In Russia, it’s not all about oil

Market analysis - 3/21/2016

Oil prices are a key factor in the health of the Russian economy, where a significant proportion of corporate profits derive from the energy industry.

Does that mean that Russia's economic outlook will necessarily improve with the rise in oil prices? If it were only so simple. 

The emerging-market party of the past decade has come to an end and the hangover has set in, as major commodity exporters have no other growth drivers to take up the slack. The Russian economy was hailed for its strength but now only seems to attract investors seeking exposure to the oil cycle without any concern for the country's underlying growth potential. As a result, potential GDP growth has declined from 7% before the financial crisis to around 1% today (see left-hand chart). The hangover is getting no relief from consumption and investment, which are beset by structural challenges..


While international sanctions on Russian imports have encouraged substitution production, the positive effects are limited. Consistently high inflation eats away at real salaries, which in turn weighs on consumer spending growth (see right-hand chart). And the contraction in available income cannot be permanently offset by redistributed oil revenues. The budgetary nexus with oil prices obviously limits the government's leeway. At the same time the pension system – which is also the government's main redistribution mechanism – turns out to be rather inefficient in addition to being expensive (see chart below). 


The economic fallout of demographic change will not make things easier. The ageing of the population and the concomitant decrease in the size of the working population will change the nature of social transfers, leading to increased spending on health care and a smaller tax base. Fiscal balances will be increasingly difficult to achieve, especially if the price of oil remains low.


The other obstacle is productive investments, which are not strong enough to support GDP growth in Russia (see left-hand chart below). The low contribution of capital to economic growth is the result of a persistent lack of available capital, which leads to chronic under-investment and increasingly outdated productive capacities.


Declining productivity gains are common among emerging-market economies, yet Russia's situation is worrying. Its productivity gains are indeed well below the levels seen in other emerging countries. The institutional framework, which does little to protect property rights, also tends to discourage foreign direct investment. This means that Russia has seen little of the technology transfers that are normally associated with this type of investment, thereby cutting its manufacturing base off from technological advances (see right-hand chart below).


These shortcomings in productive capital are not being fixed. Capital spending will only be further hampered by restrictions on access to international capital markets and the fecklessness of domestic banks. In addition, low oil and gas prices have compressed domestic companies' revenues and profits and thus their ability to accumulate capital. 


The challenges are substantial and not limited to the oil and gas cycle. Russia's relative capital self-sufficiency has given rise to an imbalance between needed and available capital. And the situation may get worse, in light of the many bonds set to mature in 2017 and the need to refinance them.

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