ECONOMIC RECOVERY IN RUSSIA

By A.I. Kolganov

THE COMPONENTS OF THE FAVORABLE CLIMATE

For more than two years now, Russia has seen growth in all the major economic indicators. Most analysts ascribe this to two factors. The first is the increase in world prices for the goods which Russia traditionally exports–particularly oil, but also metals, wood, chemical and petrochemical products. The second is the import substitution process on the domestic market which began after the ruble devaluation crisis in August-September 1998.

This second factor may serve as a long-term stimulant to growth, as long as the growth in production in those sectors which provide import substitution (the food, chemical and light industries) has a sufficient knock-on effect in other sectors, increasing demand for their products. Additionally, this growth brings with it an increase in workers’ incomes, resulting in a growth in demand on the domestic market.

The first factor is much less stable and predictable. A fall in world oil prices is already imminent, due to the increase in the production quota announced by OPEC countries. Meanwhile, the favorable conditions on the international raw materials and energy markets form the basis of the financial policy currently being pursued in Russia. The high earnings in export-oriented sectors are the main source of the increase in tax contributions to the budget and offer the hope that Russia may be able to meet its obligations in servicing its foreign debt. Meanwhile, the decree passed by Yevgeny Primakov’s government requiring exporters to sell their hard currency proceeds on the currency market ensures that there is a sufficient supply of hard currency for the domestic market and slows down the decline in the ruble exchange rate. The Central Bank is able to augment its currency reserves and maintain a policy of moderate inflationary funding for industrial growth.

THE START OF AN ECONOMIC RECOVERY?

A number of economists are now quite optimistic about the current economic growth. They are forecasting the start of a long-term economic recovery in Russia. This viewpoint enjoys particular currency among keen supporters of the reform strategy which the Yeltsin administration pursued. They believe that for all the mistakes and costs which accompanied the reform program, it has at last begun to bear fruit, and the market economy in Russia has begun functioning properly.

The main arguments adduced by these optimists go like this: First, it is not the oil and gas industries which are driving the current economic growth in Russia, because the volume of production in these sectors is growing more slowly than in most other sectors. Second, the economic growth has affected not just the primary products and processing industries, but also the engineering industry. Third, for the first time since the reforms in Russia began, investment in production has begun rising–by 6 percent in 1999. And, fourth and finally, Russia has significant potential for economic growth in the shape of its huge excess production capacity. According to research by the McKinsey Global Institute, which received wide publicity last year, Russia has enough excess capacity to support stable economic growth of 8 percent per annum.

These favorable opportunities are matched by equally favorable macroeconomic trends. Inflation last year was 24 percent; this year it is not expected to exceed 16-18 percent. The budget deficit has been virtually wiped out. The volume of tax collection has increased. The level of mutual debts between companies has significantly decreased, as has the proportion of non-monetary transactions between them.

This optimism is given further confirmation by the impressive growth in Russian industry at the start of the current year. The volume of industrial production in February 2000 increased by 14 percent on February 1999.

SHORT-TERM OPTIMISM AND LONG-TERM PROBLEMS

Despite such impressive successes, many Russian analysts are nevertheless cautiously skeptical, and some point to worrying long-term factors which may threaten this fledgling recovery. Moreover, they are not persuaded by the arguments of the optimists. Although the fuel and energy industry is not the leading sector in terms of rate of economic growth, it is this sector which, relying on high oil prices, has until now provided the lion’s share of export revenue and also ensured the increase in tax contributions to the budget. Other sectors which have seen a marked recovery either also form part of the primary products complex, or are involved in the processing of primary products, or produce consumer goods, relying on the effect of import substitution for their growth. However, neither the advantageous conditions on the world primary products and energy markets nor the import substitution effect can last forever.

The growth in production of investment goods (engineering products and building materials), just like the growth in investments, is not significant enough to form a stable basis for industrial recovery. The previous fall in investment and decline in production in the investment complex were extremely grave (over the reform period investment in basic capital fell more than fourfold, and the actual commissioning of new production capacity fell even more significantly). Thus this new growth in investments is not yet enough even to allow for obsolete and useless equipment just to be replaced.

The growth in industrial production in February is hardly a serious argument. No self-respecting economist would draw far-reaching conclusions on the basis of economic behavior over one month. Particularly in view of the fact that production in February increased by a mere 1.3 percent compared with January 2000.

Agriculture is still in a catastrophic state. The small growth in supplies of agricultural equipment does not provide grounds for optimism, given that the bulk of agricultural enterprises remain insolvent. If this situation does not improve dramatically in the next few years–in other words if there is no growth (at least twofold or threefold annually) in supplies of agricultural machinery, equipment, mineral fertilizer, chemicals to protect plants and so on–then by 2005 Russian agriculture will be forced to significantly reduce the area of cultivated farmland.

As regards the considerable volume of excess production capacity, qualitatively this capacity may indeed be enough to provide economic growth of 8 percent for the next four or five years. However, the quality of the idle capacity completely rules out such a possibility. It should not be forgotten that the crisis in the Soviet economic system was in many ways linked to the USSR’s technological backwardness compared with the developed countries of the West. The vast majority of production capacity in Soviet enterprises was incapable of producing competitive (by world standards) goods. This situation has not improved over the years of radical market reform. In fact, it has dramatically worsened.

During the privatization and “market restructuring” of Russian enterprises, a transition was made to more primitive technologies and the production of less sophisticated products. As a result, much of the more up-to-date industrial equipment was dismantled and sold at scrap-metal prices. Very often the equipment was left to the mercy of fate and became useless. The better-qualified workers, engineers and researchers abandoned Russia’s industrial enterprises.

Even in those enterprises which tried to maintain their technological standard and even attempted a partial modernization of production, the situation is not a whole lot better. The dire lack of investment in the 1990s meant that the entire stock of Russian industrial equipment quickly became obsolete. Now some of it is simply doesn’t work, and the rest, while still operational, is unable to produce goods which meet the necessary technical requirements.

For example, Russia’s motor industry has significant volumes of excess capacity. But this capacity cannot produce cars that can compete on the world markets, and their competitiveness on the domestic market is only maintained through high protective duties. Russia still boasts a major research and development potential, but even the most promising designs, which far surpass world standards, have no prospect of being produced in Russia: There is no investment and no equipment capable of producing world-class products.

THE PROSPECTS FOR ECONOMIC RECOVERY

The worst thing that Russia’s leaders could do now would be to let themselves be distracted by the optimistic forecasts for economic recovery and fail to ensure that a truly firm basis for this recovery is put in place. Unfortunately, the signs at the moment are that the economic advisers brought in by Vladimir Putin’s new administration are continuing to nourish the illusion that continuing the previous economic strategy will be enough to ensure Russia’s economic well-being. This is a grave error.

The fall in oil prices will affect the economic situation in Russia this year. It is also unlikely that today’s favorable climate on the primary products market will hold for more than a year. The opportunities for import substitution, relying on exploiting excess production capacity, will probably be exhausted within the next two years. By 2005 Russia will begin to see a serious deficit in production capacity in a number of key industries–electricity generation, oil production and transportation, agriculture, and possibly a number of other sectors. In a different economic climate, in five years it might have been possible to avoid such dangers by modernizing these industries on a massive scale. However, the economic system established in Russia today lacks the practical economic tools to mobilize the required volume of investments. Those investments that have resulted from the current economic growth are not nearly enough to cope with the problems caused by the protracted degeneration of Russia’s production potential.

It would be tragic if the need for a change in economic policy is only realized when Russia’s economy encounters long-term problems head on. If this happens, the price of the enforced economic maneuvering may be a very high one, and the social and political costs could be very grim.

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