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10.01.08
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Staying Stable
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By Felix Goryunov
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The time of economic uncertainty is over. By many estimates, the United States is heading into the recession that has been postponed since 2001. There are also indications that the economies of Japan and the major European countries will follow the downturn. For several decades, the global economy has managed to escape the kind of coincidence that would lead to a simultaneous contraction of demand in the world’s wealthier countries. Given this situation, the leaders of all national economies are being vigilant, hoping to protect their countries from the dangers of the global credit crisis and oncoming recession, provoked by the meltdown of subprime mortgage loan schemes in the United States.
Russia was only slightly shaken by the global credit crunch last fall, thanks to the prompt reaction of its regulatory bodies. The Central Bank of Russia pumped sufficient liquidity into the banking system in time, while the government said it would stand by with an open wallet in case of a financial emergency. As a result, the Russian money markets calmed, and it has been business as usual ever since. The expected downturn in the developed world would certainly affect the performance of Russia’s economy, although it is unclear as to what extent.
While Russia is reasonably well integrated into the world economy, it is not yet sensitive to contractions in demand for its merchandise exports in the West since prices for its core exports –oil, gas and metals – are now set by expanding Asian markets. Even in the unlikely case of a sizable reduction in world demand for crude oil and a fall in prices, Russia’s economy would not shrink significantly since the Ministry of Finance has allocated reserves to allow spending to continue at the rate approved in the three-year budget.
It is expected that when recession embraces the developed world, emerging market economies as a group will become major drivers of the global economy, de-coupling from dependence on the U.S. market, so Russia may foster its business relations with these fast-growing economies. Moreover, Russian business would benefit from the economic malaise in the West since international investors would be likely to pour more money into its industries undergoing technological restructuring.
This is not to say that Russia is immune to any outside turmoil, however. Last year’s increase in domestic food prices, which significantly depend on the international balance between supply and demand, is an obvious example. It can also be expected that a slowdown in the developed economies will increase competitive pressures on Russian producers of business equipment and other manufacturers as well as on domestic providers of financial and other services.
There are also several challenges facing Russia’s macroeconomic regulators. The first is consumer price inflation, which had surged to 12 percent by the end of 2007, defying the planned 8 percent annual target set by the government. Another problem is the creeping appreciation of the ruble, which undermines the competitiveness of Russian companies at home and abroad. No less serious are recent hikes in wages that overtook increases in labor productivity. Taking into account the shortage of skilled labor in several booming sectors of the economy, it is obvious that the Russian labor market will tend to become less competitive than those of other emerging economies.
These and other challenges are now on the Russian policymakers’ short list. The sustained economic development over the past nine years shows that the government has learned how to regulate a market economy. As a result, Moscow’s top politicians have an over-optimistic view of the economy, and this view has been incorporated in the Concept for Long-term Social and Economic Development of the Russian Federation to the year 2020.
Indicative innovation
This plan is scheduled for release in February, just before the presidential elections, and, after its approval by the Duma, will become an economic strategy roadmap for President Vladimir Putin’s successor. A draft of the document was discussed by senior officials from the Ministry of Economic Development and Trade at a recent roundtable with leading Russian business associations. According to a report on the discussion in the weekly magazine Ekspert, the key idea of the Concept is to make Russia a global leader through transition to an innovation economy. This strategy is based on several major points: taking advantage of existing global opportunities; forming competitive high-tech sectors in the economy and further diversifying its structure; and developing human capital, democratic institutions and insurance of personal freedoms.
As a counter to the Soviet system of central planning in which everything was implemented from the top down, indicative planning has been used in France and Japan as a way of involving private businesses in enhancing economic performance, modernizing industries and solving social problems. Indicative planning achieves these objectives by providing businesses with reliable information regarding market forecasts and government targets, while making compliance with them voluntary.
Although not obligatory, indicative plans – which were first masterminded by Jean Monnet, the father of the Common Market, for industrial reconstruction in France after World War II – are still directed by the government and come with an element of expectation. This commanding element of the new Russian economic concept is the main stumbling-block in the government’s dialogue with business. This problem has been further exacerbated by the Kremlin’s drive to increase the role of the state in the economy.
By the end of 2007, state-owned banks accounted for 43 percent of total banking assets, while state-owned corporations together with regional and municipal governments now account for much more than 50 percent of all Russia’s assets. At least six new state companies were recently created in the defense, aircraft, shipbuilding, high-tech and construction sectors, with more proposed for other sectors of the economy.
Since 2005, four state-funded National Projects have involved the government in improving healthcare, housing, agriculture and education. The Kremlin’s current economic policy in some ways resembles the huge nationalization program carried out in France by former President Francois Mitterrand between 1981 and 1982, which resulted in state ownership of 14 of the country’s 20 largest industrial firms, although the state sector still accounts for only a quarter of French industrial output.
The Russian business community’s concern over these Kremlin economic policies was so pronounced that Putin had to assuage their fears at a meeting with the board of the Russian Chamber of Commerce and Industry. “We are not going to create state capitalism. This is not our choice. This is not our way,” he said.
He also explained the rationale behind the Kremlin’s proactive policies: Russia is lagging behind technologically advanced countries in that innovation generates less than 10 percent of the country’s total output. In the West, the figure is 60 percent. Although Russian academic and R&D establishments have accumulated a considerable number of inventions and new technologies, the Kremlin believes that private businesses are failing to capitalize on the market opportunities they offer, so there is a need for a public-private partnership to start innovation projects, using state funding as venture capital for development, production and marketing of new goods, services and technologies.
This indicative planning combined with state funding of high-tech projects is designed to help Russia overcome its dependence on raw materials. The strategy would make the economy technologically advanced thanks to state corporations, which are supposed to form a backbone of highly competitive economic sectors.
Following the pattern of state-driven economic development in France, Japan, South Korea, China and Vietnam, Russia is striving to further integrate into the global economy not as the world’s major supplier of hydrocarbons, but as a dynamic innovation economy. After his election in March, the new president will have his hands full creating an institutional framework for implementation of the Concept. But it will take some time before the ambitious goals of the strategy begin to materialize. Meanwhile, the Russian economy is rolling along and needs more and more regulatory attention and care to prevent it from going astray in a deteriorating global environment.
Government supposes, market disposes
Although the abundance of natural resources is often called Russia’s “curse,” this wealth is the foundation of the country’s economic clout. Without nature’s blessing, the Kremlin would be unable to engage in expensive innovation projects. And without rising world prices for hydrocarbons, Russia would be unable to boast of sound economic fundamentals such as sustainable account, trade and budget surpluses, the world’s third-largest currency reserves, high growth rates and accelerating domestic and foreign investment.
In contrast to the economic failures of the 1990s, the construction of Russian capitalism in the 21st century has so far proved to be a success. The oncoming recession in the developed countries will put this achievement to the test.
It may seem that even if Russia does not realize its innovation strategy, the economy will go ahead by just following the road of development paved by the West. Besides extraction industries, the main growth sectors in Russia in recent years have been retail trade, housing construction and telecommunications, which were recently supplemented by the automobile and defense industries. The expansion of the banking sector and the introduction of mortgage and other consumer loans also contributed to growth.
Most of these sectors are the same that drove growth decades ago in the West and Japan, and more recently, in China. Presumably, besides capitalizing on nature, Russian economic policy-makers could just follow internationally approved development patterns and rely on market trends. This might have seemed like an ideal position if it weren’t for the unpredictability of the markets. Although paved with good intentions, the road to capitalism is full of hazards, pitfalls and cyclical ups and downs that make following this path a risk-taking endeavor.
In this respect, the prospective slump in the U.S. economy, the world’s largest and most innovative, is an eye-opening occurrence. It is proof of the maxim that macroeconomic policies must not serve fleeting political ambitions, especially when global equilibrium is endangered. But that is exactly what the U.S. Federal Reserve did while trying to fool the market. Since 2001, the Fed’s soft lending policies postponed an eventual downturn by creating a housing bubble that helped to boost consumption. The financial turmoil that is now dragging the U.S. economy into a slump is an aftermath of the bursting of this bubble.
Beware of money flows
While Russia becomes further integrated into a global economy that is going into recession, it has domestic problems that are also rapidly unfolding and need a response. The main problem is inflation.
The root cause, price increases, was diagnosed before the credit crisis began last fall. Those increases were spurred by the appreciation of food prices on the world market and then supplemented by domestic food oligopolies and tax hikes by state-owned utilities. The government tried to curb food prices with measures including administrative price freezes, but the attempts proved futile and now increased inflation is emerging on international money markets.
The growing volatility in global financial markets makes Russia’s open economy vulnerable to monetary causes of inflation. Several interest rate cuts by the U.S. Federal Reserve last fall spurred inflation in India and China and forced these countries to restrict bank lending for fear of bubbles. It may well happen that after the next cut of interest rates by the Fed, waves of money will start flooding Russia’s money markets as well. Having just returned to normal after the fall liquidity crunch, Russia’s banking business would not relish a restrictive regulation of bank lending by Russia’s central bank. And it goes without saying that such restrictions would adversely affect economic growth.
For the Russian economy, huge inflows of money are not very welcome, as its financial markets are not yet sufficiently developed. Since the 1998 default on short-term treasury liabilities, the Russian government has been over-cautious in issuing sovereign securities.
The country’s corporate equity market is performing reasonably well, showing between 20 and 30 percent increases annually in capitalization. But by international standards, it is still too small to absorb excessive liquidity. Large inflows of foreign money cannot be mopped up by Russian banks either, although they could do with some extra capital. With the share of foreign banks on the Russian market increasing from 7 percent three years ago to 22 percent in 2007, the banking sector could welcome more foreign investment, but bank mergers and acquisitions are too slow a process to accommodate even large long-term investment. Besides, Russian banks’ borrowing capacity is now restricted by higher interest rates asked by international lenders.
Russia is a huge market with a lot of room for growth, but so far its development is limited to regions with a relatively affluent population and developed infrastructure. For instance, while there is an acute shortage of affordable housing all over the country, housing construction is growing primarily in a few large cities. But even there, the housing industry would hardly absorb large amounts of money. Rising prices for new homes are already creating housing bubbles in Moscow and St. Petersburg.
The money waves that may soon reach Russia’s financial shores would first hit the ruble by creating excessive liquidity of foreign currency that feeds inflation. If that happens, the Russian Central Bank, like it or not, would have to raise the ruble exchange rate not only against the dollar, but the Euro as well. This would limit the inflationary impact of foreign capital inflows while compensating the resulting loss of competitiveness for Russian merchandise by lower prices for imported business equipment.
There are other challenges facing Moscow policy-makers in view of the recession. Among them is the dilemma of keeping the $150 billion stabilization fund in sovereign bonds denominated in or pegged to the dollar. The reserve currency’s inevitable further depreciation will be more painful for Russia than for China with its $1.3 trillion hoard of U.S. Treasury bonds.
Money considerations aside, a much more important after-effect of imported inflation will be the further erosion of Russians’ real incomes. In the last six months, rising inflation is eating into the wage gains of recent years, undermining public support for government policies. Hopefully, the menace of the oncoming recession will not shatter the Kremlin’s resolve to go ahead with its plans to further integrate Russia into the global economy. |
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