Russia: Back to growth, but economic diversification remains a challenge Global Economic Outlook, Q3 2017

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​Although Russia’s economy seems to be on the path to recovery, growth in 2017 is unlikely to be robust. The longer-term growth outlook will, in large part, be determined by the success of its import substitution strategy and ability to make headway into new markets amid Western sanctions.

Introduction

The Russian economy continues to recover. Indicators point to a third straight quarter of growth in real GDP in Q2 2017. Industrial production, after dipping in February relative to a year ago, has grown each month through May; real retail sales, after having declined every month relative to a year ago for more than two years, edged up in April and accelerated in May; and real disposable income growth has gathered pace (figure 1).1 A third quarter of year-over-year growth is likely to put Russia firmly in the black and set the stage for quicker annual growth in 2017.

During the last couple of years, one of the policy strategies that Russia accelerated through a combination of a weak Russian ruble, Western sanctions, and a self-imposed embargo on food imports was import substitution. The strategy aims to build self-sufficiency and diversify the domestic economy by providing purchase and subsidy assistance to certain sectors in order to boost nonhydrocarbon exports. While import substitution appears to have shown short-term benefits in the agriculture sector, its benefits in the manufacturing sector and on the economy as a whole are yet to be proven. The major determinants of the long-term success of this strategy, apart from the calculated selection of which sectors to target, are the level of investment in those sectors and Russia’s ability to access and compete in new markets. A pivot toward the east is evident as Russia receives increased funding from China. However, Chinese investment in Russia remains closely tied to energy requirements, and Russia’s access to new export markets has not yet materialized. Furthermore, with policy loosening likely to slow, oil prices likely to remain weak, and Western sanctions likely to remain in place through the medium term, growth in 2017 is unlikely to be robust.

Indicators point to a third straight quarter of growth

Russia’s import substitution strategy remains a risky bet

Russia’s increased emphasis on import substitution in agriculture and certain manufacturing sectors (metal production; machinery and equipment; cars, sea craft, airplanes, and spaceships) was under pressure from two factors. The primary factor was the precipitous weakening of the ruble between mid-2014 and the end of 2015 in response to a collapse in global oil prices. The significantly weaker ruble translated into higher import prices for Russian businesses and consumers. The other factor contributing to the acceleration of import substitution was the sanctions imposed by the United States and the European Union, as well as Russia’s counterembargo on the import of food from certain countries in the European Union and elsewhere. While the sanctions imposed by the West meant that Russian manufacturers can no longer import machinery, equipment, and other intermediates from these destinations, the Russian embargo on the import of food meant higher domestic prices or, in some cases, the unavailability of food products for Russian consumers. While the economic incentive behind import substitution is self-sufficiency and diversification of the economy away from a dependence on hydrocarbons, the political incentive is greater sovereignty.

While the economic incentive behind import substitution is self-sufficiency and diversification of the economy away from a dependence on hydrocarbons, the political incentive is greater sovereignty.

On the surface, the strategy of import substitution appears to have benefitted Russia’s agriculture sector in the short term. Domestic production of pork, for instance, has increased to a level of self-sufficiency.2 More significantly, a surge in the production of grains, particularly wheat, resulted in output reaching a record high in 2016.3 In fact, Russia was the world’s largest exporter of grains in 2016.4 Agriculture surpassed arms as the country’s second-largest export after oil and gas during the year.5 However, recent growth in the sector can be partially attributed to improved land management and favorable weather. Nevertheless, Russian authorities claim import substitution in agriculture will help the country move closer to self-sufficiency in certain products while boosting exports in others.6 But this comes at a cost to consumers. In the first half of 2016, expenditure on food was more than a third of total household expenditure.7 Even though inflation has slowed and real disposable income is growing, households are likely to continue paying comparatively more for domestically produced food products that were earlier imported. Furthermore, quality is unlikely to remain at par.

While investment in agriculture grew strongly in 2016, investment in manufacturing declined during the year (figure 2).8 However, the import substitution of capital goods is likely to require large investment in the development of skills, technical know-how, and manufacturing capability. Furthermore, only 10.0 percent of Russia’s manufacturing workforce is not directly linked to the hydrocarbon sector.9 In fact, most of Russia’s manufacturing output is consumed domestically and is not globally competitive.10 This is likely to make diversification away from hydrocarbons in the manufacturing sector a challenging task.

More than half (60.0 percent) of Russia’s manufacturing imports are intermediate capital goods used for further production.11 Studies across countries reveal that industries that have a higher share of imported intermediate goods tend to be more productive than industries that have a lower share of imported intermediate goods.12 The same logic has been found to apply to companies.13 In Russia, firms that import manufacturing intermediates enjoy 20.0 percent higher labor productivity compared with firms that do not import intermediates.14 In short, access to imports of high-quality, cheap, intermediate capital goods is a key determinant of competitiveness in manufacturing. Import substitution in the manufacturing sector could lead to an overall erosion in the competitiveness of the sector due to the production of lower-quality manufacturing intermediates that are expensive to produce domestically. This would be counterproductive to the administration’s goal.

Investment in agriculture grew strongly while investment in manufacturing declined in 2016

Overall, import substitution has potentially negative effects. In theory, especially when an economy is at full employment, import substitution leads to the transfer of resources from efficient sectors of the economy that function competitively without protectionism to inefficient, protected sectors of the economy, leading to an overall reduction in efficiency, competitiveness, and welfare in the long term. In Russia, rather than firing workers, the widespread practice is to build up wage arrears. Furthermore, labor mobility is usually unresponsive to systematic late payment. In such a situation, import substitution, while resulting in short-term improvements in certain sectors, could also result in the transfer of labor and other resources from productive to unproductive parts of the economy, leading to an overall loss. On the contrary, if import substitution is successfully applied to sectors that fuel higher output across the entire economy, then the overall loss to welfare might be overshadowed by the gains. This would require a carefully calibrated investment plan as well as access to and the ability to compete in new markets.

If import substitution is successfully applied to sectors that fuel higher output across the entire economy, then the overall loss to welfare might be overshadowed by the gains.

Russia’s pivot to China continues to be driven by the energy sector

One of the most important obstacles facing Russia’s economic diversification efforts is the inability to access Western financial markets. As a result, Russia has adopted a policy that pivots to the east, particularly to China. However, it appears that China’s credit line to Russia in recent years has been closely linked to the energy sector and China’s future energy requirements. In 2014, China signed a $400 billion, 30-year gas supply deal with Russia.15 In March 2016, the Bank of China extended a $2.2 billion, five-year loan to Russia’s largest state-owned gas producer.16 In April 2016, two Chinese state-owned banks agreed to extend $12 billion in funding for a Russian liquefied natural gas project in the Arctic.17 Additionally, it was announced in July 2017 that China will extend renminbi-denominated funding worth $11 billion to two Russian state entities.18 Part of this funding will go toward joint cross-border investment in China’s One Belt One Road initiative, which requires sizable investment in infrastructure and a steady supply of cheap energy. A significantly smaller part of the funding will go toward supporting innovation in Russia.19 In fact, China’s direct investment in Russia fell from $1.3 billion in 2014 to $645 million in 2015 and $350 million in 2016.20 Overall, net foreign direct investment inflow increased in 2016 after declining for two years, but the increase was driven by investments in mining and quarrying of fuel and energy materials (figure 3).21 The inability of other sectors to attract sufficient funding is likely to remain a challenge. As a result, Russia’s forward linkages into global value chains are likely to continue being dominated by the hydrocarbon sector.

Investment in mining and quarrying of fuel and energy materials dominated net FDI inflows

Policy and growth outlook

Russian sovereign debt continues to remain attractive to international investors in search of higher yield, as its two-tranche, dollar-denominated eurobond placement of $3 billion attracted demand of over $6 billion in June.22 This is in continuation of a successful return to the international debt market in 2016. Russian companies have also been raising funds in the international debt market, with the level of eurobonds issued in the first five months of the year almost equal to the total debt issued in 2016.23

International interest in high-yielding Russian debt is likely to lend support to the ruble, which, in turn, is likely to lower inflation. However, global crude oil prices, which have been trending down in 2017, are likely to have the opposite effect—weakening the ruble and fueling inflation. In fact, inflation accelerated to 4.4 percent in June from 4.1 percent in May.24 Though the increase was primarily due to a temporary rise in fruit and vegetable prices, a continuation in the downward trend in oil prices could feed into higher inflation in the months to come. This risk is likely to have an effect on monetary policy easing. The Bank of Russia cut the policy interest rate by 25 basis points in June, slowing down from a 50-basis-point cut in April.25 If oil prices drop further, interest rates might have to be put on hold or raised.

In terms of fiscal policy, the Russian administration is likely to stay the course of fiscal consolidation. The budget for the current fiscal year was planned assuming a crude oil price of $40 dollars a barrel. Since oil has remained above this mark for most of the fiscal year, it is likely to contribute to higher government revenues and a lower fiscal deficit in 2017. Moreover, the Russian administration has assumed an oil price of $40 a barrel for the next three fiscal years.26 However, failure of the existing production reduction agreement, increased shale oil production in the United States, or higher oil production in Iraq, Libya, and Nigeria could result in lower global oil prices, which, in turn, would delay budget balance in Russia.

Given the existing risks, the short-term outlook is that Russia’s return to growth in 2017 is unlikely to be robust. The World Bank projects a growth rate of 1.4 percent.27 Long-term growth is likely to be determined by the impact of Russia’s import substitution policy, which, in turn, will be influenced by the trajectory of oil prices and the likely continuation of economic sanctions.