COMMENT: Can the Russian Bear continue to roar?

By bne IntelliNews July 3, 2008

Standard & Poor's -

Over the last half decade, Russian GDP has tripled, making it the 10th largest economy in the world and in line to overtake Brazil to become the ninth largest by 2010. The principal stimulant of growth has been the rapid five-year rise in commodity prices, in particular those for gas and oil, which together make up 60% of Russian exports. Indeed, since 2003 average export prices have increased 92% (in rouble terms); such flattering gains in the terms of trade have kept the current account in surplus, despite robust demand-driven growth of imports. Contrary to many forecasts, during the first four months of 2008, export growth accelerated to 52% in nominal terms, pushing the trade surplus up $25bn above what it was during the same period of 2007.

Rapid increases in commodity prices represent an enormous net transfer of wealth away from importing countries toward exporters such as Russia. The size of the windfall usually masks and frequently even reinforces persistent macroeconomic inadequacies lurking below the surface. Only in exceptional cases, such as Norway, do governments manage to fully ring-fence export windfalls to prevent them from accelerating growth of the money supply, and creating temptations for electorally conscious budgetary committees. While Russia's revised budget code in principal segregates oil revenues straight into the Reserve Fund and the Fund of National Prosperity, in practice there are various ways to push expenditure higher. Higher expenditure is not by itself a negative development. What matters is whether public funds are spent on worthwhile productivity-enhancing capital expenditure, or whether instead they are diverted to wasteful and inflationary current expenditures, which has been the case in more than a few Eastern European peers.

Recent signs are not overly encouraging. During 2007, nominal expenditure growth accelerated to 35% versus 18% in 2004. Much of this went on increased pension and public sector wage payments. Indeed, since the start of President Vladimir Putin's first term, public sector headcount has increased by over half without an equivalent increase in government output. Despite higher numbers of public workers, public services remain very poor, a problem that the presidential administration acknowledges. Authorities are also trying to kick-start a three-year infrastructure plan, which may partially be funded by drawing down on the Fund of National Prosperity. While very sizeable commitments to investment spending are likely to be made, authorities have not fully explained how they will supervise the quality of procurement and project management for what are in some cases enormous construction projects. The risk is that public funds will be wasted.

Where credit is due

Of course, it is not only oil that's created so much wealth so quickly. Starting in the second half of 2005, Russia's financial sector began funding itself externally with renewed vigour as authorities liberalized the capital account. Since then, credit growth has surged to an average annual rate of 45%, further contributing to the growth of domestic demand, which has exceeded headline GDP growth for the last three years.

The increased willingness of the Central Bank of Russia to permit the rouble to appreciate has allowed monetary authorities to limit the impact on the money supply, despite the complications from the need to provide liquidity to the commercial banking system. Nevertheless, oil and gas related windfalls have been pushing up money growth for much of 2007 and early 2008 - as recently as the end of January 2008 M0 was expanding at near 55% (before falling back in the following few months). Structural forces, most patently underinvestment in the non-energy sectors, also explain stubbornly high inflation, which touched a six-year high of 15.1% year-on-year in May. In the past, public debate on macroeconomics in Russia began and ended with the budget. However politicians are now openly referring to the 'inflation tax,' the 'wage-price spiral', and 'overheating' as among Russia's most pressing problems. The first response is likely to be monetary, as permitting the rouble to trade more freely will help to calm imported inflation and slow down growth of monetary aggregates. The fiscal question is, as always, more politically sensitive.

While Russian prosperity has returned, it is only partially attributable to improvements in total factor productivity. Accumulating evidence of overheating and the very patchy record on oversight raise concerns about what Russia will do with its enormous windfalls.

Standard & Poor's Ratings Services sovereign rating for Russia should be interpreted narrowly as a measurement of the probability of default on obligations of the Russian Federation (foreign currency BBB+/Positive/A-2; local currency A-/Positive/A-2). The positive outlook on the rating ought not to be read as a clean bill of health for an economy that continues to be weighed down by corruption, uncertain property rights, and heavy bureaucracy. Russia's potential has always been huge. So far, its delivery has failed to live up to that potential. Most recently the newly elected President Dmitry Medvedev has promised liberalization in various sectors and a greater willingness to encourage foreign investment. For Russia's sake, let's hope that he means it.


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