March 6th, 2015

Russia’s threefold economic misery

by Friedemann Mueller Sanctions and the tumbling global price of oil […]

Team AEC

Image by © Dreamstime

Sanctions and the tumbling global price of oil have sent the Russian economy spiralling towards recession. But despite pending economic woes, Russia’s economy with its robust reserves is healthier than those of many major nations. However, the Russian economy is far from invulnerable. Indications are that Russia is turning in on itself. Yet to achieve a rebound in potential growth, Russia must open up its economy – especially to inward investment.

The performance of Russia’s economy is one that many countries – not only Greece, Italy or France but even the United States – could only dream of.

• Its public debt remains below 10 per cent of Gross Domestic Product (GDP)

• Its balance of trade is positive – Russia recorded a trade surplus of US$12.93 billion in December 2014

• Its exports exceed imports in the range of US$180 billion or 8.5 per cent of GDP
• And thanks to its huge energy exports, Russia’s current account balance is positive – though smaller at US$11.4 billion in the third quarter of 2014 (3.6 per cent of GDP) as it witnesses an outflow of currency due to an import surplus of services.

So, the federal household is positive and it can balance the negative households of regional entities – such as Chechnya and South Ossetia which rely on funding from the Kremlin. Russia’s currency reserves, approximately US$450 billion, are the fifth largest worldwide behind China, Japan, Saudi Arabia, and Switzerland.

Loss of confidence

All this looks like a sound economy. But despite these strengths the Russian economy is far from invulnerable.
The Russian economy has suffered a massive loss of confidence. The most obvious indication was the rouble’s drop during 2014 of more than 40 per cent against the US dollar.

But does the healthy condition of Russia’s economy give it flexibility and options – a freedom most euro countries do not have – to get out of the current crisis? The short answer is no.

The pressure on the economy is from three sides and is too great to easily overcome – at least as long as President Vladimir Putin’s doctrines are present.

The three pressures are the ‘resource curse’, Mr Putin’s ‘dictatorship of law’, and Western sanctions.

‘Resource curse’ is a phenomenon in economic theory which describes a fundamental distortion of the economies of energy (and raw materials) rich countries experience. There are two aspects to this.

Dutch disease

One is dubbed ’Dutch disease’, a term used to describe the problems during the natural gas boom in the Netherlands during the 1960s. Dutch ownership of natural-gas resources pushed up the country’s real exchange rate, making manufacturing less competitive.

The effect on the domestic economy, however, is that the country’s exchange rate is heavily influenced by this single product which makes other products uncompetitive and leads to a monoculture.

We can see this tendency not only in the Middle East oil states but also in industrialised Russia.

This tendency is strengthened by the fact that the resource industry pays the highest salaries and, thus, attracts the country’s brightest which are needed in the less competitive sectors.

The second negative aspect of the ‘resource curse’ lies in the fact that the sale of raw material makes a huge amount of money prompting governments to nationalise the majority of their natural resources.

More than 90 per cent of world oil reserves and more than 80 per cent of oil production is run by the state. This is a source of inefficiency and mismanagement. More so, it is the major source of corruption.

Resource-rich

Practically all resource-rich countries (defined by having more than 50 per cent of exports related to the resource business), except Norway and some Gulf countries are listed in the last third of the Corruption Perception Index 2014 of Transparency International. The least corrupt Middle East country is ranked 55 out of 175.

Russia, with more than 70 per cent of export revenues and more than 50 per cent of the tax income related to energy, is ranked 136 out of 175 investigated countries. Norway has exemplified ways to fight corruption but this requires a different understanding of the role of the state than is common in Russia.

This brings us to Vladimir Putin’s Russia. After the partially chaotic laissez-faire era under Russia’s post-Soviet leader Boris Yeltsin in the 1990s, Mr Putin ran his 2000 presidential campaign under the title ‘dictatorship of law’.

Rule of law

There was a lot of goodwill in the West and hope that this formula would be close to the West’s understanding of the ‘rule of law’. Vladimir Putin, however, weakened the parliament – the Duma – to a purely approving body. The law did not dictate activities but President Putin’s activities dictated the law.

Energy company Gazprom and parts of the oil industry were re-nationalised, the hierarchy between the federal and local levels strengthened, control over all activities in the economy increased (providing another source of corruption), obstacles for start-up enterprises intensified, and the activities of foreign actors put under suspicion.

This created a situation under which even major investment in modern technologies, research and education had no particular effect. The build-up of an internationally competitive automobile industry failed as did the development of a major IT sector.

Global crisis

Investment as a percentage of GDP in Russia is, at 26 per cent, higher than in developed G7-countries (where the average is 18 per cent) but lower by far than emerging economies such as the BRICS (Brazil, Russia, India, China, South Africa).

Investment as a percentage of GDP in China is 47 per cent. So it is no surprise that Russia, which suffered greatly during the global crisis of 2008, has since missed the economic growth of all other BRICS states.

Russia’s GDP at US$2,057.3 billion, is smaller than that of France and less than one eighth of that of the EU or the US. It does not allow big investment in either high tech nor military sectors.

Growth and development require better efficiency – which cannot be achieved under current legal conditions – and investment from outside which needs trust in a functioning and efficient system.

Partnership

Western sanctions – originally a symbolic signal directed at individuals who might influence Russia’s foreign policy strategy – have made matters worse.

Those who hoped that the partnership established in 2008 between the EU – mainly Germany – and Russia would lead to a modernisation of Russian rules, have lost confidence in any such change.

Nationalistic sentiments displayed by both the population and the government have contributed to this loss of trust. This has resulted in capital outflows, the government strengthening controls, and a dramatic decline of the rouble, mostly against the dollar but also the euro. The Russian Central Bank raised interest rates from 10.5 per cent to 17 per cent in December 2014 – which it then reduced to 15 per cent in January 2015 – and had to spend more than US$100 billion of its reserves to refinance outrunning credits which Western banks did not renew.

It is neither in the interest of the European Union nor the United States to keep the Russian economy down. In contrast, the Western world must look to Russia as a partner.

A globalised economy affords a common understanding and common norms which help prevent or manage crises.

Regional problems

A modernised Russia, as a partner, could significantly contribute to the solution of major problems such as a sustainable global energy supply, but also help solve regional problems south of Russia and in modernising Ukraine.

It is necessary that the West develops a strategy which, through dialogue with Russia, sees a way out of this misery. Sanctions can only be a part of that.

Russia is too important as a player in a globalised world.

Considering the conditions imposed by the West, President Putin’s Russia has no options and no instruments to get out of the downward spiral.

Even lifting the sanctions cannot alone provide the environment to overcome the mistrust of investors and the cooperation of partners. The International Monetary Fund expects a three per cent decline in Russia’s economy in 2015 and a similar one the year after. It may be much worse.

This leaves two scenarios:

The first: Russia becomes more desperate, less easy for the West to read, more aggressive, more dependent on China – the only Asian power which can assist Russia – less cooperative with shared problems such as solving the dispute on Iran’s nuclear programme or fighting IS.

The second: The Western alliance looks for a comprehensive strategy which includes a face-saving solution for Russia with regard to Ukraine but guides the country towards the rules Russia (then the Soviet Union) signed in November 1990 as the Charter of Paris with the rule of law, democratic and market economy standards as common principles. This requires more than the current ad hoc crisis management initiatives concentrated on Ukraine.

Territorial integrity

Germany’s Chancellor Angela Merkel’s proposal at the World Economic Forum in Davos in January 2015 cautiously tests the readiness of both sides to link progress with a respect for the territorial integrity of the Ukraine together with broad economic cooperation from the Atlantic Ocean to Vladivostok.

This proposal will exacerbate the domestic conflict in Russia. Advocates of a Russian integration into a globalising international economy – such as those of German Gref, president of Russia bank Sberbank – will argue that this is Russia’s last chance for keeping contact with, and be a part of, the developed world. The nationalistic circles dominating the Kremlin will reject the proposal as a capitulation.

Considering the bleak economic outlook Russia is facing, the Kremlin is increasingly aware that greater economic integration might be its only chance.

For the time being, Russia’s self-imposed isolation is the more probable scenario, especially given present sentiments in the West that Russia does not deserve an offer of integration.

The opportunity costs of not encouraging this will be, however, tremendously high.

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