Despite the conventional view that Russia’s economy will rebound when the price of oil swings upward, experts agree that what it really needs is an influx of capital investment. As IMR analyst Ezekiel Pfeifer writes, the Kremlin is attempting to stimulate investment by taking the risky step of allowing people’s wages to decline. The question is: Will the gambit work?
In the wake of Western sanctions and the fall in the oil price, the ruble went from about 35 to the dollar last year to around 65 as of mid-August. Photo: © Vladimir Zhuravlev | Dreamstime.com
Judging by the remarks of market analysts, the Russian economy is like a drag car: it may guzzle fuel, but when you fill the tank, it can race with the best of them. And this fuel, they think, is crude oil. “Oil prices remain the key indicator to watch for Russia,” one strategist told Bloomberg recently. This is true to an extent: a higher oil price means more money flowing into the accounts of state energy giants and into government coffers, which then gets distributed, unevenly, in the economy. The country’s GDP shrank by 4.6 percent in the second quarter of 2015, partly because oil has lost about half its value over the last year (and because of Western sanctions). But the proceeds from energy sales cannot drive the economy any longer. Instead of a drag car, the Russian economy has become more like a rundown truck: it still burns through fuel quickly, but even with all the gas in the world, it will just lunge forward in fits and starts.
While this may come as a surprise to the casual observer, economists have been sounding the alarm for years. “Even before the [current] crisis, World Bank reports said that Russia’s economy was functioning practically at the limits of its capabilities, and that in the future, given low levels of investment, it will not be able to grow at a fast enough pace,” said Mikhal Rutkovsky, the outgoing head of the World Bank’s Russia office, in mid-August. The country’s economic growth numbers bear this out. With the exception of the crisis year of 2009, Russia’s GDP grew by an average of about 7 percent every year from 1999 to 2012, as the price of oil rose from under $30 to over $100. But in 2013 and the first half of 2014, even as the price of oil remained above $90, the economy’s engine began to sputter. Growth fell to a meager 1.3 percent in 2013 and to 0.6 percent in 2014.
What happened? Economists point to a laundry list of structural issues: excessive state control of key business sectors, including oil and gas; poor management of federal budget spending, especially the runaway growth in pension payments and wages for government workers; a tax code and regulatory regime that discourage entrepreneurship; utterly inadequate support for property rights and the rule of law; and so on. These factors, combined with Russia’s opaque political system and unpredictable foreign policy, caused capital investment economy-wide to drop as a percentage of GDP from 20.2 percent in 2012 to 18.9 percent in 2014, despite President Vladimir Putin’s call for investment to grow to 25 percent of GDP. In the first half of 2015, investment fell by another 5.4 percent compared to the first half of 2014.
Virtually all economists—from the World Bank’s Rutkovsky to former Finance Minister Alexei Kudrin to current Economic Development Minister Alexei Ulyukayev—agree that reversing this trend is key to reviving long-term growth. What’s more, the government has actually started taking action meant to move the Russian economy in this direction. The question is: Will it be enough? And, if it isn’t, will the Kremlin be willing to go further?
The most powerful mechanism the government has activated to try to fix the economy’s broken structure is the drastic devaluation of the ruble. In the wake of Western sanctions and the fall in the oil price, the ruble went from about 35 to the dollar last year to around 65 as of mid-August. Whereas in past years the Central Bank might have intervened in an attempt to halt the sharp drop—depleting its foreign currency reserves in the process—this time it allowed the ruble to float freely (more or less). The impact of this policy has been massive. On the strictly negative side, inflation has spiked, going above 15 percent on an annual basis for the entire first half of 2015. On a more mixed note—although it may not seem that way at first glance—people’s real wages are down 8.5 percent over the same six-month period. In July, real wages fell even more sharply, by 9.2 percent compared to a year ago. This is not a blunder of economic planning. In fact, it seems to have been intentional.
Some background: for the last 15 years, as the Russian economy grew thanks to rising oil revenues and heightened productivity, much of the growth went into real wage increases for workers. In the year 2000, spending on wages nationwide made up about 40 percent of GDP, while now that level is around 53 percent. For comparison, the current percentage in China is less than 20 percent, in Turkey around 30 percent, and in Brazil about 45 percent. Over the period 2005-2014, real wages rose faster as a percentage of GDP in Russia than in almost any other country in the world, including fellow emerging market economies China and Brazil.
This monumental trend meant that 1) consumer spending skyrocketed and 2) corporate profits fell as a percentage of GDP. The liftoff in consumer spending was immediately visible in cities like Moscow, which filled up with mammoth shopping malls full of Western clothing stores and Apple resellers, while the city’s streets became progressively more jammed with new model cars, including fleets of luxury BMWs and Mercedes. The spending party may be finally over, however, because of this 8.5 percent drop in real wages and the devaluation of the ruble. As economist Vladislav Inozemtsev wrote in a recent article titled “The End of the Consumer Economy,” retail sales fell 9.5 percent in the first six months of 2015, with purchases of passenger cars having plunged 36 percent and those of new apartments diving 48 percent. “The decision to move to a free-floating exchange rate shows that a consumption-oriented growth model couldn’t be sustained,” said economist Natalia Orlova in July.
The question becomes: How long will Russians be willing to put up with decreasing or stagnant wages before they start aggressively expressing their frustration? Many analysts predict growing unrest around the time of State Duma elections in fall 2016. But the timing of such events is notoriously difficult to pinpoint.
Disastrous figures like these might make you think that no one has their hands on the wheel of the economy. But Economic Development Minister Alexei Ulyukayev has essentially said that this was done on purpose. He is hopeful that the drop in real wages will help deliver the economy a boost in the thing it needs most of all: investment. Ulyukayev bases his rosy view on the fact that corporate profits were up more than 57 percent from January to May this year, a fact that, he hopes, will pave the way for companies to invest. If the growth in profits keeps up, it will help reverse the trend of them becoming a smaller and smaller proportion of GDP: just as people’s wages rose in the last decade, profits have gone down, from around 37 percent of GDP in 2005 to 32 percent last year, according to economist Yevsei Gurvich (while Ulyukayev put the current number even lower, at 28 percent of GDP). This is traditional business logic: if your widget company makes more in profit, you will have more money to invest in improving your widget-production technology.
But is this logic bearing out? So far, the answer is no. Even as profits rose over the first five months of the year, investment in nominal terms fell by 18 percent, causing economists to warn of an "investment trap"—meaning that companies have money, but they aren’t spending it. This is a variation on the classic liquidity trap, in which businesses do not invest even when given large injections of capital. Firms in Russia are currently sitting on about 3 trillion rubles ($46 billion) in cash instead of investing it, and one market analyst speculated that many of them are buying up foreign currency with the money because other investments are too risky. Economists cite various possible reasons for the trap, including the extreme volatility of the ruble conversion rate over the last 10 months and general instability in the economy. After all, how can you plan investment outlays when you have to constantly reevaluate your costs and future prospects?
Besides the current “investment trap,” which might prove to be temporary, the tricky part of trying to overhaul the economy is that it can take a long, long time—much longer, perhaps, than most citizens are willing to wait. The general rule of thumb is that an uptick in investment—which, in this case, hypothetically will happen soon but has not actually started yet—takes three to four years to have an impact on the economy. This is a mature style of growing the economy—like delayed gratification. The problem, as Vedomosti columnist Maxim Trudolyubov has pointed out, is that the riches from oil proceeds bestowed on Russians (and especially on the privileged upper classes) have made them like drug addicts. Not only are they hooked on the money, but like true junkies they need higher and higher doses to stay satisfied, even as the available pot of funds is now shrinking. “Russians are highly sensitive when it comes to attempts to take anything away from them, and they do not believe their lives will improve as a result,” said economist Gurvich, stating what might seem obvious.
The question becomes: How long will Russians be willing to put up with decreasing or stagnant wages before they start aggressively expressing their frustration? Will investment pick up in time to buoy the economy before political upheaval becomes inevitable? Many analysts predict growing unrest around the time of State Duma elections in fall 2016. But the timing of such events is notoriously difficult to pinpoint. “No one knows how long Russians can continue to accept these hardships,” said Bloomberg writer Leonid Bershidsky, referring to the spike in inflation and the ruble devaluation. Many factors will come to bear: whether the Kremlin decides to escalate the conflict in Ukraine; the degree to which it carries out other productive reforms, especially in the huge and ravenous state sector; what happens to the oil price; and how the government manages its finances.
The good news for Russians, and potentially for Putin, is that there is an abundance of low-hanging fruit for the authorities to pick from, if it decides it wants to take action. Just as the Central Bank helped set in motion a sea change in the economy just by devaluing the ruble, the government could, with the push of a button, raise the retirement age, or begin privatizing state assets, or slash military spending, and thereby boost the economy’s chances of long-term growth. The bad news for everyone is that even these “easy” reforms could inflict significant pain on large swaths of the population. Other reforms—such as reining in the freewheeling security services, establishing fair courts, allowing for more flexibility in the labor market, and many more—will require political will that Putin probably lacks. Ironically, if Putin just pulls down some more of the low-hanging fruit, Russians may suffer so much in the short term that they decide his time in power needs to end. This would open the door to a new leader taking over who is willing to tackle the thornier challenges. If, instead, Putin decides not to do much of anything—a likely possibility—the economy will stagnate, idling down the highway like an old, decrepit truck.
