OUTLOOK 2014: Russia’s growth model runs out of steam (excerpt)

(Business New Europe – bne.eu – Ben Aris in Moscow – December 20, 2013)

[Full text with charts here http://www.bne.eu/story5634/OUTLOOK_2014_Russias_growth_model_runs_out_of_steam]

bne: this report is in three parts. See the end of the page for links to the rest.

Overview

* Economic overview

2013 was a annus horribilis for Russia. Indeed, it was probably the worst year the country has been forced to endure (that was not a crisis year) in the last decade and half.

The economy suffered from a “phantom crisis” that had its roots in the fears of a second global financial crisis that started in Europe in the summer of 2012. The state issued a mass of debt to build up its reserves, which crowded private companies and banks out of the market and created an atmosphere of fear amongst businessmen.

The results were soon to be seen as the economy started to slow in the autumn of 2012 and that slowdown became self-reinforcing. By the summer of 2013 growth had stalled completely and Russia underperformed, missing the 3.5% GDP target most analysts were predicting at the start of the year. At the time of writing in December, Russia looked unlikely to even manage 1.5% for the whole year. “Despite what can be viewed as a high oil price, real GDP growth slowed dramatically to 1.3% in the first nine months of 2013, compared to 4.0% in the first nine months of 2012, as have all major economic indicators,” said Aton Capital in its 2014 outlook.

Analysts totally underestimated the impact of the terrible sentiment amongst Russia’s businessmen. This climate of fear was only reinforced as the Kremlin ramped up its anti-corruption campaign in 2013, which increasingly is breaking up the old business-politics client system and has exposed all to the possibility of arrest or confiscation of assets.

Perhaps the best illustration of the fears is that companies cut inventories in 2013, leading to a collapse in industrial production in the summer. This is a typical reaction to a crisis, but in 2013 it was being used prophylactically as a way to avoid tying up cash in product and keeping companies’ resources liquid.

At the same time Russian President Vladimir Putin introduced a new law that bans Duma deputies and state officials from owning property abroad or holding foreign bank accounts. This is in effect the first capital controls that Russia has used since the 1990s and given the step from Duma deputies to businessmen is short, this measure further unsettled everyone.

And more recently the Central Bank of Russia (CBR) has started a visible campaign to close some of the 800 smaller banks, which has introduced yet another note of uncertainty in the banking sector and the possibility of a domestic financial crisis.

On top of all this have been the poor external conditions and the slower-than-expected recovery in Europe. Access to international capital markets remains muted and the problems have been exacerbated by the bubble forming in developed capital markets due to the endless quantitative easing, which has seriously distorted flows of international capital.

These are some of the superficial reasons for Russia’s slowdown in 2013, but at a deeper level Russia’s growth model has also run out of steam and the economy will not pick up unless deep structural reforms are put in place. While oil prices held up at over $100 for the year, such high prices no longer deliver growth.

Consumption was the main engine for growth in 2013, but will probably fade in 2014 and was already slowing at the end of 2013. It remains moderately robust with nominal average incomes continuing to rise by an average of 10%, ahead of inflation at about 6.3%. “Personal consumption growth has remained positive, although, with the exception of real disposable income, it has slowed dramatically compared to last year,” says Aton.

All these problems have manifested themselves in the collapse of investment, which normally is one of the three big economic drivers (along with consumption and construction).

As bne pointed out in its 2013 Outlook, investment was going to be the key variable in 2013, yet the investment numbers ended up being hugely disappointing, mirrored by the low levels of corporate borrowing, which also contributed to the collapse of industrial production. “Most concerning is fixed investment, down 1.8% year-on-year in the first ten months of 2013, vs a full 9.1% year-on-year growth in the first ten months of 2012. Equally, industrial production growth has disappointed, being flat year-on-year in first ten months of 2013 compared to 2.8% growth in the same period last year,” says Aton.

Despite the slowing growth, the continued rise in incomes over inflation means that both companies and banks have been suffering from a sustained squeeze on margins, a problem only made worse by the high cost of borrowing, as the CBR has refused to cut interest rates while it battles stubbornly high inflation.

All this has led to talk of stagnation of the Russian economy. In a much-cited speech on November 7, Economic Minister Alexei Ulyukayev outlined a gloomy economic outlook for Russia, saying that GDP growth could likely average 2.5% per year until 2030, down from the previous estimate of an average of 4%.

This is a very pessimistic call and it is probably partly aimed at the statist elements in the government, to persuade them to allow for more liberal structural reforms. Growth of 2.5% would be below the expected average global growth of 3.5% for the same period. “Ulyukayev’s statement should be viewed as a clear acknowledgment by Russia’s leadership that the country’s economic model needs to be dramatically altered given the country’s dependence on oil and other structural and institutional deficiencies,” says Aton.

So is the Russian growth story over?

Several of the factors that have impaired growth in 2013 will drop away in 2014, but the biggest fillip should come simply from an improvement of sentiment amongst Russian businessmen.

The main positive factors for growth in 2014 include:

*Low base effect: the bad numbers in 2013 set a very low bar for 2014 and growth should pick up on a year-on-year measure on the basis of the statistical comparison alone;

*Inflation to fall: the CBR has nailed its inflation-fighting flag to the mast. Confidence in its ability to deliver should bring down inflation, as one of the factors has been the high expectation of inflation amongst the population;

*Food prices to fall: a second factor fuelling inflation was the poor harvest of 2012, which sent the price of food soaring. However, the harvest in 2013 was good and this should reduce inflation towards its core level of 4-5% in 2014;

*Interest rate cuts: falling inflation will allow the CBR to cut rates and reduce the cost of borrowing, which will help spur growth. However, the cuts likely won’t begin until the first half of 2014 and take at least six months to have a positive economic impact;

*Structural reforms: the slowdown has forced the Kremlin’s hand and it launched what could be argued are the first ever sincere attempts at making deep structural reforms epitomised in, but not limited to, Putin’s goal to improve Russia’s standing in the World Bank’s annual “Doing Business” ranking. Russia has become the best country amongst the BRICs for doing business this year (from 120th to 92nd place) and this process will continue. However, the economic benefits from these changes will take years to have a major economic impact;

*External environment: in the shorter term a general pick-up in the rest of the world increasingly seems to be on the cards and this will immediately benefit Russia, if for no other reason than it will remove fears of an imminent crisis elsewhere.

The bottom line is that recovery is on the way, but a sustained recovery will probably only kick in around the second half of 2014 ­and then only if the main growth engine shifts from consumption to investment. For the full year, the consensus is that Russia will grow by about 3% in 2014, with the more pessimistic forecasters like the World Bank predicting 2% of growth and the more optimistic predicting 3.5%.

*Political overview

Putin was clearly becoming frustrated by the lack of progress by December 2013 and has taken a more proactive role in the economy.

In the short term this will only increase nerves. As Russia is not a rule-of-law country but a rules-of-the-game country, when Putin chooses to change those rules businessmen will step back and wait to see how the new rules work before committing to new big investments. This process can take several years before confidence in the new system is achieved.

Still, Putin has taken several positive steps to improve the business climate and made the government more responsive to business needs.

In December he set up a presidential economics advisory team and formally brought former finance minister Alexei Kudrin back into the government as part of this team (notably excluding Prime Minister Dmitry Medvedev.)

Putin has been steadily ratcheting up the pressure of his anti-corruption drive as this has been identified as the main drag on growth. Russia was rewarded for the efforts already been made by going from most corrupt nation in Eastern Europe according to Transparency International annual “Corruption Perceptions Index” to least corrupt ­ largely by staying at place 127 on the list, while Ukraine and Kazakhstan both dropped down the ranking precipitously. Reducing corruption will reduce the drag on the economy.

And finally in his state of the nation speech in December, Putin cited the 19th century prime minister Pyotr Stolypin as the inspiration for political reforms in 2014. Stolypin is hailed as one of Russia’s greatest reformers and personifies a policy of decentralisation. After taking office in 2000, Putin centralised control over all the regions to retake political control of the country. Now it appears he is proposing to farm out responsibility for the local economies to the regional governors again in the hope of emulating the successes of regions like Tatarstan, Leningrad and Kaluga. If he can pull this off, then this reform could be transformational.

Commodities

* Oil

Russia remains dependent on the oil price and while a fall would cause a lot of pain, a rise will not deliver the kind of fast growth it used to. That economic model, which has benefited the country in the last decade, has now been exhausted.

Happily, the consensus is for oil prices to remain strong for the foreseeable future. Between 1999 and 2007 the oil price rallied almost 800%, but it has slowed since and by the end of 2007 it is up a mere 19%, with lower growth seen in recent years.

The Bloomberg consensus average oil-price forecast for 2014 is $107.3 a barrel ­ which means the price will stay flat over the year.

* Other Commodities

The outlook for other commodities is also uninspiring. The year-on-year changes in commodity prices on a quarterly basis for the next year are for most prices to remain where they are or fall from their end-2013 levels.

Bloomberg’s consensus estimates for the average 2014 price for oil, steel, gold and copper are actually below the current prices; only for nickel and platinum would there be upside from the current levels if the analyst community is correct, says Aton.

ECONOMICS

*GDP predictions

Given that 2013 surprised so badly on the downside, analysts are very unsure what 2014 will bring and the spread on predictions is very wide. As the cause of the slowdown is at root psychological and not economic, how the mood will change as the new year wears on is crucial.

The European Bank for Reconstruction and Development (EBRD) released its latest outlook for the CEE/CIS region in November. While the headline says growth is expected for Russia in 2014, it suggests it will be slower than previously thought. However, looking closer, the forecast is even more downbeat.

The report says the EBRD now expects a slight reduction in average GDP growth to 2.8% in 2014. However, the spread of possible outcomes is very wide indeed. The forecast baseline number is actually near the top of the range surrounding the 50th percentile (the spread that has a 50% chance of happening). In other words, there is a 50% chance that average growth will come in around 0.5 percentage point (pp) higher, but by the same token growth could also fall, only much faster. The spread has the regional average dropping to zero in summer 2014.

Going to less likely outcomes: In the best (and most unlikely as it is in the 90th percentile) case scenario, growth could rise as high as some 6% next year. But if things go really wrong, then the region would contract by around 3%. That’s a 10pp spread around a prediction of 2.8% baseline growth only six months ahead. Not a very comforting outlook.

However, on balance the outlook for 2014 is better than 2013. A low base effect will boost growth and the good harvest will bring down inflation and allow for rate cuts, but to ensure sustainable growth into the medium term the government needs to get on with deep structural reforms. A start has been made and the effects are beginning to be felt, but it was a late start and the progress will be slow. Morgan Stanley….

Read Russian OUTLOOK 2014 Part 1: Russia’s growth model runs out of steam

Read Russian OUTLOOK 2014 Part 2: Turning more bullish on Russia markets [http://www.bne.eu/story5635]

Read Russian OUTLOOK 2014 Part 3: Change afoot in Russian business and banking  [http://www.bne.eu/story5636]