Roland Nash of Renaissance Capital -
Amongst both admirers and critics of Russia, there is a popular myth that it is in control of its economic destiny. It is not. For the last decade, and arguably longer, the Russian economy has been driven largely by two factors, both of which are outside of its control. For both the cost of natural resources and the cost of capital, Russia is essentially a price-taker. In this sense, the Opec oil cartel, the Chinese government and the US Federal Reserve have as much influence over Russia as the Kremlin or the oligarchs. For a country of Russia's global economic and political significance, this is not a sustainable situation.
Of course, most countries are influenced in one way or another by the price of oil and the international cost of capital. But Russia is unique to the extent that it is reliant on both. It is the world's largest producer and exporter of natural resources. Adding together oil, gas and coal, Russia exports 50% more than the next biggest exporter, Saudi Arabia, and three times as much as Australia in third place. Moreover, unlike other large natural resource producers, Russia cannot rely exclusively on their production. Despite the contribution they make to the economy, hydrocarbons provide less than 2% of the working population with employment.
Equally, Russia is particularly exposed to the global cost of capital. When Russia opened its capital account in 2006, it was under the not-unreasonable assumption that international markets would be better at allocating capital in Russia than an anaemic domestic financial market or an inefficient banking system. Unfortunately for Russia, the 2008 crisis demonstrated rather conclusively that international markets had their own deficiencies. A combination of a weak banking sector, an under-developed financial market and an open capital account makes Russia particularly vulnerable to the bipolar mood-swings of global financial markets.
The unique exposure to two variables that are outside of its control and are particularly prone to volatility make Russia the quintessential boom-bust economy. Through a managed exchange rate, Russia's markets and economy directly import the volatility of global commodity and capital markets. When times are good, there are few countries that look better. Economic growth is among the highest in the world, and the prices of all manner of asset classes balloon. When international sentiment shifts, the Russian economy and markets collapse.
The good news and the bad news
The good news is that the outlook in the near term is pretty much ideal for Russia. The structural challenges facing the US, Europe and Japan leave them little choice but to keep interest rates at virtually zero well into the future. Equally, for entirely different reasons, Opec and the Chinese government look set on keeping oil prices high. Short-term gloom may keep the lid on prices this year, but the medium-term outlook for commodity prices looks as solid as it did in 2007 when the oil price soared to near $150 per barrel.
As a result, both economic growth and asset prices could well perform tremendously over the next several years. There is no reason why Russia could not go back to the 5-7% economic growth it enjoyed for much of the last decade, or why the equity and housing markets should not again rank among the best performing globally. Indeed, because of the 2008 crisis, Russian companies and banks are healthier now than they were in 2006-07 at the height of the previous boom. The country has deleveraged and restructured, and is well placed to embark on its next boom.
But as in the past, any economic or financial growth spurt will only be partially due to productivity gains in Russia. Most of it will be for reasons outside of Russia's control. Any boom will prove no more sustainable than in the past. Indeed, the more successful Russia looks over the next cycle, the bigger is likely to be the bust the next time there is a shift in international sentiment in commodity or financial markets.
The Russian government has long been aware of their vulnerability to commodity prices and the last few years have brought home that financial markets can be equally as destabilizing. The fall in the oil price from $35/barrel to $10 between 1980 and 1986 was one of the main causes of the collapse of the Soviet Union. The 1998 crisis coincided with the lowest real price of oil in history. Global financial markets were almost entirely to blame for the collapse in 2008 when Russia was hit harder than any large country globally.
As a result, and to the government's credit, reforms are focused on the twin aims of diversifying the economy away from natural resources and creating a financial sector capable of intermediating Russian savings to Russian companies. Over-taxation of the oil sector and low taxation in the rest of the economy is one response. New reform-minded management at lenders Sberbank and VTB is another. The modernisation programme of President Dmitry Medvedev is a third. Despite critical commentary to the contrary, there is a reform programme in Russia under Medvedev and it's reasonably ambitious.
The problem is that relative to the inherent volatility in commodity and financial markets in recent years, any reform programme is simply lost in the noise. It certainly didn't help that Russia's reform programme died between 2004 and 2008. But it's unclear how much any programme would have mattered relative to an oil price which moved from $30/barrel to $150 and back to $30 in the space of five years, or in the face of the sort of financial tsunami that flew out of New York in 2008.
While Russia is in thrall to international commodity and financial markets, it remains inherently unstable. Until Russia is able to diversify its economy away from natural resources and create a financial sector capable of intermediating capital, the stability created by the Putin-Medvedev regime is artificial. Given the volatility in global markets, the reform programme is going to be a tough task, but it is critical that it's tackled during Russia's next boom. The country may not be as lucky as it was in 2009. Russia pulled out of the 2008 crisis because of actions taken by Opec, the Fed, the Chinese government and the foresight of Finance Minister Alexei Kudrin, pretty much in that order. If this combination fails to materialize next time there is a bust, the consequences could prove far more destabilizing. In a country with a political system as inflexible as that of Russia, large economic busts can have particularly unpredictable consequences.
Roland Nash is Chief Strategist of Renaissance Capital
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