Last year was a very difficult one for Russia. The currency depreciated, GDP contracted, and the Treasury ran the budget with a deficit and depleted the Reserve Fund by more than half. Unsurprisingly, since then and up until recently, the consensus outlook for Russia ranged from gloomy to cautious. My interpretation of what was occurring in the Russian economy is a bit different – since early 2009, after the government and the Central Bank devalued the currency and brought the ruble to more of an equilibrium level, money markets began recovering. In previous notes, I mentioned that the slow devaluation orchestrated by the Central Bank may have helped a few major companies and banks avoid financial problems, but this also destabilized money markets and created problems for the entire economy, as by printing rubles and lending them to select banks (while gradually devaluing the currency) the Central Bank encouraged speculation against the ruble. Money stopped circulating and began flowing directly to the forex market. After the Central Bank was finished with these exercises, the situation gradually stabilized, so that money demand started to rise and the economy began recovering.

That said, my view was always that the bottom was reached in January 2009 (or more broadly, in 1Q09) and thereafter m-o-m (and Q-o-Q) recovery was sustainable (even though y-o-y numbers remained negative for some time due to the base effect – as cheap credit artificially inflated domestic demand in 2006-08). The most recent industrial output figures fully confirm this view – industry grew by more than 10% y-o-y in 5m10, consumption eventually delivered positive y-o-y growth, and investment also entered positive growth territory.

It is remarkable how Russia’s performance this year looks healthier than that in many other countries, as economic expansion is being driven largely by private money since public spending was not growing y-o-y in early 2010 and is not supposed to grow significantly for the year as a whole. The government’s recent decision (approved by the Duma last week) to amend the 2010 budget and increase expenditures by over R300 bln does not alter this view much, even though it raises concerns about the possibility of future amendments. Indeed, the fact that the economy delivered very strong results in 1H10 without any additional government stimulus means that additional government spending is (and always was) useless, if not harmful, as it only helped maintain high inflation and never stimulated growth, while this year inflation decelerated to below 6%.

Overall, the Russian economy appeared rather flexible and showed a strong ability to grow after the government was forced to scale back its intervention. Firm growth this year is being driven by organic, not overheated, domestic demand, so that the system seems able to find a sort of balance in various respects, such as an equilibrium exchange rate, investment/GDP ratio and rate of growth in consumption. In the past, the government always tried to pull the system out of this equilibrium, thereby creating various distortions.

Meanwhile, the Russian government was not alone in its efforts to generate imbalances – other governments have done similar things while increasing their economic intervention over the past decade (not to mention some of the European governments or the US administration, which slashed rates after 2001 and expanded the budget deficit). My view has always been that governments are primarily to blame for the current global economic turmoil. The private sector simply responded organically to the populist moves that regulators in the advanced economies exercised over the past decade. Economic populism in the advanced economies combined with a number of politically motivated decisions was the source of the current crisis. Cheap money encouraged excessive risk taking, while redistribution of wealth in the EU reduced the competitiveness of the region’s economy. Eventually, excessive spending resulted in excessive borrowing. Increased military spending in major countries also contributed to economic distortions. Debt/GDP ratios in many countries exceeded the “critical” 60% and even climbed to 100% or more. Needless to say, debt service is now becoming a major impediment to growth worldwide.

Despite the very negative media coverage that Russia “enjoyed” last year, the country is largely immune from such problems. The major macroeconomic risk is associated with the excessive dependence of the budget on the oil price – I broached this issue in the past, suggesting that with the break even price of oil staying at around $95/bbl, there is no other way for the government to proceed, apart from containing (ideally cutting) spending. Otherwise, the country enjoys a positive current account surplus, while its budget deficit will stay this year at around 3% of GDP or even less (Finance Minister Alexei Kudrin mentioned that the federal budget deficit was only 2.4% of GDP in 1H10, which is quite encouraging even though still an estimate, as the official budget execution numbers and GDP statistics for 1H10 have yet to be released). The country’s total external debt/GDP ratio last year stayed below 40%, and it will be closer to 30% this year – a very manageable level.

Overall, despite numerous institutional drawbacks, Russia’s macroeconomic conditions look solid and much better compared with all of the former Soviet republics (including the Baltic states). Russia’s GDP per capita was the highest among all of the republics of the former USSR (excluding the Baltics), while its total external debt/GDP ratio (private and public debt) was moderate. Even though GDP per capita in the Baltic states was higher last year, it is clear that this wealth was largely borrowed (another illustration of the geopolitically motivated decision in favor of accelerated accession of those countries to the Eurozone). Unsurprisingly, growth is not expected in these countries this year, while Russia’s GDP per capita will return to more than $10,000 (I expect around $10,600). The relatively low debt/GDP ratio will allow the Russian economy to grow faster compared with many over-indebted countries, including those in the periphery of the Eurozone.

It is remarkable that Russia’s GDP per capita stayed higher than in many other former Soviet countries, despite the fact that Russia for years continued subsidizing countries such as Belarus and Ukraine through discounted energy prices. Only a few countries out of the 15 former Soviet republics were able to increase their GDP per capita in 2009 over the 1991 level. Aside from Russia, this group included energy-rich Kazakhstan, Azerbaijan and Turkmenistan (and even in the case of the last two, the difference was not significant).

The wealthy countries became even wealthier after the breakup of the Soviet Union, while republics with lower income became poorer (again, this refers to the Baltic countries, which had a higher GDP per capita in the USSR and were able to “upgrade” their GDP per capita thanks to borrowing and subsidies from the EU). Even though “upgrades” in Russia and Kazakhstan were based on natural resources, they looked more organic compared with those countries that borrowed extensively and which are now supposed to repay debts that exceed 100% of GDP. Interestingly, the population has fallen by 11-17% in the Baltic countries since 1991, due largely to emigration, which helped inflate per capita GDP. In Russia, the population contracted less, by 4.4%, while in Central Asian countries, populations have risen significantly, which has reduced GDP per capita. Meanwhile, in the entire FSU region, the population contracted by a modest 2%, while dollar-denominated GDP increased by around 1.8%, i.e. both numbers remained essentially unchanged over nearly two decades, while redistribution of income took place.

The data also illustrate who eventually subsidized whom in the past – after the Soviet republics became independent, Russia benefited more with respect to its GDP per capita. From this standpoint, speculation regarding the Kremlin’s intention to spread its influence across the former Soviet republics should take into account the economic costs of such a policy. At a relatively low level of GDP per capita (by international, not regional, standards), it seems as though Russia is unable and unwilling to play the same consolidating role that Germany plays in the Eurozone by redistributing its nearly $200 bln current account surplus across the region.