Russia's brave bet on organic growth

By bne IntelliNews October 17, 2013

Ben Aris in Moscow -

Russia's growth over the first nine months of this year was 0%, Deputy Economic Development Minister Andrei Klepach said on October 15. While the rest of the world is fixated on trying to spur growth, the Kremlin is largely ignoring the problem of its stagnating economy, preferring to concentrate on the deeper problem of persistently high inflation. It is a brave bet that assumes Russia will be lifted out of its economic malaise by organic growth next year.

The first question that springs to mind is: will it work? The short answer is that despite the recent disappointing data, Russia has some really big fundamental advantages - and not just its massive $500bn-plus cash pile (although that helps a lot, of course). Low unemployment, low debt levels and rising incomes all combine to put Russia in a totally different place to the rest of the world. On balance, there is a good chance that the bet will pay off - and if it does, then Russia will be much better placed to put in many years of strong growth.

But first the bad news. After almost a decade of 6-8% GDP growth, much has been made of the economy now effectively stagnating. Nominal GDP growth over the first six months of this year was a meagre 1.5%, but in real terms there was no growth at all, said Trade and Economic Development Minister Alexei Ulyukayev in October. Russia's economy has stalled.

Part of the reason is that the Central Bank of Russia has kept interest rates high (8.25%), making borrowing unaffordable for many companies, while the rest of the world has cut rates to near zero to spur growth. Indeed, despite monthly predictions by economists it would cut interest rates, the CBR this month decided yet again to leave them unchanged as inflation was still above target at 6.1% in September.

Another reason is that the government has rather perversely chosen now to implement its own version of austerity, imposing the first real budget cuts in a decade and reducing its oil price assumptions used in the budget. This bucks the global trend of austerity being abandoned and spending increased to pump-prime growth in flagging economies.

Russian government spending has been rising by between 20% and 40% a year for most of the last decade, but this year spending was slashed by 5% in real terms and big expenditure programmes, like re-equipping the military, have been put off until at least 2014. At the same time, tariff hikes on things like power have been frozen for a year - they were supposed to be increased by some 15% this year - which is a throwback to the inflation-busting policies of the 1990s. This starves utilities of investment capital.

And various ad hoc measures have been introduced. There is an unpopular change to the way state pension fund contributions are calculated to create extra cash for the budget, and the Kremlin says it will dip into the Reserve Funds to pay for infrastructure spending next year.

The reason for these measures is that the budget is about to go into deficit for the first time since the Yeltsin-era - as soon as the fourth quarter of this year - and deficits are anathema for this government. "The annual target for government expenditures this year is RUB13.4 trillion ($419bn) but the government will spend RUB4.4 trillion in the fourth quarter, implying a substantial increase in spending from the average quarterly tally over the first nine months of RUB3.0 trillion. So the budget will run a small deficit for the full year, which will be covered by borrowing," Evgeny Gavrilenkov, chief economist with Sberbank CIB, said in a recent note.

Maybe the biggest concession to the slowdown has been the decision to borrow more. The budget includes $7bn of international borrowing a year and Russia got a Eurobond issue away in September for this amount. But from next year instead of issuing one bond, the state plans to hold bond investor meetings every three months or so and could increase the amounts offered. The Finance Ministry also just announced it will increase domestic borrowing to RUB800bn ($25bn) by 2016 - almost double the RUB440bn it is expected to borrow this year.

These measure are all a bodge to keep the show on the road - the economic equivalent of putting duct tape on a hole in the roof. In the meantime, things are continuing to get worse; the economic slowdown is now starting to affect incomes and shopping, which has replaced oil as Russia's main economic engine. Retail trade decelerated in August by 4% on year on the back a slowdown in growth of real incomes by 2.1%, reports Rosstat. A further drag on consumption comes from the CBR's decision to crack down on the white-hot consumer lending by imposing much tougher conditions on retail-oriented banks this year.

And domestic companies are equally pessimistic, with growth in corporate borrowing in the red, which in turn meant that capital investment - usually another economic driver - also turned negative again in August. At the same time, capital flight is running unchecked, at about $12.9bn in the third quarter and $48.1bn over the first nine months - way ahead of the CBR's forecasts at the start to this year of $10bn for the whole year.

So the Russian economy is going to hell in a hand basket, right? Well, not quite, as there is some good news too.

Focus where focus is needed

Despite the economic slowdown, the CBR is probably right to focus on bringing down inflation over boosting growth.

One of the reasons that Europe has to do something about its lack of growth is so it can grow its way out of the debt hole in which it finds itself: between 80% of GDP and 130% for most countries on the Continent. Even the US' debt burden is now over the unsustainable 100% of GDP. By comparison, Russia's sovereign debt/GDP external debt is only about 14%.

A second reason is that unemployment across Europe is running extremely high, with youth unemployment in countries like Spain at over 50% - a potentially explosive situation. In Russia unemployment is at 20-year record lows.

Third is that the standard of living in the West is falling, with per-capita incomes in the US, for example, falling by $1,000 a year for the last five years. In Russia average incomes continue to rise, although the rate of growth has slowed this year.

Thus, the average Russian hasn't really been affected by the crisis or the subsequent slowdown. Anyone who wants a job has one. Their pay continues to rise. And the chance of another crisis seems remote. However, having lived through almost a decade of hyperinflation, Russians have a deeply ingrained fear of inflation, which also eats into their savings; savings they rely on for their old age in lieu of a properly functioning pension system. High inflation is Russians' biggest concern, with 68% of respondents putting it as worry number one in a poll by the Levada centre earlier this year.

The government has a lot more time and space to deal with its economic problems than the rest of the world and has chosen to deal with the deep structural problem of inflation first, banking on a global recovery to provide the stimulus to spur growth, rather than trying to engineer it with rate cuts and stimulus programmes.

And that doesn't seem like such a poor bet. The global economy seems to have passed through the nadir and economists are almost universal in predicting an upswing in 2014. Russian growth may only be 1.5% this year - the slowest since the 1990s - but the consensus is it will pick up to 3% next year.

Indeed, foreign investors seem a lot more optimistic about Russia's future than the Russians themselves. Domestic investment may be negative, but Chinese investment in Russia is up 40-fold in the last eight years to $4.9bn by the end of 2012. Likewise, Russia has seen a bum-rush of European retailers arrive in the last few years. Russian President Vladimir Putin said in September that foreign direct investment into Russia has trebled in the first six months of this year alone to $55bn and this shows no sign of slowing down.

The irony here is that the Kremlin needs to do more to convince its own business people to invest in Russia if it wants the boom times to return. As the chart of capital outflows below shows, it is the return of flight capital that really fuels growth in Russia, not foreign investment.

If Russia is to boom, flight capital needs to come home

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