Russia: Stable but Critical

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By Carnegie Endowment :

As Russia's presidential elections next March approach, gauging the state of the Russian economy is not an easy task. On the one hand, the economy is growing; the budget is balanced; government debt is well below 10 percent of GDP; the ruble is stable; and inflation has started to fall. On the other hand, GDP growth is slower than before the global financial crisis and depends on inventory accumulation and taxes on imports; capital continues to flow out of the country; and the strong budgetary and balance of payments positions rely on a high oil price.

While few things look likely to slow growth in the short run, risks abound in the medium term. Declining investment poses the biggest worry, but the government's dependence on a rising oil price and its persistently weak bank supervision also threaten growth and stability. The country's next president - the first to serve a six-year term - must mitigate these risks and position Russia for a stronger economic future.

Investment Worries

After a brief spurt of intensive recovery from summer 2009 through the first quarter of 2010, Russia's GDP growth has slowed but remains solid compared to developed economies: About 4 percent in 2010 and 4.1 percent in the first quarter of 2011, according to official data. However, this growth is twice as low as before the crisis and, more importantly, official numbers must be treated with caution. Nevertheless, few things seem capable of deterring Russia's growth in the short run (aside from another global crisis, of course).

In the medium term, however, Russia's "modern" growth model, which combines stagnating exports and reduced demand for domestically produced goods and services, is not sustainable. Inventory accumulation, which cannot drive growth for long, accounted for 130-140 percent of growth in 2010 and the first quarter of 2011. Meanwhile, consumption rose, but most of the new demand went to imports. Increased revenue from import taxes accounted for an additional 30-40 percent of growth as a result, but imports cannot drive any economy.

Most worryingly, investment volumes declined in early 2011. The decline was partly due to an increase in payroll taxes, which was introduced in 2011 and hit small businesses particularly hard, as their tax rate increased from 14 percent to 34 percent. This hike compelled firms to reduce investment, as weak demand prevented them from raising prices to pass the cost on to consumers. Growing corruption and racketeering by government officials further discouraged investment, while political uncertainty, which has increased sharply with the 2010 campaign, intensified capital outflows. Since August 2010, more than $75 billion (more than 5 percent of 2010 GNP) have fled the country.

Economic growth cannot occur without investment. Already, investment is relatively low in Russia, making up only 21 to 22 percent of GDP, compared to the 25 to 30 percent needed in most developing economies. But investment is not likely to grow until Russia's investment climate improves dramatically; this will require political reform, the active opening of the economy, and the pursuit of foreign investment.

Moreover, two huge, recently enacted programs (for social services and the military) forced cuts in infrastructure, science, public health, and education spending - all sectors essential to the economy's future. Demographics may also hurt Russia's growth soon, as the labor force is set to decline faster than the overall population.

Dependence on the Oil Price

Russia's dependence on the oil price poses another significant medium-term risk. Already, two-thirds of Russia's exports and almost half of its federal revenues are tied to the oil price. In fact, given current spending and investment trends, Russia's budget and balance of payments will only stay balanced if the oil price continues to rise; even if it rises by 2 percent annually in real terms, the Economic Expert Group and the Gaidar Institute estimate that the deficit could rise to 10 percent of GDP by 2020 (from 0-2 percent currently) if today's tax burden and economic growth rate hold and the government enacts all programs planned for the next five to seven years.

Meanwhile, if the oil price were to stabilize - not even fall - the country's fiscal position could easily deteriorate further and the implications for the current account balance could be even more dramatic. The current account strengthened in the first quarter of 2011 and led the Bank of Russia to allow significant ruble appreciation (15-20 percent) against the currencies of Russia's biggest importers. But this was due entirely to the rising oil price, which increased from $70 per barrel at the beginning of 2010 to $107-108 per barrel in the first half of 2011.

History suggests that, if the current account balance shrinks to zero, a severe financial crisis and ruble devaluation are all but inevitable. At the current oil price and rate of import growth - 41 percent from January to April 2011 - Russia has just five to six quarters before this occurs. Of course, the outlook if the oil price were to fall is even worse.

Insufficient Banking Regulation

The final medium-term risk Russia faces is its consistently weak banking supervision, as shown by the bankruptcy of Mezhprombank (Russia's 21st-largest bank) last year, as well as the downfall of the Bank of Moscow, Russia's fifth-largest bank, and its implications for VTB, the country's second-largest bank, this year.

Historically, the City of Moscow served as the Bank of Moscow's main shareholder, holding 46.5 percent of shares. Meanwhile, the bank's top management held 20.7 percent of shares and enjoyed the confidence and protection of Moscow's then-mayor, Yury Luzhkov. Most of the city's agencies and firms used the bank to finance their programs, including employee salaries, pensions, and benefits. In addition, the bank's portfolio was largely composed of firms affiliated with its management.

Market players were well aware of these connections, but the Central Bank, which regulates and supervises banks in Russia, failed to find any violation of regulations. The majority of credits were given to offshore companies or Russian special purpose vehicles (SPVs), but were guaranteed by solid, third-party collateral, and the bank's financial position alarmed neither auditors nor supervisors.

After Sergey Sobianin was appointed mayor of Moscow last September, however, problems began to emerge. Sobianin announced his intention to privatize the city's stake in the bank, in part to address the huge municipal deficit. But when state-controlled VTB lobbied for the shares, the city handed them over without a market sale, rejecting offers from Alpha bank and the Bank of Moscow (which attempted a leverage buyout). In other words, VTB engineered a hostile takeover with the help of the city government.

But, because VTB bought less than 50 percent of the shares, it needed several weeks - as well as the introduction of criminal cases and warrants against several Bank of Moscow managers - to gain full managerial control. By the time VTB was ready, the Bank of Moscow's old management had transformed the country's fifth-largest bank into its largest bankruptcy. The Bank unpledged all collateral and, after re-estimating the value of its credit, had to accept losses that exceeded its capital 2.5 to 4 times.

Due to the hostile takeover, the bankruptcy also implicated VTB, which lost nearly 20 percent of its capital and could lose up to 40 percent once the Bank of Moscow is consolidated. At the end of June, the Central Bank and Deposit Insurance Agency announced a large-scale recapitalization of both banks. This marks VTB's third request for state support since the financial crisis erupted.

Thus, though more than 40 percent of Russia's stimulus during the Great Recession went to support its banking system, regulators still seem ignorant of the lessons from the crisis. While other countries are moving toward solid, comprehensive financial sector regulation, Russian authorities refuse to do the same. As a result, Russia's banking system remains weak and strongly susceptible to any new shock.

Introducing a stronger financial regulation system - along with reforming the investment climate and reducing Russia's dependence on the oil price - will be some of the biggest headaches for Russia's next president, regardless of which candidate wins.

See also S&P 2010 Vs. 2011 on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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