We are half way though the year and the economic recovery is well underway in almost all of the Central and Eastern Europe (CEE) markets after several years of grinding recession. The economies of the Commonwealth of Independent States (CIS) are doing a lot less well but Russia and Ukraine are both recovering nicely from their economic crashes. So it is a good time to revisit our article “A tale of two countries: Russia vs Ukraine in 2017”  which was published in January to see just how close to expectations the two rivals are doing.

Ukraine has emerged from its meltdown in 2015 and was growing more strongly than Russia in the first quarter of this year, expanding by 2.5% against the weak 0.4% Russian growth.

Obviously much of Ukraine’s growth is a low base effect as its collapse in 2015 was spectacularly bad. The economy shrank by 0.4% a year earlier but it does represent a mindboggling 22 percentage point change in growth from bottom of the crisis in the first quarter of 2015 (-17%) to the last quarter of 2016 (4.8%).

Nevertheless, even this 2.5% growth is a disappointment, especially after the economy's performance in the last quarter of 2016. The National Bank of Ukraine (NBU) revised down its year-end forecast from 2.8% to only 1.9% in June due to the detrimental effects of an economic blockage of the Donbas imposed earlier this year.

When Russia melted down in 1998 its economy contracted by about 5% that year, but it bounced back in 1999, growing by 10% in a year, a record that has never been beaten. Ukraine’s recovery should have been much more prominent than the actual results.

The difference is that Russia’s growth at the close of that decade was helped by a strong recovery in oil prices, which more than doubled in price to around $25 a barrel as Putin took office. Also Russia wasn't fighting a war with its neighbour. Today Ukraine’s recovery has been helped by a similar, but still modest, rise in steel prices, its major export-earner.

Russia’s performance has also been disappointing. While the economy has clearly emerged from a two-year recession, the 0.4% growth in the first quarter is mild to say the least. However, the economy is picking up momentum fast and produced growth of 0.5% in February, 0.8% in March, 1.4% in April and an unexpected 3.1% in May, which economists say is a one-off.

Still, Russian’s real disposable income is still falling, so while the macro situation has improved the population are not feeling any benefits.

Moreover, some of the economic drivers in Russia have stalled. Last year’s bumper harvest is unlikely to be repeated this year and agriculture, the only sector growing in 2016, contracted in the first quarter of this year by 0.9%.

Consumption is another driver but there too things are going badly. The Watcom shopping index, that tracks footfalls in the main malls in the Russian capital, is having its worst quarter in four years this year – and Moscow is usually insulated from economic shocks compared to the rest of the country due to its concentration of wealth.

 

 

The Central Bank of Russia (CBR) updated its forecast for growth this year at the June meeting but is predicting only 1.3–1.7% of growth this year and 1–1.5% next year.

The health of Russia’s economy remains extremely exposed to the price of oil. The recent recovery has been given a fillip by $50 oil, at which level the Russian economy more or less breaks even, but investment bank Goldman Sachs issued a report on July 11 predicting oil would fall back to $40 later this year, at which level the Russian economy makes a loss. Indeed, Saudi Arabia just exceeded its production limit for the first time since brokering a deal to curb global crude supply to counter a glut last year, by pumping 10.07mn barrels a day in June, according to reports, which is expected to put downward pressure on oil prices in the second half of this year.

Russia is now caught in a middle-income trap, where wages are too high for the productivity of the workers, making Russian goods uncompetitive. Structural growth is constrained by the tight labour market and historically low levels of unemployment. And it is constrained cyclically as corporates are still deleveraging, while the consumer prefers to save rather than borrow and spend. The fixed capital investment needed to break out of the middle-income trap is simply not there.

The bottom line is until the state can move about half the population out of the public sector (or public sector dependency) into the private sector, Russia’s growth is constrained to around 2% at best for the foreseeable future. President Vladimir Putin has made a lot of noise about creating a digital economy, but nothing has actually been done about it. And clearly he is not going to sack half the population until at least after the 2018 presidential elections (if then).

In this regard the outlook for Ukraine is much better, simply because it has made no reforms at all for most of the last 20 years, so if it does anything at all then it should enjoy all the catch-up growth the rest of the region, and especially Russia, have already exhausted.

 

 

The amount of catch-up growth Ukraine has ahead of it is clearly visible in a comparison of GDP per capita. The two countries are about as similar in terms of demographics, education and the industrial base as it is possible to be, although Russia has the advantage of its mineral resources. Yet the differences in per capita GDP are huge.

The size of the Russian economy in dollar terms has halved since 2014 and ended 2016 at $1,325bn, but this contraction is still no way near the six-fold collapse in Ukraine. For most Russians some belt-tightening is sufficient to get through these lean years, while in Ukraine livelihoods have been destroyed. This contrast is clearest in the relative levels of unemployment: Russia’s economy is enjoying full employment, with residual unemployment of 5.2% in the first quarter against the 10.5% in Ukraine after minimum wages were doubled last year.

Both countries have been through the mangle in the last five years, with Ukraine’s per-capita GDP halving from a peak of $3,854 set in 2012 and Russia’s falling slightly from a peak of $15,409 also set in 2012. The difference is that even at its peak Ukraine was one of the poorest countries in Europe, while Russia had already overtaken Portugal in absolute per-capita terms and was hot on the heels of Spain before the 2008 crisis pulled the rug from under its feet.

 

 

As far as cash in the central bank is concerned there is also no comparison: despite the collapse of the oil prices in November 2014 Russia remains in an extremely comfortable position, while Ukraine is verging on the edge of insolvency.

Russia pulled further ahead in July, reporting gross international reserves (GIR) crossed the $400bn line again for the first time since 2013 to reach $412.2bn. That is a massive 13 months of import cover, which allows Russia’s economy to weather even the biggest shock, as the collapse of oil prices was.

In contrast Ukraine has also improved its GIR position to accumulate $18bn as of July 1. But the two countries are in different leagues. Ukraine’s GIR covers about 3.8 months of import cover, which is enough to ensure the stability of the national currency, but leaves it badly exposed to external shocks and makes the IMF tranches essential to ensure economic stability.

Both countries are looking at the international capital markets to borrow more. Russia just raised $3bn in Eurobonds to high demand to help cover the 2% of GDP budget deficit expected this year, and despite the brouhaha surrounding its relations with the US government, bankers say some 80% of the buyers of the Eurobond were US investors who paid the lowest yields ever for the Russian paper. The finance ministry says it will probably come back to the market again in the autumn to refinance another $4bn of bonds that come due this year.

Ukraine has not tapped the international markets since the change of government three years ago, but is revving up to do so in the autumn, according to what Finance Minister Oleksandr Danylyuk told bne IntelliNews at the EBRD annual meeting in May. Proportionally the Russian Eurobond has little impact on the country’s financing, whereas a Ukrainian Eurobond of benchmark size would make a big difference and remove a lot of the leverage the IMF has over the government to ram through reforms.

 

 

Looking at the nuts and bolts of the economy and the differences are also dramatic. Major progress has been made in reforming the banking sectors and both countries have closed down large numbers of dodgy banks in the last years. Russia started the process three years ago and Ukraine really only got into gear a year ago, but both counties have halved the number of banks they have – and still have too many, say experts.

Russia has gone from about 1,300 banks in 2008 to just over 600 now, while Ukraine has reduced the number from about 200 to just under 100 now – including nationalising its largest commercial lender PrivatBank in December.

 

 

At street level punters in both countries are still feeling the pinch, despite the macroeconomic recovery. Incomes in Russia have fallen hard due to the crisis and are about half the level of the boom years in dollar terms, although this fall has been mitigated by the devaluation in 2015 as the cost of living has also fallen.

Real Russian wages returned to the black last year and have been rising in real terms for 10 straight months as of June. However, the more important real disposable wages (nominal wages adjusted for inflation and after utilities and food are subtracted) are still in the red.

Russians are still feeling the pain of the crisis, a fact readily visible in the retail turnover numbers. However, after a decade of 10% wage growth Russians have built up a significant buffer and, while life is harder, the income levels are still high enough to cope.

 

 

Looking at the fundamental Russian indicators of real wages, inflation and unemployment – the things that most affect people’s daily lives – clearly the crisis is over and all these numbers are converging on “normal” values now, a remarkable bit of economic management by the CBR and the finance ministry,

 

 

Ukraine’s wages have always been low and below the level of the end of the Soviet Union in 1991 in real terms. As the chart below shows, nominal wages have been rising strongly in the last two years, but most of these gains have been eaten up by 20%-plus inflation until recently.

The government has been forced to adopt administrative methods to cope with this problem and in October decided to double the minimum wage to $110 a month, which will affect two out of five workers. Taken with falling inflation there have been some very large jumps in real wages in the first quarter of this year. Real wages were up 21% y/y in January, 18% y/y in February, a whopping 37.2% y/y in March, and 20.4% y/y in May, according to the State Statistics Service of Ukraine. Nominal wages have more or less doubled over the last year to UAH6,209 per month ($239) in May, but are still less than half the Russian level.

Doubling the minimum wage move was welcomed by workers, but it also causes economic problems as it makes struggling state-owned enterprises even more uncompetitive and may affect both the already high unemployment levels and inflation.

 

 

Still, rapidly falling inflation in both countries – in Russia consumer price inflation (CPI) was 4.4% in July and in Ukraine it was 15.6% – has improved the buying power of both populations.

 

 

Nevertheless, the rising real incomes means the populations of both countries have started to go shopping again. Ukraine’s retail sales turned positive in 2016 after crashing in 2015. Retail sales fell by 31.1% y/y in March 2015, the nadir of the crisis, but went back into the black in January, growing by 0.1%. Apart from a small setback in February, retail sales surged in March, up by 13.4% that month, before settling into a more steady growth rate of about 5% a month since then from a low base.

Russian retail sales also appear to be recovering at last, after three years of decline, growing by 0.7% y/y in May. Looking at Rosstat's updated figures, retail sales achieved positive 12-month growth in April, but just barely. The car market in particular has finally started to grow again with the purchase of new cars up 7% in April and 15% in May after years of decline.

But in neither market is consumption strong enough to drive economic growth. Both have only just returned to normality and in both countries further growth is limited by the poor economic growth, low level (or contraction) of real wages, and the disinclination to use credit to fund purchases.

 

 

Industrial production in both countries is in the black but remains very fragile.

Ukraine’s industrial output was up a modest 1.2% y/y in May, reversing the three months of falls previously, the State Statistics Service reported on June 22. However, over the first five months of this year industry remained in the red, falling by 1.3% y/y over the period.

Russia is not much better off. At first glance Russia had an excellent May when industrial production soared by 5.6% y/y, according to Rosstat, and was much higher than Alfa Bank’s forecast for 1.9% y/y and consensus forecasts of 2.4% y/y. However, Alfa Bank says this is a one off and attributes this to two factors: May has a lot less days than other months due to holidays; and the abnormally cold weather (there was a hurricane in Moscow that killed 11 people) boosted consumption of electricity and gas (up 4.7% y/y) although manufacturing improved (up 5.7% y/y in May), and the PMI indices are still strong, albeit lumpy.

 

 

Finally foreign direct investment (FDI), the litmus test of government’s policies to revamp their economies, has been extremely disappointing in both countries.

Ukraine has basically attracted no FDI in the last three years, despite its ra-ra Western rhetoric. The major investor into Ukraine, ironically, remains Russian banks. The NBU estimated net FDI at $0.5bn in 5M17, down from $1.9bn in 5M16 largely as a result of discontinued debt-to-equity swaps in the banking system. Capital inflows to the official sector totalled an estimated $1.4bn in 5M17 compared to $0.2bn of outflows in 5M16.

Having said that UkaineInvest director Daniel Bilak told bne IntelliNews that the beginnings of a autopart cluster has been built in the west of the country on the Hungarian border to take advantage of Ukraine’s super-cheap labour costs.

Russia has fared a bit better and attracted $7bn in the first quarter of this year – its best result in three years. Russia has risen to seventh place among European countries popular with foreign investors, according to the results of a poll conducted by Ernst & Young consulting services and published on the company's website on June 1. Compared with the same period of 2015, the number of transactions in Russia involving foreign capital has increased by 61%.

But Russia’s results are still way off the peak year of 2008 when it took in $74.8bn of FDI. Most of this was invested into retail and marketing, as Russia remained an attractive destination for consumer good producers, even in the crisis years. FDI was still running at between $35bn and $70bn for the years after the 2008 crisis until 2013, but it dropped off after that as the “silent crisis” of 2015-2016 really started to eat into Russian’s disposable income. If the current rate of FDI continues it will lead to circa $25bn of FDI this year, but that still would be less than the period immediately after the 2008 crash.

As a side note, Chinese investment into the region has gone up a gear and here too Russia does a lot better than Ukraine. It is actually very difficult to know how much the Chinese are investing as they move so slowly, but according to Macro Advisory the total stock of Chinese investment into Russia is of the order of $33bn which is pretty significant. And the Russia China Investment Fund (RCIF), with its local partner the Russian Direct Investment Fund (RDIF) has become notably more active, investing into equity and promising a new $11bn fund specifically to finance projects stymied by the Western financial sanctions imposed on Russia.

So far China has not committed itself to any major investments in Ukraine other than buying one small bank, the Bank for Reconstruction and Development (UBRD), in June. All-in-all it seems the situation in Ukraine is still too unstable for it to be able to attract any serious investment.

Both countries have emerged from the crisis and are starting to recover, however Ukraine remains a lot more vulnerable than Russia to any shocks in the near future.

As ever, Russia is benefiting from its raw material base and the residual, but significant, income it can earn from these exports. The importance of oil, gas, metal and grain for Russia is not the prices these commodities command, but the mere fact of them as they will always provide the government with a large cushion, which gives Russia an advantage over its peers. The upshot is the Russian recovery will be steady, but is ultimately limited by its deep structural problems.

Ukraine faces more difficulties now but could boom if reforms are put in place. It finds itself in a similar place to Russia of a decade ago and this first round of reforms is very hard to make as the government is in effect in permanent crisis. Commentators worry that the Petro Poroshenko government has lost its enthusiasm for reforms, as they are so painful and like Putin, the Ukrainian president is already looking to the next elections on the horizon.