Russia: No quick fix

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Russia: No quick fix

Russia: No quick fix

Global Economic Outlook, Q1 2014

Subdued investment, weak export markets, rising household debt, declining confidence, and deteriorating demographics continue to weigh on Russia’s economy.

Russia’s economy continues to face short- and long-term challenges, so it was not surprising when growth disappointed in the third quarter as well. Industrial activity was weak, investments remained subdued, and oil revenues were weighed down by slowing global growth. More worryingly, consumer lending growth shows no sign of returning to manageable levels, thereby posing risks for the financial sector and consumer spending. The latter has been a key driver of economic activity, and any hit to this segment will hurt economic growth. Meanwhile, policymakers face the daunting task of pushing up potential GDP growth. To this end, they need bold reforms to expand the private sector, diversify the economy, boost entrepreneurship, invest in knowledge, and tackle corruption.

Industrial activity was weak, investments remained subdued, and oil revenues were weighed down by slowing global growth.

Economy chugs along in the third quarter

Real GDP grew 1.2 percent year over year in Q3 2013, the same pace as Q2 and much below the high growth rates (around 7 percent) experienced before the global downturn of 2008–2009. Trends haven’t changed much since Q2; fixed investment growth is lingering in negative territory. Investments are not likely to revive sharply in the short term, given subdued demand and the curtailed investment plans of public sector behemoths. Meanwhile, industrial output also fell in Q3; figures for October show no improvement, and output is down 0.1 percent year over year. Other indicators lend credence to a gloomy short-term scenario for industry. For example, new car sales dipped 8 percent year over year in October despite a government program initiated in July to lower the cost of car loans.

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Russia_figure2-Retail_sales_growth

Growth in consumer expenditure is also likely to have fallen in Q3 due to increasing concerns about the economy, rising household debt, and declining consumer confidence. This is worrying because consumer expenditure has been a key driver of economic growth in the past few years, especially with subdued investments and exports. The dip in consumer spending growth came about despite real wage gains due to a tight labor market and slowing inflation. Given that the contribution of consumer spending to the economy is likely to weaken further in 2014–2015, it is imperative for policymakers to revive investment and exports.

Bank of Russia warns against high consumer lending

Concerns about consumer lending refuse to die down, and the Bank of Russia (BOR) noted risks from the segment to overall stability in the financial sector. Consumer loans have been rising at a fast pace, and banking sector experts warned of a potential bubble in 2014. The unsecured segment, in particular, is worrisome. Despite central bank intervention and warnings, unsecured retail loan growth was still high at about 37 percent year over year in September, but this was lower than the above-50 percent growth in the beginning of the year.

The problem for consumers and banks is on two fronts. First, for banks, the share of short-term loans in the total loan portfolio has increased over the years as they cater to rising consumer demand for unsecured credit. Households in Russia have been increasingly turning to credit to fund their purchases, including durables. Second, for consumers, debt-servicing costs remain high due to tight monetary policy; the average cost of debt as a share of household disposable income stood at 20 percent at the end of 2012. This poses risks for consumer finances and, in turn, bank profitability. Currently, non-performing loans amount to 7.7 percent of total loans, up from 5.9 percent in the beginning of the year. The International Monetary Fund has cautioned on this trend, advising BOR to adopt ceilings on loan-to-value and debt-to-income ratios.

The clouds dominate, but they are not so dark

In Q4 2013, a slight uptick in economic activity is expected due to a low base. However, it will not be enough to propel annual GDP growth beyond 1.5 percent, lower than the government’s revised forecast of 1.8 percent. Growth is likely to pick up, albeit moderately, in the latter half of 2014 due to monetary policy easing starting sometime in Q2 2014. Nevertheless, the central bank is expected to remain hawkish with cumulative rate cuts of not more than 100 basis points next year.

Hydrocarbons account for nearly two-thirds of Russia’s exports and half of the government’s revenues.

The economy will receive a boost from the stimulus measures announced earlier this year. Although the government is yet to provide details, it is expected to spend $40–50 billion on infrastructure and sops to industry, especially small and medium enterprises. This could boost fixed investment; growth in the segment is likely to rise to 4.5–5.0 percent by the end of 2015. However, until medium-term challenges are tackled, any sharp reversal in capital outflows is not expected. According to the BOR, net capital outflow is set to touch $62 billion this year, up from $56.8 billion in 2012.

Russia_figure3-GDP_growth_russia

An overreliance on commodities

Russia’s overreliance on hydrocarbons makes its growth heavily dependent on the fortunes of the global economy. Hydrocarbons account for nearly two-thirds of Russia’s exports and half of the government’s revenues. Of late, global economic growth has been slowing with emerging giants like China and India dipping to a lower growth trajectory. What has added to woes is a revival in oil in the United States due to the discovery of recoverable shale deposits. So, with oil prices declining by about 9 percent since Q1 2012, Russia’s GDP growth has declined from 4.8 percent to 1.2 percent during this period. Meanwhile, in the realm of public finances, public debt and deficit are manageable. However, the non-oil budget deficit is a concern. According to the Economist Intelligence Unit, Russia’s non-oil budget deficit is expected to rise from 3.6 percent in 2007 to 10.3 percent of GDP in 2013.

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Meanwhile, reserves where oil can be easily extracted are slowly declining. This spells trouble for Russia’s hydrocarbons sector, given that any new exploration has to focus on remote areas like the Arctic and on shale formations in Bazhenov, Siberia. Although the latter is rumored to hold as much as 100 billion barrels of recoverable oil, the formations under it have not been extensively explored. So, the complexity of the extraction process is not yet clear to investors. At the same time, its remote location implies that setting up the requisite infrastructure for oil exploration, drilling, and transportation would require large investments. Given this and the complexity of extraction from shale, the cost of production is likely to be high. A review of the taxation structure has been an encouraging development in recent months. Companies operating in Bazhenov will not need to pay the mineral extraction tax. Thus, the government is also considering cutting their export duty liabilities.

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Other medium- to long-term challenges

A key medium- to long-term challenge for Russia’s economy is the country’s ageing population. According to projections by the World Bank and United Nations, the share of 15–64-year olds in total population is set to decline from 71.1 percent to 68.7 percent between 2013 and 2018.1 To offset the economic impact of this, productivity has to be increased through large investments in both physical and human capital. Unfortunately, fixed investment as a share of GDP is currently low (average of 21.3 percent between 2007 and 2012) relative to emerging-economy peers like China (44.1 percent) and India (30.4 percent). Human capital is another area where Russia’s edge is quickly eroding. The World Economic Forum’s human capital index ranks Russia 51 among 122 nations, with managerial talent in particular ranking pretty low.

What compounds the misery in Russia is its lack of a diversified and sound private sector.

What compounds the misery in Russia is its lack of a diversified and sound private sector. Currently, institutional factors like the strong presence of the state in the economy and widespread corruption explain, to a large extent, the lack of entrepreneurial culture as well as sound managerial talent. No wonder then that Russia ranks low in measures of global competitiveness. According to the World Bank’s ease of doing business survey, Russia ranked a dismal 92 in 2013.2 This is an improvement over its 2012 rank (112) and is above China (96), Brazil (116), and India (134) for the year. Nevertheless, with the current pace of economic reforms, it has a long way to go before attaining President Putin’s objective of making the country one of  the top 20 places to do business.

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Recognizing the country’s medium-term weaknesses, the Ministry of Economy recently downgraded its average annual growth forecast until 2030 from 4 percent to 2.5 percent. This is lower than the expected global growth figures (3.0–3.5 percent) for that period. To regain the initiative would be a tough task and will require bold economic policy. Unfortunately, given the current trends in governance, this is not likely to happen very quickly.

Endnotes

View all endnotes
  1. Oxford Economics database, “WDI population ages 15–64 (% of total) (Russia).”
  2. World Bank, “Ease of doing business index” (1=most-friendly business regulations), 2013, http://data. worldbank.org/indicator/IC.BUS.EASE.XQ?order=wbapi_data_value_2013+wbapi_data_value+wbapi_ data_value-last&sort=desc, accessed December 17, 2013.

About The Author

Akrur Barua

Akrur Barua is an economist and a manager at Deloitte Research, Deloitte Services LP.

Global Economic Outlook, Q1 2014: Russia
Cover Image by Jessica McCourt