Written by Ed Dolan Sunday, 06 May 2012 13:57
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Ed Dolan is the author of TANSTAAFL


Vladimir Putin’s decision to return to the presidency has touched off a wave of protests in Russia.


The motives behind the protests are partly social and political (see this recent post), but economics also plays a role in Putin’s fading popularity.


It is far from clear that the present regime will be able to continue to offer growth and rising incomes in exchange for a monopoly of political power, as it has in the past. Here are some of the problems facing Russia’s economy in as we look toward the March election and beyond.


Faltering Growth


Putin assumed power as Acting President of Russia on December 31, 1999.


That year marked the beginning of the country’s recovery from almost a decade of post-Soviet contraction.


By 2004, Putin was confident enough to promise that economic  output would double in ten years. As the chart shows, the early 2000s were boom years for Russia. From 1999 to 2008 Russian real GDP, measured in constant rubles, increased by 82 percent.


More important for Russian living standards, real GDP measured at purchasing power parity, boosted by steady appreciation of the ruble, increased by 128 percent over the same period. If you choose the right ten years and the right income measure, then, you can say that Putin delivered on his promise.



Going forward from  2008, however, things do not look so good.


The Russia economy experienced a sharp recession following the global financial crisis. It has now largely recovered, but the IMF forecasts growth averaging less than 4 percent for the next five years. It is likely, then, that the next doubling of the Russian economy will take more like 20 years than 10, and even that is subject to serious downside risks.



Russia’s oil wealth was the main driver of its prosperity in the early 2000s, but although vast oil reserves remain, they will be a less certain engine of growth in the years ahead.


As Renaissance Capital oil analyst Alex Burgansky explains, Russia is a mature producer that must drill 5,000 to 6,000 new wells each year just to keep output from falling. What is more, those wells must be drilled under more and more difficult conditions, in remote Eastern Siberia or offshore in Arctic waters. The oil is there, but increasingly, the government must provide tax concessions to make the difficult new wells profitable. That puts additional pressure on the government’s strained budget, a topic to which we will return below.


The combination of higher production costs and increased tax concessions means that the world oil price necessary to balance the government’s budget is steadily climbing. As the following chart shows, the actual price for Russian oil has been below the budget-balancing level since 2008 and is likely to remain there at least through 2013. To be sure, there are big risks both ways for world oil prices. An event like an Iranian blockade of the Straits of Hormuz could send the price soaring, to Russia’s advantage, but a global recession could send it crashing, as happened after the Asian financial crisis of the late 1990s.



The Curse of Riches


Russia’s status as the world’s largest oil exporter has also made it susceptible to the curse of riches. The curse has two parts. The first is the Dutch Disease—the tendency of large natural resource exports to drive up a country’s real exchange rate, making the rest of its economy uncompetitive on world markets. As the next chart shows, Russia’s real effective exchange rate rose steadily throughout the early 2000s. After dipping during the global crisis, it reached a new high earlier this year. That leaves Russia’s non-oil exporters and its import-competing light industry constantly struggling to survive.



Russia’s recent entry into the WTO will only exacerbate the effects of the Dutch disease. True, adherence to WTO rules may strengthen the non-oil economy in the long run, but in the short run there will be painful adjustments as protected domestic farming and manufacturing face increased import competition.

The second part of the curse of riches is the tendency of resource wealth to shift the focus of both business and politics away from wealth creation toward rent seeking. Unless an oil-rich country starts with an institutional framework as strong as Canada’s or Norway’s, it is all too likely to fall victim to pervasive corruption. Transparency International’s Corruption Perception Index ranks Russia as among the most corrupt countries (154th and falling out of 178 surveyed in 2010). The World Bank ranks it far below the best (120th out of 183) as a place to do business.


During his term as president, Dmitry Medvedev has repeatedly spoken out against corruption and oil dependence, but has made little visible progress against either. It is hard to imagine that Putin’s return to the post will bring better results.


Fiscal Policy


Superficially, the Russian government’s finances look in good shape. It ran a substantial structural surplus every year from 2000 to 2008. Even after a series of deficits since the global crisis, its gross government debt, just 12 percent of GDP, is the lowest in the G-20. Those good indicators are due in large part to the accumulation of a sizeable stabilization fund during the pre-crisis boom.  Drawing down the fund  during the recession allowed the government to implement vigorous fiscal stimulus without large-scale borrowing.


Below the surface, though, all is not well.  A recent IMF study compares Russia’s finances to those of other oil exporters that have managed their national wealth well (like Norway) or poorly (like Nigeria). In the IMF view, best practices require that governments save a substantial part of current oil income in order to accumulate a fund of financial assets to benefit future generations after oil income begins to decrease. Among other things, that requires the government to orient its fiscal policy around a sustainable level of the non-oil deficit, that is, the deficit excluding oil revenue. The IMF study notes that although Russia adheres to some best practices on paper, it departs from them in practice.

  • The Russian budget has an official target of 4.7 percent of GDP for its non-oil deficit; however, the target was suspended during the financial crisis, and, as the following chart shows, has not yet been reinstated.



  • Best practices call for using reserve funds, managed within the framework of a multi-year budget plan, to delink expenditures from volatile oil revenue. The Russian government has a multi-year budget on paper, but in practice, it has resorted heavily to supplementary budgets that undercut medium-term targets. One result is that the reserve fund, which should by now be growing again, is still being depleted and may have been emptied entirely by the end of 2011. (Final data are not yet available.)
  • Best practice calls for an independent fiscal agency to ensure adherence to medium- and long-term budget targets. Russia lacks such an agency, even on paper.



What Lies Ahead?


Does Russia’s unsustainable fiscal policy and oil dependence mean it is on the brink of a crisis? Not really. Fiscal unsustainability has a way of unfolding in slow motion. Tyler Cowen has just written a book with the intriguing subtitle How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better. We could paraphrase that to read How Putin has fed the Russian people on low-hanging petrofruit and why it will (eventually) make them sick.


The question, is how far off is “eventually”? In one sense, eventually is already here. The years of doubling GDP each decade are already over. That growth spurt was not just the result of good luck with oil prices, but also of a one-off rebound from the collapse of real GDP that followed the end of the old regime. The 4 percent growth rates forecast by the IMF will not be enough to make everyone happy simultaneously—the generals with new rockets, the pensioners with decent benefits, the middle class with a growing service economy, and above all, the vast army of corrupt hangers-on, on whom Putin’s political machine depends.


Eventually could arrive even sooner, and with more of a bump, if oil prices were to crash, as they tend to do after every major global slowdown. Today’s financial news is full of warnings of an EU recession (already more of a reality than a warning), stagnation born of policy paralysis in the United States, slowing growth in Brazil and India, and a hard landing in China. If even half of those risks materialized, they could send oil prices down well below their present level. This time Russia would have to face the crisis without the comfortable reserve-fund balance that it had on hand in 2008-2009.

No one thinks any of this will threaten Putin’s re-election next March. After all, he not only gets to pick who runs against him, but he also gets to count the votes. The real question is whether a weaker economy will force him to change political strategy in his next term. Up to this point, a strong economy and personal popularity have marginalized any real political opposition. Now that may be changing. The regime may be losing the support both of the middle class and of the nationalist right wing. If that happens, watch for a “No more Mr. Nice Guy” stance from the Kremlin.

Last modified on Monday, 07 May 2012 09:52

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