Russia is entering a fourth phase of transition since the fall of the Soviet Union, where it is finally getting to grips with some of the long overdue deep structural reforms and investment into infrastructure to transform it into modern market based economy.
The first period was the chaos and widespread poverty that followed the collapse of the Soviet Union in 1991. That ran until the economy was reset by the deep devaluation of the ruble in the August 1998 financial crisis that revalued the ruble more fairly and re-monetized the economy, killing off the so-called “virtual economy.” Russia then boomed through to 2011 when the petro-fuelled economic growth model was exhausted. By 2011 economic growth began to slow and by 2013 it fell to zero, despite oil costing more than $100 per barrel.
The third phase began in 2012 when president Vladimir Putin retasked all Russia’s spare cash into modernizing the army and in preparation for the subsequent show down with the west that followed the annexation of the Crimea in 2014.
That has meant a decade of austerity for the population, which has been eating into Putin’s popularity. A recent poll in April found that the number of Russians that would vote for Putin if elections were on Sunday is at an all-time low, although his personal popularity remains in the 60s. The economy is growing again, but the 2.7% growth in 2018 will slow to 1.3% this year and real disposable incomes in the first quarter of this year fell again as Russian incomes enter their sixth year of stagnation.
Russia’s economy has become a tale of two cities: Russia’s banks and leading corporates putting some of the best profit numbers in the last three years in 2018, but none of this money is trickling down to the man in the street.
The various crises of recent years has forced a consolidation on many sectors – especially those catering to the consumer. The madcap rush to win market share is over and companies and banks are now increasingly focusing on efficiency and improving profitability. Sectors like retail have just seen their first mega-mergers with market leaders joining forces with rivals to create some of the biggest players Europe-wide: the merger between white good retail M.Video and Eldorado last year has been followed by the attempt from supermarket chain Magnit to buy rival Lenta this year.
Now the military modernization phase is over and the Kremlin is turning its attention back to fixing its economic problems. It has to. Social disquiet is rising, trust in the government has fallen to a 13-year low, and it is only a matter of time before the population start protesting. The government has cut back on military spending and launched a massive state-lead investment program. The boom in the noughties was fuelled by the state hiking public sector wages by 10% a year for a decade; this time round the Kremlin is hoping to improve prosperity by supply-side investments into the social sphere and infrastructure.
Remaking the Russian economy
The new blueprint worked out last year is enshrined in the so-called May Decrees. The details are outlined in the RUB25.7 trillion ($390bn) spending program planned for the 12 national projects that runs through to 2024 – although much of the detail remains missing. The goal is to “transform” Russia with investments largely into infrastructure and the social sphere to produce better than global average growth.
Putin unveiled the reform plan during his state of the nation speech on March 1. The President wants productivity growth to accelerate to 5% per year (since 2009, the average growth was only 1%) during next decade, the share of SMEs in GDP to go up to 40% (from current level of 20%), the number of people employed in SMEs to go up from 19mn to 25mn people, and to halve the number of people living below the poverty line (currently 13.8% of the population or 20mn people).
Russia doesn’t have such a bad record on the impact of infrastructure spending: Russia has been investing 1.3% of GDP in infrastructure between 1995-2016 to produce an average growth rate of 2.4%, which implies a multiplier of 2.3, according to Dr Vladimir Popov of the Dialogue of Civilizations Research Institute (DOC) in a recent paper looking at OECD members’ investment and growth in the last decade, which is better than the emerging markets average but still a fairly mundane result.
The goal is to increase Russia’s economic growth to 3% by 2021 and then maintain it at above the global average growth rate through to 2024 at least.
It has been a long standing trope that Russia has not made any reforms, but a reform program is actually well underway. However, so far it has been limited to the financial and fiscal sectors.
The stand out success so far as been the clean up of the banking sector launched by Elvira Nabiullina, who took over as Central Bank of Russia (CBR) governor in 2013. Nabiullina has been closing two banks a week like clockwork since she took over and the clean up is coming into its end game as the number of banks in Russia fell below 500 in November 2018.
At the same time the tax service has been transformed following a near-miss crisis in 2016 when the government nearly ran out of money: MinFin was unable to fill a RUB2 trillion hole in the budget. It was bailed out at the last minute by the nominal “privatisation” of a 19% stake in Rosneft that later transpired to be little more than a loan.
The scare caused MinFin to push head with tax service reforms and hunt for new sources of revenue. The tax service was given a new revolutionary IT system that saw tax revenue rise by 30% in 2018, although the overall tax burden remains almost the same.
MinFin has also introduced a raft of measures to increase revenues including a make over the mineral extraction tax (MET), the mandatory payment of 50% of income as dividends for all state-owned enterprises (SOE), a 2pp increase in the VAT rate, and an increase in retirement ages, to name some of the most prominent changes.
More recently federal treasury system has been revamped as MinFin takes “manual control” of the most indebted regions. During the crisis debt in some regions ballooned to the point where debt servicing consumed some regions entire tax income and nearly caused a crisis.
All these changes produced a 2.7% budget surplus in 2018 – the biggest surplus in years – and Russia is currently running a triple surplus as the trade and current account surpluses are also at levels not seen since the boom years.
The May Decrees move the action into the real economy. The liberal branches of the government – the ministries of finance, economics and social, as well as the Audit Chamber now headed by former Finance Minister Kudrin – will oversee the social spending.
And about a third of the spending is targeted at infrastructure that will be supervised by the state’s de facto development bank VEB.RF (formerly Vnesheconombank) headed by Putin confident Igor Shuvalov. Previously Putin personally oversaw all the large scale state sponsored infrastructure spending which he handed to his inner circle of “stoligarchs”, or state sponsored oligarchs. However, the new system institutionalises this system of hands on control in the shape of VEB, which in effect becomes a “ministry of infrastructure.” In a recent development VEB said in April that it was in talks to buy the bridge building company Mostotrest that built the Kerch straight bridge connecting Crimea to the Russian mainland from its owner stoligarch Arkady Rotenberg. If the deal goes ahead then VEB will directly control both the capital and the construction companies that will carry out the infrastructure investment.
The jury remains out on the effectiveness of this model of reform and investment. As with so many of the Kremlin’s plans it is a hybrid model which attempt to bring in elements of the market to improve efficiency but leaves final control in the Kremlin’s hands. Russia observers are watching the GDP numbers careful to see if growth does accelerate to 3% in 2021, which will be the first acid test for the scheme.
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