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INSTITUTE FOR THE ECONOMY IN TRANSITION RUSSIAN ECONOMY: TRENDS AND PERSPECTIVES October 2006 MONTHLY BULLETIN Moscow 2006 Institute for the Economy in Transition, 1996.

5 Gazetny pereulok, Moscow 103918, Russian Federation Phone: (495) 203-88-16 Fax: (495) 202-42-24 E- Mail: todorov@iet.ru 1 UT Politico-Economic Situation in October 2006UT......................................................................................... 3 UT Budgetary and Tax PolicyUT....................................................................................................................... 5 UT Monetary and Credit PolicyUT.................................................................................................................... 9 UT Financial MarketsUT.................................................................................................................................. 12 UT Real Economy: Trends and FactorsUT....................................................................................................... 21 UT The situation in industry in October 2006UT............................................................................................. 26 UT Foreign TradeUT........................................................................................................................................ 29 UT Comments on the draft Federal Law On 2007 Federal Budget as concerns expenditures on agricultureUT.............................................................................................................................................. 32 UT Autonomous Institutions in the Educational Sector: Hopes and Risks of the NoveltyUT......................... 36 UT Current Problems with VAT in RussiaUT.................................................................................................. 38 UT Issues considered at the meetings of the RF Government on October 4 and 19, 2006UT........................ UT An overview of economic legislation adopted in October 2006UT........................................................... UT The Review of Legal Documents on Taxation Issues between September and October 2006UT............ UT Review of Budget Legislation: October 2006UT....................................................................................... Politico-Economic Situation in October The October agenda was formed largely by what had happened in Georgia in the last days of the prior month (on September 25, local authorities had detained several Russian military and local residents and accused them of espionage and preparation of terrorists acts; in a few days, the Russians were released and handed over to a EOSD representative. While failing to constitute a genuine sensation in international politics, the scandal was followed by quite a bizarre reaction of Mr. S. Ivanov, Russias Deputy Prime Minister. He labeled Georgia as a mob state, while Russia called for an urgent meeting of the UN Security Council and undertook and number of steps that further tightened the economic sanctions against Georgia that had been in force since the spring 2006, including suspension of any transportation ties with the country and issuance of Russian entry visas, ban on money transfers, among others). The Russian authorities began carrying out raids on Georgian migrants and searching offices of companies allegedly owned by the Georgians. The state-controlled TV channels were attacking both Mr. Saakashvili and the particularly notorious Georgians who allegedly turned out to be apt to committing crimes than any other nation, etc. Thus, within a few days Russia found itself on the verge of a military conflict with a neighboring state.

While the genuine sense of the Georgian authorities move remained clearly obscure (for having released the Russian military, they de-facto admitted their defeat in the diplomatic conflict), there is something else in this situation that really matters. That is, the situation around Georgia, given that the mandate of the Russian peacekeepers stationed in Abkhazia and South Ossetia, which had long been agreed upon with Georgia, has expired now, permanently implies Russias involvement in a military conflict, should there be any in this particular region. This can mean unpredictable consequences, so far as Russias political regime and the Problem 2008 are concerned. Meanwhile, Ms. Anna Politkovskaya, a famous Russian journalist was gunned down in Moscow, on October 7. That became a second shocking assassination over a short period of time, following that of Mr. Kozlov, Deputy Chairman of Russias Central Bank. Ms. Politkovskaya has focused on Chechnya and activities of Mr.

R. Kadyrov, local prime minister. Basing on numerous evidence and video documentaries, she has portrayed Mr. Kadyrov in a very negative way. That, of course, could not help fueling his dissatisfaction, especially in the light of his fight for presidency in Chechnya and the rise of a serious antiKadyrov coalition that unites pro-Russian Chechens around Mr. A. Alkhanov, the incumbent President of the Republic. We believe it is Chechen military that drives the course of events in the Republic. This allows an important conclusion, that is, the completion of the arming of yesterdays rebels and criminals in Chechnya is posing a clear danger not only locally but to the whole country as well.

On October 8, 9 Subjects of the Federation held a new round of regional elections. The Central Electoral Commission already called them a rehearsal before the 2007-08 election cycle. Underlying the elections was an intrigue around the future of a new political brand, that is, the Russian Party of Life (which consequently, in late October, at a unifying congress was renamed as Just Russia:

Motherland/ Pensioners/Life.

To ensure, at least, a minimal base for our comments, let us note that United Russia overshot a 50% barrier in 3 regions (Jewish AO, Lipetsk oblast and Chuvash Republic), while it failed to collect a 40% of vote in two other regions (Karelia and Astrakhan oblast) and got between 40 and 50% of vote in the other 4 regions). As for the Communists, they managed to overcome the minimal barrier in all the regions, except for Tyva, with their score varying between as much as 19% in Chuvashia and 14.8% in Novgorod oblast, and humble 7.2% in Sverdlovsk oblast. The Party of Life failed in Primorsk krai, Novgorod oblast and Jewish AO and grabbed 10-15% in other regions. It did not run in Astrakhan oblast, but backed Motherland there, which ultimately got 16.7%. Finally, in Tyva the Party of Life got even 31%. LDPR overcame the barrier in 3 regions, albeit by a thin margin. It is worthwhile noting as a background that United Russia boasted its plan to get over 40% of vote everywhere, while in some regions governors even assumed increased obligations in this respect.

Interestingly, in some regions the Party of Life bumped into the use of administrative resource against it. Initially, the newly born bloc had not been allowed to run in Sverdlovsk oblast, Tyva and Jewish AO, but Mr. S. Mironov, its chairman, managed to protect his party fellows, and the Supreme Court of RF ordered to restore all the party lists. The party also found itself under fire on the part of some state-controlled TV channels and other media.

Whether one can expect a further rise of the actual left-wingers (at least in some regions, Motherland and Pensioners have been campaigning on their own and in some regions, for instance, Sverdlovsk oblast, even outran the Party of Life), or this is just another futile attempt, is not clear as yet. Another fact is clear, though, that is, the Party of Life has grown as a rival to UR and become immune to attempts to take it away from elections. Because of this, UR clearly takes it very seriously.

Next half-year should show which Kremlin clans would get together under the Party of Lifes banners.

So far Mr. Mironov keeps operative control over this political project. Remarkably enough, already in the aftermath of the regional elections, the city of samara saw the second round of the mayoral race, in which Mr. Tarkhov, a local oligarch and the candidate from the Party of Life grabbed 56% of vote and defeated Mr. Limansky, now ex-mayor and candidate from UR. Hence, it is not granted that the Party of Life is doomed to get just 10-15% of votes in the future.

In the light of the above, political analysts proved to be wrong when forecasted a notable fall in the CPRFs electorate. Rather, it seems that the newly founded party has stolen the URs electorate or appeared attractive to the undecided one. At this point it should be noted that the Party of Lifes capacity is great, for only one-third of voters casts the ballot at regional elections and the bulk of them have been supporters to UR, or it might well be that the URs vote was purely manipulative and their success was ensured by means of bribing technologies; the proportion of such voters is limited, though, therefore the lower the turnout at the polls is, the more valuable the percentage of such votes is.

As for democrats, they appeared extremely loose at the elections. As a rule, they did not take part in local races anywhere at all, but if they did, they were challenged by administrative resource. To cite a particular example, of Yablokos three regional party lists, one in Karelia, was excluded from the race by an order of a local court of law. The Supreme Court of RF consequently proved the accuracy of the verdict which was based on a very unpleasant reason, that is, a violation of the party members rights in its charter. We do not believe Yabloko will suffer yet greater oppression in the future, for that would open the way to unification of democrats on the basis of the Union of Rightist Forces, aka SPS.

The existing SPS and Yabloko brands de-facto are dead, while their leaders for some reason have refused to unite or re-brand the parties. One can agree with Mr. Yavlinsky who argues that presently there is no sense for democrats to take part in the parliamentary elections.TF FPT Overburdened by their P negative ratings, the democratic party structures have been incapable to attract sponsors and supporters. Meanwhile, this sad forecast should not be applied to the liberal ideology, as the parties in question do not hold a monopoly on that.

October 2006 saw a continuous tendency of the year towards reduction of the scale of economic cooperation with the West. To be just, however, the tendency is reciprocal. To begin with, in October, Mr. A. Miller, Chairman of the Gasprom board declared the company would develop Shtokman field without any overseas partners.

It had been long supposed that in cooperation with them (speculations mostly centered on Chevron, ConocoPhilips, Statoil and Total) the Russian gas giant would develop Shtokman and build a plant to produce liquefied natural gas there. The estimated cost of the project was USD 18 bn. The picking of a partner was viewed as Mr. Putins political resource. Despite the forecasts, at the last Russia-EU summit in Lakhti, the Europeans consolidated stance was that Russia should ratify the Energy Charter, which Moscow was refusing to adopt (at this point, it was Germanys stance on the matter that was most critical)TF FP. It is becoming increasingly evident that, without meeting this condition, Gasprom will P T not be able to enter the gas-distribution business in Europe, and, it does not appear a welcomed owner of European assets to the EU nations in general.

October 2006 also saw the continuation of the attack on Sakhalin Energy project (where Shell is a principal stakeholder and Mitsui and Mitsubishi minority ones). The RF Rosprirodnadzor, the environment protection agency, had launched the attack in September when Mr. Mitvol, its Deputy Head assessed the damage caused to the local nature at the level of USD 50 bn. Mr. Yu. Trutnev, the RF PT TP In his note to party fellows, he, however, concedes that the situation may change in a year. In all likelihood he ties the situation to the outcome of the trial on the partys charter.

PT TP The Charter implies uniform procedures of production, sales and transit of energy sources, as well as those of uniform tariff policy procedures of access to pipeline Minister of Natural Resources seemed to agree with his colleague and while extending the timeline of the examination till late November, he threatened the project with criminal proceedings.

The attack was further intensified by Zarubezhneft that stated an estimated USD 1.5 bn. increase in the project costs. With all actual doubts as to whether the project is beneficial for Russia (clearly, it would have appeared far more promising under the present tax regime and the proportion of Russias profit is very much dependent on the profitability rate of the project, which in this particular case one would find it more beneficial to lower, as well as at the stage of construction to raise costs to ensure deductions from profits), the project by itself is legitimate and forms one of the biggest investment undertakings in Russia. Furthermore, it is equally bizarre that prior to its development Gasprom begins to pretend to the purchase of a considerable stake in it by encouraging the shareholders with the help of RF government agencies. Meanwhile, the shareholders are unlikely to give up and remain confident in diplomatic resources of the West and Japan. One can cautiously agree with them on this, for any revision of Sakhalin-2 is impossible without a dramatic revision of Russias status in the world legal system, which in turn bear risks for overseas assets of the Russian origin.

Meanwhile, Russian business has demonstrated a certain success in terms of its internationalization.

More specifically, Rusal and Sual and international trader Glencore that has an impressive record of doing business in Russia (it once had managed MECHEL), have successfully completed negotiations on their merger. In the event the deal is not torpedoed (for instance, by overseas antitrust agencies or courts of law that currently consider numerous lawsuits against Mr. O. Deripaskas companies), should such a monopoly be founded, Mr. Deripaska would get control bloc in it, while Mr. V. Vekselberg and some other shareholders- 22% and Glencore- 12%. Mr. A. Bulygin, Rusals nominee, would become the head of the companys executive body.

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