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Russia: Investments vital to sustain growth

Thu, Nov 30 2006, 11:37 GMT
by Lars Rasmussen

Danske Bank A/S  |  View company's profile

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• This report intends to give an overview over the macro economic development in the last 5-6 years in Russia. After the financial crisis in 1998, Russian growth made a strong rebound, initiated by large spare production and considerable terms-of-trade improvement. In recent years, growth has been driven by the positive development in oil and gas prices – Russia’s main export articles.
• With rising wages and falling unemployment, domestic demand is accelerating and private consumption is fuelling imports, which is sprinting ahead by 20% y/y. At the same time, the export industries - mainly the oil and gas sector - are beginning to look stretched on the back of years of low investments in new production possibilities and infrastructure combined with rapid production growth since 1998.
• We argue that for Russia to sustain its solid economic growth, it will have to increase its level of investment - especially in the oil and gas sector. To lift investments, Russia has to deal with serious corruption issues and red tape.
• In our forthcoming paper, we will give an overview of the development in the external balances and the monetary policy as we argue that being bullish on the rouble is much like being bullish on the oil price.

Russian growth situation

Rebounding after the 1998 crisis

The Russian economy has made significant progress since the financial crisis in August 1998. The crisis led to the collapse of the banking sector, falling GDP, a massive rise in unemployment, and a strong jump in inflation as a result of the government default on debt and the devaluation of the rouble. After the crisis in 1998, initial growth fundamentally reflected large spare production capacity, and considerable terms-of-trade improvement on the back of the devaluation of the rouble (RUB).

Recent years’ growth driven by private demand
Economic growth has been strong in recent years with yearly growth rates above 6% in real GDP since 2000 and above 7% y/y in Q2 2006.

Growth has been supported by strong domestic demand - mainly stemming from private consumption, but also from investments. Public consumption has had a slightly positive effect on growth in recent years, while net exports have contributed negatively to real growth since 2001. The latter fact is at first glance surprising as Russia is a large net exporter of both oil and natural gas. This illustrates the hefty demands for import goods.

The increase in the natural gas and oil price since 2002 has played an important role for the private sector, as it has lifted private and public exports earnings.

As energy related earnings went up, the economy enjoyed higher income, increased wages, and falling unemployment. Since 2000, real wages have been rising yearly around 10%, and the unemployment rate has been halved to 6.6% in October 2006 since beginning of 2002. This has boosted private consumption.

Higher incomes have spilled over to higher credit lending to the private sector and domestic credit as a share of GDP has now risen to 25%.

Growth in bank lending to private households has accelerated since 2002 and is currently growing over 80% y/y, whereas bank lending to the corporate sector is growing more modestly at 30-40% y/y.

Booming imports and a stagnating export sector
Positive development in energy prices has boosted the export sector. The composition of Russian exports shows that the share of nominal exports related to the oil or gas sector has gone up from 40% in early 1999 to around 65% in mid 2006.

Given the relative high importance of energy-related products in exports, net-exports growth is closely related to the oil price. Evidently, the rise in energy prices has provided Russia with a huge windfall gain.

The large and increasing surplus in net-exports only tells a part of the Russian trade story. Adjusted for prices, a different story appears. Looking at exports and imports in real terms - measured in volumes - net-export balance is, in fact, deteriorating - explained by increased demands for imported goods. In fact, real imports have been growing at 20% y/y over the past 4-5 years. In the same period, real exports have only been growing only around 10% y/y and the tendency has clearly been negative in 2005 - where exports only grew by 5.3% y/y in Q3.

Low investments behind drop in exports growth

Low real growth rates in exports are due to low in-vestments in the energy sector. The chart below shows a substantial growth pick-up in oil production after the 1998 crisis - where growth rates initially were facilitated by the sizeable spare production capacity - has flattened out and has even been falling this year.

Growth rates in oil production peaked in 2003-04 - going over 10% y/y, but have since then been declining rapidly due to rising scarcity in production capacity. Gas production is still growing, currently around 3-5% y/y, but the International Energy Agency (IEA) has stated its concerns over the possibilities of increasing gas production further with-out substantial increases in investment levels.

Another reason is the decreased competitiveness of the Russian industrial sector on the back of a strong real appreciation in the rouble showing signs of Dutch disease symptoms, which we shall discuss more in detail in our forthcoming paper.

There are two dominating suppliers in the Russian oil and gas industry - Lukoil and Gazprom. Gazprom - 50% owned by the Russian state - provides 90% of Russian gas supplies and controls 16% of the world's gas reserves. Lukoil is the biggest oil producer in Russia, supplying roughly 20% of Russian oil. Both companies are running low on excess capacity due to years of underinvestment in future production and infrastructure. Scarcity in production capacity, due to underinvestment, is a general issue for other major players in the Russian energy oil and gas market. According to its latest oil report (Nov. 2006), the IEA projects that Russian oil sup-ply growth will be negative throughout 2006.

Investment levels are not only low in the energy sector, but also in the rest of the economy. Comparing Russia with a broad class of countries, we see that Russian investment as a share of GDP in 2005 is at levels with richer Western European countries and way below peer income countries like Baltic States and most of the Central- and Eastern European countries. China stands out with yearly investments as a share of GDP well above 40%.

Although there has been some pick-up in investment in production capacity in 2006, as the chart below indicates, the impact from low investment has led to a doubling of the average age of the capital stock since 1990.

Combining this with low excess capacity in the production sector and low storage capacities in the oil and gas sector, there is a very high demand for new investments in order to bring labour productivity and competitiveness up, and thereby enhance potential GDP growth over the medium term.

Inflation has been reduced, but still seen high

After the very high inflation in 1998, price growth is now more stable. Producer prices are currently growing at single digit numbers for the first time since 2002, and the consumer price is looking to grow by 9% y/y this year.

Continuing the road towards even lower inflation has a high priority in the government and the central bank. This is good news for Russia, as it will increase competitiveness in export sectors not related to the energy industry.

Investor concerns

Corruption and red tape are main concerns

We believe investments are weak due to an unsatisfying investor climate infected by corruption, red tape, and national intervention in the energy and banking sector as a concern to potential domestic as well as foreign investors.

In 2003 CEO of Yukos, Mikhail Khodorkovsky was imprisoned and Yukos was charged with tax evasion for an amount of over US$7 billion, which led to the breakdown of the company. Speculation as to whether the government’s actions against Khodorkovsky and Yukos were in retaliation for Khodorkovsky's support of political groups that oppose the government's policies has been a major concern for many foreign investors.

The impact was a sharp downturn in FDI inflow to Russia as foreign investors became more reluctant to move into Russia. In fact FDI inflow as a share of total investments dropped from 11% in 2003 to 5% in 2004, as a more or less direct impact from the Yukos case.

Another issue which especially concerns foreign investors is the Russian state’s growing role in the energy sector. This was lately seen from the Kremlin’s determination to increase pressures on foreign oil companies involved in Sakhalin-I and Sakhalin-II projects, and on its decision that Gazprom should develop the world's largest offshore gas field, Shtokman, without any foreign energy companies as partners. In fact, there is widespread criticism of Russia’s tendency to use its energy re-sources as a security policy instrument. This was lately exemplified when Russia came to an agreement on natural gas prices with the Ukraine and Georgia respectively. The Ukraine secured its gas delivery at half the price of Georgia’s deal.

Earlier this year, an annual survey was taken of 155 foreign corporate investors for The Foreign In-vestment Advisory Council (FIAC) - an organisation established in 1994 to improve the business climate in Russia. The survey shows that investors are deeply concerned over issues such as corruption and administrative barriers. 80% of participants in the survey mention corruption among the biggest disincentives to investment. About the same number mention administrative barriers. Al-most two-thirds of current foreign investors believe their company has been affected by corruption in Russia - especially involving tax authorities. Transparency International publishes annually a survey on corruption across 150 countries.

Unlike the Ukraine, which has fought corruption with some success since 2000, and the Baltic States, which have been even more successful, there has, according to the survey, been no real progress in fighting corruption in Russia since 1998. In 2006, Russia was placed 121st in the survey out of 163 countries. The same level as Rwanda.

On top of widespread corruption among tax-authorities, traffic-police, courts, judicial authorities, custom officials etc., and on top of significant administrative barriers, the latest relapse in the democratic development is extremely concerning. This includes the killing of central banker deputy Kozlov, who led the fight against corruption in the banking sector, and the killing of Anna Politkovskaya, known for her opposition to the Che-chen conflict and Putin administration.

The tendency is clearly negative in terms of democratic development. According to surveys from Transparency International Russia has not moved towards being a more free and democratic country in the last decade. Looking at sub-components in the index has worsened mainly on the back of less free banking sector - where the two state owned banks Sberbank and Vneshtorgbank are the dominant players in the banking sector - reduced protection of intellectual property rights and an un-even implementation of new laws. In fact many foreign investors have experienced problems in executing court rulings, and in obtaining satisfaction from contractual agreements.

According to the FIAC survey, many investors still see the Russian market as a big potential, on the back of the size of the Russian market and the country’s impressive economic growth that has improved the average Russian’s purchasing power against a background of increasing wages and falling unemployment. The survey further suggests that foreign investors see a slight improvement of the investment climate in 2006 compared to 2005, and the majority expects this to improve even more in the coming years. In this light, it is a positive step for Russia that it can now step into the final stage of entry talks with the WTO’s 149 members, as a membership could force a reform process in Russia.

Outlook for Russia

Challenges for growth

We believe that the economy could be up for 5-7% y/y growth over the next years, being around 5% if the oil price weakens from current levels around 7% if the oil price heads over USD 65 per.

To sustain high growth in the longer term, Russia will be to speed up pace in investment growth, and reduce its exposure to the energy sector.

To lift investments, the Russian authorities will have to speed up the structural reform process in order to invoke transparency and create a fair playing field. This could be on issues such as the respective roles of the state and private capital in the development of key sectors of the economy, particularly in natural resources. It involves a sincere effort towards fighting corruption at all levels.

This will help the business climate and improve investor sentiment, so that in the longer term Russia will have a more diversified productive sector, reducing the economy’s dependence on oil and its exposure to the fluctuating energy prices.

It is important to stress that unemployment is falling and is now under 6.6%. Population growth in Russia is negative (700.000 a year) and the labour force is projected to start declining from 2010 on-wards. This will enhance the need to bring up labour productivity via bringing up the technological level of capital stock, together with a top priority to further increase educational levels.

It is encouraging that Russia is now approaching WTO membership as it will commit politicians to bringing copyright laws and enforcement systems into line with WTO rules on intellectual property. But do not expect any miracles, this is a long process.

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Published on  Thu, Nov 30 2006, 11:48 GMT

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