Vladimir Putin's much anticipated speech at the St. Petersburg International Economic Forum in mid-May was largely devoted to policy prescriptions for improving the Russian economy. But Putin’s remarks were surprisingly thin when it came to the actual problems that currently face the economy and their causes. At the same time, the initiatives outlined by President Vladimir Putin may lay the groundwork for radical changes in economic policy.
Current Trends in the Russian Economy
The sharp decline of the growth rate in Russia after the 2008 crisis has been a surprise for Russian policymakers and experts alike. For nearly a decade (1999—1H 2008) the average growth rate of GDP was 7 percent per year. Following the global financial crisis, the growth rate has steadily declined. Beginning with the end of 2011, the Russian economy has experienced a steady deceleration of growth that pushed the country into recession, first, at the end-2012 and once again in the first quarter of 2014.
For quite some time, Russian officials have claimed that the reasons for the slowdown lie outside of Russia, but seldom present compelling arguments to back up this contention. Even a brief analysis of major indicators raises serious questions about this hypothesis.
For example, crude prices since the beginning of 2011 have fluctuated inside a fairly narrow corridor of 100-120 dollars per barrel. Russian export volumes of hydrocarbons (oil and gas) account for about two-thirds of the country’s total exports and have remained quite stable in physical terms, even expanding due to the growing export of refined products.
External financial market conditions have been generally favorable to Russia as well. Spreads on Russian government bonds declined faster than for emerging markets as a whole. From mid-2009 until the end-2013, Russian banks and companies increased foreign borrowings by 220 billion dollars.
What Is Going on?
The main factors slowing the Russian economy are to be found within the country, not outside. And they are not hard to spot. On the one hand, according to Gaidar’s Institute, the Russian economy had exhausted nearly all available reserves to expand its current productive capacity by the time of the crisis of 2008. Against that backdrop, a sustained slowing down of the economy was basically inevitable. The 2008—2009 crisis somewhat obscured this state of affairs, but by the beginning of 2012, when the Russian economy had once again reached its pre-crisis level, these limitations again became clearly manifest. On the other hand, since 2013 growth of investment in Russia began to slow significantly. If in 1999—2011 the ratio of investment growth to GDP growth had been maintained at 2:1 level (normal for an emerging market economy), by 2013 investment growth completely stopped. During 2009—2013, the production of investment goods declined every year, and by the end of that year production in many sectors was actually below 2008 level.
Decline in Investment
In the first four months of 2014, investments fell sharply, declining by 4,3 percent year-on-year. This cannot be attributed solely to the Ukraine crisis. In January-February 2014 (that is, before the annexation of the Crimea was on the agenda), investment decreased by 5,0 percent compared to the previous year.
It’s not hard to identify the main sources behind the fall of investment in the Russian economy, namely the poor investment climate and inadequate property rights protection. Cheerleaders for the Russian economy are fond of pointing out that in the last few years Russia has improved its ranking in the World Bank’s Doing Business index, going from 123rd place in year 2011 to 92nd place in year 2014. But this success can be misleading. Like any other ranking system, Doing Business has its own quirky features. After all, its main task is to compare countries in terms of their formal regulatory environment with the implicit assumption that in all countries surveyed these institutions work properly.
The Numbers Don’t Tell the Full Story
The Russian government has recognized this bias and has built a somewhat effective strategy of advancing Russia’s ranking based on the improvement of formal processes without changing the actual practices of law enforcement and the legal system. And this approach can be rather successful. For example, a change in property registration procedures in Russia means that this process now takes less time than in the United States, which explains why Russia jumped from 51st place in 2011 to 17th place in 20141. And the 10th place of Russia in “contract enforcement” is fully explained by the quantitative approach only (number of procedures, time and price of legal procedures).
While the speed and the number of procedures are important for businesses, they may be used for comparison assuming that institutional framework works properly in all countries. At the same time, the Global Competitiveness Index of the World Economic Forum demonstrates that the quality of institutions protecting the property rights in Russia is well below the average.
The sharp deterioration in economic trends in Russia that began toward the end of 2011 also has political roots. It’s hard to overlook the psychological effect of Vladimir Putin’s September 24, 2011, announcement of his decision to return to the presidency. That decision helped trigger an acceleration in capital flight 2 and a decline in investment activity.
During Dmitry Medvedev’s four-year tenure as president, many Russian businessmen had hoped that the government’s reform and modernization agenda, however slow and inconsistent, might gradually lead to a significant improvement of the economic environment. But the clear sense that Medvedev-era reforms were frozen or reversed outright following the May 2012 presidential election dashed any remaining hopes.
Putin’s Proposals
Political and economic life Russia is heavily dependent on a personalized system of power where almost all decisions depend on the views and positions of just one person. For the most part, there are no formal checks and balances (these existed even in the Soviet Union) or alternative decision-making centers. That is why the views of Vladimir Putin should be treated seriously, regardless of whether they reflect the results of formal deliberations with government ministers and experts or simply impromptu commentary.
In his May speech in St. Petersburg, Putin acknowledged that the Russian economy faced serious challenges, stating that ”growth rates below that of the world GDP is a very serious challenge … to which… we should certainly respond.” Putin identified several main goals for economic policy that he hoped will lead to qualitative structural changes, namely
- Changes in the structure of Russian exports, with a focus on accelerated growth for non-resource based exports. Putin suggested 6 percent per annum as a reasonable target;
- Intensive import substitution based on providing special protections for products produced on the territory of Russia. (Putin appeared to misspeak, saying that such measures would be implemented “in accordance with WTO rules3”),
- Creation of a professional training system for blue collar workers,
- Technological modernization and overhauling of industry.
The main emphasis of the constructive part of the Russian president's speech was devoted to investment incentives. On the one hand, this emphasis suggests that Vladimir Putin attributes deceleration of the economy to the decline in investment (although he did not exactly speak directlyabout that). On the other hand, within his proposals there were no concrete measures aimed at dealing with institutional obstacles. In an article on economic policy published ahead of the May 2012 election, Vladimir Putin bluntly pointed out that the insecurity of property and unfair legal proceedings are a major obstacle to economic development. But in the St. Petersburg speech, there was not a word about these issues. Much of what was said in the speech implies, if not a turn to a Soviet–style economic system, then a move to active use of the state intervention toolkit for the economy.
Central Bank to the Rescue
According to Putin, Russia has to implement a massive technological renewal, which will be directed, encouraged, and (to some extent) financed by the state. Curiously, Putin didn’t say a single word about technological cooperation with foreign companies, private sector-based initiatives or the development of small and medium-sized businesses. Rather, state policy to encourage investment, according to Putin, should focus on the formation of a system of “access to cheap investment resources4” and support for investment projects via state guarantees.
No comprehensive description of these mechanisms was provided, so the best one can do is try to understand their essence based on fragmentary (and sometimes contradictory) comments in recent weeks. Judging what was said by different ministers, the President and the government have obtained the consent of the Central Bank of Russia (CBR) to finance investment projects that receive government guarantees. The CBR will provide long-term financing in the form of three-year credits to banks that would be issued against their loans to companies that receive governmental guarantees. The magnitude of this lending has not yet been announced. We can assume that there is an ongoing struggle behind the scenes between the supporters of the policies of dirigisme, who insist on not limiting the size of such instruments, and supporters of the current macroeconomic framework, which prohibits monetary financing of the federal budget deficit5. The latter’s fears are not in vain. Assuming that the annual amount of such credits might be equal to, say, 5 percent of total investments in the economy, (that would result in 1percent increase in GDP) this amount would be equal to the annual increase of the Bank of Russia balance sheet.
And a Fiscal Stimulus too
In his speech, the Russian president proposed to reestablish the tax credits for income tax and property taxes for new production capacities. Many businessmen believe that such credits can support investment activity6, although their use until 2002 and later after the partial recovery in 2006 and 2009 produced no visible result. The recipients of such taxes are regional and local budgets and, thus, no impact on the federal budget could be envisaged.
Putin also insisted on the speedy creation of a special “Industry Development Fund”. As described in a draft law (“On Industrial policy”), such a fund might be established starting in 2015. Initially, its volume will be 30 billion rubles, which would then increase to 50 billion rubles per year. However, the Ministry of Finance and Ministry of Industry have not reached an agreement on the basic principles of this fund. The Ministry of Industry advocates issuing budgetary loans directly to businesses for investment projects while the Finance Ministry proposes to compensate partially the interest rate on loans obtained from banks.
Going Clean?
The government is also discussing mechanisms to promote investments aimed at reducing pollution using the so-called Best Available Techniques approach7, which would increase the tax burden on companies that use “dirty technologies.” One can only welcome the desire of the Russian authorities to decrease the harmful environmental impact of industrial activities. At the same time, however, it should be noted that such European regulations were developed over a 30 year period, and trying to apply them in Russia may be problematic. Past attempts by the Russian authorities to make businesses invest in environmental protection have ended in failure. The credibility of such initiatives is not helped by one peculiar phrase in Putin’s speech: “It is necessary to ensure the localization in Russia of the production of equipment conforming to the principles of best available technologies.” This comment is particularly strange, given that the Russian economy produces hardly any modern technologies and the localization of the production of components for single species of imported process plants is unlikely to be economically feasible.
A New (Old?) Legislative Framework
Finally, it is also clear that the government is looking at various legislative initiatives.
Since early 2012, the so-called National Business Initiative on improving the investment climate has been implemented. According to the initiative’s framework, representatives of the business community and government agencies get together to discuss the possibility of improving current legislation in order to make it more business-friendly. Their ideas are collected in 15 separate “roadmaps,”8 which ultimately should lead to changes in 160 federal laws. Originally, the goal was to complete this job by the end of 2018. In his speech, Vladimir Putin proposed completing it by the end of 2015. The implementation of such “road maps” definitely will remove a certain part of the bureaucratic burden on business. Still, such task forces are unlikely to affect the activity of the so-called power ministries (siloviki) whose good offices are widely used in Russia for corruption schemes and to exert pressure on private business.
Monetary Stability at Risk
In short, Putin once again is demonstrating that he remains a supporter of more active state intervention in the economy. He believes that only the state can understand the structural changes needed to improve the economy—and only the state can implement them. In addition, Putin continues to embrace protectionist approaches that might lead to serious restrictions of competition, especially in the sector of public procurement. Presumably, the implementation of these proposals will lead to an increased monopolization of the Russian economy and the active use of public resources for the benefit of cronies and oligarchs close to the regime.
But the most important element of the new (old) deal is Vladimir Putin's decision to remove an essential element of the macroeconomic framework that has served Russia so well since the end of the 1990s and to allow, once and for all, the use of monetary financing of government approved projects by the Bank of Russia. Together with the gradual removal of limits on the budget deficit,9 and the increased size of non-oil budget deficit,10 such steps may lead to an increase in inflationary pressures and macroeconomic imbalances in the economy.
Sergei Aleksashenko, the former deputy chairman of the Russian Central Bank, is a visiting fellow at Georgetown University.
Notes
1 The specificity of this indicator may be supported by the 3rd place of Belarus in this sub-ranking.
2 In Q4-2008 capital outflow was 135 billion.
3 In his speech Putin has indicated industrial sectors where he is looking for active import substitution: software, radioelectronics, power generation equipment, textile and food industries.
4 This term has been used by two presidential advisors (Sergei Glazyev and Andrey Belousov) during the past 20 years. They insist that high interest rates are the main obstacle for investment in Russian economy.
5 From the Central bank viewpoint crediting banks using government guarantees as colateral in its nature is similar to direct credits to the government that is prohibited by the law. On the other hand such a system allows Minfin to not count guarantees as deficit and to not violate deficit constraints established by Putin.
6 For example according to the poll data (ordered by business ombudsman) 47 percent of respondents say level of taxation is an essential break for business development, another 27 percent say it is influential (http://doklad.ombudsmanbiz.ru/pdf/upp_vciom_web.pdf). But those numbers are rather stable year from year.
7 This is an idea borrowed from the EU. BATNEEC (Best available techniques not entailing excessive costs) regulation was launched in 1984 and renewed in 1996.
8 Realization of those road maps was the main instrument for the Russian government to improve country's position in Doing Business ranking in registering property rights as well as in tax and custom procedures.
9 In recent two years the real federal budget deficit is higher that is established by the law. That becomes possible as government actively uses quasi-fiscal financing (resources of National Welfare Fund or credits of Vnesheconombank). Above that in 2014 243 billion rubles of pension savings have been nationalized and counted as revenues. There are rumors that pension savings in 2015 may be nationalized as well.
10 Non-oil deficit (federal budget deficit ex revenues from export duties and natural resources extraction tax on hydrocarbons) increased from 6,5 percent of GDP in 2008 to 10,3-10,4 percent of GDP in 2012-2013. According to Minfin forecast it will reach 10,1 percent of GDP in 2014.
