COMMENT: Russia must modernise or die

By bne IntelliNews June 3, 2010

Ben Aris in Moscow -

In what amounts to a call to arms, Russian President Dmitry Medvedev at the end of May issued a dire warning to top officials of United Russia, the party which dominates the government: Russia will fail unless its social structure and economy are modernized. "We have no other alternative," he told the Duma deputies. "If we fail to modernize, the country will collapse and the economy will degrade."

The global crisis has been a game changer for Russia. Over the last decade, the country grew fat on record high oil prices. But with the international capital that paid for much of this growth unlikely to return anytime soon, for the first time Russia will have to reform or else it could face another bust as soon as 2013, according to two reports released in May.

Unlike its Bric peers of China, India and Brazil, Russia had a terrible crisis. After five years of ballistic growth, the Russian economy contracted by 7.9% in 2009. Analysts believe the economy will bounce back strongly in the second half of this year thanks to higher-than-expected oil prices and a gradual recovery in consumption, but the respite will only be temporary. Two papers released in May warn that after good years in 2011 and 2012, the economy could slump again, contracting by about 1.4% in 2013, unless the modernisation campaign launched by Medvedev this spring bears fruit.

An unexpected recovery in oil prices at the start of this year has temporarily taken the pressure off the Kremlin. Oil has risen from $42 per barrel at its nadir in 2009 to hover at over $70 for most of this year - a "comfortable" level for Russia, according to Prime Minister Vladimir Putin. However, the Organisation for Economic Co-operation and Development (OECD) warned in its May economic outlook that the commodity-fuelled recovery will falter and die if oil prices and capital inflows continue to rise, as the return of easy money will sap the Kremlin's political will to push through the deep and painful reforms necessary to put the economy on a sustainable growth path. "If oil prices and capital inflows continue to increase, avoiding excesses will be the main policy challenge," the OECD said.

The high oil prices have already greatly improved the country's finances and given the Kremlin some wiggle room. Russia's GDP growth reached 5.5% in April on year (albeit from a low base) and the state expects total growth in 2010 to be 3.4%. Both the OECD and the World Bank have revised Russia's GDP forecast upwards for this year to 5.5%. However, leading Russian investment bank Renaissance Capital warned in another paper that if the government fails to implement the sweeping reform agenda introduced by Medvedev, growth could falter as soon as 2013.

No return to good old days

The noughties was a decade of easy living, but that's all over now. The crisis has fundamentally changed the game. Russia has grown rapidly by borrowing heavily to pay for investment; now that such capital has dried up and is unlikely to come back for many years, Russian companies will to have to work a lot harder to maintain growth.

Russia's government has ramped up its spending to see the economy through the crisis. Currently, it needs oil prices of between $100 and $110 per barrel for the budget to break even, up from the $70 break-even price for oil before the crisis. Clearly, even the lower price isn't sustainable and Russia is now even more vulnerable to oil prices than prior to the crisis. The government desperately needs to find an alternative way to finance the economy's makeover.

With the international credit markets largely closed, the Kremlin has turned to the only alternative source of capital available: foreign investment. But things here are not going well. "The investment slump has been the key factor behind GDP decline," says Vladimir Tikhomirov, chief economist with Uralsib. "The total 2009 investment volumes have fallen to 2007 levels."

Foreign funding was the largest driver for investment growth, reaching a record high of $82.3bn in 2007, but the turnaround was so fast because during the pre-crisis period the bulk of funding for fixed investment was from foreign credits, which had a short maturity. Over the course of just one year, between spring 2008 and spring 2009, fixed investment in Russia went from 20% annual growth to a decline of more than 23%.

So far this year, total foreign investment (which includes credits) has recovered a bit, up by 9.3% in the first quarter on year to $13.1bn, but the much more significant foreign direct investment (FDI) plummeted by 17.6% over the same period. High oil prices will keep the boat afloat for the meantime, but it won't last. "Global monetary and fiscal easing is likely to keep commodity prices up, resulting in a current account surplus and a return of capital inflows," says Alexei Moisseev, chief economist for Renaissance Capital. "That means for Russia more of the same: cheap money resulting in a quick recovery, including inventory build-up, the utilisation of existing capacity and a return of cheap credit. However, this will end and, since we do not expect structural changes to the economy until after the 2012 presidential election at the earliest, we think a bust similar to that of in the first half of 2009 will follow."

Renaissance are predicting that after a good year in 2010, growth will peak in 2011 at 8.1% - one of the strongest years on record - before collapsing again; by 2013 the economy will contract again by 1.4% and Russia will be in real trouble.

Hence Medvedev's call to arms. Russia could grow by 6-8% a year - faster than in the boom years - if it successfully implemented Medvedev's modernisation programme, reckons World Bank Vice President for Europe and Central Asia Philippe Le Houerou. And the International Monetary Fund recently published figures that suggest Russia could be the fastest growing Bric nation on a purchasing power parity basis. But the clock is ticking. The Kremlin has roughly three years to make these reforms work and Medvedev is warning that that's not an exaggeration: this time the Kremlin has to make the reforms stick.

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