Russia has fallen into the middle income trap and it is going to struggle to climb out again. One of the things that keep countries in this trap is that while life could be better, it’s actually not that bad. The Kremlin is banking on the population’s preference for the status quo over radical change to ensure that President Vladimir Putin is a shoo-in at the March 2018 presidential elections. But another six years of Putin's rule will only make it harder to escape from Russia’s mediocrity.
Russian do want change, and polls show they want it more than ever before. But they just don't want very much change. The population is haunted by the very recent memory of the nightmarish 1990s when incomes were counted in the $10s and inflation hit a peak of 2400% (that’s 6% a day). Any change must come with guarantees of preserving what they already have.
And life has improved out of all recognition in the last two decades. From a basket case in 1992, today Russia has become a more or less a normal country. It is the only emerging market that has been reclassified “high income” by the United Nations Development Programme (UNDP) in the last decade and has incomes on a par with the poorest EU member states.
Although a lot of money has been invested into things such as new equipment and technology, profits and productivity are rising more slowly than costs. The trap is despite the fast catch up of the early phase, the economy becomes increasingly uncompetitive as time passes.
The Russian economy demonstrated astonishing growth between the two financial crises of 1998 and 2009 in its catch-up phase. The gross domestic product expanded 83% in these 11 years, productivity was up by 70%, and fixed capital investment doubled in real terms.
Whereas in 1999, per capita GDP (in purchasing power parity – PPP – terms) was $9,300 (only 25% above the global average), by 2008, this indicator had increased to $21,600 (78% above the global average). At the same time Russia's share in the world economy (calculated at prevailing exchange rates) grew fourfold over the same period, from 0.6% to 2.7%. And most importantly the welfare of the population increased considerably: real wages increased by 3.4 times, and real pensions increased by 2.8 times.
Russia raced ahead until 2014, when it suddenly hit the brick wall of the “silent crisis.” It has been losing ground to its competitors ever since – especially now that Central Europe is booming.
The rule of thumb is the middle income trap kicks in when salaries are 40% of the US average, according to the European Bank for Reconstruction and Development’s chief economist Sergei Guriev. Currently the US per capita income is $58,030; as of the end of 2016 against Russia’s is $22,540, or 38.8%.
To catch up with countries with a similar level of economic development, Russia needs to increase capital investment by an additional 1% of GDP per year, said Guriev at a conference of the New Economic School in Moscow this week, as well as make a lot of really obvious investments into infrastructure, social services, education and health, among other things.
One of the most insidious parts of this trap is that life at this level is actually not too bad – especially when set in the context of a country emerging from the poverty of the early stages of transition. In order to boost productivity both company owners and the workers have to make a big effort and take risks. The forces of “creative destruction” need to be unleashed where successful companies flourish, but the inefficient ones go bust. Transition country leaders are more focused on keeping people employed because of the hardships that went before, and so support the inefficient companies for the sake of the jobs they provide. Likewise, the workers would rather keep a secure but low paying job than take risks on a much better one that comes with the possibility of it blowing up.
All this conspires to make it hard for a country in the middle income trap to climb out of its potential and move on to the next stage.
Much has been written on the rising poverty in Russia, but again put it into the European context and life in Russia is not so bad. Russian poverty is on a par, or better, than the EU average and most of the developed world. The current Russian poverty level is 13.1% of the population, but that compares favourably with the US poverty level of 12.9% and is better than both Portugal and Spain – two countries the Kremlin said it wants to catch up with – that have poverty levels of 18% and 21.1% respectively. Likewise, Russia per capita income is 114% and 85% of per capita income in Portugal and Spain respectively in PPP terms.
Thanks to the residual oil and gas revenues, Russia continues to make incremental progress, although clearly the collapse of oil prices in 2014, and the associated deep devaluation of the ruble, have knocked the country back; but after a decade of 10% annual wages increases, there is a very large income cushion to fall back on. But to escape the trap the government will have to make radical and deep reforms – and that boils down to getting the work force off the government teat and into the private sector.
Another myth about Russia is the size of the public sector. The most widely quoted estimate is the estimates of the Federal Antimonopoly Service (FAS), which said state-owned companies actually account for a whopping 70% of GDP. However, as bne IntelliNews reported the actual size of the public sector is more like 40% – although there is a lot of uncertainty over the actual number.
The problem the Kremlin faces is that to really make a difference it needs to basically sack half the workforce and tell them to find a better job – and in most regions these private sector jobs simply don't exist. Even after the elections are passed and with radical reforms clearly on the agenda, the Kremlin is unlikely to make this move.
Moreover, the people themselves don't want it. A fascinating survey by Carnegie Endowment for International Peace found that Russians are evenly divided on the need for radical reform: 42% of Russians advocate decisive and full-scale changes, another 41% called for minor changes and a gradual improvement of the current situation. It was the poor that are keenest on fast change, while the middle class are for the status quo. Surprisingly, the young were least keen on change.
And this “it used to be a lot worse,” thinking is part of the reason so many Russians will vote for Putin: a poll by the state-owned pollster, the Russian Public Opinion Research Centre (VTsIOM), reported 84% will vote to keep Putin and 70% will turn out to vote.
But the people are discontented. The standard of living has clearly fallen over the last four years so Russians want something to change. Another survey by the Institute of Sociology of the Russian Academy of Sciences found that the phlegmatic Russians are keener on change than ever before. Unsurprisingly the respondents to this survey were wholly focused on raising the standard of living and improving social services, while political changes remain a secondary concern. There is a basic tension in Russian society between the desire for change and the fear of reforms that may upset the hard-won “not that bad” status quo.
The survey found that over the past 10 years, most respondents preferred stability to change: in 2007 the ratio was 60% to 40%, in 2012 72%/28%, and in October 2016 61%/39%. The tables finally turned this autumn and by December the ratio had flipped to 49%/51%.
This survey, by contrast with Carnegie's, found that the desire for change was much stronger with the young than the old: of Russians aged 30, 62% support the reforms; of 31-40-year-olds 51% want changes; and over 41-years the majority are for keeping the status quo. The crisis has gone on too long and people are tired of coping. While there is a mild economic recovery at the federal level, on the ground real incomes only went positive earlier this year and the more important real disposable incomes (money left after spending on food and utilities) is still just in negative territory.
What can the government do to get out of this trap? The answer is pretty obvious and most of the key elements are already in the plans being proposed. New economic drivers need to be found in the form of new business, technology and added value production, but so far the only effective investment the government has made is into agriculture. The government has gone a bit blockchain bonkers, but this initiative has yet to produce many jobs. To get these to work, institutions need to be made more efficient, rules simplified and the rule of law and property rights vigorously enforced.
One indicator of the problems is the lack of small and medium-sized enterprises (SMEs) in the economy. Large business is more productive everywhere, but the gap between large and small business in Western Europe is 40%, and in Eastern Europe it is 70%, according to the EBRD. Another recent survey found that 80% of SMEs had been approached by officials for bribes.
Most of Central Europe had the needed deep reforms forced on them by their EU accession bids and are booming as they begin to move beyond the middle income trap. None of the Eastern European countries have made these changes. The earliest these changes could appear is in the second half of next year, but don't hold your breath.