Russian leaders are optimistic about the economy’s outlook, perhaps for good reason. Exports have grown steadily, rising oil prices are supporting the balance of payments, and industrial production is recovering. However, domestic consumption remains weak, casting doubt on the strength and sustainability of the recovery. While Medvedev’s ambitious plans for modernization could aid the recovery, they currently lack both details and execution mechanisms.
Signs of Strength
Russian leaders have become increasingly optimistic about the country’s economic recovery. President Medvedev’s forecast of a 7.5 percent (y/y) decline in 2009, which would require 12.5 percent growth (q/q) in the fourth quarter, is particularly positive. The Ministry of Economic Development and Trade gives a more cautious, but still optimistic, assessment of 0.6 percent (q/q) growth in the third quarter.
The rising price of oil has benefited the federal budget and the balance of payments.
Several recent developments support such optimism. First, Russian exports, in terms of physical volume, have grown steadily since spring, briefly returning to pre-crisis (i.e., spring 2008) levels this autumn, though the trend is still down.1 China, where a strong stimulus package and state accumulation of natural resources fueled growth, and Europe, where consumers took advantage of the summer’s low gas prices to stock up for winter,2 were largely responsible for this improvement.
Second, the rising price of oil has benefited the federal budget and the balance of payments, both of which largely depend on oil exports for stability. The federal budget is based on oil being priced at $41 per barrel, but since January, it has averaged $60 per barrel. The higher-than-expected price, in addition to export duties and a mineral extraction tax, boosted the budget by RUB 614 billion, or 12 percent of total federal income, from January through October.
Similarly, the current account balance, which turned negative in the fourth quarter of 2008, has significantly improved this year. As a result, the Bank of Russia was able to freely float its currency from March through August of this year. However, after facing an excessive supply of foreign currency in September and October, the Bank began intensively accumulating international reserves again, driving up the value of the ruble.3 Ironically, this appreciation, coupled with high interest rates in Russia and low ones elsewhere, is now causing the supply of foreign currency to grow again as the ruble becomes an attractive currency for carry trade.
* DD for Local Goods and Services – domestic demand for goods and services less total imports.
** AD – the sum of external demand and domestic demand for local goods and services.
Third, industrial output in Russia has been surprisingly strong, with September data showing rapid 2.5 percent (m/m) growth. However, this may simply reflect rising exports and recovering inventories (as was the case in February); several months’ data is needed to assess whether or not the growth will be sustained. Because exports are still 15 to 20 percent below their historic peak, reached in fall 2007, they have the potential for further expansion. However, many experts agree that GDP growth will be limited to 3 percent per year if external demand remains the sole driver of growth.
However, a weak outlook for domestic demand is likely to offset these strengths.
Finally, after exceeding 8 percent from January to July, consumer inflation slowed rapidly in August. As a result, inflation, which plagued Russia prior to the crisis, is expected to be significantly lower than the official government forecast of 11 percent this year, may moderate even further, reaching 6–8 percent in 2010. While the theoretical link between a recession and falling inflation is clear, Russia has never before experienced the two in tandem; the three consecutive months of zero inflation (i.e., August to October) caught many experts by surprise.
Medium-Term Weaknesses
However, a weak outlook for domestic demand is likely to offset these strengths. Real household incomes, which accounted for more than 55 percent of GDP in the first half of 2009, have declined continuously since April, falling 4.9 percent (y/y) in September alone. Incomes are expected to continue to decline at least until spring 2010,4 largely because Russia’s labor market remains weak, salaries in non-export sectors have stagnated, and wages in the public sector are not indexed to inflation. Only pensioners will see an increase in real income next year, as nominal pensions grow by 45 percent. However, while pensioners account for more than 28 percent of the population, their income accounts for little more than 8 percent of total household income. As a result, the increase in pensions will do little to strengthen domestic demand.
Government spending on investments, repairs, and renovations, which have the highest multiplier effects on the economy, must be actively reduced.
Furthermore, aggressive expenditure increases, enacted from 2007 to 2009, coupled with falling revenues, have seriously strained the federal budget. Federal budgetary incomes fell 33 percent (y/y) while regional ones declined 25 percent (y/y) from January to September 2009. Because expenditures on wages, pensions and social benefits cannot be cut, investments, repairs, and renovations, which have the highest multiplier effects on the economy, must be actively reduced instead. As a result, aggregate public demand may decline by 3.5-4 percent of GDP in 2010 from the 2009 level.
Regional governments, which receive no revenue from foreign trade and lack the authority to impose new taxes, face an even harsher fiscal reality. Only broad-based economic growth will help raise their revenues, which come from profit and income taxes. While 2009 budgets were maintained at 2008 levels in nominal terms, the current budget actually reflects a contraction in real expenditures, given the 10 percent inflation rate experienced since 2008. Wages and various social payments have increased in 2009, forcing regional governments to cut purchases of goods and services by about 2 percent of GDP. However, even these cuts were not enough to balance the budget; a gap of RUB 500 billion, or 1.25 percent of GDP, is still expected by the end of 2009.5 Preliminary assessments suggest this gap will persist in 2010 even if regional expenditures continue to remain nominally stable. The “easiest” way for regions to finance this gap is through late payments to suppliers of electricity and gas.
Other Focal Points of Public Attention
Additionally, analysts have been debating the fate of AvtoVAZ, Russia’s only remaining car producer. AvtoVAZ incurred tremendous losses in 2008, amounting to $1,000 per car sold despite record sales volumes. In 2009, the company has experienced further losses, with sales having declined by approximately 50 percent and still continuing to fall. As a result, the government took control of the company in August. The new management, which has a strong track record in private business, has developed a comprehensive restructuring plan, setting operational profit as the immediate goal, debt/equity conversion as the short-run goal, and technological renovation and modernization as the medium-run goal. Unfortunately, to achieve its first objective, the company must fire 35 to 45 percent of its 102,000 workers. However, while the government insists that the company return to health, it fears that layoffs could engender social unrest, particularly in the one city, Togliatti, where AvtoVAZ is concentrated. As a result, the government prohibited mass layoffs, thus limiting the company’s potential.
Plans for modernization lack tangible goals and execution mechanisms. However, they should not be completely discounted.
Medvedev’s and Putin’s calls for “modernization,” or radical change in the structure of the Russian economy, have also garnered attention. According to the ideas they have announced, modernization would reduce Russia’s dependence on natural resource exports and lead to the emergence of knowledge-based industry clusters, as well as massive technological innovation in industry and infrastructure. It would increase the economy’s overall efficiency. However, both leaders emphasize that they do not envisage any change in the political system as part of the plan. As of today, these plans lack tangible goals and execution mechanisms. However, they should not be completely discounted: when Mikhail Gorbachev first mentioned perestroika and glasnost in 1987, few people took notice.
Sergei Aleksashenko, former deputy minister of finance of the Russian Federation and former deputy governor of the Russian central bank, is a scholar-in-residence in the Carnegie Moscow Center’s Economic Policy Program.
1 This should not be overemphasized. More than 85 percent of Russia’s exports are comprised of six commodities—oil, gas, ferrous and non-ferrous metals, primary chemicals and fertilizers, and timber—with limited linkages to the broader economy.
2 The price of Russian gas in Europe is linked to oil prices with a 6-9 month lag. Therefore, low oil prices in December 2008–January 2009 were reflected in low gas prices this summer. Aware of this connection, European countries decreased their gas purchases in the spring and actively used stored gas instead on the assumption that they would be able to buy gas at low prices in the near future.
3 Since February, the ruble has appreciated by more than 13 percent in nominal terms against the USD-EUR basket (55% /45%), against which the Bank of Russia sets the exchange rate.
4 Projections are the author’s, unless otherwise noted.
5 Putin highlighted this issue in early September, assessing regional debt at Rub 160 billion (0.7 percent of GDP) as of September 1.
