20 years under Putin: a timeline

With Russia suddenly unable to access imports that it had grown dependent on, government officials have promoted import substitution as a way to make structural changes to the economy and help the country recover in the short term. Unfortunately, according to IMR analyst Ezekiel Pfeifer, the opportunities presented by domestic production of things like dairy products, chemicals, and naval vessels are limited.

 

There was a 29 percent boost in Russian cheese production in the first four months of 2015. Photo: armenpress.am

 

Both Russian consumers and the Italian economy are suffering from an affliction rare in the modern Western world: the absence of Italy’s famous Parmigiano-Reggiano cheese, or Parmesan, from supermarket shelves. This is the result of the Kremlin’s ban on foodstuffs from a range of Western countries, a measure that was recently extended for a year in response to Western sanctions directed at Russia. But according to President Vladimir Putin and other officials, there is a silver lining to this painful sacrifice: the ban is giving domestic agricultural producers a chance to supply Russians with local bounty. Russia’s national cheese institute even says that industry players want to purchase the equipment necessary to make a version of Parmesan. (The institute didn’t have the technology as of March but said it was hoping to obtain it by the end of the year.) And indeed, there has been a 29 percent boost in Russian cheese production in the first four months of 2015, a figure that Putin touted in his speech to investors at the recent St. Petersburg International Economic Forum.

Cheese, however, will not be a panacea for Russia’s economic problems—nor will increased agricultural production overall, or import substitution as a trend in the near-term, even though officials are pitching it as a cornerstone of Russia’s nebulous recovery plan. Agriculture makes up only about 4 percent of Russia’s GDP, and last year the sector would have seen a 5.2 percent loss if not for state subsidies. Even if enough money were poured into the sector to make it profitable, the results would take years to appear. As one farmer said, livestock and agricultural products need time to grow: “Fruit orchards and perennials take five to eight years.” Government regulation is an issue as well. Take the example of Parmesan: the Italian delicacy is made with raw milk, which Russian law does not allow in cheese-making, meaning that Russian producers would have trouble duplicating it even with the proper equipment.

To be fair, it’s not that import substitution is just a crazy idea dreamed up by the Kremlin. It is a logical response to the circumstances currently facing Russia: a suddenly weakened currency and restricted access to imports. Indeed, imports fell by 9.2 percent in 2014, or by $29 billion, and Russian consumers should hope that some of them can be replaced—because certain parts of the economy had become quite dependent on foreign goods. Russian industrial production went from 9 percent dependence on imports in 2006 to 15.9 percent in 2013 (including a jump for machine-building of 13.4 percent dependence in 2006 to 36.5 percent in 2013). Many industries significantly cut down on this reliance in early 2015—by up to 70 percent for investment purchases—but they only replaced this spending with domestic purchases by 15 percent or less. In the software sector, it is considered a victory that the share spent this year on imports, which was about 75 percent in 2014, will drop a few percentage points.

Certain sectors, such as commodities and chemicals, are benefiting more from the cheaper ruble and are jumping onto the import substitution bandwagon. They are seeing big gains from exports, because they receive foreign currency that converts to more rubles than it used to, which they can use to pay their domestic expenses and make a profit. A recent analysis by Russian economist Dmitry Belousov identified metals and chemicals as two of the top five industries with potential for a decrease in imports and an increase in exports. It said the decrease in chemical imports could reach $17.8 billion and in metals $8.7 billion, while it estimated the near-term export expansion potential for chemicals at $11.6 billion and for metals at $4.8 billion. Those would be significant figures for the Russian economy.

But Belousov also noted that the ruble’s real effective exchange rate compared to the dollar/euro basket—in other words, its exchange rate after you take into account inflation, which in Russia has ranged from 5 percent to above 8 percent in recent years—has reached essentially the same level it was in 2008. Therefore, the advantages of the ruble’s current weakness are more limited than they might seem at first glance. “The potential for production increases due to the devaluation of the ruble has already been virtually exhausted,” Belousov wrote. This means, he said, that import substitution should focus more on sectors in which Russia specializes or has an inherent edge.

To be fair, it’s not that import substitution is just a crazy idea dreamed up by the Kremlin. It is a logical response to the circumstances currently facing Russia: a suddenly weakened currency and restricted access to imports.

What else, besides chemicals and metals, does Russia specialize in? Weapons, many would say, and indeed the military-industrial complex is thinking about how to address the very serious problems presented by being cut off from components made in Ukraine and the West. The Russian navy is designing new warships to replace ones that depended on foreign components, as well as a replacement for the Mistral-class helicopter carriers Russia had ordered from France. “In essence, we can only thank our Western foes for allowing us to finally revive the branches of our industry that were previously kept down,” Deputy Prime Minister Dmitry Rogozin, who oversees Russia’s arms industry, blustered in April.

But even if these projects are completed on schedule—which is not likely given the industry’s recent track record—they would take many years. The newly designed corvette naval vessels aren’t supposed to join the Russian fleet until 2019, and the design for the Mistral replacement hasn’t even been confirmed yet. Meanwhile, Russia is losing clients in Eastern Europe due to the EU’s embargo on arms purchases from Russia (although Russia is still the world’s #2 arms exporter behind the U.S., as it has been for years). In other words, Russia not only is losing buyers of its exported arms; it won’t even be able to meet some of its domestic military needs without years of investment.

This is all despite the fact that the government continues to spend trillions of rubles on the military—1.7 trillion rubles in the first four months of 2015, to be exact, or $31 billion, equal to 8 percent of GDP—despite the fact that many economists say the country’s defense spending is a large part of what is holding the economy back. (For comparison’s sake, 8 percent of GDP is more than any other major country in the world except Saudi Arabia. In 2014, the U.S. spent 3.5 percent of GDP on defense and China spent 2.1 percent.) One of the most vocal economists on this subject, former Finance Minister Alexei Kudrin, got fired from the Cabinet in 2011 over his objections to increases in military expenditures—and he was arguing about an increase from under 3 percent to over 4 percent.

Some say the crux of the problem lies in an economy-wide shortage of a crucial ingredient for growth: capital investment. In order to create capacity for import substitution, investment is needed in new facilities and equipment and technology. In that way, the trend of import substitution could be a very positive one for the Russian economy—if it actually happens. The Industry and Trade Ministry created a fund last year for import substitution projects and said the program will cost at least $50 billion (although it has allotted only $44 million thus far, and government enterprises themselves have taken virtually no steps to replace imports). If this money goes toward effective capital expenditures, it will be well-spent.

But the country’s track record for investment spending in recent years has been horrendous. Despite Putin’s order upon regaining the presidency in May 2012 to increase investment in the country by 10 percent a year, in order to reach the level of 25 percent of GDP by 2015, such spending has instead been on the decline almost continuously ever since. The level of investment in 2013 was just 20.3 percent of GDP and in 2014 dropped to 18.9 percent of GDP. The first quarter of this year saw yet another drop in investment, by 6 percent, compared to the first quarter of 2014. Economic Development Minister Alexei Ulyukayev said in a recent interview that he thinks Russia has still not reached the bottom of this downward trend.

Earlier this year, two economists wrote an article in the Russian journal Issues of Economics about the dependence of various industries (textiles, machine tools, plastics, etc.) on imports from 2006 to 2013 and the potential for decreasing that dependence. The authors concluded that certain Russian industries could have success expanding production of finished goods, such as electrical appliances, using imported components—a step in the direction toward import substitution. Ultimately, however, the authors said: “Import substitution and a decrease in industrial dependence on imports will require the modernization of production facilities—that is, a radical activation of investment and entrepreneurial activity in the Russian economy.”

As economist Sergei Pukhov of the Center for Development said in March, investors are reluctant to make capital outlays at such an unstable time for Russia. Even if businesses and the government did kick start such spending, it usually takes three to five years for it to have a positive effect on the economy. By then, Russia may be re-integrated into the system of world trade, opening domestic producers back up to international competition.

Perhaps Putin, or other people in the government, have a better plan for fixing the economy? Apparently not—Kremlin aides say that Putin is standing pat for now and not considering any new major economic proposals. And that means that the Russian economy (just like Sochi, Kursk, and other cities recently) will just go deeper and deeper underwater.

Russia under Putin

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