Ben Aris in Moscow -

Russia's economy is not just slowing; it is stagnating. In the first few months of this year, GDP growth slowed to a crawl and the Kremlin is starting to panic, setting off a lively public debate over how to kick start growth that so far has brought little consensus. Currently, the argument is over the efficacy of a potential interest rate cut, but even if rates are cut and that does bolster growth, the much deeper and wider questions on how to restructure the Russian economy remains.

Like many other countries, Russia saw its GDP growth fall off a cliff at the end of last year. At the start of 2012, the economy was chugging along at a more than respectable 5% of growth, but by December that had slumped to just 2.2%. And as we headed into the new year, economists were shocked by it tumbling again to a mere 1.6% growth in January - below even analysts' pessimistic forecasts of 1.9%. Most people are sticking to their full-year GDP forecast of 3.5% of growth for this year, but doubts are already appearing and even if Russia grows this much, it is still well off the 5% that President Vladimir Putin called for at the start of the year.

The powers-that-be can be broadly split into three camps. The statists, led by Putin, who want to cut interest rates and so provide some stimulus to the flagging economy. The Ministry of Economic Development wants to tap more of the $500bn-plus in the central bank reserves and spend Russia's way out of trouble. And the liberals, including the Finance Ministry, want the government to rapidly implement reforms and improve the business climate so the private sector can lift Russia Inc up again.

In more general terms, the dispute is over the goal-setters and the bean counters. Putin's popularity (currently at around 65%) is predicated on the economic prosperity that he delivered over the last 13 years - incomes have gone up some 16-fold since 2000 - so an economic slump represents a huge political danger for the erstwhile strong man. On the other hand, the economy ministry says 5%-plus growth is impossible before 2016 at the earliest.

The economy ministry's most optimistic forecast is for 5.4% growth from 2016 - and only if the government carries through on all its proposed reforms and creates 25m new high-tech jobs - something no one expects will actually happen. The ministry's more likely "target" scenario is Russia will be putting in a meagre 4.1% of growth by 2016, which is barely above stagnation levels. Currently, the economy ministry's GDP growth forecast is just over 3% for this year and 3-4% for a few years thereafter.

Eroding independence

An increasingly bitter dispute has broken out that could end with the independence of the Central Bank of Russia (CBR) being eroded, if the Soviet-style command economy thinking of the statists is allowed to triumph.

The main issue being discussed in March was the efficacy of an interest rate cut. The CBR raised overnight rates to 8.25% in a surprise hike in September citing inflation concerns, at a time when the rest of the world has slashed rates to near zero.

Russian companies are up in arms as a result. Oligarch Oleg Deripaska recently described Russia's central bankers as "leeches" who were "sucking all the blood from the economy" thanks to the high cost of borrowing, which contributed to the terrible first-quarter of RusAl, Deripaska's aluminium company.

But the CBR is sticking to its guns. Outgoing governor Sergey Ignatiev - who will be replaced in June by Putin's current economic advisor, Elvira Nabiullina - has rebuffed the growing criticism, arguing that the economy is already running at full potential; a rate hike would produce no extra growth but would stoke already higher-than-desired inflation rates (over 7% in February against the target of 4-5%). This is an argument echoed by the International Monetary Fund.

The economy ministry is on the other side of the fence and wants growth increased through state investment in infrastructure, which will be funded by diverting revenues from crude oil and gas production fees and export duties normally destined for off-budget reserve funds. The government has already promised to pull an additional RUB100bn ($33bn) from the reserve fund to spend on infrastructure.

However, the economy ministry is talking about even more dramatic changes that would require the lifting of the strict "budget rule" just approved by the Duma in December, which ties the government's hands when it comes to spending petrodollars with the surplus automatically paid into the Reserve Fund that saved Russia's economic bacon during the 2008-2009 meltdown. "This is good news for growth expectations in the short run, but constant changes to the budget framework would damage the predictability of the Russian business environment," argues Natalia Orlova, chief economist with Alfa Bank.

The finance ministry has taken the most sensible, but hardest to pull off, stance. It rejects any increases in state spending, stressing instead the implementation of structural reform as well as improvements to Russia's investment climate. The finance ministry says balanced state finances and accompanying stability are the key factors in improving the investment climate.

Again the government has already launched 22 "roadmaps" of reform, but at issue is how soon (if ever) these reforms will have an impact. Given the first roadmaps were only launched last year and several - like those for the power sector and customs service - are still being discussed, it seems unlike they will make a difference for a few years yet.

At the same time, the government has clearly launched its first really concerted attack on corruption with new investigations and laws being introduced on an almost weekly basis since November. But the jury is still out on how effective this campaign will be. "Even the inner circle, those by [Putin's] side, there are so many thieves and corrupt officials there," Mikhail Gorbachev told the BBC in an interview in March. "If things don't change, Russia will continue to drift like a piece of ice in the Arctic Ocean."

What will happen next is anyone's guess. However, Russia-watchers are nervous that the first repercussions will be felt at the CBR, which could lose some of its independence.

On March 15, Putin ended mounting speculation by naming the former economy minister Elvira Nabiullina as his candidate to be the new governor of the CBR.

Putin's choice drew mixed reactions. On the one hand Nabiullina is seen as an extremely competent economist and was a successful minister. Moreover, she immediately suggested there will be continuity with the policies of the old team, as she asked Ignatiev to stay on at the CBR as an advisor. But on the down side, she has no banking experiences and her public office career so far has focused entirely on promoting economic growth - not fighting inflation.

The upshot is that observers are expecting the CBR's policy to shift towards a "dovish" double mandate of controlling inflation, but tempered with efforts to accelerate economic growth. In practice, that means she will be quicker to cut interest rates than Ignatiev was, with analysts expecting the easing cycle to start as soon as April and a total of 75 basis points of interest rate cuts to come over the rest of the year.

The corollary is that her appointment over the market's preferred choice of the current first deputy chairman of the CBR, Alexei Ulyukayev, does represent a mild erosion of the central bank's independence because she is clearly a Putinite. She comes directly from the presidential apparatus where she has been a presidential advisor for the last four years.

Still, when Nabiullina takes over in June, she is unlikely to start a revolution. And given inflation traditionally falls away to next to nothing over the summer, she will have some room for cuts that won't stoke inflation, say economists. "First, the global context favours this step - several emerging market countries are currently cutting interest rates to prevent international capital inflows," says Alfa Bank's Orlova. "Second, President Putin's recent decision to limit tariff hikes at 6% year on year should keep cost inflation low, giving the CBR room to cut its policy rates. The president's preference for a lower interest rate seems to be an important factor in his decision on the new CBR chairman."

Tail and headwinds

In the meantime, Russia is facing a tough time. State spending has always been the first thing that governments reach for when trying to stimulate (in the UK the state now accounts for 50% of GDP, on a par with Russia). However, because of the inflation fears and a non-oil budget deficit of 10.4% of GDP (the deficit if you count out oil revenues), former finance minister Alexei Kudrin says the Russian government's hands are tied: the current budget saw spending increased by a mere 5% over last year, which is the first cut in spending in real terms after more than a decade of 20%-plus year-on-year increases. For the government, money is clearly very tight. "The non-oil deficit... has increased from 1.8% of GDP in 2004 to 13.7% of GDP in 2009 and now stands at 10.4% of GDP," Kudrin wrote in an op-ed in March. "Despite attempts to curb the expansion of government spending in the face of rising oil and gas revenues, the government stepped up spending. By the standards of the developed countries, and even countries BRIC countries, government spending growing is running at an unprecedented rate: from 2000 to 2012, federal government spending increased 12.5-times in nominal terms and by 3.6-times in real terms."

That level of spending has come to an end: even with oil prices well over $100 since the start of this year, the federal budget is barely in the black. Increasing budget spending is not an option. Russia has to turn to its companies if the economy is going to recover quickly.

Historically, there have been four important drivers of the Russian economy: extraction, construction, investment and, of course, consumption. However, none of these factors are doing very well.

• Extraction

The extraction of oil and many other natural resources is weak thanks to the lack of demand in the rest of the world due to the global slowdown. Russian industrial production suffered its worst contraction in January for since October 2009, down 11.8% on month. Uralsib notes that the main contribution to the weak industrial data was from the extraction sector, which contracted 3.6% on month and 1.2% on year in January, after growth of 2.1% and 0.2% respectively in December.

In general, manufacturing is growing strongly, but here too it is starting to max out. "Manufacturing production continues to grow faster than mining and quarrying, but only because mining sector growth is so slow," says Sanna Kurronen, an economist with Danske Bank. "However, the manufacturing production level is also close to its potential and investments are needed to increase the production more rapidly."

• Construction

Construction is one of the more prospective drivers, as demand for new housing remains unsated. However, here too growth has been slow. Real estate prices have remained stable and construction - particularly in residential - accelerated in 2012, up 2.4% in 2012 form the year before, but this is not enough to drive overall growth and well below the pre-crisis double-digit growth. Indeed, there is a sufficient overhang in things like commercial space from the boom years, although other segments like warehousing are already starting to recover slowly. Still, construction material production slumped in January due to the lack of capital investment and this will be a difficult year for the real estate business.

• Consumption

Consumption was the saving grace of the Russian economy in 2012, fuelled by white-hot consumer lending, up just under 40% from the year before - a pace that was maintained in the first few months of this year too.

The predictions of 3.5% growth for this year are largely based on a continuation of the growth in consumer demand. But economists had a nasty shock when consumer data disappointed in January. "Retail trade growth decelerated sharply to 3.5% year on year in January after 4.5% year on year in 4Q12. Consumption drivers also weakened; real disposable income growth was up only 0.7% year on year and unemployment jumping to 6.0% from the recently revised year-end figure of 5.1% was a negative surprise. Retail loan growth was 39.6% year on year, close to the 39.4% in 2012," say analysts at Uralsib.

What is confusing is that consumer borrowing is still running white-hot, so why is demand falling? Alfa Bank speculated that the reason is consumers have over-borrowed and its economist Orlova came up with the frightening estimate that 80% of new borrowing is being taken out to cover old loans now.

Alfa Bank speculates that the high borrowing by consumers is now destructive: Orlova estimates that 80% of the loans taken out since the start of this year were used to pay off old loans. If she's right, then going forward more borrowing will actually destroy demand, not support it.

The sliver lining in this very dark cloud is the fact that the CBR is well aware of the problem with consumer borrowing and has already moved to reduce it by imposing tough Basel III rules on the sector that kick in this June.

• Investment

The biggest unknown this year is what will happen to investment and, as bne pointed out in its Outlook 2013: Confused picture for Russia report, the forecast for this year depends heavily on what happens to investment. Investment was above expectations in January, but still far too weak to support growth. The problem is that it is too little and of poor quality. "The fact that investment growth came in higher than expected in January, posting a 1.1% year on year increase, is positive but does not change the overall growth outlook. Investments contribute around 23% of GDP, and this item's growth is quite unstable, being heavily dependent on budget spending," says Orlova.

The Russian economy needs investments of 25% to 29% to expand, so everything depends on the government's success in boosting investment through reforms and improving the investment climate. Without this investment, the potential growth rate of the economy will fall to 2.5%-3.0% over the long term say economists.

And the need is already pressing. Danske Bank issued a report at the start of this year entitled, Russia: where to find new growth drivers, which was mildly optimistic. However, it concluded: "We continue to expect decent GDP growth from Russia of over 3% year-on-year in 2013-14, as domestic demand keeps up the good performance. However, the long-term potential growth level is edging down, as investments in production capacity and infrastructure are not sufficient."