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Russia's Second Quarter Contraction Is No Big Deal

Data in July points to an improving economy - contradicting scaremongering stories based on an entirely predictable - and predicted - contraction in the second quarter

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This post first appeared on Russia Insider


Confirmation from Rosstat - the Russian government’s statistical agency - of a 4.6% contraction in GDP in the second quarter, has led - predictably enough - to a resurgence of some of the apocalyptic predictions of the last year.

There is no justification for this. 

All recessions have their peculiar features. However he classic pattern of a recession in a market economy is that a fall in demand - usually caused by the bursting of a credit bubble - leads to a cut in production and investment, with producers preferring to draw down their existing inventories rather than buy in new products.  

In time demand recovers, production rises as demand has to be met and as depleted inventories have to be replenished, and the recession ends. 

This is the pattern the Russian economy is following.

The fall in demand that struck Russia in the early months of 2015 was not caused by the bursting of a credit bubble. The Russian authorities have a horror of bubbles, and whenever there has been any sign of such a bubble - as in the early months of 2012 - they have always acted decisively to stop it.

Rather what caused demand to fall at the start of this recession was the combination of the inflation and the high interest rates caused by last year’s devaluation of the rouble. That devaluation of the rouble was in turn caused by last year’s collapse of oil prices, energy products being for historic reasons Russia’s main export product.

In the early weeks of 2015 food price inflation in Russia was running at over 20%. By some estimates real incomes fell by as much as 9%.  

The inevitable result was a fall in demand, causing a recession.

I saw evidence of this when I visited Moscow in February, as did Dr. Gilbert Doctorow when he visited Russia a few weeks later.  It was apparent that the inflation spike was hurting badly, especially those with low and fixed incomes. 

As well as the inflation spike, the very high interest rates - caused by the Central Bank’s need to damp down inflation and to support the rouble - increased the cost of borrowing, cutting demand for expensive items such as cars that are usually bought on credit, and hitting investment.

With producers responding to the fall in demand as one would expect by cutting inventories, production inevitably fell.  

Since it takes time for information to be passed down from consumers to producers down the supply chain, the major cutbacks in production and spending took place in the second quarter rather than the first, as decisions made in the first quarter were fully implemented in the second. This is why with a GDP contraction of 4.6% in the second quarter, the recession appeared deeper in the second quarter than the first, even as sentiment in the economy actually began to improve.

This is the picture that the statistics have been reflecting. As I have pointed out on several occasions, given what happened at the end of last year it could not have been otherwise.

The point is that as the inflation spike burns its way through and as interest rates fall, demand will first stabilise and then recover.  

According to Rosstat prices stopped growing in the second half of July and weekly price inflation has now been zero for several weeks. 

This is usually the case in Russia in the summer months. However the fact that it is happening this year so soon after the inflation spike of the winter shows how quickly the situation is returning to normal.

At the same time as inflation has fallen, interest rates have been cut.

With both prices and interest rates falling, early indications are that demand has stabilised and stopped falling at its previous speed in July - and may even have increased that month.    

As always the process takes a little time to work itself through, so that while the fall in industrial output appears to have slowed in July, manufacturing continued to contract.  However as demand recovers and as it becomes necessary to replenish inventories, industrial output will rise, bringing the recession finally to an end.

As I have said previously, the Economics Ministry is predicting the end of the recession in the final quarter, and this remains its opinion and the general consensus.

This recession - as all recessions do - has exposed weaknesses in the Russian economy. Of these the most important is not that Russia’s major export is energy products. This a grossly overhyped issue that wildly overestimates the importance of foreign trade to a continental sized economy which the World Bank estimates on a purchasing power parity basis is now the fifth biggest economy in the world.  

The economy’s vulnerability to movements in oil prices is anyway now largely mitigated by the floating exchange rate (see for example the opinions of Aleksey Ulyukaev - Russia’s Economics Minister - given at the beginning of July when the oil price appeared to have recovered - about why Russia would not be worried by a $40 a barrel oil price).  

As I have also previously said, further downward movements in oil prices and the rouble are now unlikely to change the underlying inflation position or affect Russia’s recovery.

The Russian economy’s key weakness is not the fact that it exports mainly energy products, but the weakness of its financial system - a fact recently acknowledged by the Central Bank, which described Russia’s financial system as “shallow”.  

For an economy of Russia’s size the financial system is too small, which is why Russian banks and companies have until recently looked outside Russia to western Europe for part of their finance.

It is because the financial system is too small that the rouble is so volatile and the government is unwilling to run a budget or trade deficit, even at times such as these when oil prices are low and when the recession could be smoothed by the government running a bigger deficit.  

By contrast Saudi Arabia, with an economy far less diversified than Russia’s, is able to maintain a currency peg with the dollar and cover a budget deficit estimated at 20% of GDP by borrowing from its banks, which are much more liquid than Russia’s. 

The weakness of Russia’s financial system is a reflection of its youth. It has only been functioning properly for about 10 years. It would be asking a great deal to expect a financial system this young to achieve levels of depth and sophistication comparable to those of Western financial institutions in such a short time.   

The weakness and small size of Russia’s financial system is not however something written in stone.  

A country as large and wealthy as Russia can certainly develop a financial system big enough to fund the needs of its economy.  

As Russia Insider has discussed previously, the great benefit for Russia of the sanctions is precisely that it is obliging Russia to make reorganisation of its financial system a priority. 

Thus we are finally seeing steps to create a new interbank payment system alongside SWIFT, a new credit rating agency, and a new bank card independent of MasterCard and Visa, at the same time as the Central Bank has been busy withdrawing licences from unstable banks.

Above all it is reflected in the Central Bank's and the government's single-minded focus on reducing inflation to an annualised level of 4%. As the Russian authorities understand well, the Russian financial system cannot fully expand and modernise whilst inflation remains as high as it has historically been in Russia.

With younger people - some of whom have experience working in Western financial institutions - now joining Russia’s banks in increasing numbers, what these steps mean is that the modernisation and expansion of Russia's financial system to the point when it finally becomes fit for purpose is now only a question of time.

In the meantime, if the recession has exposed weaknesses in Russia’s economy, it has also highlighted its strengths.

Despite the fact that the country is in recession - and despite the very high interest rates at the start of the year - there have been no mass redundancies (unemployment has barely risen), no mass plant closures, no flood of bankruptcies or of home repossessions or of farm foreclosures.  So far this has been almost entirely an output recession.

This reflects the low level of debt in the economy.  

This low level of debt is partly a reflection of a lack of investment in the economy caused by the weakness of the financial system.

It is however also a reflection of the authorities’ deep aversion to credit bubbles and the steps they have repeatedly taken to prevent them.

The result is that in Russia - as in the West until the 1980s - demand has risen on the back of higher wages, not through credit growth.

This explains the country’s resilience in the face of recession.  It is why the country can absorb the inflation and high interest rates of the start of the year, and the temporary drop in output they caused, without this affecting the country’s underlying stability.


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