Is Russia's Economy Doomed to Collapse?

July 1, 2016 Topic: Economics Region: Eurasia Tags: RussiaMonetary PolicySanctionsTradeDefense

Is Russia's Economy Doomed to Collapse?

Putin must undertake serious reforms to keep the country competitive.

The bulk of those projects are long-term and even if they are realized, their effect (if any) may only become visible in several years’ time. At the same time, Russian counter-sanctions (or embargoes on food from Western countries) are seen by Russian politicians as an opportunity to boost domestic agricultural and food production. Despite many reports on the success of this policy, statistical data provides a very weak and nonobvious foundation for this.

Yes, agricultural production grew in 2015 by 3 percent, while the economy in general fell by 3.7 percent. But the growth of agricultural production has been rather stable in Russia since 1999, averaging 3.3 percent per year (meaning 2015 was below average), with some fluctuations related to weather conditions.

The most significant and evident growth in 2015 was recorded in poultry and pork production (8.6 percent and 12.9 percent, respectively) but once again, this growth started in 1999–2000 and no acceleration was registered in 2015. Compared to those two champions, the situation in milk and beef production is definitely lagging behind: milk production is stagnating while growth in beef production was sluggish, and its level in 2015 was well below that of 2010. It is important to note  that much of Russia’s meat production comes from small farmers and households, and is not going to the market but rather being consumed at home. And if we look at sausage production, the lack of any growth is evident.

Production of butter, cheese and the Russian cottage-cheese-like staple known as tvorog has definitely benefited from Russian counter-sanctions; acceleration there is sizable, and started in 2014, when Russian counter-sanctions were first declared. Nevertheless, according to Russian statistics, growth was recorded not in cheese production but in “cheese product,” a specially defined statistical entity that is produced with palm oil and contains no animal fat at all (imports of palm oil to Russia in 2015 increased by more than 40 percent over 2013). There is no such clear evidence in the production of butter and cottage cheese, while multiple reports in regional mass media demonstrate that the quality of much of their production is unacceptable. The poor quality of local dairy products has become evident across the country, forcing Rosselkhoznadzor (the Russian equivalent of the FDA) to issue a special information letter describing the problem and methods of control.

The clearest example of the counterproductivity of Russian counter-sanctions is fresh fish production. In 2011–13 this sector grew quickly, and seemed inclined to mimic the success of pork and poultry production. But when Russian counter-sanctions were imposed, the import of whitebait was prohibited as well. But whitebait production is a high-tech endeavor, and Russia was not able to substitute for it. As a result, in 2015 fresh fish production fell by 20 percent compared to 2014 (while production of frozen fish is growing steadily).

Russia Will Not Become Venezuela

It has become evident that the Russian economy can no longer rely on exceptionally favorable external conditions (further growth in natural-resource prices and increasing external corporate debt). In fact, the reverse is true: Western sanctions have aggravated Russia’s external environment. Given the country’s authoritarian political regime, the economic policy of the government has become completely dependent on Vladimir Putin’s personal views and his “economic doctrine.” A brief overview of its elements:

1. Putin does not support (or at least has not thus far supported) returning to a Soviet-style command economy. So far, the Russian president has not questioned the key element of a market economy: free-market pricing. Moreover, the Russian authorities are slowly but steadily liberalizing electricity and gas prices.

2. The same relates to the free floating of the ruble: after the CBR had spent 175 billion in 2008 and another 120 billion in 2013–14, Russian foreign exchange reserves were depleted, and after Western financial sanctions were imposed, Putin acknowledged and supported the position of the CBR to not spend a dollar more, supporting the ruble rate. Those two points are a dividing line between Russia and Venezuela, where the economic situation is very close to disaster though the bulk of the problems could be solved by transitioning to a free-floating exchange rate.

3. Putin remembers the 1998 crisis well. He was and apparently still is quite frightened by it. Having analyzed the causes of that crisis, Putin recognized the budget deficit as the main culprit. That is exactly why he believes that the budget deficit ceiling, set at 3 percent of GDP, is not subject to change. He is prepared to cut any expenditures over the short or medium term, but is not ready to agree to even a temporary and insignificant increase of the budget deficit, which will have no bearing on the macroeconomic situation in the country. For instance, he has rejected the underlying idea of the “Russia 2020” plan, based on temporarily increasing the deficit in favor of boosting expenditures on healthcare, education and science, after those items were displaced by military expenditures.

4. Putin supports dirigisme in economic policy. He believes the state to be infallible; thus, any government decision, restriction or regulation is always beneficial. For the very same reason, Putin tolerates lack of progress on systemic privatization (when the government steps out of the economy). Conversely, he accepts it when state corporations periodically acquire private enterprises from competitive sectors, even if they are outside of their dedicated sphere of interests.

5. Putin does not believe in competition and private-sector initiative. He does not view either of them as an economic engine, which is why he easily raises social security taxes and taxes on small businesses. For the same reason, he was reluctant to conduct economic amnesty, and then substantially curtailed it.

Forecasting the medium-term economic scenario for Russia, I do not want to read the fortune of oil prices, which constitute the factor most obviously capable of boosting or bursting the entire Russian economy. I take it as a given that the current level of oil prices (fluctuating between $35 per barrel and $50 per barrel) is sustainable for my horizon. If it is, then there are two cards in the hands of Vladimir Putin that may improve the situation in the economy: one is in foreign policy, another in domestic policy.

In foreign policy, the evident joker is Russia’s policy vis-à-vis Ukraine in general, and in the Donbass in particular. If Putin recognizes that Western sanctions are much more influential than he believed, and that their long-term negative effect is damaging the future of the Russian economy, he may decide to give up on the Donbass separatists and implement the Minsk II provisions. This will result in the removal of sanctions, which will grant Russian banks and companies access to capital markets. Moreover the government will be able (if needed) to borrow in Western markets itself, thus avoiding extra cuts in expenditures.

Moreover, within a year and a half to two after the removal of Western sanctions, many European companies will return to Russia to renew old investment projects or to launch new ones. Of course, we cannot anticipate an enormous inflow of foreign capital, but it could be enough to give the Russian economy 0.2–0.3 percent of additional growth per year.

As of today, I do not see much of a chance that Vladimir Putin is ready for this scenario. He would interpret giving up the Donbass amid the current situation as a political defeat and a concession to the West, and he is not ready to accept that he is weak. If the Russian economy does not deteriorate significantly—say, another 5 percent decline within a year and/or 30–50 percent devaluation of the ruble; I give very low chances for both—there will be no trigger for the Russian president to change his Ukraine policy.

In domestic policy, the fundamental problem that explains the downturn in the Russian economy is the demolition of the rule of law and property rights protection that has occurred in Russia in the last fifteen years. The consequence is a decline in investment activity. Declining investment in the Russian economy (excluding investments related to the Sochi Olympics) started in 2012. Private businessmen are concerned about property rights facing massive racketeering by security-service employees; on average three hundred thousand criminal investigations are launched against businessmen annually, and though only 2.5–3 percent of them get sentences, 85–90 percent of them lose their businesses. The restitution (or, more accurately, the implementation) of rule of law that will result in property-rights protection is not an economic, but a political goal, which is fully in Vladimir Putin’s hands. In many of his speeches, the Russian president has acknowledged that the legal system does not function properly in Russia and that the activity of law-enforcement agencies should not be hostile to business, but in real life, the situation is worsening from year to year.

I do not believe that Vladimir Putin will launch a comprehensive political reform to include political competition, fair elections, fighting corruption, and radical transformations in law enforcement and the legal system. He understands very well that even minor steps in this direction will inevitably lead to losing of his grip on power and personal control over the country, and ultimately to the collapse of his regime. Vladimir Putin is a gambler in politics, as he once was in his private life, but he is not committed to political suicide. His examples of worst-case scenarios in political leadership are Viktor Yanukovych, the Ukrainian president who was removed from his post by the parliament, and Mikhail Gorbachev, the president of the USSR who lost power and allowed the country to collapse. Vladimir Putin will do his best to avoid these two scenarios from being repeated with him in a starring role.