MACRO ADVISOR: Russia’s ‘localisation’ phase of economic development

MACRO ADVISOR: Russia’s ‘localisation’ phase of economic development
Russia destroys the nefarious cheese from the West.
By Chris Weafer of Macro-Advisory May 4, 2016

British Prime Minister Winston Churchill famously noted of the US that “it is a country which can be relied on to do the right thing, but only after it has exhausted all other possibilities”. That comment may equally have been applied to many developing economies over the past half century, and certainly to Russia over the past quarter century. The exhaustion of all the easy options and the inability, or ill-advisability, to default to a muddle-through and do-nothing stance forms the present backdrop to the Russian economy.

Where the country is today is at the start of the third, and most critical, phase of its development thus far. Getting policies and attitudes right this time will see the economy return to a sustainable and relatively strong growth path, with all of the associated social and political changes which result from economic expansion. Getting it wrong raises the spectre of Brezhnev-style stagnation and the unpredictable social and political consequences which the Kremlin administration and the so-called national elites must fear the most.

The chaotic 1990s framed the first phase of the country’s socio-economic development. We cannot talk about any meaningful political changes in this period, because even though Boris Yeltsin deserves huge credit for preventing a reversion to communist rule, there were no changes which might have helped economic and social development. Instead, the bulk of the population remained at, or below, the poverty line and a significant number of state enterprises passed into private ownership at heavily discounted valuations. The Gaidar reforms did arguably prevent the economy from collapsing even more, but they delivered little in terms of creating a growth platform.

The period of crisis resulting from the 1998 default marked the end of ‘Phase 1’ and the start of ‘Phase 2’. The people were not only ready for stronger government, but needed a focal point, ie. national leader, they could believe in. Discussions about what course the country might have taken with a leader other than Vladimir Putin really miss the point: a weaker leader at that time would not have survived.

No question that Putin got lucky with the almost immediate start of the oil price recovery, which he added to with the insistence that the oil sector oligarchs stop playing corporate games and start to invest. Phase 2 of Russia’s economic development was a hydrocarbon-funded boom that was primarily driven by consumers and budget spending. The greatest reform was in the financial sector, which saw an emerging and booming credit industry, and one of the strongest periods of appreciation in any world stock market, ever.

But while posting strong annual growth and an improved financial position, which helped Russia once again take its place at the top table of global politics, the real story was something akin to a country of 143mn people winning a $3tn lottery (the value of hydrocarbon exports between 2000 and 2012) and spending it. There were some useful economic reforms, including a very significant improvement in the nation’s balance sheet, and corporate governance improved significantly from the lawless 1990s. But while there were occasional bursts of enthusiasm for meaningful and growth changing reforms, the reality was that there was never any real support for these programmes. Indeed, there did not need to be, because the core belief was that the hydrocarbon bounty would always deliver economic growth and, more critically, help maintain the socio-political status quo.

While the combination of expanded sanctions and the oil price decline, both of which started in August 2014, pushed the economy into recession, the reality is that Phase 2 of the economic model had started to reach its end from late 2012 and that fact became very obvious during 2013. In that year the economy only grew by 1.3%, even though the price of oil averaged close to $110 per barrel and there was no hint of the geopolitical problems ahead.

Is Russia in Phase 3 yet? Probably, but the structure of what will be the basis of this phase is still being formed. What we can say, however, is that the truism of the Churchill quote is now becoming more evident. If the Kremlin does nothing other than wait for an end to sanctions and a rally in the oil price, then the best one can hope for the economy is growth in the low single figures – at best. If that were to happen, the consequences for the previously stable, if not irrelevant from an investor and business viewpoint, socio-political pact would be hugely unpredictable. The idea that Russian’s legendary stoicism would survive a prolonged period of economic – and lifestyle – disappointment is a dangerous assumption.

The country’s economically active population has enjoyed 15 years of improving lifestyle and growing expectations of much more to come. A government cannot just turn that off and blame external forces and hope to get away with it. Today workers are quicker to protest if, for example, wages are delayed, than was the case in the 1990s. Opinion polls show that while a large majority of people support the national leader they also expect he will “fix” the problems. How that may play out against a backdrop of a prolonged slump is unknown (there is no historic precedence) but most of the scenarios give rise to the hope that, this time, there will have to be more serious efforts to change the economic drivers and to improve investment conditions. There are no other simple or default options, or at least none without scary consequences for the administration and the elites which support it.

We do at least have an emerging picture of what the new economic model may look like. It has been called import-substitution or localisation. More recently we have heard the phrase “competitive economy” used. In simple terms it is the promise to create a more competitive economic base so as to encourage more investment into manufacturing and service sectors. Partly that is to reduce imports with a greater availability of domestically produced goods that are competitively priced. Partly it is the hope that Russia may start to export more goods outside of extractive industries, wheat and military equipment.

Slow and painful does it

So far the evidence does offer more reason for hope than despondency. The 180-degree turn in ruble policy in early 2015 is a big deal, both politically and economically, and is a very clear example of an effective policy change when there is absolutely no other viable alternative. There is, of course, a huge amount that needs to be done, not least of which will be the effort to persuade investors, including Russian investors who have taken well over $1tn in cash out of the country since the mid-1990s, to back the new economic model. That will neither be easy nor quick even under more favourable conditions than the country has seen over the last few years.

The bottom line is that Phase 3 will be slow and painful. The scale of what needs to happen is so large that the impact on headline growth will, at best, not be seen for years. There is, for example, no point in growing more food until the infrastructure to handle, store and transport the product to markets is put in place. A similar picture exists in most other manufacturing sectors, which are badly in need of modernisation.

Most business leaders and investors could draw up a wish list of government actions; everything from having the state take a step back to allow private enterprise develop to devolving greater self-determination to the country’s more successful regions. In the end it will come down to what the administration wants. If that is the continuation of the stable and safe socio-political balance of the past 16 years, then it has to get the economic challenges right – and soon.

Chris Weafer is a founding partner of Macro-Advisory.