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Six steps to return Russia to economic growth

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The Russian economy is under pressure: it’s time for an alternative.

 

Kirill Rodionov
9 March 2015

In late January 2015, the Russian government adopted an anti-crisis programme. The plan includes a number of measures intended to provide sustainable development of the economy, and social stability in 2015. The Cabinet of Ministers plans to substitute imports, remove barriers for business, and compensate inflationary costs for the country’s poorest.

The document also proposes to support employment, optimise budget expenditures and restoring the banking sector to health. The government is preparing to put a series of legislative acts in place by the middle of March; and the coming months will show just how effective those measures will be. Right now, though, it’s possible to draw up an alternative plan; in six steps.

The food import limitations implemented in August 2014 should be abandoned.

Cancel the food embargo

The food import limitations implemented in August 2014 should be abandoned. The embargo has already resulted in price increases. According to Rosstat, the state statistical service, inflation rose to 11.4% in 2014, and the prices of products included in the sanctions list rose by 17.9%. In January 2015, consumer prices rose by 3.9% – the highest since February 1999 (4.1%).

16 years ago, Russia was in the midst of another currency devaluation, and currently the country is experiencing a similar situation: between June 2014 and January 2015, the rouble exchange rate declined from 33 to 68 roubles per dollar. In turn, this decline has led to a dramatic rise in import prices. At the same time, Russian manufacturers have used import limitations as an opportunity to raise prices on their products. The result is inflation that continues to rise and rise.

End the import substitution strategy

It is no secret that Russia is critically dependent on imports. Today, foreign products in the country’s hi-tech and engineering sector have a 70%-90% market share. Indeed, there have always been voices within the expert community who support the raising of tariff barriers: this would prompt national businesses to take the lead and improve their operations.

The recent crisis has led to such a policy. In fact, import substitution has been one of the reasons behind the government’s decision to launch the food embargo campaign. The Cabinet hopes to repeat the experience of the 1998 crisis, when a huge devaluation sparked a sharp rise in the economy’s industrial sector – 8.4% of annual growth in 1999, which was much higher than in 1997 (1%) and 1998 (-4.8%). But that growth was possible thanks to the low absorption of idle capacity: according to the Sberbank Center for Macroeconomic Research, the coefficient of idle capacity usage amounted to 45% in 1998. In 2014, the coefficient calculated for extraction, processing and allocation was equal to the level of 66%, 64% and 56% respectively; at the same time, a significant share of capacity in these sectors is obsolete. It is thus impossible to use them in order to accelerate growth.

Improve the business climate

As Sberbank’s experts note, the lack of idle capacity makes investment necessary for the economy to grow. But entrepreneurs put up their capital only when they feel confident in their property rights. And Russia has huge problems in this area.

During the last decade, the country has seen a number of illegal seizures of private companies – from Mikhail Khodorkovsky’s Yukos in 2004 to Vladimir Yevtushenkov’s Bashneft in 2014. To guarantee property rights, the government should ban security officials from interfering in business activity without a court decision. And given Russia’s low ranking in the World Bank’s ‘Doing Business’ Index (62) and the Heritage Foundation’s Index of Economic Freedom (143), the Cabinet should also reduce the level of red-tape that entrepreneurs have to get through.

Resolve the corporate debt crisis

Improving the business climate will stimulate economic activity. But it will be impossible to achieve a high GDP growth rate without resolving the severe corporate debt crisis. Until recently, foreign loans had been the main driver of growth for Russian banks and companies. In July 2014, their debt amounted to $650 billion. But following Western sanctions, borrowers can no longer re-finance their loans. To avoid default, several Russian state companies began to demand money from the National Wealth Fund and from Central Bank reserves. This, in turn, may cause a further devaluation of the currency, as well as inflation and budget problems. That is why it is better to sell assets to clear corporate debts.

Mass privatisation will de-leverage Russia’s companies and de-monopolise the economy.

Cut budget expenditures

The corporate debt crisis has coincided with the fiscal instability caused by falling oil prices. The Treasury is critically dependent on revenues received from energy exports. In 2013, the share of oil and gas revenues within the federal budget came to 46%.

Therefore, the fall in oil prices will inevitably affect the sustainability of the fiscal system. The situation gets worse when you consider that the 2015 budget was calculated based on an oil price of $96 per barrel. Moreover, the rouble devaluation means the Cabinet runs the risk of a sharp budget crisis: energy revenues are received in dollars, while budget expenditures are nominated in roubles. However, to curb fiscal problems, the federal government should cut its expenditures on subsidising state companies (2.8% of GDP in 2013), law enforcement activities (3.1% of GDP) and national security (3.2% of GDP).

Stop confrontation with the world

Last, but not least: the government should stop its confrontation with the outside world. After the annexation of Crimea, foreign investors began reviewing the risks of doing business with Russia. The war in Donbas was followed by a series of Western sanctions, which deprived Russia’s banks and companies from international financing. The downing of MH17 and the consequent reaction of EU and US leader in part triggered the rouble devaluation.

Unfortunately, there is a high risk of further escalation in the conflict, which, in turn, will bring about a new wave of sanctions. The latter will have a detrimental impact on the economy, which is already experiencing a recession. According to Anders Aslund, Russia’s GDP will plummet by 10% in 2014.

Russia will have to implement reforms without any money at all, just like in the early 1990s.

Reform is unlikely

To combat the situation, the government should launch reforms aimed not only at restructuring the economy, but also at preventing a fall in real incomes. But this scenario is unlikely.

The only factor liable to affect the situation is the population’s dissatisfaction with living conditions. As previous experience shows, massive protests take place only during federal election campaigns; otherwise, they occur mostly in the regions. That is why regional governors and city mayors will feel the people’s pressure in 2015 and 2016. Meanwhile, the federal government will use its financial resources to support the status quo.

The evidence is the Cabinet’s inability to introduce the reform programme developed by German Gref, Minister of Economy and Trade, in 2000. The only effective reform measure implemented under President Putin was the tax reform of the early 2000s. Soon after the oil price hike, the government stopped considering structural reforms, and instead continued to spend petro-dollars and nationalise the economy.

The 2008 crisis has not reversed this trend: since then, federal expenditures have risen from $6.5 trillion to $13 trillion, while the share of state property within the economy has reached 70%. Therefore, in all likelihood, significant changes will become reality only when the Treasury’s coffers are empty. And Russia will find itself having to implement reforms without any money at all, just like in the early 1990s.

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