COMMENT: Russia’s manufacturing slump should be temporary

COMMENT: Russia’s manufacturing slump should be temporary
Russia's manufacturing slumped at the end of 2018, but Capital Economics believes the slow down is temporary
By Capital Economics in London February 13, 2019

We suspect that the sharp slowdown in Russia’s manufacturing sector in the second half of 2018 was due to a fall in public spending on military and railway transport. If we’re right, manufacturing should recover in 2019 as defence and infrastructure expenditure picks up. This could plausibly add 0.2-0.3%-pts to GDP growth this year, adding to reasons to think that growth will hold up a bit better than most expect.

GDP data for 2018, released last week, showed that Russia’s economy grew by 2.3% over the year as a whole. However, these data masked a sharp slowdown in the second half of the year. Revisions to the back data means it’s unclear how abrupt the slowdown was, but our Tracker suggests growth peaked at about 2.7% y/y in Q2, before weakening to 1.5-1.8% y/y in the second half of the year.

This slowdown seems to have been driven by the manufacturing sector. Monthly activity figures show that growth in the sector slowed from 4.2% y/y in Q2 to just 0.8% y/y in Q4. While the sector constitutes little more than 10% of Russian GDP, it accounted for about half of the overall slowdown in economic growth in the second half of 2018.

There was no obvious reason for this weakness in manufacturing. It came at the same time that the manufacturing PMI actually improved, while capacity utilisation rates in the sector rose. But from what we can see, it was a result of a collapse in output in one sub-sector, ‘other vehicles’ (which includes products like ships, trains, aircraft and military vehicles). Output in this sub-sector rose by 19.6% y/y in Q2, but fell by 29.9% y/y in Q4, knocking 2.5-3.0%-pts off manufacturing growth.

We think that there are two plausible explanations for the weakness in this sub-sector. The first is that a fall in military spending dragged on output. Public finance figures show that consolidated government expenditure on ‘national defence’ fell to a near three-year low of 2.9% of GDP in December.

The second explanation is that the boost from a sharp rise in the production of trains in late-2017 and the first half of 2018 faded. It looks like Russian Railways added new electric trains in this period, particularly within Moscow to meet higher demand during the World Cup.

If we’re right, there is reason to think that ‘other vehicles’ production – and, as a result, manufacturing output – will recover.

The 2019 federal budget envisages that, following a fall in spending last year, military expenditure will be higher in 2019 than in 2018. The budget also suggests that infrastructure spending will rise. A recovery in ‘other vehicles’ output could add 2-3%-pts to manufacturing production growth this year, contributing about 0.2-0.3%-pts to GDP growth.

Stronger growth in the ‘other vehicles’ sub-sector should help to offset the headwinds from the slowdown in the global economy. This is one reason why we expect that the Russian economy will hold up fairly well this year – our GDP growth forecast of 2% is a bit higher than the consensus expectation.

Liam Carson is an emerging market economist with Capital Economics in London. This note first appeared on the Capital Economics website here