MOSCOW BLOG: Russia must reform now or face stagnation

MOSCOW BLOG: Russia must reform now or face stagnation
Former finance minister Alexei Kudrin is due to present a new reform plan to Putin this month
By Ben Aris in Berlin May 5, 2017

There is a historic battle going on amongst the Kremlin’s intellectuals over Russia’s perennial question: What’s to be done? Should Russia prudently husband its financial resources and concentrate on making workers more productive, or should it borrow heavily and drop a ton of money on the economy in the hope of kick-starting a virtual cycle of growth and investment. Russian President Vladimir Putin is due to choose one of these options this month.

The economy already came to a shuddering stop in 2012 when incomes were still rising by about 10% a year, when oil prices were still over $100, and when its leading banks and companies were still welcome on the international capital markets.

The easy catch-up growth had been exhausted. No amount of oil money was going to bolster growth. The deep structural reforms had been left undone and suddenly they became an unbearable ballast. And then everything got worse with the annexation of Crimea, the de facto invasion of Ukraine, Western sanctions, a war in Syria and the double whammy of the collapsing oil prices and ruble values.

The Kremlin’s efforts to contain the damage have been remarkable in that Russia has avoided the debilitating collapses of the past, but insufficient to return to the 6-8% GDP growth of the boom years in the noughties. And currently there is no prospect of return to those halcyon times anytime in the foreseeable future. Even according to the ministry of economy’s official forecast the best Russia can do in the next three years is to grow at 2.4%.

The country faces the very real danger of sliding into long-term stagnation and eventual irrelevance despite is brisling arsenal of nuclear weapons and newly revamped conventional army. The Kremlin can’t bully its way back to prosperity. Some fundamental changes need to be made, otherwise Russia will simply get left behind.

Russia’s high competent, but largely powerless, liberal reformers have been putting their heads together and former finance minister Alexei Kudrin is due to present Putin with a new plan, a Strategy for Modernising the Economy and Social Institutions in a meeting later this month.

Typically, the contents of the plan have not been made public and its methods and goals are not up for public debate. Kudrin has made it clear that this plan will be presented to Putin as only he is authorised to make the final decision. And doing things this way is how Russia found itself in the hole it is today.

Of the details that have been released, Kudrin is aiming to increase growth to about 3.5% a year and intends to do it by making more and better use of Russia’s world-class human resources. That means spending a lot more on education and healthcare by increasing public spending by 0.8% and 0.7% respectively, according to reports.

Russia’s education system was close to collapse thanks to a decade of neglect and endemic corruption by academic staff that was undermining academic standards. The bill to gain access to one of Moscow’s prestigious institutes in the early noughties was around $10,000, according to bne IntelliNews reporting at the time.

However, a deep reform followed by a crack-down on academic corruption has seen Russia’s universities recover some of their former glory and start climbing back up the global rankings in recent years. Taking a leaf out of the highly successful Chinese reforms, Kudrin wants to equip Russian universities with the latest scientific technology, which in China has led to an explosion of online entrepreneurship and rapid increase in the number of patents issued by China. In 2015, the emerging world overtook the developed world for the first time in terms of patents issued, applying for 1.49m patents, led by China with 1.1mn, vs 1.48m applications in the West, according to figures from the World Intellectual Property Organisation.

The investment into healthcare could be equally productive. A World Health Organisation report issued in the late 1990s found the number one most productive investment a government can make is into healthcare. Not only do workers live longer, they stay at work longer and if they are in good health they are more productive. But even more important is the reduction in massive healthcare costs for taking care of ailing pensioners. The reason governments don’t invest heavily into health is the benefits to the country will come long after the current crop of politicians are literally dead.

Still, the point is not lost on Kudrin, who wants to see life expectancy grow from 71.5 to 76 years, which is also tied up with his plans to raise retirement ages from the current 55 years in order to plug the hole in Russia’s demographic triangle caused by the economic chaos of the early 1990s.

The third plank of the plan is to spend heavily on economic multiplying infrastructure. In the US the government found that each dollar spent on building highways added $6 to GDP as businesses could easily expand their reach and hence their market. Kudrin is also calling for new high-speed rails and motorways. For example, there is still no motorway between Moscow and St Petersburg, by far Russia’s two largest local economies that are both bigger than most Central European countries.

These changes alone could revitalise Russia’s flagging economy, but the big question on how Kudrin intends to pay for all this remains unanswered. He has hinted at diverting more oil revenue to fund the programme as well as cutting defence spending – indeed, it was his very public resistance to hiking military budgets in 2011 that lost him the finance minister’s job in the first place, long before it became clear what Putin intended to do with the modernised army.

Kudrin has also suggested that Russia increases its deficit from 1% to 1.5% of GDP by borrowing more, but this is where the argument gets stuck.

Kudrin has been offered the job of prime minister to put his plan into action, according to a reliable bne IntelliNews source, but only if he can get a consensus amongst the various Kremlin fractions.

Opposing him is the so-called Stolypin Club, headed by presidential ombudsman for business Boris Titov, which wants a more traditional Keynesian solution by massively increasing borrowing and using the cash to stimulate growth immediately through state-lead investment programmes. Kudrin’s version is slower and more difficult to implement, but it should lead to a higher quality of growth. And it has the big advantage that it won’t be as vulnerable to Russia’s endemic corruption and stealing by the very oligarchs that are close to Putin.

Currently the two camps appear to be at loggerheads with no compromise in sight. That makes Kudrin’s meeting with Putin in May all the more important as the president may attempt to break the stalemate. If Kudrin can be overwhelmingly convincing he may well make the jump to prime minister in short time, incumbent Prime minister Dmitry Medvedev seems to be on his way out, according to bne columnist Mark Galeotti.

Whatever is decided this month, the government have an uphill battle ahead of it. All three of Russia’s biggest economic drivers – consumption, construction and investment – are in retreat. At least one, preferably two, need to be turned around if the economy’s health is to recover.

A government mortgage subsidy programme (that was just ended thanks to falling interest rates) means mortgage lending is outperforming non-mortgage loans, but that has failed to turn the construction sector around, which is actually declining faster now than it was last year. The value of construction works completed contracted -5.0% in March alone, according to Rosstat.

Consumption dynamics are also mixed, according to Alfa Bank’s chief economist Natalia Orlova: social indexation is less efficient at stimulating consumption growth than public salary indexation and, “unless retail loan growth accelerates to 18% y/y in 2017, consumers will have to pay interest payments on debt, thus reducing their spending power even more”, says Orlova. Real wages are growing again, but the all-important real disposable wages that drive consumption continue to shrink, albeit at a slower pace than last year.

On top of this, when Russians do go shopping they are buying more imported products. The first quarter saw strong import growth that only undermines the health of public finances and is probably a reflection of companies building inventories because of the strong ruble-dollar exchange rate. The government’s talk of possibile tax increases in its 20/20 tax manoeuvre has spooked consumers, causing them to put off buying and preferring to save instead.

Finally, fixed investment is woefully inadequate. Corporate loans declined 0.9% m/m in March (or 0.1%, excluding FX effects) due to a decrease in FX loans, while corporate deposits were down slightly too. The retail loan book was up 0.7% in March, but consumer credits are still only just starting to climb off the floor following the total collapse in the business sector in the last two years and won’t have any impact on growth for quite a while yet.

All-in-all, total fixed investments fell by about 12% in real terms in 2014–2016 and the ratio of fixed investments to GDP is just 21%. For Russia to return to the boom years fixed investment needs to grow by 20% a year.

The villain in this story is the government, as investments at all levels – state, regions and municipalities – are all shrinking. In 2015–2016, investments of domestic private and joint private-state firms also declined. Even the fully foreign-owned firms are hunkering down to wait for an economic U-turn and have cut investment plans sharply.

Only privately owned domestic firms are making any sort of investment and now account for 55% of total investments against the government’s less than 20% share. This is the point of attack for the Stolypin Club and could make a big difference to growth prospects at the cost of ramping up Russia’s currently minuscule state debt. But it would be a big gamble. We will just have to wait and see if Putin is willing to throw the dice or stick with his old friend, “Mr Prudence”, Kudrin.

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