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Russia’s economy grew by close to 4 percent in 2010. Compared with developed economies, this was a robust achievement, given the uncertainties faced by the global economy and the continuing debt crises in some small European economies. These economies could still endanger the stability of the European economy more widely, and thus cast a shadow on the prospects of Russia’s major trading partner.

Still, Russia’s growth was about 1 percentage point lower than was generally expected a year ago. Inflation was slightly higher. These differences can be explained largely by the extreme summer weather and numerous forest fires that plagued the country. As a result, Russia’s grain harvest was about 25 percent below the recent average. While Russia has emerged as a major exporter of grain — especially of feed wheat — in past years, it banned grain exports last August; the ban remains in effect until this summer.

On the positive side, the price of oil has surpassed the levels foreseen by markets and expected by Russian policy makers. Instead of $80-85 per barrel, the market price has exceeded the $100 level. Consequently, Russia’s annual budget deficit remained below 4 percent of GDP, when a deficit topping 5 percent of GDP had been expected. If oil prices continue to rise, Russia could balance its budget sooner than its announced target of 2016. However, much will depend on the government’s spending decisions before the elections for the Duma later this year and for president in early 2012.

Contrary to the last two years, when the government boosted pensions very strongly — first by a quarter and then by almost half on average — an increase of just 10 percent was announced for 2011. That would increase the average pension after inflation by just a few percent. It is difficult to believe that such restraint would hold, given the very low general pension levels in Russia and the one-third share (and growing) of the electorate that is of pension age.

Moscow political turbulence feeds into capital outflow

Russia has not benefitted from an upsurge in financial inflows to emerging economies. While a number of countries have taken measures to contain inflow to stem inflation and exchange rate strengthening, Russia saw an increased outflow in the third and especially the fourth quarter of 2010. This may not be a general phenomenon, but perhaps reflects the changing political and economic power in Moscow after its longtime mayor, Yuri Luzhkov, was fired by President Dmitri Medvedev last September. Luzhkov, his wife, and many of their associates now have good reason to park their monies in foreign safe havens.

One sign of these changes is the outflow of money from the Bank of Moscow. It has been controlled by the city of Moscow that is Luzhkov and his circle, but the bank — for years among the 10 largest in the country — is facing an end of one or another kind. Moscow policy making and financial flows are now coming under the control of the Kremlin, with Sergey Sobyanin, the former head of the presidential administration, now the city’s newly appointed mayor.

Imports are again growing steeply

The great fiscal surprise of 2010 was the unexpectedly strong recovery in imports. Before the crisis, the dollar value of imports grew by 20-30 percent annually, as Russian households and companies alike used their increased income for the wider selection, better quality, and well-known brands that global markets offer. With Russian growth driven by consumption, this was particularly evident in the imports of consumer goods. China won big market shares in Russia, while traditional investment goods producers like Germany and Japan were relative losers.

During the crisis, imports collapsed by 40 percent. A recovery was expected, but its strength — at about 30 percent in 2010 — was a surprise. A modest correction of 15 percent had been widely expected. This is partly due to the social policy measures adopted at the time of the crisis. Contrary to households in other countries, Russian households did not suffer income losses from the crisis. This was primarily due to pension hikes.

The steep increases in pensions were justified by the idea that generally low-income pensioners would put their additional revenue toward domestic goods and services. Higher pensions would not only be socially justified, they would also alleviate the crisis. What actually happened may be that as Russians pensioners (most of whom are female) live in three-generation families, grandma’s better pension actually gave the younger generations more leeway to purchase imported goods and services. The socially motivated government expenditure unintentionally wound up supporting imports.

If true, this would strengthen the argument that last year’s surge of imports did not just signal a recovery to pre-crisis import levels, but rather a recovery to previous import growth trends. Russia would thus again take its place as a very fast-growing import market.

To many observers, this raises the issue of sustainability of Russia’s trade balance. The share of exports in current price GDP has been declining for years. Production of Russia’s few export products has increased slowly, while imports have surged. If trends continue — which is likely — Russia’s trade balance will turn negative in several years.

Contrary to some interpretations, this would not be a tragedy. A fast-growing economy should usually have a negative trade balance, financed by capital inflow used for needed investment. Russia could well be an example of this. Public foreign debt is very small and the creditworthiness of the country leads to low debt costs. Russia’s companies, on average, are not deeply in debt, despite some much-discussed exceptions to the rule. Under these circumstances, import of capital would be naturally healthy, assuming it is used productively. This condition is a prime reason why emerging economies might prefer foreign direct investment to financial investment.

Russia now seems to admit that it also needs foreign investment, not only to gain in technologies and know-how, but to contribute reliably to the investment financing it so badly needs.

Post-crisis growth will not reach pre-crisis level

The consensus view is that Russia’s post-crisis growth potential is slightly lower than it was pre-crisis. While growth potential before the crisis was about 5 percent annually, the post-crisis figure is usually thought to be 4 percent or less. Actual growth will differ depending on export prices and changes in the economy.

The differences pre- and post-crisis are many, and the most important one has nothing to do with the crisis itself. In the early 1940s, Russian women had very few children because of the war. Given the regularity of Russian reproduction patterns, they again gave birth to small numbers of children in the late 1960s. Those women came into child-bearing age in the early 1990s. The economic and social turmoil of the time were not conducive to large numbers of births. These children are now around 18 years old and entering labor markets, higher education, and potential military service. The number of the18 -year-olds will soon be close to half that of a few years ago. This poses huge challenges to the availability and cost of labor, the sustainability of the current higher education system, and to pension costs. It also makes military reform aimed at producing leaner and meaner armed forces inevitable.

Most observers believe Russia will grow at about its potential growth rate in 2011-13. If oil prices are high, finance easily available, and progress made in economic policy and reform, growth will top 4 percent. If oil prices are low, finance is more costly and less available, and economic policy and reform deteriorate, its performance will be worse. Still, it should be noted that growing on a par with the world generally and faster than Europe is certainly respectable.

Public faces numerous fiscal dilemmas

In the 2000s, Russia maintained large budget surpluses on top of fast-growing export tax revenues. This made it possible to accumulate reserve funds, which were much-needed during the crisis. The regime would like to return to surpluses, but unless the price of oil continues to rise, that will not be feasible for years.

Russia faces a number of economic challenges. Its fiscal dependence on energy taxes is excessive at almost one-half of all revenues. A major reform of the tax system — including a progressive income tax — is politically unpopular and administratively burdensome. The federal expenditure structure is also peculiar. Pension hikes have increased overall social expenditures, but education, housing, healthcare, and other areas have hardly benefited, despite the priority programs announced five years ago. The military has gained modestly, but it is difficult to see where the twenty thousand billion rubles for the military, recently promised by Prime Minister Vladimir Putin, might come from. Russia’s armed forces would need an upgrade, but the military is a weak pressure group, while pension recipients amount to one-third of the electorate — and the share is growing.

One way out, mentioned by President Medvedev in his latest state of the nation speech, would be to shift more social expenditure from the center of the country to the regions. For that, the regional tax base should be strengthened as well. If regions were to have added fiscal responsibility, it would be logical to make governors again elected, not appointed by the president, as they are now.

Growth must be based on investment and competitiveness

Available forecasts see Russia’s consumption driving investment. This must be the case, or Russia will face a dim future. Soviet capital stock has not really increased since the mid-1970s, and what Russia inherited is now old, worn out, often in the wrong location, and producing goods no longer in demand.

In the 2000s, the Putin regime prioritized reserve funds over building roads and other infrastructure. The investment share of GDP is about average globally, but much below that of emerging and developing economies generally. There is no way Russia can become modern and competitive without large investments — not only in physical, but also in human and social capital.

There is good news, however. Ample finance remains globally available, Russia has expressed a willingness to accept foreign investment, and domestic financial performance may be improving. But there are also signs of trouble. Russia’s position in competitiveness assessments has deteriorated once again, corruption is likely worse than ever, and the elections cycle adds to overall uncertainty. Investors like IKEA have suffered, and cases such as those involving Mikhail Khodorkovsky, a former oil oligarch who was wrongly sent to jail, and Sergei Magnitsky, an attorney who died in police custody, offered another reality check on the Russian business environment.

Russian and foreign research put Russian productivity at one-third of world’s top level, at most. Jobs have survived, as wages have been low, the ruble often undervalued, domestic energy and raw materials prices cheap, and unutilized capital stock available. These benefits are all transitory, however. Wages are bound to increase further as the labor force shrinks. No currency can remain permanently undervalued, and resource prices must be increased, not least to maintain energy export volumes by increasing domestic energy efficiency. Capacity utilization ratios were very high just before the crisis, and will rise again to that level soon. Russia’s path forward is thus clear: either it invests in physical, social, and human capital—or it fails to become a wealthier and more modern society.

Source: Russia's Economic Prospects