Russia’s economy is not just in recession – it has entered a period of stagnation that will last at least four years, according to Natalia Orlova, chief economist at Alfa Bank, in an interview with bne IntelliNews.
One of the most perceptive observers of the Russian economy, Orlova has regularly called events well ahead of time. She predicted the collapse of consumer credit in 2014, as she was the first to realize the Russian population had over-borrowed during the credit binge of the previous years, which led to the collapse of consumption. Then early last year she realised the devaluation effects from December 2014 were working their way through the system faster than expected and has been accurately predicting inflation dynamics since, as the currency yo-yos on the back of oil price swings. So for Russia’s leaders it will be worrying that she is very pessimistic about Russia’s chances for even a recovery in the medium term.
“The best the Russian economy can hope to achieve in this period is the potential growth rate of between 0.5% and 1%,” says Orlova.
There are many factors to blame for this stagnation, but at root is the government’s oudated economic model. It failed to respond to some very large changes that have occurred in the last few years and has in effect abandoned Adam Smith’s “invisible hand” mechanism for regulating a market. “[President Vladimir] Putin’s vision of economic development doesn’t value changing the rules of the game. He is happy with the state companies’ control of the economy and will not take the risk of implementing structural reforms. He is not comfortable with relying on the invisible hand of the market and prefers to use the visible hand of the state instead,” says Orlova.
Take the recent budget debate as an example, which is dominating policy-making at the moment. Putin has set a 3% federal budget deficit as a red line that should not be crossed. But with oil prices hovering around $40 a barrel, the Russian government is simply not earning enough to be able to keep the deficit at below 5.1% of GDP unless deep cuts are made, Economy Minister Alexey Ulyukayev said recently. However, the president has ruled out cuts to the two biggest items: social spending because there is a general election in September, and military spending as Putin wants to catch up with the West in this sphere as fast as possible. Freezing pensions and wages are amongst the few options left to the embattled Finance Minister Anton Siluanov.
“If you freeze public sector wages without doing reforms, what is the point? All freezing wages does is reduce consumption and hence growth. A freeze is a tactical move, but there is no strategy behind it without changes to the system,” says Orlova.
It is a conundrum. The “liberal bloc” – as Orlova dubs the people at the central bank, and the finance and economy ministries who are trying to push through pragmatic policy – are calling for a spending freeze including military spending because there is no money, as well as for deep structural reforms.
However, the “business bloc”, which is dominated by the large state-owned enterprises (SOE), wants to see things develop differently. They are quite happy with the status quo: they like the stability; they like being in control of their companies; and, more importantly, they like the fact the main source of Russia’s cash flows through their accounts as that translates directly into political power.
It is clear that cuts need to be made for economic reasons, but it is highly likely that social spending will be increased in the run-up to the autumn election for political reasons. “There is huge uncertainty and there is no economic logic which will help to forecast,” says Orlova, stopping short of finishing the thought: the situation is uncertain, because ultimately Putin will make the final decision on whether to increase spending or not, and it is impossible to second-guess him.
The situation has been made much more difficult by Russia’s political showdown with the West over Ukraine and Syria. Specifically, this has brought to an end the 1990s policy of greater integration with the West, but more generally, Orlova argues, there is a process of fragmentation going on worldwide as part of the post-2008 economic crisis fallout.
Up until 2014, Russia’s goal of full integration was manifest in its accession to the World Trade Organization (WTO). However, since the annexation of Crimea in 2014 and the subsequent sanctions, the goal has been reversed and self-sufficiency in all strategic sectors is now key. “Self-sufficiency dominates and economic reasoning is no longer dictating trends. The strategic goal of global integration has gone. And it is not just in Russia – the whole world has changed. The WTO is breaking down as a number of countries are becoming more protectionist. All countries want to support growth at the cost of their neighbours. China is doing the same. The Brexit is the same in the theme. Why should Russia integrate with a world that has no interest in integration?” asks Orlova.
The decision to turn inwards has only been reinforced by Russia’s decision to face down the US in its high-stakes geopolitical confrontation. “Before it was easy,” says Orlova. “All you had to do was open up to the West, import technology and grow. A number of companies benefited and they wanted to keep those benefits. That means closing the borders again, as development will be driven by low efficiency state-owned companies that control their sectors, but have little interest in competing globally. The fact that the rest of the world has gone into recession does not help,” says Orlova.
It is possible to turn the Russian economy around, but that would require two key changes: a recovery in Russia’s demographic profile and resurgent flows of investment.
The dip in the population size caused by the chaos of the 1990s is about to hit the working population. Russia’s population has been growing for the last few years thanks to a very effective Kremlin policy to support families, but it will start to shrink again soon, which will depress growth. The dip will pass in about four years, but there is little the government can do about it now, other than try to improve productivity.
The second, and arguably even bigger problem, is the collapse of investment in Russia’s economy, not only by foreign investors, but even more tellingly by domestic investors.
As a transitional country, Russia needs to see fixed investment grow by 20-25% a year if it is to catch up with the developed world. That happened briefly in the boom years when Russia was on course to merge with the developed world, but investment is going backwards fast now. “In the best-case scenario, investment will start to grow again in 2020 if some reforms are put on the agenda. We need at least a year to draw up a plan, another year to put it into place and another year for it to start having an effect,” says Orlova. “The fall in the population size will also reverse from about 2023 when the 90s dip starts to leave the working population age, which will also boost growth. But this means we are consigned to at least four years of stagnation.”
What’s to be done?
Russia is faced yet again with the perennial question: “What’s to be done?” And actually the answer is obvious, but the political will is lacking.
There are constant calls for the need for deep, structural reforms, but what exactly does this entail? The goal of these reforms is to create an environment for more private investment and that boils down to breaking the workforce’s dependence on the state sector.
Today, Orlova estimates about a third quarter of the working population are paid directly from the state budget. If you add in private companies that are dependent on state orders, that share rises to as much as 70% according to some estimates; as bne IntelliNews reported recently, state procurement makes up a quarter of GDP.
The government should move people out of the public sector and the simplest way of doing this is to privatize as many of the state enterprises as it can. The Kremlin relaunched its privatization programme in 2008 and again in 2015, but failed to sell anything. In the politically fraught atmosphere, the current third attempt is also likely to fail.
The government needs to encourage more investment from abroad, but it is even more important to encourage domestic business to invest. However, the 2015 renationalization of Bashneft by the Kremlin, the ever-increasing power of the state companies and the “private” companies owned by a coterie of oligarchs close to Putin, in what bne dubbed ZAO Kremlin in a 2007 cover story, have undermined the confidence of “real” private sector businessmen. Russia’s own entrepreneurs, who have amassed billions of dollars and gained the relevant experience, are the answer to Russia’s growth conundrum, but they continue to whisk their profits abroad as fast as they can, unsure of their future at home.
“There is still plenty of money in Russia and the lack of investment is not due to the high interest rates. Why don't people invest? It is because of the lack of visibility and weak rule of law. And people can’t see how to grow their market share if they are in competition with the state companies. So they make their money and they take the profits away from their business. It is a comfortable existence,” says Orlova.
Given the solution to Russia’s problems is so obvious, why hasn’t the Kremlin acted? Putin is very publicly getting this advice from his close friend and the former finance minister Alexei Kudrin as well as the current Finance Minister Anton Siluanov, to mention two of the more prominent ‘liberal bloc’ members with direct access to the president. But he continues to ignore them for political reasons. Putin is preoccupied with the geopolitical showdown with the West at the moment and has no time to deal with domestic economic issues. And with the Duma elections in September and presidential elections in 2018, this is a bad time in the electoral calendar to be sacking millions of public employees and forcing them to find private sector jobs.
More subtly, the state is reluctant to carry out privatization, because that would mean addressing the huge losses that its economic model has created. Poor management means most of the big state firms, especially the banks, have made trillions of rubles in losses, which they are currently able to hide under their revenue streams for the moment.
The most obvious example is the de facto collapse of the state development bank Vnesheconombank (VEB). Nominally a vehicle to make badly needed infrastructure investments, in fact the bank has been bankrolling showy prestige projects like the Sochi Olympics and racking up lots of bad debt in the process. VEB asked the government for a $20bn bailout that the state can ill afford and a fudge was found in March, which will at least leave the bank alive if not recapitalized. The problem is that if the government simply closed VEB down, then it would have to book the entire $20bn loss – and probably a lot more than that.
Looking round the state sector and this story is repeated over and over again. VTB Bank also hit the state for a RUB300bn handout in 2015, but as bne IntelliNews reported in the cover story “Russia’s state banks are rotten”, it too has an extremely large share of illiquid assets on its books that are unrealistically valued. VTB reported tiny profits for 2015, but, according bne IntelliNews sources, much of this was done by buying some land and then inflating the value in its accounts. Bottom line is that the bank earned RUB1.7bn ($25mn) in profits versus Sberbank’s RUB223bn ($3.25bn), which was still a modest result for Russia’s retail behemoth. The situation at the state-owned Russian Agricultural Bank is even worse according to insiders, as its balance sheet is full of fake and failed loans.
Booking all these losses is clearly way beyond the government’s means, but the nature of debt is such that you can ignore the problem as long as you can refinance it – “extend and pretend”, as it’s known in the industry. But you can’t do that forever. Unless the system is reformed, Russia will face yet another big crisis eventually, irrespective of how strong Putin’s hand is.