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Russia's Economy: Actually Import Substitution IS Happening

Articles in Forbes claiming that import substitution is not happening show a superficial understanding of industrial processes and of the Russian economy

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This post first appeared on Russia Insider

Two separate articles which have recently appeared in Forbes - by Mark Adomanis and by Kenneth Rapoza - make the same point, which I fear is likely to become the next cliche about the Russian economy.

This concerns the much talked about subject of import substitution.  Adomanis and Rapoza have looked at the state of the Russian economy and say it is not happening. 

As a general point, when made about the current Russian economy, this is the sort of claim that tends to be made by commentators who lack experience of industrial processes, and who therefore underestimate the time and effort needed to develop and produce a new product and bring it to the market.

To expect an economy as large and complex as Russia’s to change significantly in just a year is to ask a lot - in fact more than is humanly possible in the real world.

Beyond that there is the fact that this claim simply overlooks the overriding issue of the macroeconomic conditions in Russia during the period Adomanis and Rapoza are writing about.

As the Western media never ceases to remind us, following the rouble’s devaluation in 2014 the Russian economy has been in recession. 

Interest rates in December 2014 went up to 17%, and inflation at its annualised peak in 2015 hit 16%.  Unsurprisingly, both investment and demand crashed, and in the second quarter of 2015 output plunged.  The GDP contraction in 2015 over the whole year was 3.7%, whilst industrial output fell by between 3.4-3.5%.

Since then the situation has stabilised.  

There have been no further big falls in output since the second quarter of 2015.  Output is broadly flat - though at the depressed levels reached in the second quarter of 2015.  Inflation has been falling fast and is now running at an annualised level of 8.6% - in other words at roughly half the rate of a year ago.  Employment has held steady, and there are the first tentative signs of a recovery in investment.

Interest rates however at 11% remain very high, and continue to be a significant drag on the economy as a whole.   

The government is not compensating for this interest rate drag by increasing spending.  On the contrary it is cutting back spending in response to the oil price fall.

The result is that the government ran a budget deficit in 2015 which it is now confirmed came to just 2.4% of GDP - lower than early estimates at the start of this year - whilst despite the further oil price fall it aims for a deficit this year of no more than 3% of GDP - though the emerging consensus is it will be closer to 4% of GDP.

To expect that in conditions of recession, at a time of falling investment and demand and with the government refusing to provide a fiscal stimulus, the manufacturing side of the economy will be coming forward with a host of new products, and to talk of the failure of an income substitution programme because this is not happening, is more than a little surreal.

The test will be what happens when investment and demand fully recover, which because of the high interest rates the government does not now expect to happen until the second half of the year.

There is anyway a larger point to be made about the whole issue of import substitution, which goes back to my original point about the time and effort needed to develop a new product and bring it to the market, which I mentioned at the start of this article.

The government has long range programmes to replace imports in certain key sectors of the country’s industry as part of a long term programme of strengthening those sectors so as to rebalance the economy towards high technology manufacturing.

Typically these are in sectors where very long lead times are needed to turn out products.

A good example is the aircraft building industry, where the Russian government has very ambitious plans to replace imported aircraft and engines with new domestically produced and designed aircraft and engines.  

An abundance of projects for new aircraft and engines exist, but the very long lead times involved in bringing such projects from the initial concept stage to series production (typically ten years) means these will not start to appear in quantity before 2020.

The government has similar ambitious plans for other key industrial sectors eg. the high-end car industry (“Project Kortezh”), shipbuilding, certain types of advanced electronics, the space industry etc.  

These are all sectors with long lead times that require long range planning and investment such as only the government can provide - which is precisely why the government involved itself in them in the first place as it does to a greater or lesser extent in all major industrial economies including the US. 

These plans were mostly formed in the mid to late 2000s, though some are more recent still.  Again as in aircraft building because of the long lead times, these plans will only start to bear visible fruit by the end of the decade. 

In other sectors industry can be left to take care of import substitution by itself.  

Here the government’s role is to shape business conditions so as to make industry more flexible and more responsive to market signals - which is precisely what it has in fact been doing.  

The key stimulus is however provided by the recovery of economic competitiveness caused by the rouble’s devaluation - whose effect will however only become fully felt once investment and demand recover (see above).

Even in these sectors, in the case of products that Russia either makes in limited quantity or which it does not make at all, there are still significant lead times, that would make it all but impossible in the best conditions for new products to appear in large quantities in the short time since the devaluation took place a year ago.

In sectors where Russia already has a significant presence the lead times are shorter and the stimulus is greater and here despite the recession shifts are becoming increasingly visible.

One such sector is agriculture, which is responding strongly, with the target of food self-sufficiency in key food products within reach.

Agriculture is a special case, but the same appears to be happening to a lesser degree even in the volume car industry, which has been especially badly hit by the fall in investment and demand during the recession, shifts appear to be happening.  

Though demand for all brands of cars has fallen sharply during the recession, it seems that sales of cars made by the domestic producer AvtoVaz have fallen by less than those of foreign brands.    

That suggests that those Russians who can still afford to buy cars are more likely now to buy them from AvtoVaz than they were before the devaluation - not because they have any special love or loyalty for AvtoVaz, but because since the devaluation its cars have become cheaper than those of its foreign competititors.

The government has in fact for some time been pressing foreign car manufacturers with factories in Russia to locate the complete manufacturing cycle in Russia rather than rely on imported components.  There is some anecdotal evidence this is happening.

To suggest therefore that an import substitution process has already failed even before it has properly begun is therefore wrong.  It also suggests a superficial understanding not just of the Russian economy, but also of economic and industrial processes in general.

Adomanis and Rapoza - Rapoza especially - also make some very questionable claims about the level of diversification of the Russian economy.  I will however leave discussion of that to others.


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