From Communism To Modern Day Capitalism: A History On Russian Economics

Official Name:  Russian Federation.

GDP and global rank (2010): US$ 2.37 trillion ranking as the 6th largest in the world.

Per Capital GDP and rank (2010): US$10,816 ranking as 52nd largest in the world.

Local Currency: Russian Ruble (RUB)

How did Russia get to where it is today?

In 1921 the Soviet Union government approved the “New Economic Policy” (NEP) which called for virtually all aspects of the economy to be centrally planned especially farming and agriculture. All workers were now working for the collective good of the state and individual profits were not allowed. Everyone was on equal social status terms with the hopes that all citizens would be self sufficient and properly taken care of. The plan was an immediate failure as five million people died in a famine within years. In 1928 the NEP was replaced with the “five year plan” with the objective of achieving a communist utopia where the nation is self sustaining with a strong global economy. The five year plan called for building a heavy industrial base immediately despite the Soviet Union still being underdeveloped and lacking readily available resources and foreign investments. Every five years the leaders would come up with new objectives in a new five year plan. The majority of citizens in Soviet Union were illiterate peasants with no formal training and education and the central government used propaganda tools and disinformation so the workers can buy in to the “constant struggle, struggle, and struggle” to achieve greatness. Factory output increased drastically however another famine as a result of collectivization of farms resulted again in millions of deaths.

In 1933 the second five year plan was established with a focus on steel production. Upgrades to railways and communication were also undertaken. Coal and oil production began however total output fell well below the initial objectives.

In 1941 Germany declared war on the Soviet Union and resources were shifted to the war effort to construct tanks and other weapons. The war was disastrous for the Soviet Union which had lost a large majority of their farms, hospitals, railway system and leaving over 25 million people homeless and 20 million casualties. Economic recovery and reconstruction was simply impossible. Despite all this Soviet Union leader Stalin promised that his nation will become the leading industrial power within the next 15 years.

The Soviet Union established universities and placed an emphasis on education with a priority of serving the state first. A political, economic and proxy war was launched against the United States and her allies being other non communist nations in Western Europe. An advanced weapons system was developed including nuclear weapons and ballistic missiles. The Soviet Union launched the first satellite that was successfully orbited in to space in 1957 named Sputnik 1. This launch ushered in a new era of technological and scientific developments which greatly benefited the Soviet economy and morale as the Soviet Union proved to the world they have more knowledge in areas of science, engineering, and especially space exploration.

Economic activity continued to increase during the 1960s and 1970s as improvements to central planning resulted in strong growth in national income, total output and most importantly GDP. Economic reform policies were set up which allowed businesses (as opposed to the central government) to have greater flexibility in terms of investments in new equipment that can maximize productivity for the state. By the 1970s signs of danger started to appear such as a lack of labor force to keep pace with the growing economy due to a declining birth rate. By the 1980s advancements in computer technology and other technology sectors had slowed down drastically due to growing disillusionment of the Soviet system and the misuse of resources towards a military buildup instead of industries that will benefit the people. The only positive sector in the economy was the natural gas industry which had consistently surpassed targets set forth in the five year plans.

Suddenly oil prices dropped drastically in 1985 and 1986 combined with a lack of foreign exchange reserves, the costly and failed war in Afghanistan (Soviets “Vietnam” war) and the loss of central control over many republicans led to a weakening of the Soviet central government. In 1990 the Soviet economy was 36% the size of their economic and political rival the United States and it was imminent that the communist days will soon be over. In 1991 the Soviet Union finally collapsed officially ending the cold war and ushering in a new era of what should be freedom democracy and capitalism. As such the Soviet empire dissolved in to 15 republics the largest being the Russian Federation which is the focus of this article.

Russia held its first ever elections in 1991 electing Boris Yeltsin who had plans for drastic market reforms through the use of “shock therapy” which Poland has done earlier to a great degree of success. The reforms involved withdrawing regulations, price controls and subsidies to the state owned industries and opening up the nation to import goods at cheaper prices thereby killing all monopolies the government had set up.

There were major obstacles towards adapting a capitalistic system which included the fact that the population was simply not ready for such a drastic changes within such a short span. The political and economical systems were both changed at the same time to a democratic/capitalist system which was constantly labeled as evil during the communist days. Moreover, the end of the cold war brought an end to the large military budget which kept almost 20% of the nations workers employed. Many factories had transformed from designing military equipment to producing basic household goods such as tables and chairs resulting in a major drop in demand for high skilled engineers and scientists that used to design complex military equipment. Employment was also hit hard by the fact that the communist system did not reward taking risks since very few managers had experience with opening a business from scratch or investing in a new venture.

Capitalism was simply not working in Russia. Despite the extremely high level of education especially in the fields of science, mathematics, engineering etc the Russian population simply lacked business skills. The economy underwent a depression in the mid 1990s. Life expectancy declined sharply and the poverty rate was estimated to be as high as 49% in 1993. The central bank was printing money at an alarming rate and brought in a period of hyperinflation. Economically speaking many Russians felt that they were better off during the communist regime and many communist supporters clashed with economic reformers.

In the late 1990s the Russian government held auctions to sell off equity in assets in some of the largest companies to gain additional revenues. The bidding process was for the most part open to individuals that have served the party at high levels and were well connected and had access to large amounts of capital. Very well known Russian businessmen such as Roman Abramovich rose to riches through these auctions. Oil fields, telecommunications, mining were all up for grabs and the few exclusive owners became known as the “Russian Oligarchs”

Russia was hit hard by the Asian financial crisis in the late 1990s as sales in oil, natural gas, metals were grinded to a halt. The ruble lost tremendous value in currency and the government found itself unable to pay loans it had received and was even unable to pay its public sector employees. In order to fight this problem, interest rates on Russian bonds were selling as high as 200%. On August 17, 1998 Russia devalued the ruble, defaulted on domestic debt and caused a worldwide financial crisis forcing one of the largest and most reputable American hedge funds Long Term Capital Management to lose billions of dollars in less than four months from their investments in Russia. An IMF bailout did not help the situation as the government was still short funds to pay obligations despite receiving US$22.6 billion.   

Russia bounced back from the financial crisis as oil prices rose during 1999-2000. The domestic economy also benefited as imports were more expensive so Russian companies benefited from the devaluation of the ruble. Vladimir Putin won the Russian presidency in 2000 as he brought political stability. The Russian economy grew every year of his presidency with GDP expanding over 70% during his terms, poverty was slashed in half and the average salary of a worker increased from US$80 a month to US$640. This was all achieved through the implementation of a flat income tax of 13%, a reduction in corporate tax and energy policies which promoted increased output and sales in the global stage. Major pipelines were built opening up Russian oil to be exported to major Asian markets such as China, Japan, Korea and a second pipeline connecting Russia with Western Europe. Noticing this investors began flocking in to Russia again, and in 2011 Russia  grew by 4.2% which was the world’s third highest growth rate.

Oil and gas remain Russia’s represent Russia’s largest economic activity and largest export. Russia has the largest oil reserves and is the largest exporter of natural gas. It has the second largest coal reserves, the eighth largest oil reserves and is the largest producer in the world in total production. Russia accounts for 12% of the world’s oil and produces close to 10 million barrels of oil per day and has on reserves 74 billion barrels.

Mining is also equally important to the Russian economy as the nation is one of the world’s leading mineral exporters. Russia is a leader in producing minerals such as aluminum, coal, cobalt, diamonds, gold, iron, phosphate, potash and many others. Over 1 million people are employed by the mineral industry and investments in mineral operations account for 20% of all investments in the Russian economy. Over 20,000 deposits have been explored and more than 30% has been successfully mined. Russia is the fourth largest steel producer and the world’s largest steel exporter. In addition, Russia is the world’s largest nickel producer.

Other industries play a vital role in Russia’s economy such as the space industry that consists of over 100 companies and employs 250,000 people. In 2011 Russia had the largest number of successful orbital launches and is the global leader in this field. The space industry continues to fuel scientific research and advances in technology.

Information technology is a booming sector in the Russian economy due to the successful educational system, in fact Russia has more academic graduates than any European country. Software outsourcing is exploding bringing in over US $1 billion in revenue on an annual basis and has grown by over 50% in the last 7 years. The government is capitalizing on this trend by investing heavily in the construction of IT related technology parks to promote companies to open R&D centers in Russia. Well known corporations such as Intel, Boeing, Motorla have already increased R&D activity inside Russia and many other companies are following suit.

It is fun to note that today Moscow has more billionaire residents than any other city in the world including New York and London.

Will economic expansion continue?

According to a recent report by Standard & Poor, they believe the Russian economy will slow down in 2012 despite rising oil prices. With the global economy in its fragile stage, analysts are lowering their projected forecasts for Russia to under 4%. While this figure is still impressive, many investors will look towards other developing or developed nations that can offer higher returns.

ETFs of interest

SPRD Russia ETF RBL  holds 90 of the largest Russian companies. The fund is highly diversified with energy making up 51% of the fund which includes the largest extractor of natural gas in the world, Gazprom and Lukoil Oil Company, the world’s second largest public company in terms of proven oil and gas reserves. These companies represent 20% and 10% respectively of the total fund value. The average market cap of the companies in the index is US$28 billion. The fund offers an attractive dividend yield of 2.16% and for the past three years has an annualized return of 43.85%

Van Eck Global Market Vectors Russia Small Cap ETF RSXJ holds 33 Russian companies that are classified as being “small cap” and generate at least 50% of their total revenue within Russia. An investor would invest in this type of fund when they believe that the Russian economy will continue growing. Small cap companies benefit the most when the economic conditions in their home country improve, as opposed to multinational giants who are affected by changes in the global economy. The largest holding in the fund is Transfnet who owns the largest oil pipeline system in the world and transports around 93% of the oil produced in Russia. Another holding in the ETF is Pharmstandard, the largest Russian pharmaceutical company with over 200 products used in the treatment of diseases. The company has six manufacturing facilities in Moscow. These companies success is directly related to the direction of the national economy, and if the economy continues growing it is possible that many of the companies in the fund will experience tremendous growth and mature in to large caps.

Companies of interest

Mobile TeleSystems OJSC MBT is Russia’s largest mobile operator with over 100 million subscribers. Total revenue exceeded US$11 billion in 2010 and the company has a net income of $US1.3 billion in the same year. MTS holds the rights to provide cell phone services in 81 out of 83 regions in Russia as well as several neighbouring countries. In 2010 the country made a large investment in Comstar, the largest Russian fixed internet and cable TV provider as part of their expansion and investment plans. The company is looking to add to its presence in India where they have established joint ventures to offer cell phone services to the Indian population.

Mechel MTL is one of Russia’s largest mining companies active in four unique segments: mining, steel, ferroalloy and power. Mechel produces coal, iron ore, nickel, steel, heat and electric power. With over 30 production facilities and 93,000 workers Mechel controls over 25% of Russia’s coal facilities. Mechel is the only coal mining company in the region of Eastern and Central Europe and is developing the world’s largest coal deposits in the Elga Coal field. To facilitate exports, Mechel is developing a 321 kilometer railroad to link the mining field to ports for export. In 2010 Mechel earned US$1.9 billion in profit.     The company is owned by one of Russia’s richest men Igor Zyuzin who is worth an estimated US$6.4 billion.