MACRO ADVISOR: It's far too early to judge Russia’s import-substitution drive

MACRO ADVISOR: It's far too early to judge Russia’s import-substitution drive
Russian cheese is a symbol of the localization drive.
By Chris Weafer of Macro-Advisory April 13, 2016

It is far too early to consider whether import substitution has worked as a growth driver for the Russian economy. There was never any possibility of an early or major shift in consumer and business demand to locally manufactured goods or services – one big reason being that Russia’s economy cannot provide the domestic alternatives to imported goods and services, as the capacity and skill sets simply do not yet exist in sufficient volume.

It is therefore wrong to start judging whether import substitution, or localization in government speak, has worked or not; this is a long-term policy which is only beginning and which will need years to build before it can start to make a meaningful contribution to growth. The over 3% growth in the output of the agriculture sector in 2015 was one of the few success stories for import substitution, but has limited near-term extra upside until investment grows and starts to more fundamentally change the industry. The same applies to most other industries that have the potential to be part of the longer-term import switch story.

Very likely the earliest we will be able to state whether import substitution has worked will be the end of this decade, if not nearer the end of the next presidential term. The reason for that is because so many of the economic sectors that will need to be part of the import-substitution policy have been neglected since before the collapse of the Soviet Union and the foundations will have to be built, or rebuilt, before those industries can deliver and sustain growth.

One of the basic problems in Russia’s economy is that the main growth driver since 1999 was the trickle-down effect of hydrocarbon wealth, which led to the boom in the consumer, construction and service sectors. That was partly due to the low base-effect from the 1990s, but also due to the real growth in salaries and pensions every year since 1999. Budget spending more than doubled in the dozen years since 1999 and a lot of that also fed into the consumption story. The creation of the credit boom was another factor that was also indirectly created by the oil wealth effect.

That boom, which saw the value of Russia’s economy expand from just under $200bn in 1999 to over $2,000bn in 2012, also meant that while the Kremlin regularly talked about reforming the business environment and creating new growth initiatives, in reality there was no urgency and no incentive. The voters were happy and the elite quite satisfied with their gilded lot.

That started to change from mid-2012 when quarterly growth slowed and, critically, not as a result of any external shocks. In 2013 the economy expanded by only 1.3%, or two-thirds the growth rate of two years earlier, and despite the fact that the oil price averaged $110 per barrel and the global economy recovered. That is when Russia’s real economic problems started. The oil price collapse pulled the economy into recession and the impact of Western sanctions is helping keep it there. But when oil rallies and sanctions start to ease, the country will still be left with the basic problem that neither the consumer, nor hydrocarbon wealth, is capable or returning the economy to the 3.5-4.5% annual growth required. 

The economy needs a new growth driver and that driver has to be based on import substitution. Localization is a much better description, because while the former implies simply reducing the country’s dependency on imported goods and services, the latter implies the creation of a more competitive economy that can also lead to an increase in the export of manufactured goods outside of the extractive industries.

The ‘buy local’ campaign was a popular political reaction to the geopolitical tensions with the US and EU in 2014, while the sanctions and ruble collapse added the economic rationale. But over the past 12 months there has been a greater focus on localization as both a credible alternative growth strategy and also one which actually could work, ie. unlike the grandiose and fanciful innovation and technology based programmes touted in 2008 and 2009. The oil price recovery soon buried them, but, as was proven in 2012 and 2013, that cannot happen again.

Local hero

So, what do we now know of localization and why may it work? The first point to make is that the impact of the economic crisis, including the slowdown that preceded it, appears to have finally convinced the government and Kremlin policy advisors that the country has reached a crossroads. Real changes will have to be made or otherwise the way ahead will be similar to the Brezhnev stagnation era with all of the social and political uncertainties which would come with that.

The second point is that localization is realistically the only way the country can boost long-term growth. The third point is that the policy is evolving slowly and as the result of a broadly based effort. We have come to learn that government policies announced as a knee-jerk reaction to a crisis have very little credibility. Those policies, or strategies, which evolve over time and are built in increments are usually more sustainable.

It is fair to say that localization is still a work in progress. Some aspects are now known, while there is a lot more to be clarified before the implications for the economy and for investors are properly understood. What we know at this stage is:

  • The commitment to a longer-term weak ruble, ie. to prevent it rallying beyond RUB57-58 against the dollar, is now a critical part of the story. Foreign businesses will not invest in a factory in Russia without the commitment to a competitive environment and the ruble exchange rate is top of the list of concerns;
  • The government will focus on more basic industries, such as food, medicines, auto-sector parts, and other machined goods, which the country has the best chance to manufacture efficiently. It appears that the original idea of creating a high-tech sector, other than to serve the defence industry, is more of a longer-term ambition with modest expectations;
  • Western companies will be a key part of the process. The Asia-pivot, widely touted in 2014 as an alternative to western partnerships, is now confined to the extractive industries and transport infrastructure;
  • No increase in taxes or other state costs for businesses and a commitment to further improve the countries ranking in such surveys as the World Bank’s “Doing Business” survey by reducing time, procedures and costs for businesses.

There is a lot about localization which we don’t yet know. That’s because the government agencies have yet to figure out much of what needs to be done. For example, will a factory elsewhere within the Eurasia Economic Union also qualify as locally sourced? Will there be penalties against goods that are on the government’s localization wish-list, but which are still manufactured elsewhere? For investors, the questions include whether to build a factory or create a JV with a local partner or simply tough it out and stick with imports? Clearly there is a lot yet to be clarified and all with major implications for investment flows and the country’s future economic growth.

But the one thing we do know is that the scale of what needs to be done is huge. Almost a quarter century of neglect and poor management in basic industries will need to be addressed before the country can hope to be able to substitute the enormous volume of imported goods and services, paid for with hydrocarbon wealth in the 2000-2012 period, and have a made in Russia label on goods, other than military equipment, in foreign markets. That will take many years.

Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer