Publication: Monitor Volume: 7 Issue: 60

Russia’s State Statistical Office announced on March 19 that industrial output in February was only 0.8 percent higher than it had been in February 2000. February marks the third consecutive month of falling or low industrial output growth, and as such raised questions about the durability of Russia’s surprisingly strong recovery from the August 1998 economic crisis. That Russia’s recovery has been driven by the industrial sector, and by manufacturing enterprises in particular, makes these questions all the more pressing.

Russia’s accelerating economic expansion–GDP growth has been officially reported at 3.5 percent for 1999 and 7.7 percent for 2000–was made possible by 8 percent growth in industrial output recorded in 1999, and by 9 percent industrial growth in 2000. The industrial expansion was driven by production growth in the manufacturing sector, which averaged 12 percent during 1999-2000. By contrast, output growth in the energy sector averaged only 3 percent during this time. This was not a coincidence: Government regulatory agencies after August 1998 protected Russia’s energy-intensive manufacturing sector by ensuring that energy prices rose much more slowly than prices overall. Relative to industrial prices overall, prices for gas and electricity dropped by 20 and 40 percent, respectively, during 1999-2000. Along with the weak ruble which followed the collapse of the exchange rate after August 1998, cheap energy allowed Russian manufacturers to under price their competitors on foreign and domestic markets. Production in chemicals and light industry therefore grew by 40 percent or more during 1999-2000, while output in ferrous metallurgy and machine building rose by a third.

The gravy train for the manufacturing sector, however, is now coming to a halt. Whereas industrial producer price inflation had fallen to 29 percent in January, inflation rates for electricity and gas tariffs had risen to 40 and 65 percent, respectively. Moreover, United Energy Systems (UES) and Gazprom–Russia’s electricity and gas monopolies–are increasingly demanding payment in cash, rather than accepting settlement in barter, promissory notes or other monetary surrogates. UES was collecting 75 percent of its revenues in cash in December (compared to 30 percent at the end of 1999), while Gazprom’s cash take had risen from 40 percent to 67 percent. The shoe is now on the other foot: The Russian government is permitting the energy monopolies to force higher prices on the manufacturing sector. The disastrous winter in Primorsky Krai–where thousands of Russians suffered through months of inadequate electricity and heat supplies–seems to have convinced the government that UES in particular needs to be able to charge higher prices to cover the costs of maintaining Russia’s electricity infrastructure (Wall Street Journal, March 20; Sotsial’no-Ekonomicheskoye Polozhenie Rossii, February 2001).

And higher prices for UES may already be paying dividends. After dropping 5 percent during 1999-2000, production of thermal energy rose 3 percent during December 2000-February 2001 (compared to the same period in 1999-2000). Along with the oil sector–which continues to benefit from high export prices–UES’s turnaround during the last three months helped energy output to rise 4 percent during this time. But now that manufacturers are increasingly paying the full costs of the energy they use, production growth is coming to a virtual standstill. Output growth in this sector has slowed to only 2 percent in the last three months. Ferrous metallurgy, which reported 32 percent output growth during 1999-2000, did not register any output growth at all during December 2000-February 2001. Virtually no output growth was reported in the energy-intensive wood and paper products and construction materials branches as well.

The manufacturing sector is not only subject to rising energy costs, but is increasingly feeling the effects of the firmer ruble. The exchange rate has been stable at around US$1=28 rubles since early 2000, while industrial producer prices rose 40 percent during this time. Inflation has driven up the value of the ruble in real terms, cutting into the profitability of exports and making imports more affordable. Volumes of imported light automobiles and trucks rose 35-40 percent last year, while imports of beer and butter rose 45-50 percent in volume terms. Surging imports kept production growth in the machine-building branch to only 1 percent December 2000-February 2001, while food processing output dropped slightly during this time.

The response of Russian manufacturers to higher energy prices and a firmer ruble has to date been one of the great unanswered questions of Russia’s economic recovery. The official data for the last three months suggest that the answer is not pretty, and that the manufacturing sector continues to be full of white elephants. On the other hand, the fact that thermal energy production has stopped falling thanks to rising prices and better cash flow bodes well for preventing a repeat of the “Primorsky Krai” scenario of collapsing energy infrastructure.