Ben Aris in London -

While Western Europe is once more staring into the abyss of sovereign default, Russia is expected to see economic growth pick up next year. But even Russia's leading officials admit that the state is carrying the can, while the private sector and consumers have yet to recover from the shock of 2008's collapse.

This must change or Russia will be caught in a "periodic devaluation trap," argues Deputy Economy Minister Andrey Klepach. But so far, the state has been unable to come up with anything better than pumping more investment into the economy through the massive state-owned enterprises. The race is on: make deep qualitative changes in the nature of the economy or consign Russia to the boom-bust cycles of a commodity-dependent economy.

A troika of top Russian officials appeared at the Adam Smith annual Russian banking conference in London at the start of December and laid out a set of encouraging macroeconomic results. On the face of it, the pace of economic growth is picking up, while the deficit has fallen further and faster than anyone expected, and Russia's economy now appears to be amongst the healthiest in the world.

On closer inspection, however, the official numbers disappointed and the private sector appears to be moribund. The government's results paint a rosy picture in the European context of bailouts and spiking credit default swap (CDS) spreads, but it is the blanks in between that are the cause for worry.

The bottom line is the state and state-owned business have enough money and momentum to keep the economy climbing out of the deep hole it fell into in 2008, but everyone is still waiting for consumer and small business confidence to return to the point where Russians start to shop again and business start to invest again. "Russia enjoys a very low debt/GDP ratio of about 10%, so we can borrow and remain reluctant to cut spending. The deficit is projected to be 4.8% this year, 3.6% next year before falling to zero in 2015," Deputy Finance Minister Dmitry Pankin told delegates. "We are not under a lot of pressure and we can continue fiscal stimulation, as there is no danger of solvency problems."

Fragile: handle with care

Still, economic growth remains very fragile. Russia's economy bounced back in the last part of 2009 and this growth extended into the start of 2010, Klepach said. Then it began to falter and was slowing even before it was knocked sideways by the fires in Russia over the summer. More fundamental domestic-based, consumption-led growth only appeared in the last months of 2010. "The growth of the Russian economy was almost exhausted in the first quarter of 2010, but then it started to recover in September," Klepach said. "At the start of this year, the key drivers of the economy were all external and supported by the recovery of oil prices which goes hand in hand with [the growth in] Russia's GDP. So in September, we saw the start of a third wave of growth and expect that growth for the full year will be about 3.8%."

As he went on, a picture of a state-led recovery appeared from the statistics. "In the fourth quarter, we saw the start of a pick-up in investment, which was faster than expected: we were expecting 2.5% [increase in the rate of investment year-on-year], but in October saw 5.5-6%," said Klepach. "Much of this investment was going into energy and into the metal and engineering sectors. But it is hard to get a clear picture of what is happening in investment, as the state is also investing heavily under state programmes."

Looking at unemployment gives a clearer picture. Again the macro results were better than expected, but the numbers that give a better insight into what is happening on the ground were disappointing. "Unemployment dropped faster than expected, but in all in all the sectors are now employing less people even though those people are paid more than before the crisis," said Klepach. "The change in consumption is not reflected in these numbers and has remained more or less flat and well below the government forecasts: retail turnover growth won't reach the government's forecast of 5% this year."

Indeed, the latest forecast for consumption growth is closer to 2% for the year. But while before the crisis increases in income were multiplied in the retail turnover results, so that the approximate 5% increases in income turned into 15%-plus increases in buying, even though real incomes have risen over the last two years - this year incomes are up some 5% - retail sales have multiplied down. This strongly suggests that Russian shoppers are still feeling shell shocked by the crisis and have changed they way they buy: instead of leveraging their ever-increasing incomes to buy on credit (which multiplies retail turnover up very fast), they are saving until they can buy goods in cash. In other words, Russian shopping habits have reverted to those of pre-2001 before retail credit first appeared.

Companies can't invest unless they have rising sales, as Russian private industry is now suffering from overcapacity, while the state is doing all the investment. Klepach admitted as much. "The key drivers for 2011 are all the natural monopolies' plans [for investment] - nothing is expected from the private or SME sectors - so the state is leading the recovery," Klepach said. "The investment plans by Gazprom alone will have a huge impact, while investment in other sectors is still minimal."

Structural problems

Klepach also pointed out some worrying changes in the structure of the economy. What sales increases there have been are mostly going to imports, which have been rising fast. That is bad news for domestic industry, as again badly needed sales aren't materialising. "The growth of the internal demand is mapped to imports," said Klepach. "Now the ratio of import/export production is worse than before the crisis. Food imports have fallen or remained stable due to the protectionist measures. However, in durables and investment sectors the sensitivity to imports is enormous and their gain is enormous. Joining the WTO will not help and won't slow the growth of imports - in fact it will do quite the opposite and exacerbate it."

He was also pretty negative on the outlook for the recovery of consumption and suggests that income growth now is below a level that can kick-start the pre-crisis virtuous circle of spending, profits, investment, wage rises. "The second key question for the growth in 2011 is what will the consumer do? Incomes are still rising, but they are rising half as fast as they did pre-crisis. However, we expect that lending will increase, but this is counteracted by the changes to the saving levels of the population," said Klepach. "Russians have traditionally been big savers with 20% of total income being saved. However, saving fell heavily in the crisis to 13% before rebounding to 19%. From here on, the level of saving will slowly fall to about 13% in 2013."

This is bad news because if this trend continues, then the value of the ruble will come under pressure. The ruble had been appreciating strongly for the years before the crisis, but has fallen in value in the last year. Indeed, Klepach said that if there is no change in the current trends, then Russia will face another bout of devaluation of the ruble to bring it into line with new structure of the economy. "In 2012, the ruble appreciation will stop and there will be a devaluation shake up. This happens every few years," said Klepach. "Or we will have to dramatically open our economy to foreign investors and get a steady flow of investment."

Will this happen? Alexei Ulyukaev, first deputy chairman of the Russian central bank and the third member of the troika to speak at the conference, offered a bit more hope. Like the others, the picture he painted of the banking sector was positive. Non-performing loans, capital adequacy ratios and liquidity in the sector are all extremely strong. More importantly, he pointed to a recovery in lending, with consumer lending growing the fastest. "We expect lending to growth by 12% by the end of the year," said Ulyukaev, "which if you take out 8% inflation, is a real increase of 3%, but retail lending is growing faster than corporate."

He went on to say that the private banks are increasing lending faster than the state banks, which is also good news as they have been, "more realistic about the state of the economy than the state banks." He also said that banks were in robust health and that the lower-than-expected bad debt levels will give the bank sector a capital boost in the new year. "The need to increase bank capital will be solved organically as reserves [set aside to deal with bad debt] are at a historical high and next year some of this money will be transferred to boost the capital base," said Ulyukaev.

Ulyukaev comments that retail borrowing is growing give some cause for optimism. But the race is on: the main drag on Russia's growth is a lack of confidence amongst people and small business owners. And why shouldn't there be? After all, this is a population that has been hit by three major crises in the last 20 years. Typically, in the previous crises it has taken four years for confidence to fully return and we are still only two years into this one. Most analysts are expecting next year to be much stronger, but the current picture suggests that while the state-led recovery will bring improvements next year - essential to restoring confidence - the really strong growth led by investment, construction and spending like last time may not appear until 2012.

Vasily Vysokov, president of the Rostov-on-Don progressive Centre-Invest Bank, put his finger on the problem when he said: "We shouldn't increase the rate of growth of a bad economy, but use the crisis to change the nature of the economy and its direction. The state support takes money out of the pockets of those that work well and puts it in the pocket of those that work badly."

Happily, the government seems to get it, which is what President Dmitry Medvedev's modernisation drive is all about. Unhappily, the state is not doing very well at implementing this programme and the fact that all the plans for improving the economy in 2011 rest with the "surprises in store from Gazprom's investment programme," noted by Klepach, testifies to the government impotence in making a difference. Still, at least the Kremlin realises the scale of the problem and also what they need to do to avoid failure. "The economy is now starting a new phase of growth. Where there will be big qualitative changes otherwise the economy will not be competitive and we will not be able to escape this periodical devaluation trap," said Klepach.