NO SURPRISES

By Andrei Kolganov

There is nothing surprising in the fact that the economic revival in Russia which began in late 1998 is now giving way to stagnation. Even when the recovery was only just beginning, independent experts were pretty accurate in their predictions of how long it would last: If Russia’s economy was going to develop by inertia, then the factors which brought about the economic upswing would play themselves out in about two to two-and-a-half years. And that’s exactly what happened.

ECONOMIC GROWTH HALTED

The signs of an imminent downturn were already quite visible in the middle of 2000. Although the macroeconomic situation remained favorable (inflation was averaging no more than 1.5-2.0 percent per month, the money supply was slowly growing, the degree of monetization of the turnover of goods and services was growing, individual incomes were growing in real terms, and companies’ long-term debts were decreasing), there were dangerous symptoms building up in the production sector. There was a downturn in company profitability in almost every branch of the economy. The short-term investment boom–which in any case had not affected all industries–began to drop off. In a number of branches of the manufacturing industry, particularly in the consumer sector, investment growth did not simply slow down, but actually started to decline. The decline in profitability and fall in investments were directly linked, because over two-thirds of investment in Russian companies’ capital assets comes from their own funds.

At the end of last year, these alarming symptoms were dramatically confirmed. In the last two months of the year, economic industrial growth gave way to a small decline in production. Does this mean that all the opportunities for economic growth have been exhausted, and the Russian economy is heading for another downward spiral in the protracted crisis?

There is no simple answer. Events may take various turns. To understand what realistic prospects for economic growth remain in Russia, we need to examine the reasons for the upswing that has now come to an end.

WHERE DID THE RECOVERY COME FROM?

In contrast to the stagnation now looming over us, the economic upswing of the last two years was truly unexpected. The catalyst was the abrupt change in Russia’s economic policy in 1998, which external factors necessitated. The growing pyramid of domestic and foreign debt and the inability of the government to resolve this problem through a rational macroeconomic maneuver resulted in the financial collapse of August 1998. The fourfold devaluation of the ruble created highly favorable conditions for Russian exports (which were suffering at the time from an unfavorable world market) and adverse conditions for import. As a result, there was an increase in export incomes and economic growth in industries providing import substitution (mainly in consumer products) on the domestic market. Primakov’s government exploited this growth in export income by making it compulsory for exporters to sell all their hard currency proceeds, which enabled the government to stabilize the currency market and secure an increase in tax revenue for the budget.

A second factor was the general rise in world prices for oil and some other primary products, which began in 1999. This did not simply increase the inflow of export income and tax revenue, but also had a strong knock-on effect on the economy. In the fuel and primary industries there was a growing demand for pipelines, drilling equipment, construction equipment and other engineering products. Investment in the oil sector grew at an annual equivalent rate of more than 90 percent.

A third factor–which does not get very much coverage, but which had a major effect on the economic situation in most secondary industries–was the fact that wages were halved in real terms as a result of the August 1998 financial crisis. This considerably reduced companies’ production costs, increased profitability and allowed them to increase investment in their capital assets. In addition, this reduction in real incomes was an additional factor governing the shift in consumer demand away from imported products towards domestically produced ones.

THE LIMITS OF MARKET GROWTH

This brief review of the factors influencing the economic recovery demonstrates that none of them was of a long-term nature. The world market is now gradually shifting towards a reduction in prices for fuel and primary products. Given the worsening economic conditions in the United States and the prospective depression in European economic activity, the trend towards a reduction in prices for these products will become even more marked. Import substitution in Russia’s domestic market has already played itself out. It is not merely that the balance between imported and consumer goods on the domestic market has been restored: In 2000, as real incomes grew, there was a steady increase in the share of imported goods being bought by consumers.

A growth in incomes in real terms naturally creates a general increase in demand on the consumer market. However, this increase in demand mainly affects imported rather than domestically produced products. In addition, a growth in real incomes counteracts the advantages gained by a reduction in labor costs.

All these considerations were quite evident two years ago. In order to ensure longterm and stable economic growth, the essential thing should have been to give the recovery an additional boost with some long-range strategies. The key one should have been to embark upon a modernization of the capital assets of the Russian economy.

THE “2003 PROBLEM”

This is the name given in Russia to the problem of the serious aging of the capital assets. This was already a problem before the radical market reforms even began. The reforms themselves, which led to a fourfold cut in investment in capital assets, greatly exacerbated this problem. Between 2003 and 2005 a considerable proportion of the capital assets in such sectors as agriculture, energy, pipeline transportation, and the housing and utilities infrastructure will urgently need replacing. The winter of 2000-2001 has seen major failures in the heating supply system, gas leaks and explosions, and prolonged power cuts in a number of regions; these were only the first warning signs of the impending problem.

Russia must face the fact that it has no option but to implement a massive overhaul of the capital assets in almost every branch of the national economy. However, even the growth in investment which accompanied the economic recovery of 1999-2000 was not nearly enough to redeem the situation in any meaningful way. The government’s current economic policy simply ignores this problem. Officials responsible for the economy continue to speak smugly of an economic upturn. And even when the problem is acknowledged–as with electricity–hopes for a solution are pinned on a market-based restructuring which is supposed to secure an influx of foreign investment on its own. For some reason the dismal results of the market-based restructuring of energy in California have not put our reformers off.

However, the secret to ensuring long-term economic growth lies precisely in resolving the problem of overhauling the capital assets. This is an extremely tough challenge, because the country is still suffering from a major lack of investment (both in terms of money and ideas). Mobilizing investment is of defining importance for the economy, because only a broad-scale modernization of the capital assets is capable of creating a rising domestic market for the manufacturing industry in the long term, and at the same time ensuring that Russian products become increasingly competitive.

A YEAR WASTED

The Putin administration which came to power in early 2000 has done nothing in the last year–not only in terms of developing a strategy capable of providing for an overhaul of the capital assets, but also in terms of eliminating those economic threats which are visible today. This is universally recognized, and the influential business magazine Expert writes about this quite openly. But does this mean that the worst case scenario has been realized?

There are serious grounds for doubting that things would have changed for the better even had the Putin administration and the Kasyanov government adopted a more proactive approach. The government’s and the president’s existing draft solutions for a whole range of serious economic development problems (restructuring transport and energy, reforming the pension system and the housing and utilities infrastructure, and reforming education) are based on inertia and the single-minded liberal approaches which have already brought Russia seven years of harsh economic crisis. Applying them to the current situation would mean that instead of stagnation or weak, unstable growth, the country would be subjected to a new edition of the crisis.

All these reform projects have one feature in common. They all imply an increased burden on the end user, be it companies (as customers for electricity or rail services) or ordinary people (who will have to pay more for rail tickets, electricity and education, and make extra contributions to the pension system). Much we are told of the benefits of these reforms in the long run, however, their immediate effect will be a rapid and significant shrink in demand on the domestic market, which will have a depressing effect on the economy and will inevitably bring about a decline.

Engineering a decline is an easy trick–one our government is quite capable of. But the government failed to harvest the fruits of the recovery which caught it unawares, and failed to create the conditions necessary to allow it to allocate resources for an accelerated renewal of the capital assets. It did not even manage to balance the budget, when all tax collecting targets had been more than met. And again, all hopes are being pinned on the idea that the “market will sort everything out”–all we need is a market-based restructuring of this or that industry, or this or that branch of the economy. The only good news is that neither the president nor the government seem to be in any hurry to implement these solutions.

IT’S NOT ALL THAT BAD

Are there any favorable prospects for the Russian economy? It is hard to believe so–too many problems have accrued. However, we should not paint too gloomy a picture. There is no crisis looming in the short term. The Russian economy probably faces a slow down in the rate of development, and a period of slight decline. Even the mounting problems of upgrading equipment in various sectors of the economy will not in itself bring the economy to its knees. However, delaying their solution, in unstable market conditions, is fraught with risks. There is still some time in hand before these risks will pose a direct threat. This time could be used to find solutions.

Andrei Kolganov is a doctor of economics and a senior research fellow at Moscow State University.