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Russian Economy Exiting the 'Grey Zone'

Growing statistical evidence confirms likely onset of recovery

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When asked about the state of the Russian economy during his marathon question and answer session Putin spoke of it as being in a “grey zone” between recession and recovery.

He nonetheless predicted only a very small contraction this year of just 0.3%, which points to expectation on the part of the government of a return to growth later in the year.

If in Putin’s opinion the economy is in a grey zone he clearly doesn’t expect it to remain there for very long.

So what is the condition of the Russian economy? Is Putin justified in saying it is in a grey zone and that recovery is round the corner?

It is now looking increasingly as if the industrial recovery in February was not a flash in the pan, with more evidence of an industrial recovery in March. The GDP contraction for the first quarter looks like being less than 2%. Weekly inflation continues to be 0.1% pointing to an annualised rate  of inflation for the whole year of less than 6%. 

As I discussed previously, statistical increases in both the rates of output and of inflation are inevitable in the coming months because of the base effect  However in the case of inflation this is purely a statistical phenomenon whilst in the case of output there does seem to be a genuine recovery underway.

All this suggests Putin is right and that recovery will now happen soon if it is not underway already.

The rouble meanwhile has closely tracked oil prices which have been firmer since the collapse at the start of the year.

That collapse as I have explained previously was the consequence of the Federal Reserve Board’s decision in December to increase US interest rates.  

Though the actual increase in US interest rates in December was insignificant it came with guidance from the Federal Reserve Board that it would go on increasing interest rates throughout 2016.

That spooked the markets, causing oil prices and stock markets to collapse, and provoked threats from China to devalue the RMB.

The response of the Federal Reserve Board was to throw in the towel, reverse its guidance, and put further rises in US interest rates on hold.

The result was that March came and went without the increase in US interest rates talked about at the end of last year taking place.

The result has been a global stabilisation of oil prices and stock markets.

In the case of oil prices it is increasingly looking as if the sell-off at the start of the year was anyway over-done with indications that the oil market is firming anyway as more and more marginal producers are being pushed to the wall.

Meanwhile as I predicted the vast flood of Iranian oil some were talking about at the start of the year has simply failed to materialise.  

With production in the US at last showing signs of falling with demand for oil steady the other factor that governs the oil price - supply and demand - also points towards a firmer price.

It is these factors - the stop in increases in US interest rates and the changing dynamics of supply and demand - which explain the oil price rally that has been underway since February.

By contrast the oil production cap that was discussed at the recent summit in Doha - which would have frozen Saudi and Russian production at the record - and unsustainable - levels they had reached at the start of the year - was of only marginal importance.

The collapse of the production cap agreement at Doha will therefore have only a marginal effect on the oil price - a fact that became immediately clear when after an initial fall the oil price rebounded within hours.

With inflation steady despite the oil price fall at the start of the year the impact of movements in oil prices on the Russian economy is anyway being overstated. A further collapse in oil prices - if it happens - will not in and of itself derail the recovery from the recession that is now underway.

The single factor holding the Russian economy back now is not the oil price. It is the sky-high real interest rates.  

The very latest guidance from the Central Bank however suggests that even the Central Bank has finally come round to the view that there are no grounds to delay cuts in interest rates for much longer.  

With early cuts in interest rates now likely against the background of what is probably already an ongoing recovery the question would appear to be less whether growth will return but how strong will that growth be.

In passing, as someone who is regularly accused of taking an over-optimistic view of the Russian economy, I have been surprised at how effortlessly it has brushed off the market collapses at the start of the year.

Meanwhile as the evidence of a pending recovery accumulates - within the 2 year timescale predicted by Putin at the start of 2015 - it is interesting to see the latest attempts of those who take a perennially pessimistic view of the Russian economy to justify their continuing pessimism.

One has come from Alfa Bank’s Natalya Orlova, whose pessimistic predictions have been recycled in an article for Business New Europe by Ben Aris.

According to this view, since no visible signs of import substitution were discernible in 2015 except in the agricultural sector that means that the whole policy of import substitution has been a flop, confirming that the economy is failing to diversify because of the “appalling business climate” and political meddling by the Kremlin, and is therefore doomed to a state of permanent stagnation.

Meanwhile an article in The Financial Times - dealing more in what looks to me like futurology than economic analysis - claims Russia’s future growth rate is close to zero because the sharp decline in the workforce caused by the 1990s demographic collapse supposedly cannot be offset by increases in productivity or higher immigration.  

This supposedly means that any attempt to increase the economy’s level of growth beyond just over zero will immediately hit upon capacity constraints causing the economy to over-heat leading to wages rising in a way that will cause inflation to take off.

I would say straight away that both views have for me something of the look about them of clutching at straws by people whose expectations of the Russian economy always border on the cataclysmic.  

I remember for example attending a conference with Orlova in Moscow in the spring of 2014 in which she predicted that the economy would by now be running a trade deficit (in fairness to her she did admit that the rouble was overvalued).

Suffice to say that any discussion of the progress of import substitution in 2015 that fails to take into account the fact that 2015 was a year of recession with sharp falls in investment and demand caused by high inflation and high interest rates is essentially worthless.

Not only is it completely unrealistic to expect import substitution to take off in just one year but to expect it to do so when general economic conditions are as harsh as they were in 2015 is unreal.  

The test of the import substitution programme will come when investment and demand pick up - as they are now beginning to do - at which point the positive response of the agricultural sector to the incentives already provided may be a harbinger of what is to come.

As for the claims in Ben Aris’s article that a country that can make Angara rockets has lost the skills to make toothpaste, that strikes me as frankly silly, whilst any comparison of the state of small and medium sized businesses in Russia to the Mittelstand in Germany is simply absurd given that owning a business in Russia was actually illegal just a quarter of a century ago.

What of the argument that the decline of the working population dooms Russia to indefinite stagnation?

I am not competent to discuss demographic questions, though it is worth pointing out that Russia’s demographic situation is looking far more healthy than the Western and Russian liberal consensus was predicting just a few years ago.

My clear view however is that what has historically held the Russian economy back is not a lack of people but a lack of investment and management skills.

The lack of management skills is something that can only be improved over time but those I know who know about such things tell me that though progress is necessarily incremental it is happening all the time as more and more Russian businesses learn to work within the disciplines and opportunities provided by a market economy.

In that respect the recession has been useful by forcing businesses to work more efficiently and better and by forcing badly run and insolvent businesses to close. That of course is what recessions are supposed to do in market economies.

As to increasing the economy’s rate of investment, the whole policy of the Russian government since Putin’s re-election in 2012 has been focused on increasing the rate of investment and anyone who is unaware of the fact has simply not been following Russian policy closely.  

It is precisely in order to increase the rate of investment that the government has focused so single-mindedly on its anti-inflation strategy (high inflation being a known disincentive to long-term investment) and why it has been working so hard to improve the business climate. 

I would add that it is precisely because the government has been so focused on bringing inflation down in order to achieve higher rates of investment - and therefore more sustainable growth in the future - that the growth rate fell in 2012.

As the government and the Central Bank both made clear at the time they decided to accept a trade-off: sacrificing short term growth in order to extinguish inflation so as to secure higher and more sustainable growth in the future. 

To that end credit conditions in 2012 were sharply tightened and interest rates rose - and have remained high ever since - which is the true reason - not the famous "structural factors" - why after 2012 growth fell.

On the question of the business climate Ben Aris’s claim that in Russia it is appalling is flatly contradicted by the findings of the World Bank’s Ease of Doing Business report, which shows on the contrary that it is improving rapidly.

The factors that have worked against the rate of investment in Russia's economy being higher such as the high rate of inflation, the historic over-valuation of the rouble, the high interest rates and Russia’s undeveloped financial system are anyway gradually being put right. It is always possible to wish this was being done faster than it is. However my opinion is that it is being done as fast as is practicably possible, and it is simply not realistic to ask for more.

As to a falling working population creating capacity constraints in the future, that is a strange claim given that the people who make it also tend to be the ones who complain about the high level of import penetration in the economy.

Provided the economy is able to retain the competitive advantage it has achieved through the fall in the rouble the collapse of imports ought to create plenty of space for the economy to grow rapidly in the short to medium term  

Ultimately the whole question of whether the falling working age population creates capacity constraints turns on whether or not the economy is actually working at maximum capacity with its current working age population now.  

Bluntly I don’t think it is - not remotely - in which case the whole problem of capacity constraints supposedly caused by Russia’s falling working age population simply doesn’t exist.

For the future if the economy takes off and sustains a high rate of growth because of a surge in investment and productivity it will have no difficulty finding all the labour it needs not just from a higher birth rate within the country or by immigration from Central Asia and the near abroad but also because of immigration from farther afield - probably starting with Eastern Europe - just as was the case with the US in the nineteenth century.

It is anyway a basic economic fallacy to think that higher wages automatically lead to higher inflation. On the contrary in a dynamically growing economy higher wages are necessary in order to provide the demand such an economy needs in order to grow in a sustainable way.  

Higher wages only cause a serious inflation risk if there is a disconnect between supply and demand because supply is maxed out. In an economy such as Russia’s where there is potential for supply to grow rapidly through higher investment the serious inflation risk discussed in The Financial Times article simply doesn’t exist if the problems on the supply side (discussed previously) are sorted out. On the contrary the growth in output and the growth in demand from the higher wages in that case support each other.

That this is in fact the true situation in Russia is shown by the dynamic response of the country’s agricultural sector to the opportunities created by the cut in food imports caused by the rouble's devaluation and the food embargo. 

Not only has the demand for food products been quickly met but the brief spike in food prices caused by the cut in food imports and by the rouble devaluation has quickly come to an end as the gap in food supplies has been rapidly closed. 

The government anyway accepts that in order for growth in Russia to be high inflation in Russia will have for a time to be higher than it is in the more mature economies of the West.

Central Bank Chairman Nabiullina has said in my presence that according to the government’s and the Central Bank’s calculations an inflation rate of 4% - the Central Bank’s current target - is optimal for the economy at its present stage of development in order to achieve a high and sustainable level of growth over the medium to long term. 

Higher inflation than this target would disincentivise investment. Lower inflation would stifle growth.

These discussions about the long term should anyway not distract from the situation of the economy now.

All the indications are that Putin is right to say it is in a “grey zone” and to think it will not remain there for much longer. One way or the other Russia looks set for a return to growth.

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