Why Russia needs a more liberal economic policy

The economic agenda of Russia’s third president is predetermined – either by Putin or by objective necessity. Both factors require deregulating domestic prices for electricity and gas, in order to stave off an infrastructure collapse.

At the St. Petersburg Economic Forum, government leaders talked readily about how prosperous Russia will be in coming decades. Finance Minister Alexei Kudrin promised that by mid-century, Russia will overtake France and Germany in terms of per capita GDP. Senior Deputy Prime Minister Sergei Ivanov predicted that Russia will be the world’s fifth-largest economy by 2020, with GDP approaching $4 trillion. Looking decades into the future is a thankless task; too many variables, too much uncertainty. It’s far more rational to trace the economic contours of the next few years, when Putin’s place will be taken by someone else.

In contrast to Putin, the next president will be constrained by more than some behind-the-scenes commitments to his predecessor. The basic instruments of economic policy over the next four years – budgetary and taxation policy, investment by the monopolies, the rates for their services – have been decided and adjusted already. The major trends and problems are also predetermined. However, we shouldn’t assume that the next president will be able to sit back and do nothing. The costs of any errors will rise, and so will the intensity of political competition. Still, every cloud has a silver lining: “lean years” are more suited than petro-euphoria to the task of preparing for an economic breakthrough.

The powerful influx of money that is entering Russia thanks to high oil prices will be reversed three years from now. Comparisons with the Putin era will not be in the new president’s favor.

For the ninth consecutive year, Russia is living with two surpluses: in its trade balance and in its federal budget. Exports exceeded imports by $164 billion in 2006, and the government collected $75 billion more than it spent. Hence the rapid growth in gold and currency reserves and the Stabilization Fund; hence the reassuring sense of absolute macroeconomic stability. Even Yegor Gaidar, who can hardly be described as a Putin administration sympathizer, says he can’t see any reason for a crisis to develop in the forseeable future; however hard they tried, the experts at the Transition Economy Institute have been unable to find any fatal problems.

The clouds will start to gather two years from now: imports have been growing at a much faster rate than exports for several years, and in 2009 the positive trade balance will be negated. A year later, the budget surplus will evaporate as well: by 2010, nominal spending will almost double as compared to 2006.

This striking change will have many unpleasant consequences. The most obvious of these will be a decline in the ruble’s nominal exchange rate. The 1990s offer examples of how Russian citizens and Russian enterprises react to the ruble’s instability: they convert their savings and assets to foreign currency.

The capital outflow will also hit hard at the Central Bank’s reserves. According to a forecast from the Macroeconomic Analysis and Short-Range Forecasting Center (TsMAKP), reserves will decline by $90 billion between 2011 and 2013. Russia hasn’t experienced anything like that since 2000.

A weaker ruble and lower reserves will be only the first alarm bells. Thanks to petro-abundance, Russian citizens have grown accustomed to seeing their incomes rise by 10-15% a year. TsMAKP analyst Dmitri Belousov points out that this is an abnormal situation: rising prosperity can only be stable if labor productivity rises just as fast as incomes. Labor productivity in Russia rose by 5.5% last year, and Belousov predicts that income growth will slow to that figure within the next five years.

But even the current rates of productivity growth cannot be sustained automatically. Until now, productivity growth has been provided by companies starting to use capacities that were suspended owing to declining demand in the 1990s. From now on, labor productivity growth will need to be real: generated by investing in new technology and equipment, as well as cutting redundant jobs. The potential for job cuts is indicated by a simple comparison: the average worker in Russia produces 1.5 times less than a worker in Poland and 3.5 times less than a worker in the United States. In the long run, freeing up more workers will certainly be positive, especially in Russia, with all its demographic problems. But the political elite has been postponing this process as long as it can, since restructuring industrial enterprises will lead to an upswing in unemployment and social protests. Over the next four years, the elite won’t be able to delay the inevitable any longer.

The new president won’t find it so easy to hand out petrodollars, trumpet the growth of gold and currency reserves, and plan new national projects. He’ll have far less room for maneuver than Putin in his second term. Putin could afford to authorize many billions in additional spending to extinguish the fire of public outrage provoked by the clumsy monetization of benefits; Putin could do this because Kudrin provided a fire extinguisher of impressive size. Putin’s successor won’t have this kind of insurance available to him – not even if oil prices remain high. The government might have some bonus revenues only if oil prices are over $70 a barrel, but there’s small hope of that.

In terms of budget policy, the successor will be tied hand and foot. Suffice it to note that the budget for his first three years in office will be passed six months before the presidential election of 2008. The draft budget for 2008-10 is fairly generous (spending stood at 16% of GDP in 2006, compared to the planned 19% in 2008), and lacks a reserve of stability: no more budget surpluses as of 2009. Any additional spending will be covered by petrodollars formerly directed into the Stabilization Fund. The government admits that between now and 2020 it will have to spend far more petrodollars than in 2000-06: 3.4% of GDP as compared to 2.6%. The dependence of the budget (and the government) on raw materials export prices will only grow, with no bonus revenues in sight.

The economic agenda of Russia’s third president is predetermined – either by Putin or by objective necessity. Both factors require deregulating domestic prices for electricity and gas, in order to stave off an infrastructure collapse. Gas prices for households and industry will double by 2010. This will lead to a steep rise in electricity prices, which will be fully deregulated by then. Housing and communal services fees will also rise: in Moscow, payments per apartment will grow by about 20% a year through to 2011 – the municipal administration describes this as a gradual increase. As of 2012, it will cease to be gradual; tariff regulation for housing and communal services is likely to be abolished.

The average Russian family spends 8.3% of its income on housing and communal services fees. It isn’t hard to predict how this proportion will change following deregulation: in countries with free-market economies, households spend about 20% of their budgets on utilities and similar costs. Russia doesn’t have much time to bring family spending up to this kind of structure. The accumulated debt to the sector is too great: neither the unpopular government reformers of 1992 nor the ultra-popular Putin of the 2000s have dared to deregulate this market – thus dooming it to chronic underinvestment.

Problems at the macroeconomic and microeconomic levels will continue to grow. By the time the 2011-12 political cycle rolls around (parliamentary and presidential elections), the business and administrative elites will go into it in a far more fragmented state than they are experiencing during Putin’s last year in office.

Disappointment with the third president could be a good backdrop for Putin’s triumphant comeback to the Kremlin. But the new-old president would find it very difficult to live up to expectations if the 2008-12 period has been wasted in terms of the economy. The oil and gas sector stopped being the driving force of economic growth in 2005. The other driving force – a consumption boom – will start to peter out within a couple of years, due to slowing income growth. Kudrin said recently that this will happen as soon as 2009. The analysts at AT Kearney think likewise: they predict that by 2012, consumer demand growth in Russia will be similar to the figures for China, India, and Brazil (Russia is currently ahead of its BRIC neighbors by 50%, 100%, and 200% respectively). There’s nothing bad about this, says Yevgeny Gavrilenkov, chief economist at Troika Dialog Investment; Russia will just have to learn to live in these changed conditions.

A new driving force has already been identified: investment growth. But the state, which has become Russia’s chief investor in recent years, will have to relinquish this role to the private sector: the proportion of state investment in GDP will decline by 2010 – the budget isn’t infinitely elastic, after all. State-controlled corporations will also have to restrain their appetites, as they come to feel the impact of their debt burdens.

From the macroeconomic standpoint, the outcome is clear: insufficient domestic resources will have to be supplemented by external resources, and a positive balance of capital operations will have to compensate for a negative trade balance.

There’s nothing ultra-difficult about this; in fact, several of Russia’s neighbors have coped with this problem. “Kazakhstan’s balance of current operations will be negative this year,” says Yulia Tseplyaeva, chief economist for Russia and the CIS at Merrill Lynch. “And they’re not too scared by the prospect.” The government of Kazakhstan is counting on foreign investment, so it is only encouraging foreign companies to move into its natural resources sector.

Valery Mironov, an analyst from the Development Center, describes the next president’s greatest challenge as follows: “We are standing on the threshold of transition from the first stage of growth in Russia’s ability to compete, based on cheap energy and labor, to the second stage, based on being attractive to investors.” At the St. Petersburg Forum, Kudrin declared with delight that capital inflow will be over $70 billion this year – a record level in Russia’s post-Soviet history. But Kudrin failed to mention that the record inflow between January and April has been replaced by a rapid outflow in May and June. What’s happening? Russia is still a magnet for speculative capital, not venture capital. CalPERS, the world’s second-largest pension fund, still doesn’t rate Russia as a country suitable for large-scale, long-term investment (in contrast to the ratings of Russia’s former satellites in Eastern Europe). Investors pay close attention to the opinion of CalPERS. In order to catch up with Eastern Europe, Russia will have to reduce its levels of state regulation and corruption, and cut state spending; in short, it will need to adopt a more liberal economic policy than the policy it has pursued in the Putin era.

Some say that Russia will never adopt a responsible economic policy until oil prices fall. Yet Russia needs to keep moving forward, in order to ensure successful transitions of power in 2008 and later. Average incomes are now around $500 a month (hardly an enviable level); what citizens find satisfying is not their income level as such, but the fact that it’s 10% more than a year ago. Stability will outlast the incumbent president only if the economy can continue to grow rapidly – but this cannot be achieved without economic reforms, even if raw materials prices remain high. Russia’s third president won’t be able to use the heady effect of petrodollars as an excuse for inaction.