Russian Economy: from 2019 to 2020

At the end of January, Rosstat presented preliminary data on Russia's economic performance during 2019. In anticipation of the official publication, IQ.HSE interviewed a prominent  Russian expert, Director of the HSE Centre for Business Tendency Studies (CBTS) Georgy Ostapkovich, about the 2019 results and the outlook for 2020.

Growth Not Impressive

Russia's economy in 2019 could be described as consistently and moderately growing, without indications of either a significant upward trend or a new recession similar to that of 2015 and early 2016.

By the end of 2019, the country's GDP, the key economic performance indicator, showed limited positive growth at rates nearly half of those observed in 2018, which is far from impressive for a catch-up economy.

Consistent with the Russian Ministry of Economic Development's earlier projections, the marginal GDP growth rate in 2019 is likely to be around 1.3% (versus 2.3% in 2018).

This is nearly 2.5 times below the global average; with slight variations, this economic lag has been observed over the last seven years, bringing Russia's share of the global GDP down to less than 2%.

Dependence on Consumers

On a positive note, Russia has somewhat exceeded its 2018 economic results in all basic sectors of its economy.

This positive trend is led by the manufacturing industry (about 30% of value added in GDP) and trade, including wholesale trade (approximately 14.5% of GDP), due to high proportions of food and fuel sales.

Agriculture performed relatively well, at least compared to the extremely unfavourable results of 2018. Transport and construction showed small yet positive growth. The services sector faced some uncertainty.

Sluggish performance in the services, retail, and construction sectors (in particular, housing construction) is by no means unexpected, as these sectors are highly dependent on consumer demand, which, in turn, is constrained by declining – or more recently, stagnant – disposable household incomes.

Good News in Finance

Thanks to the Russian Ministry of Finance's strict enforcement of the fiscal rule and the Central Bank's conservative monetary policy, 2019 has seen perhaps the best in the post-Soviet period fundamental financial results needed for macroeconomic stability and economic development.

These include, in particular, Russia's accumulated international reserves which currently stand at nearly US$ 550 billion. 

  Russia's gold and foreign exchange reserves virtually offset the country's foreign debt and exceed its annual imports by more than double.

  The liquid part of the National Wealth Fund (NWF) is approaching 7% of GDP and thus can be used to finance economic development.

  The national budget and balance of payments are in surplus.

  As is traditional, Russia's balance of trade is also in surplus.

  The share of external national debt in Russia's GDP is one of the lowest among developed and developing economies.

   The Russian federal bond (OFZ) market is performing fairly well due to a high yield, with the share of foreign investors never falling below 30% in recent years.

These developments almost guarantee macroeconomic stability, including low volatility of the national currency, not only for the current period but also for the near future.

Inconvenient Questions

But why, despite a favourable financial situation, is the Russian economy performing poorly? And more importantly, why have household incomes declined over the last six years?

The latter seems counterintuitive. According to classical economic theory, incomes should begin to grow six to nine months after the onset of GDP growth. Yet in Russia, the physical GDP volume, according to the Federal Statistics Service, has been on an upward trend for 14 consecutive quarters (year on year), but household incomes have declined or stagnated over the last six years.

It appears therefore that financial resources are at least partially wasted on non-performing projects, unproductive costs and excessive accumulation of inventories, and therefore fail to produce a multiplier effect that could contribute to people's wellbeing and living standards.

There are two potential sources of finance for public benefit projects in Russia:

 oil export revenues, provided that the cut-off carbon price beyond which oil and gas revenues may be channelled into the NWF is raised from the current US$ 40 to at least US$ 46 per barrel;

 using the accumulated budget surplus which is effectively frozen at the moment. A discussion of whether a budget surplus indicates prosperity and budget deficit is bad news has been ongoing since the times of Adam Smith and David Riccardo, the founders of modern economic theory. As an example, despite a chronic budget deficit, the US appears to perform fairly well in terms of economy and living standards.

The question of how the respective proportions of external debt and sovereign funds (i.e. the NWF in Russia) impact on the economy is debatable. As a reminder, Russia's national debt is minimal and the NWF resources are sufficient to fuel the economy.

However, by looking at the share of debt in other countries' GDP, one can see that it tends to be high in first-world countries such as Japan (with external debt around 250% of GDP), Italy (132%), the U.S. (108%), Belgium (107%) and France (around 100%), and low in poorer countries such as Afghanistan (around 8%), Solomon Islands (10%), Botswana (12%) and Nigeria (14%).

The question is whether large public debt is really bad for the economy or whether it depends on how this debt is managed? Or perhaps the reason why some countries have relatively small public debt is that potential funders will not lend to them?

The size of sovereign funds is also a controversial matter. Just one developed economy – Norway – is in the top ten of countries with large sovereign funds. This may mean that developed countries trust their ability to manage the economy without a huge financial safety cushion to protect them against 'black swans'.

Russia's NWF accounts for approximately 7% of the GDP, placing Russia at the bottom of the top twenty countries in terms of sovereign funds, below not only Brunei and Kuwait (with sovereign funds exceeding 400% of the GDP) but also CIS countries such as Azerbaijan, Kazakhstan and Uzbekistan.

Household Incomes, Once Again

In 2019, the state, mass media and civil society focused in particular on two economy-related problems:

 current trends in real disposable household incomes; and

  income inequality.

Calculated according to Rosstat's new methodology, the incomes of Russian households have dropped by 8% since 2014 but have rebounded slightly over the last two years (by 0.2% in 2018). This is certainly a welcome trend, because even a 0.1% increase means around 60 billion rubles of additional income, but if household income growth continues at such minuscule rates, bringing it back to higher levels may take a while.

Why have incomes increased recently? Three key factors may be at play:

  inflationary pressures (translated to rising prices) have been much lower;

 consumer lending and related household debt have gone down, particularly in the second half of 2019 (according to Rosstat's methodology, with amounts spent on debt repayment subtracted from real disposable income);

  certain categories of people had their earnings indexed, sometimes at rates higher than the current inflation rate.

Since Rosstat has not yet published its 2019 data, it is unclear which income group (low, medium or high) has benefitted most from the increase.

  If the benefits spread evenly across all income groups, this is a positive development.

  If low-income households were the main beneficiaries, this will help reduce income inequality.

  If the richest group benefitted, while nothing changed for the poor, this will worsen the social divide.

It appears that the 2019 results will once again demonstrate the Matthew effect of accumulated advantage, i.e. 'the rich get richer and the poor get poorer'. The number of Russians living in poverty (i.e. below the subsistence level) increased by 100,000 in the first nine months of 2019 compared to 2018 (year on year), an indirect indication that low-income people did not see an income increase.

Inequality in Wealth

Despite numerous expert statements in the mass media about increasing inequality in Russia, Rosstat’s data suggest the exact opposite, as the Gini coefficient, the most commonly used measure of inequality, has been going down in Russia for six consecutive years.

Dropping from 0.420 in 2013 to 0.411 in 2018, it places Russia in the middle between higher and lower Gini index countries, close to the US and China.

What experts are probably concerned about, and rightly so, are differences in the level of wealth, such as cash, securities, owned production assets, real estate and personal possessions. While no official estimates are available in Russia for this type of inequality, one can assume, given the high share of rental income in the economy and substantial corruption, that the situation is critical.

Wealth inequality has been on the rise worldwide. The wealthiest 1% of the world’s population now own more than half of the world’s wealth, and the world's 100 richest people own as much as the poorest four billion.

External Risks

In 2020–2021, the world’s economic situation is likely to worsen leading up to a new global crisis. The threat is real, although the timing is uncertain.

All crises originate in the largest economies, and the current situation is a cause for concern:

 The US-China trade war may reach its peak after the US Presidential elections on November 3, 2020;

  Facing a high trade deficit, Donald Trump, if re-elected, may launch trade disputes against some EU countries;

 China may see an economic slowdown this year due to its trade war with the US;

 There is still uncertainty regarding the EU economy, whose aggregate GDP is comparable to that of the US. Germany, the largest EU economy, has already entered recession;

 India is facing an economic slowdown, and Japan's chronic economic stagnation continues.

What does it all mean for Russia?

Unless faced with a global economic crisis on the scale of the Great Depression, serious damage is unlikely. Russia's substantial reserves, fairly stable economic situation, and low inflation and unemployment will help the country overcome economic turbulence.

But fiscal problems are inevitable due to a fall in commodity prices (80% of Russian exports) and increased capital outflow.

How this will impact on household incomes, wages, unemployment and inflation rates is hard to predict. But one can be certain that dealing with the crisis will require additional finances, which could otherwise have been spent on socioeconomic projects, and may disrupt the supply and demand balance.

Traditions Not Necessarily Good

Save for a drastic slowdown in the global economy and international trade, particularly between the EU and China, the key consumers of Russian exports, the country's economy in 2020 will remain basically the same as in 2019 and may show some limited growth of 1.5% - 1.7% according to the more optimistic forecasts.

A few 'traditional' problems are likely to constrain further growth, namely:

 limited investment and innovation by Russian businesses wary of economic uncertainty;

 limited consumer demand due to low household incomes;

  poor labour productivity – often caused by high wear and tear of production facilities rather than the human factor – capacity underutilisation, and skills shortages.

Upgrading production facilities requires investment. Today, the share of investment in Russia's GDP is 20%–21% but needs to be at least 25%–27% for sustainable and accentuated growth. At the time of China's double-digit economic growth, investment reached 40%–42% of its GDP.

New Barriers

Alongside traditional problems, there are a few more recent ones likely to cause economic slowdown in the near future:

 demographic pitfall;

 decline in retail sales;

 negative changes in the labour market.

Recently, Russia has been facing a demographic pitfall, and the country's population will continue to age and decline. The country’s workforce is shrinking, in particular the most productive 23–47-year-old group essential for the key economic sectors such as the manufacturing industry, agriculture, construction and transport.

Russia's worsening demographics are affecting (and will continue to affect) the retail sector, with hyper- and supermarkets losing customers, as generations Y (born 1984–1995) and Z (born 1995–2000) replace baby boomers (born 1946–1960) and the older generation X (1961–1980) in the consumer market.

The incoming and outgoing age groups have different consumer mentality:

 Russian baby boomers lived most of their lives amidst long queues and shortages of basic consumer goods, especially in the years preceding the USSR collapse. They are therefore used to stocking up on food and non-food items for future use, sometimes to excess.

 young adults from generation Z who literally go to bed with their gadgets are unlikely to be buying a month's or a week's worth of groceries. Whenever they get hungry, they will go to a nearby convenience store or order food online.

This change in consumer behaviour patterns may lead to a certain decline in retail turnover, which, in turn, will affect the manufacturers of consumer goods, forcing them to cut production, and ultimately slow down the country's real GDP growth.

Contrary to what some ‘experts’ have been fretting about, the third potential negative change in the labour market has little to do with technological unemployment, because people will simply switch to new jobs created by the digital environment. The real challenge is that of a widening gap between well-educated, highly skilled employees taking up high-paying vacancies and those lacking education and skills who will end up in low-paying, often seasonal jobs.

This will further increase income inequality in society. Faced by many countries, this challenge can be addressed by investing public funds in human capital (healthcare and education).

Things Not Likely to Get Worse in 2020

In case of moderate economic and political developments in Russia and worldwide, stepping up the implementation of national projects (with a respective increase in financing) could be the main driver of Russia's economy in 2020.

An increase in household spending could also contribute to positive GDP growth. Higher consumer spending may be induced by:

 an increase in real disposable household incomes. These are likely to rise by 1.2%, in quantitative terms, i.e. by more than 700 billion rubles per year; and

 a further increase in consumer lending. A rise in consumer lending observed in the first half of 2019 prompted heated discussions and forecasts of an upcoming recession. While lending rates slowed down in the second half of 2019, banks will probably do their best to step them up again.

In Summary, What Can We Expect in 2020?

 The manufacturing industry, one of the pillars of the economy, will continue to grow faster than other sectors.

 A slight increase can be expected in construction, perhaps in an effort to create a reserve of housing properties to meet the 'presidential' target of providing 120 million sq. metres of housing by 2024.

 The expected growth of the manufacturing industry and construction is likely to boost the transport sector.

 Retail services are unlikely to show significant growth due to sluggish dynamics of household incomes.

 Growth is expected in digital commerce, ICT and export services.

 Inflation rates will continue to decrease to reach 2.7% by mid-second quarter, but then higher government spending and rising food prices will probably cause a rise in inflation, reaching 3.6% by the year end.

 In this inflation context, the CBR is unlikely to cut the year's key rate below 5.75 - 6 points.

In sum, unless 'black swans' fly in, nothing indicates a decline in Russia's currently stable macroeconomic situation in 2020. The most important thing is to make sure stability goes hand in hand with economic growth and better living standards for the Russian people.
IQ

Author: Georgy Vladimirovich Ostapkovich, February 12, 2020