Russia’s economic recovery has been impressive since the country’s financial crisis in 1998. But power remains concentrated in a small number of large industrial groups. A much broader industrial and entrepreneurial base is necessary if Russia is to achieve its economic ambitions, says Ben Aris –
Russian president Vladimir Putin set Russia the task of overtaking Portugal in economic terms during his state of the nation speech in April 2002. But the slow place of structural reform means that Russia is more likely to end up looking like India or Indonesia.
Russia has put in three years of sterling growth, averaging 6.5% of GDP increases since 1999 but it needs to grow at more than 8% a year if it is to overtake Europe’s poorest nation before Putin officially retires in 2017.
Following the devaluation of the rouble in 1998, the raw material producers have been raking in the money and reinvesting in themselves to produce double-digit growth.
At the same time, rising incomes and the advent of consumer credit mean that any business catering to consumers is also growing strongly. However, the middle layer of Russian industry remains mired in economic misery.
Investment is the key to picking up the pace of growth. However, according to official figures fixed investment has levelled off at 16% to 17% of GDP, most of which is going into raw material extraction.
As a proportion of GDP, Russia’s fixed investment is on a par with such countries as the US. That is not nearly enough. Russia needs to spend far more than the tick-over equilibrium level that the developed world is able to maintain. For example, utilities monopoly United Energy Systems chief Anatoly Chubais estimates that the company needs to spend $5 billion a year to stand still but can only afford a fifth of that amount at the moment.
Investment is also going to the wrong places, with the fuel and energy sector plus what the government invests in the public sector still accounting for two-thirds of all investment.
Most of the remainder is pumped into the fast-moving food processing industry and other sectors catering to the consumer. But these sectors account for a relatively small part of GDP.
At heart, Russia still remains dependent on oil production and so is vulnerable to the vagaries of the international commodity markets.
“The economy remains highly concentrated in at least three dimensions,” says Chris Ruehl, chief Russian economist for the World Bank.
“Ownership in the private sector is concentrated in a few conglomerates. New firms and start-ups, the drivers of growth in other transition economies, have been slow to develop, with the enterprise structure inherited from the socialist period still dominating much of the economy. Above all, Russia’s economic performance remains crucially dependent on natural resource exports, in particular on oil.”
Investment in oil has put the budget into profit and ended the 7% to 8% deficit that hung, like the sword of Damocles, over Russia for most of the 1990s until it crashed down on August 17, 1998.
Russia runs no danger of another oil-price inspired crash, but it is not out of the woods yet. Growth is still a slave to what happens outside the country; Ruehl says that the Russian economy has yet to reach critical mass.
Most of the fast growth of the past few years has been achieved by doing little more than putting idle workers back to work. However, as companies start to run into capacity constraints further productivity gains will only come from big capital expenditure on new equipment.
As companies have until now made virtually all their investments out of retained earnings – bank loans remain stuck at about 4% of the total invested capital – the lack of long-term affordable credits is the biggest impediment to continued fast growth.
The Central Bank of Russia has made a start on bank reform and is trying to lower interest rates – the CBR’s discount rate remains a high 21%.
But Sberbank’s continued dominance of the retail sector and monopolization of the only source of long-term funds in Russia means that little will change on this front in the near term; bankers say the current round of reforms will only begin to take effect in four or five years.
In its latest transition report, the European Bank for Reconstruction & Development says savings have reached 30% of GDP in Russia, while investments amount to 15% of the GDP. In the EU countries, these two indicators are more or less equal, the sign of well-balanced investment activity.
In the meantime, the only people with real money in Russia are the big industrial groups collected around a raw material producer. Peter Boone of Brunswick Warburg, a Moscow-based investment bank, estimates that a mere eight industrial groups account for 20% of GDP.
The Big Eight, some of them run by reformed oligarchs from the Yeltsin era and new entrants, are capably managed. They snapped up many of Russia’s most attractive assets during the fire sale that followed the 1998 crisis.
Investing heavily in their new companies, these oligarchs have begun to understand the idea of return on capital, and have split their businesses into clearly defined compartments, each of which has to be profitable in its own right.
“The industrial groups are now buying assets in different sectors, such as chemical, pulp, timber or agriculture, and pulling together something that can reach critical mass or take advantage of the economies of scale,” says Alfa Bank chairman Alexander Knaster.
“It remains to be proved if these groups will add value or not but they are doing the basic things – putting in decent management and imposing some financial discipline.”
The game has changed for Russia. Growth is no longer the issue and sustained growth seems assured, but the pace of growth is the key. Too much economic power in the hand of only a few companies could ossify the economy, leading some economists to talk about Russia’s growing “chaebolization” – a similar experience, that is, to South Korea’s in the 1980s and 1990s.
The small and medium-size enterprises (SMEs) are unable to compete with the Big Eight, which are simply spending their way into several sectors and crushing competition by sheer size. Size also gives the big companies a measure of political clout that they are not abashed in using to bolster their position.
On the flip side, while the Kremlin has done impressive work pushing through reforms to tax, customs and property rights, it has done virtually nothing to reform the judicial system and reduce regulations and bureaucracy. Under Putin bureaucracy has grown, and this continues to hold the SMEs down.
A recent World Bank survey showed that when a firm employs more than seven people it attracts the attention of the local administration, bringing down a shower of grasping inspectors and special rules. The same survey found there is no legal requirement for eight out of 10 permits demanded by regional authorities.
“The regulatory glass ceiling for small firms means they spend most of their time dreaming up schemes to stay below the local authorities’ radar,” says Ruehl. “Consequently, small businesses are not absorbing their share of workers from restructured or downsizing state firms, which is key to the transition process.”
The big companies are already having an easy time picking over the best opportunities. The economy runs the danger of an ever-widening gap between the few dominant industrial groups, which exercise both monopolistic and political power, and the broad base of SMEs.
However, after a slow start to the year, Russia’s companies put in an unexpectedly good performance in the second half of 2002, hinting that things might be going faster than expected.
Brunswick’s Boone argues that the Big Eight will never be very good at manufacturing, as their strength is in wielding political clout to control infrastructure-intensive industries such as raw material extraction. These companies are not nimble enough to make money from the low-margin, high-volume mass-retail markets.
Goskomstat reported in November that the five basic sectors of the economy had picked up some momentum by the start of winter and retail trade, in particular, continued to storm ahead, rising 9.9% year on year by October.
At the same time, total corporate profits in September (excluding small business, banking and agriculture) were up by a massive 50% to Rb184.5 billion ($6.2 billion) after a sharp fall at the start of the year – the third increase in a row after 10 months of decline.
Leading analysts have begun to suggest that Russian companies are getting better at adapting to new pressures from imports and rising costs. Alexei Moisseev, chief economist at Renaissance Capital, says: “These results, along with continued rising industrial production, attest to the underlying resilience of the economy, with the strong growth in investment in 2000 and 2001 finally starting to make itself felt.”