographic situation. As a result of EU enlargement, it is now surrounded by EU member states and stands to benefit from its proximity to western European markets as well as its position as a ‘stepping stone’ to markets in mainland Russia and other CIS countries. The Rapporteur hopes that the attention of foreign and Russian investors can be sustained beyond symbolic events (such as the recently celebrated 400-years anniversary of the town of Kaliningrad) and ad hoc arrangements so as to provide steady support for the region’s infrastructure, institutions and social programmes on a par with neighbouring countries.

70.       Competition policy: Making competition policy work and strengthening the competitiveness of various economic sectors is a daunting task given the high concentration in ownership in many industries. For more competitive sectors, such ownership concentration would not be a major problem, provided Russian regional markets can stay open to international and intra-regional trade, and the competition authority (the newly created Federal Anti-Monopoly Service) proves itself strong enough to regulate effectively. Speedier reform of state-controlled monopolies, such as in natural gas, electricity, rail transport and banking, is necessary so as to ensure better resource allocation, fairer competition and more investment. The OECD experts believe that the tension between business imperatives and social obligations would be eased by a clearer separation between the state’s regulatory function and its ownership role.

71.       Reform of infrastructure industries: A quality infrastructure – encompassing energy, telecommunications, transport, water supply systems and municipal services – is a vital element of an efficient economy, especially in a country the size of Russia. The importance of some sectors, such as transportation, goes well beyond core sectoral functions and is deemed essential for preserving national unity, implementing industrial policy and regional development priorities, as well as for supporting social policies for vulnerable groups of population and serving national security. Even though infrastructure networks have reasonably good coverage in Russia, the management of infrastructure services needs to improve18. Although putting in place regulatory systems that encourage investment and private sector participation, promote efficiency and stimulate competition has been a slow process, reforms have accelerated since mid-2003.

72.       Thus, autonomous regulators have been established in electricity and telecommunications sectors; railways restructuring is close to the final stage of a four-phase redress programme, with Russian Railways (state rail monopoly) now planning to sell parts of its key subsidiaries, including profitable freight business, to strategic investors and the state ready to take over the cost of phasing out internal cross-subsidies and to allow new independent companies into the market. A new telecommunications law of 2004 introduced rules for universal service obligations, economically balanced tariffs and fair access to network interconnection. Private sector participation should, however, be further increased, not least through public-private partnerships and concessions, especially for big projects with long payout periods.

73.       Demographic trends and challenges: In the decade following the break-up of the Soviet Union, Russia was seen by some observers as sliding into a demographic abyss that would compromise the country’s long-term social and economic development. Russia’s population (142.8 million in December 2005) during this period shrank by more than 4 million people (or about 3%) as a result of very low birth rates and very high death rates. According to Council of Europe figures, Russia now registers more than 170 deaths for each 100 births and has the highest abortion rates in the world. The US Census Bureau is projecting a further decline of the Russian population in a range of some 19 million from 2000 to 2025, and the United Nations Population Division foresees a drop of 21 million in that period. To make things worse, the spread of HIV/AIDS in Russia has gone beyond being only a medical problem and is seen by some specialists as a threat to the country’s national security. The Russian Ministry of Health reported a 30-fold increase in the number of cases in the last seven years, while unofficial estimates are that five times more - about 1.5 million (or 1% of the population) – are infected with HIV in Russia, 80% of them under the age of thirty.

74.       Reversing this trend of depopulation or at least stabilising the situation requires some difficult measures to be introduced in politically sensitive domains such as migration, health, family planning, social security and employment policies. Special attention is needed to improve child healthcare facilities, HIV/AIDS prevention, control and treatment measures, and lifestyles in general. Although exact figures are not readily available, the army of illegal working migrants (mainly from the former Soviet Republics) in Russia is estimated from 5 to 15 million or about 3-10% of the population. While contributing to the creation of welfare, they also incur losses to the country through tax evasion and capital repatriation. Illegal migration thus calls for an urgent and appropriate solution. Ultimately, the wealth of this country will depend on its people rather than on its natural resources.

75.       Overall, the Government is aware of the key challenges that it faces. Measures are promised to improve the social infrastructure and improve quality of life, such as through investment in housing, health and education, and the establishment of a smaller, all-professional army and tighter state control on alcohol sales. Social development is certainly desirable: despite net immigration, the country’s manpower is being rapidly eroded with the workforce projected to drop sharply from 2008-10 as the post-war ‘baby boom’ generation retires. Not surprisingly, in his state-of-the-nation address on 10 May 2006, President Putin focused on the problem of Russia’s demographic decline, calling it the greatest threat to the country’s future.

76.       Some caution is necessary, for reforms during previous years have often been unsuccessful. Private land ownership, for instance, and private pension provisions have been poorly introduced and remain only partially implemented. This once again highlights the need for an efficient administrative operation, which has credibility with the population – so that successful implementation of administrative reform is in itself a top priority. Difficulties might arise as several wide-ranging reforms are implemented in parallel. Opinion polls suggest that, though Russians are highly supportive of the government, they are sceptical as to whether its agenda can be achieved.

IV.       Further required reforms and Europe’s role

i.       New Economic Programme for the period 2006-2008

77.       In December 2005, the Ministry of the Economy published a programme for the country’s economic policy for the period 2006-2008. The programme has been basically approved by the government but ministries have been asked to come up with further proposals for an “Active Economic Policy” during the period in question.

78.       The programme reflects a certain competition between, on the one hand, a more reform-minded Ministry of the Economy and forces within the government that are in favour of a more interventionist economic and industrial policy. The abundant inflow of revenue from the raw materials sector has also led to a certain lessening of the economic and budgetary discipline that characterised earlier years.

79.       The programme stresses the need to further increase the competitiveness of companies, and the government itself. It therefore calls for a strengthening of market economy institutions and increased competition in all walks of economic life. Other emphases are to raise the efficiency of the government bureaucracy, develop financial markets and fight an inflation that is still considered too high.

80.       However, in addition to these more traditional accents, the programme mentions a number of new “national-strategic projects”, including a more active industrial policy. Among the “national strategic projects” there are four major priorities concerning the modernisation of agriculture, providing quality education and healthcare, as well as ensuring access to affordable housing.

81.       Among areas for a proposed new industrial policy are the oil and gas sectors, airplane construction (both military and civilian), the armaments industry as well as agriculture and transport. These are called “key sectors of national importance”. For the raw materials sector the programme calls for tax incentives in order to tap new reserves, new government pipeline projects and an upgrade of refineries. Airplane construction is to be sorted under a new and predominantly state-owned consortium. The armaments industry is similarly to be consolidated within large industrial and research centres benefiting from state support. Transport infrastructure and agriculture are to be improved.

82.       Clearly, Russia has made considerable progress since the financial crisis of 1998 – and now faces two key economic challenges. The first is to continue to build its export volumes (in both manufactured goods and raw materials) and to support the gathering pace of imports - without succumbing to overheating. The second is to promote diversification and production capacities, across the economy, to ensure its long-term health. Both of these will require greater levels of investment, and a more liberal business environment coupled with an efficient and reliable administration. A successful outcome in this respect will essentially depend on the country’s human resources base which as we have seen is facing severe constraints and threats. Global financial markets are counting on delivery.

ii.       Europe’s contribution sought

83.       European countries have a vital interest in Russia’s success in meeting these challenges, given their proximity, and the intensity of their trading links. It is in the interests of all for European companies to increase their direct investment in Russian business, including the productive sector, – and as liberalisation and the fight against corruption and crime proceed, this should be increasingly possible. At the same time, it is in the interests of all that Russia should accede to the World Trade Organisation at the earliest opportunity.

84.       As suggested above, Russia is active in many crucial areas of reform, and the speed of progress has been impressive but there is more to do. International economists are calling for a range of further measures and commitments that would not only encourage foreign investment but would also assist domestic enterprises and would stimulate both domestic demand and investment, so helping Russia to repatriate some financial resources lost through years of massive capital flight and underinvestment.

85.       Despite improvements in corporate governance laws, it remains difficult to find out who actually controls companies. Russia needs to streamline its disclosure laws, strengthen enforcement and put in place clear rules on mergers and acquisitions. Allied to this, the government correctly identifies the priority of judicial and administrative reform: lack of confidence in the way Russian courts enforce existing laws, the prevalence of organised crime, and the perception of endemic corruption in the public sector continue to deter investors. Russia needs to go further in its efforts to protect private property rights, tackle corruption and make contracts easier to verify and enforce – and Europe is committed to continuing its cooperation in this vital area.

86.       Investor confidence will be enhanced by the rapid adoption of International Financial Reporting Standards, to which Russia is now committed, and better protection of minority shareholders. Some economic commentators are concerned, however, that political and commercial uncertainty is once again becoming a factor impacting confidence, and is causing a ‘risk premium’ to be attached to Russian investments, particularly in the light of the forced break-up of Yukos. To be credible, the rule of law needs to be seen to apply at all levels.

87.       Any perception of arbitrary state power diminishes the business community’s confidence in property rights, and act as a barrier to entry. It is crucial, therefore, to maintain and to respect pluralistic democratic institutions, with checks and balances, and to allow the operation of a free press, which should be an important weapon for Russia in the fight against corruption. Russia could demonstrate its resolve in this field by acceding to the Civil and Criminal Law Conventions on Corruption (respectively, CETS No. 174 and 17319) and by joining the Council of Europe’s GRECO – the Group of States against Corruption that was set up to monitor and evaluate under peer pressure the observance and implementation of international legal instruments. Since April 2005, the Council of Europe, the European Commission and the State Duma Commission on Combating Corruption are working together in a joint EU-financed project aimed at aligning Russia’s anti-corruption legislation with European and worldwide standards.

88.       The process of privatisation for state-owned companies remains opaque and confusing. There needs to be an open and demonstrably fair selection process for bidders, allowing foreign companies to compete with domestic firms, but also providing clarity of ownership. Investors are currently concerned that previous privatisations could be challenged in the courts because of inconsistent and unclear legislation (this essentially does not apply to foreign companies as they did not take part in the first wave of privatisations). Similar clarity and transparency would be welcomed in the awarding of government contracts.

89.       In its legislation, Russia needs to ensure that newly-liberalised markets operate on a level and well-regulated playing-field, and are not over-managed. UES, the state electricity firm, has been broken up, and the new management system is seen as viable; however, the industry is badly in need of an independent regulator. The same holds true for the gas sector, a priority for Russia, where Gazprom itself holds the regulatory power. Reform of Gazprom (though not break-up) has been promised – including the opening of its infrastructure, and increased access for private investors – but there are fears that this process will be stalled by vested interests.

90.       Russia still needs to relax foreign ownership limits in a range of industrial and service businesses, such as banking and insurance, domestic transport and energy, and revise its regulatory procedures to attract investment. An important step in that direction is the adoption by the Russian Government and Parliament of the federal law on the conclusion of concession agreements with domestic and foreign investors. In some cases, too, liberal reform has been left incomplete. Telecommunications is a case in point, where recent legislation implies that foreign firms may invest in Russian telecoms companies, but the method of awarding licenses and allocating frequencies is uncertain, and has deterred investment.

91.       Given commitment in these areas, there is huge potential for European businesses to collaborate with, and contribute to, Russia’s long-term success. In addition, Russian membership of the Council of Europe and participation in the Russia-EU Partnership and Cooperation Agreement provide excellent opportunities for working together to realise shared goals. The EU and Russia have a history of close cooperation. Since 1991, more than 2.6 billion € have been allocated to Russia under the EU’s TACIS programme, to promote the transition to democracy, promote judicial reform and the rule of law, and to improve cross-border security, as well as social and environmental questions. Sector-based trade agreements on steel and textiles have also been agreed. The TACIS programme could usefully be extended so as to support vocational training of managers, especially those working in the real sector enterprises.

92.       The EU and Russia agree that many issues – including, but not limited to trade – are most effectively handled on an international basis and accordingly, at the St Petersburg Summit in May 2003, it was decided to intensify cooperation still further. Accordingly, in May 2005, the partners signed an agreement establishing four ‘common spaces’, so as to provide a comprehensive framework for action. A year later the parties also agreed to ease visa regulations with a view to eventually allowing visa-free travel and signed a readmission treaty.

93.       The ‘Common Economic Area’ aims to put in place the conditions for increased and diversified trade and investment; it will cover a wide range of areas, such as industrial cooperation and enterprise policy, but also specific issues such as property rights, competition and agriculture. It offers a forum for tackling many of the issues – and seizing the opportunities – that this paper has outlined; and this will be given new impetus by Russia’s future membership of the World Trade Organisation. Environmental issues will form a central part of this space, particularly following the Russian parliament’s ratification of the Kyoto Protocol.

94.       The Russia-EU energy dialogue, launched at the joint summit in 2000, has proved highly important in tackling a wide rage of energy issues at political, administrative and industrial levels, especially regarding the territoriality clauses in supply contracts, trade in nuclear materials and the physical security of the transport of energy supplies. Future co-operation could be usefully extended to areas such as energy efficiency, technology transfer, Russia’s energy sector reform, investment protection, closer interaction in gas and electricity markets, as well as the management of pipeline networks.

95.       The ‘Common Space of Freedom, Security and Justice’ is intended to strengthen cooperation in the areas of justice and home affairs, to tackle the threats of organised crime, terrorism and other cross-border crime, such as smuggling and the trafficking of people and narcotics. Both Russia and the EU have been hugely impacted by these problems in recent years, and intend to step up cooperation to combat them, since multilateral solutions are vital if they are to be contained. For the EU, this cooperation must take into account the balance between security on the one hand, and freedom on the other. It is hoped that this ‘space’ will involve regular EU-Russia consultations on human rights, recognising that the maintenance of personal freedoms and the freedom of the press is as important to international confidence as the maintenance of stability. This common space will also work on migration and border issues on visa and immigration rules, with the long-term goal of visa-free travel between Russia and the EU.

96.       The ‘Common Space of Cooperation in the field of External Security’ plans to increase cooperation on security issues and crisis management, to address regional conflicts, the proliferation of weapons of mass destruction, the spread of international terrorism, and to improve the coordination of responses to major natural disasters. Here the EU and Russia will exploit the opportunities for joint action within the framework of an international order based on cooperation, expressed through bodies such as the United Nations, the Council of Europe and the OSCE.

97.       The ‘Common Space on Research, Education and Culture’ will capitalise on the shared intellectual heritage of Russia and the EU, to improve links and exchanges in the fields of education and culture, to develop shared expertise and promote best practices. Since 2003, there has been a Science and Technology Cooperation agreement, with opportunities for the participation of Russian scientists and researchers in EU-funded activities.

98.       In the last seven years, Russia has succeeded where many thought that it would not. It has embraced rapid and far-reaching change, to reach the remarkably strong position that it is in today. The value of oil exports has been a major support, but this cannot be relied upon in the future, as Russia knows all too well. Many challenges lie ahead, therefore; but as this report suggests, none are insurmountable. In a globalising world, international cooperation will be the key to success. Europe, more than any other region of the world, is linked to Russia – by history, by a shared intellectual heritage, by common problems of security and by rapidly-increasing trade, not least in energy. Both commercially and politically – with investment, technology and cooperation – Europe is committed to doing all that it can to help Russia succeed in its transformation.

* * *

Reporting committee: Committee on Economic Affairs and Development

Reference to committee: Doc. 10343; Ref. No. 3025 of 23/11/2004 and Doc. 10361; Ref. No. 3045 of 24/01/2005.

Draft resolution adopted by the Committee on Economic Affairs and Development on 18 September 2006.

Members of the Committee: Evgeni Kirilov (Chairperson), Antigoni Pericleous Papadopoulos (Vice-Chairperson), Márton Braun (Vice-Chairperson), Konstantinos Vrettos (Vice-Chairperson), Ruhi Açikgöz, Ulrich Adam, Hans Ager, Abdülkadir Ateş, Doris Barnett, Veronika Bellmann, Radu-Mircea Berceanu, Akhmed Bilalov, Vidar Bjřrnstad, Jaime Blanco, Luc Van den Brande, Patrick Breen, Milos Budin, Erol Aslan Cebeci, Ingrīda Circene, Valeriu Cosarciuc, Ignacio Cosidó, Giovanni Crema, Ioannis Dragassakis, Iván Farkas, Joan Albert Farré Santuré, Relu Fenechiu (alternate: Gheorghe Miutescu), Urszula Gacek, Carles Gasóliba, Francis Grignon, Kristinn H. Gunnarsson, Alfred Gusenbauer, Nick Harvey, Norbert Haupert, Anders G. Högmark, Željko Ivanji, Ivan Ivanov, Miloš Jeftić, Karen Karapetyan, Orest Klympush, Anatoliy Korobeynikov, Zoran Krstevski, Jean-Marie Le Guen, (alternate: Mr Michel Hunault), Harald Leibrecht, Rune Lund, Gadzhy Makhachev, (alternate: Liudmila Pirozhnikova), Edward Maniura, David Marshall, Jean-Pierre Masseret, Miloš Melčák, José Mendes Bota, Attila Mesterházy, Ljiljana Milićević, Neven Mimica, Gebhard Negele, Bujar Nishani, Conny Öhman, Ganira Pashayeva, MM. Jakob Presečnik, Jeffrey Pullicino Orlando, Luigi Ramponi, Maurizio Rattini, Maximilian Reimann, Dario Rivolta, Maria de Belém Roseira, (alternate: Maximiano Martins) Volodymyr Rybak, Kimmo Sasi, Bernard Schreiner, Samad Seyidov, Leonid Slutsky, Geraldine Smith (alternate:Tony Lloyd), Christophe Spiliotis-Saquet, Aldona Staponkienė, Frans Timmermans, Jelleke Veenendaal, Oldřich Vojíř, Varujan Vosganian (alternate: Mircea Mereută), Robert Walter, Paul Wille, Tadeusz Wita, Rosmarie Zapfl-Helbling, Kostyantyn Zhevago.

N.B: The names of the members who took part in the meeting are printed in bold

Head of Secretariat: Mr Newman

Secretaries to the committee: Ms Ramanauskaite and Mr de Buyer


1 Notably, Doc. 7453 (Rapporteurs: Mr Blaauw and Mr Novak) and Resolution 1078 (1996), as well as Doc. 8294 (Rapporteurs: Mr Telgmaa and Mr Wielowieyski) and Resolution 1180 (1999) on the Economic situation in Russia and Ukraine.

2 Ensuing from a motion for resolution (Doc. 10343) presented by Mr Sasi and others

3 Following the official announcement of a unilateral moratorium on debt payments and a widened trading band for the rouble, the exchange rate of the rouble depreciated by 103% in September 1998. This led to an immediate surge in monthly inflation from 3.7% in August to 38% in September 1998 and a hike in yearly inflation. It took five years of disinflation efforts to bring inflation down to the pre-crisis level.

4 They exceed the entire sovereign external debt.

5 Russia’s oil reserves are the world’s second largest after Saudi Arabia.

6 This calculation assumes that oil prices had been stable since 1999 at their average price in the previous 15 years, which was about US$ 19 per barrel for Urals crude. (This compares with current pricing of about US$ 56 per barrel (February 2006)).

7 About 23% of the wells held by private licensees currently stay idle, according to the Russian Ministry of Natural Resources.

8 See also the accompanying Explanatory Memorandum in Doc. 10368 and Addendum by Ms Sabine Leutheusser-Schnarrenberger, Rapporteur of the Assembly’s Committee on Legal Affairs and Human Rights.

9 WimpelCom has since settled the case by clearing the reduced tax claims (of the tax inspectorate for 2002) and related fines and penalties; the company stated though that it did not agree with the claims of the tax authorities.

10 Private household plots of no more than 2 hectares produce about 93% of the country’s potatoes and some 80% of the vegetables, mostly for private consumption but also for sale at local markets.

11 See www.worldbank.org/trade/russia-wto for the detailed policy papers.

12 The Russian sources indicate that about 60 anti-dumping procedures were underway, in 2005, against Russian companies, causing the latter losses totalling US$ 4 to 5 billion a year.

13 EBRD is the largest institutional investor in Russia, with a total of €5.9 billion invested in 210 projects.

14 Presidential promise earmarks a 50% public salary increase in real terms and a substantial increase in pensions over the next three years.

15 Stemming from the Assembly debate on 22 June 2005 on the basis of the report by Mr Atkinson and Mr Bindig on behalf of the Monitoring Committee.

16 OECD Investment Policy Review of the Russian Federation: Enhancing policy transparency, 2006

17 There are 89 constituent entities in the Russian Federation: 21 Republics, 6 Territories (‘Kray’), 49 Regions (‘Oblast’), 2 federal cities (Moscow and St. Petersburg), one Autonomous Region and 10 Autonomous Districts (‘Okrug’). They are grouped into seven federal districts.

18 For instance, transport costs still amount to 15-20% of the price of domestically made goods compared with a 7-8% level in the industrialised countries; low road and seaport capacity limits the flow of transit traffic; containerisation facilities are inadequate; and cumbersome customs clearances drag out delivery periods and create opportunities for corruption, which further adversely affect the competitiveness of Russian goods. Moreover, 28,000 villages with a total population of 12 million have no round-the-year access to ground transportation means.

19 This treaty has been signed but not yet ratified by Russia.