Rebooting Russian industry

By bne IntelliNews February 25, 2011

Ben Aris in Moscow -

If you leave your computer on for too long, it starts to slow down. Files fragment over the hard drive and applications tussle with each other for access to the RAM. Eventually, it will slow to a crawl or even crash. That's why manufacturers recommend you reboot your machine from time to time to keep it running at optimal performance. The same sort of thing has just happened to Russia's industry.

Russia's economy hit a brick wall in September 2008 and factories simply stopped working, crippled by debt and forced to sell off their inventory rather than pay expensive workers to actually make anything. However, as the economy comes out the other side, imports of machinery have soared, according to Deputy Economic Development Minister Andrei Klepach, as factory owners start to retool and concentrate on their best selling products as they attempt to capture a bigger share of the domestic market.

Evgeny Gavrilenkov, chief economist at Troika Dialog, says the Russian economy demonstrated balanced growth in 2010, with GDP growth coming in close to 4.0%, while retail sales (a proxy for household consumption) expanded 4.4% and investment rose 6.0%. "This is a more sustainable model than that in place before the crisis in 2008, when the economy was overheating and consumption and investment growth were in the double digits and GDP growth was around 7.0%," he says.

While many of Western Europe's economies struggle as their austerity measures start to bite, Russia's factories are roaring ahead. The crisis has been a catalyst for domestic production and in some sectors the local companies are finally starting to force out some of the foreign products that have dominated the market for so long. The easy money during the boom has gone, but importantly the easy credits offered by international banks has also gone, which have refocused managers' attention on efficiently making and selling popular products.

Analysts were predicting very strong growth in the second half of 2010, but the summer's fires caused a second round of fear and it wasn't until the last quarter that the recovery began to gather momentum. According to the state, GDP growth was nearly 5% in the last quarter, making an average of 4% for the whole year.

The turnabout in industry has been sharp and dramatic. Industrial production was up a massive 43% in November from October and continued to climb well above the consensus forecast in December, resulting in growth for the whole year of 8.2%.

Encouragingly, most of the growth has come in the manufacturing sector that caters to the Russian consumer, where industrial production was running with increases of around 10% on month from October to the end of the year, according to the most recent data. Car production grew over 130% on year in December, while production of pharmaceuticals doubled over the same period. However, Russia Inc. is still running a lot more slowly than it was pre-crisis, with capacity utilisation at about 60% to total capacity in January, so there is still plenty of room to grow.

Renewed confidence

The upswing has lifted business confidence across the board. A quarter of industrial managers interviewed by the state statistics service Rosstat in January said they were "optimistic" about prospects for this year - up from 5% who were asked the same question at the start of 2010 - while over 70% said the situation was "satisfactory."

Under pressure to keep the cash coming through the front door, managers have started to remake their businesses along more rational lines. Exports are driven almost exclusively by raw materials exports, but imports soared by nearly a third to $248.4bn in 2010 from $191.8bn a year earlier - almost exclusively made up by the import of machinery. "Import substitution has started, but it is limited to a few sectors like food," says Peter Westin, chief economist at Aton Capital. "Companies are tooling up, as the crisis has caused a real change in the structure of the economy."

Everyone is waiting for consumer demand to kick in again, which already accounts for 52% of GDP, according to the Bank of Finland (exports including raw materials make up 30%). Although the economy contracted, the Russian worker was not badly winded by the economic crisis and average salaries carried on increasing throughout to end up 4.4% in 2010. Heavy state spending has been particularly supportive for the average worker, but this money is not yet feeding through into demand.

Raw materials still dominate Russia's economy, but slowly the most progressive sectors - mostly connected to the consumer - have developed to the point where domestic production is pushing out foreign competition. The process got a big leg-up from the 30% devaluation of the ruble in the first half of 2009, which drove consumers en masse into the arms of cheaper domestic producers.

Nowhere was that clearer than in food. Oddly, for the third-largest agricultural producer in the world, Russia has been importing about 40% of all its food (65% in Moscow); the country grows a lot of grain, but for Brie or Pate de Canard, Russians traditionally turned to Western Europe. That has begun to change. "As a share of total imports, food - and this includes agriculture, hunting, fishing, food, beverages, and tobacco - has fallen from more than 20% in late 1990s to below 15% in recent years," says Westin. "The reason for the spike up to 17.5% in 2009 was due to the crisis: imports fell across the board, but food has a lower elasticity and so increased its share of overall imports as it is more of a necessity."

As things return to some sort of normality, it remains to be seen if these changes will be lasting. The devaluation effect has already worn off and Troika's Gavrilenkov says this will undermine the push towards import substitution. But having made the change to "made in Russia" goods, local producers are going to work hard to keep their new customers and continue to grind away at the competition.

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