How Russia can boost growth

For 2014, we project that Russia’s economy will grow at an estimated 0.3-0.5 percent. This is the lowest growth rate since the global financial crisis but higher than the high-risk case scenario which was expected since the geopolitical tension started and the sanctions of the EU and the US took hold. This means that Russia’s expected economic performance in 2014 will be similar to that of the Euro-zone, even though Russia is much more dependent on the European market than the EU is on Russia.

In the last half year, we witnessed a fast adjustment to a relatively stable but slightly lower trajectory for Russia’s economy. Contrary to our March projections which assumed a one-time deep shock due to geopolitical tensions we now project a more drawn-out impact. We expect to see continued strong but rather short-lived market responses if tensions increase, with a quick pricing-in of additional risks. Nevertheless, in our view, much geopolitical uncertainty prevails and this risk environment is reflected in our spectrum for the outlook growth with two alternative scenarios straddling Russia’s baseline scenario (Figure 1).

So why should we worry about Russia’s economy if the country could avoid a recession and will perform similarly to the Euro-area? To start with, there are enough concerns about the economies in the Euro-zone. Any performance matching their anemic growth should worry policy makers everywhere.

However there are three deeper domestic issues which risk jeopardizing Russia’s medium-term prospects.

1. Loss of confidence. Investors continue to shy away from Russia and limit their exposure to the country which resulted in negative investment growth in the first half of the year. Households are growing increasingly careful when making consumption decisions. In the second quarter, consumption growth was one of the lowest in years, bringing Russia main growth engine to a near standstill. That should be a wake-up call for any high or middle-income country. Then growth is not just a number anymore but it is directly impacting the potential improvement in household welfare.

2. Russia’s low growth potential and sanctions impact. Sanctions and geopolitical tensions had some impact, but the reason for Russia’s low growth trend is not a new one and related to Russia’s low potential growth of 1-2 percent. Russia’s economy started slowing in 2012 due to structural constraints to growth. With the economy operating close to its potential, growth is constrained by inefficient factor allocation, non-competitive markets and a dearth of innovation. Recent geopolitical tensions certainly added to this and created uncertainty which markets had to internalize. Several rounds of sanctions, countersanctions and measures to stabilize the economy created an environment of higher risk which in turn lowered domestic demand. Large capital outflows, poised to reach well over US$100 billion this year and the Ruble loosening about 20 percent of its value compared to the Euro-US$ currency basket since January created difficult borrowing conditions for investors. The weakening Ruble and consumer price inflation climbing to around 8 percent stopped consumers in their track.

3. Impact on the poor. The picture is quite sobering (Figure 2). Low growth prospects leave little potential for further poverty reduction and increased shared prosperity. In the past, rising wages and pension transfers allowed Russia to reduce poverty significantly and to expand the ranks of the middle-class. Also, there are concerns about increasing inequality. While the Gini coefficient remains in line with the average for 2007-2013, at 0.42, it is unfortunately not recording the changes in the shape of the distribution. Looking at indicators for recent middle-class dynamics in Russia (defining it as people with per capita income exceeding US$ 10 PPP per day), we see a steady increase in the share of the population belonging to this group to 68.4 percent in 2012. Within the Europe and Central Asia region, Russia is one of the best-performing countries when this middle-class definition is applied. However, a closer look to the distribution indicates that this growth was driven by the expansion of the share of the relatively better-off people within that group. In contrast, the share of the population at the low end (with an income of US$10-25/day) stagnated at around 47 percent. Unless Russia pursues structural reforms to expand the economy’s potential, low investment makes it less likely that well-paying jobs will be created. High inflation poses a risk to real income growth and could hurt consumption growth.

What policies or priority reforms could turn this picture around?

Macroeconomic stabilization measures will remain important in the coming months. But there is growing uncertainty about Russia’s broader medium-term economic policy objectives. Some measures and policies under discussion have the potential to alter how the economy operates and might turn out to be detrimental to its competitiveness. For example, renewed government interest in supporting selected firms and sectors that would benefit from import substitution, such as the ban of pork products at the beginning of this year, constitutes protectionism. They could delay structural reforms which would help the Russian economy to become more competitive globally.

Beyond hoping for high oil prices, a return to stronger growth in Russia will depend on solid private investment and a lift in consumer sentiment. This will require a higher degree of policy predictability than presently, but most of all more structural reform efforts. Russia should learn from the lessons of the Euro-zone countries: reforms which were avoided there in the good years, can’t be postponed anymore in the bad years. Russia might have a few bad years ahead.

Published in collaboration with The World Bank’s Future Development Blog

Author: Birgit Hansl is the World Bank’s Lead Economist for the Russian Federation.

Image: A general view shows the Moscow International Business Center and the Mercury City Tower. REUTERS/Sergei Karpukhin