BEAR MARKET: Russia’s peripheral reform

BEAR MARKET: Russia’s peripheral reform
Russia needs to make deep reforms if it is grow again
By Bear Market Brief November 21, 2016

Russia’s economy is doing better. Though not in the sense that growth rates are set to return to their 2000s highs of between 7-8%, it seems the current crisis has actually bottomed out – which according to officials, it has been doing for nearly a year.

Projections for GDP contraction this year have improved to only 0.6%, and the World Bank’s latest forecast for 2017 is 1.5%. Moreover, Russia’s PMI (the Purchasing Managers’ Index, a measure of manufacturing activity) hit 52.4 in October, which not only indicates growth, but is also a four year high for the index.

 

 

However, it bears mention the situation is not all roses. Consumer indicators continue to lag, particularly in terms of wages, and while a growing number of Russians see the overall economy stabilizing, they remain fearful of pay cuts if not outright job loss.

Moving beyond the crisis remains a key question as well: there is an increasingly common expert consensus within and outside of Moscow that Russia’s economic growth is now structurally capped at about 1.5%. In other words, the oil-based growth model that delivered dramatic economy results from Putin’s ascendance through the financial crisis is no longer effective. Indeed, and bearing note, the current economic difficulties became noticeable in fall 2013, before Western sanctions and the oil price plunge.

To address this issue, authorities have begun to talk of a need for structural reform. Though the “structural reform” has become somewhat of a buzzword, the term generally refers to efforts to free Russia from dependence on oil, primarily through reducing the state’s footprint on the economy – some 70% – through privatization, increases in efficiency, and attracting foreign investment. It also usually entails the optimization of spending, particularly on the social safety net, and sometimes the military. The question remains: what steps have been taken to date?

Privatization That Isn’t

A centre piece of the economic agenda until and through the next presidential election has been privatization. Several large companies have been targeted or are on the list, including Bashneft, Rosneft, VTB, and potentially Sberbank as well, among others.

To date, two privatizations have been closed, with another in the works. In July, the state sold a 10.9% stake in diamond company Alrosa for $814 mn. In early October, Rosneft purchased a majority stake in Bashneft for nearly $5bn. And by the end of the year, theoretically at least, Rosneftegaz should sell a 19.5% stake Rosneft for roughly $11bn. Though Russia has more than sufficient reserves (and borrowing capacity) to make ends meet should proceeds not reach the budget by years end (they must be disbursed as dividends), it will have to eat a sizeable amount of the dwindling Reserve Fund if not. In perhaps an indication of its confidence in the deadline, MinFin has asked for a trillion ruble disbursement from the fund, just in case.

However, none of the aforementioned deals are really privatization. In the case of Alrosa, a small deal designed primarily to test foreign investor interest in Russian assets, the state retained operational control. In the case of Bashneft, the buyer was Rosneft, which was technically allowed to participate because it is not directly owned by the state. And for the Rosneft sale, the most likely buyer of the stake – again, not a majority stake – is Rosneft itself. Recent reports suggest Rosneftegaz, the seller, may lend Rosneft capital in order to complete the purchase. Considering that both companies are in effect Russian, the deal effectively means that Russia is lending itself money to buy a piece of itself from itself.

Making Ends Meet

Over the past two years, MinFin’s favorite words have become “optimization” and “mobilization,” bureaucratic jargon for spending cuts and tax increases. Budget optimization has taken on two forms: outright cost slashing and efforts to improve the efficiency of spending. In addition to fairly steep cuts to spending on healthcare and education, financial planners have also moved to slash transfers to regions (much to the chagrin of leaders such as Ramzan Kadyrov), and decided instead to have wealthier regions share a greater share of their revenue with their poorer counterparts. To further optimize spending, federal officials have turned towards project financing, by which a national and local project offices will fund state projects on an individual basis. Despite several administrative niggles, the idea is a good one that will hopefully reduce the number of bloated and wasteful federal projects, particularly in infrastructure construction.

On the revenue side, the key focus of officials has been on increasing excise taxes on a number of goods, such as on gasoline, tobacco, and alcohol. As a local joke now goes, discussions of the budget are now impossible without vodka. Moscow has also implemented the Platon system, which charges truckers for transit on Russian roads, and has brought in RUB16.7bn over the past year that will be used primarily to finance road maintenance in the regions.

 

 

The Outlook

To be clear, many of the measures described above are good for Russia’s budget and sorely needed, the optimization measures in particular: they will allow more efficient state spending in the long run. However, they are more short-term fiscal adjustments then they are reform, let alone structural reform.

Indeed, it is sort of peripheral reform that impacts the economy only on its margins. The approach is much like improving the aerodynamics of a plane that has lost engine power mid-flight: it will glide for longer, but it does not address the fundamental issue. Real reform measures such as raising the retirement age and broad privatization that cedes operational control (efforts to date have likely increased state control of the economy, if anything), have all been discussed in government circles with the omnipresent caveat “after the presidential election.” In other words, the present strategy privileges spending the Kremlin’s financial capital over its political capital.

Putin seems to be preparing for more serious moves, as evidenced by the appointment of skilled technocrats such as Sergey Kirienko. But he faces two key problems. First, structural reform necessarily requires unpopular measures, and the reserves that can cushion their social impact are dwindling. Steps like raising the retirement age or turning mandatory funded pensions into private pension capital are likely to be unpopular among the populace, while major privatization efforts are unlikely to please elites, as demonstrated by the recent arrest of Economic Minister Alexei Ulyukayev. Indeed, many government players who opposed Rosneft’s acquisition of Bashneft were investigated, too. Second, the more difficult Russia’s financial situation becomes, the more unfavorable privatization will be: premiums will be smaller and to Russians, it will feel more like a fire sale. The difficulties faced by many state companies in selling non-core assets over the past year such as hotels, pawn shops, and vineyards (why they still own these in 2016 is another matter) does not inspire much confidence.

Overall, it is premature to judge whether “reform” has been successful. But regardless of how successful it has been, from both a political and financial perspective, this is the easy part for Russia’s leadership.

This blog originally appeared on bearmarketbrief.

 

 

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