_ Vasily Astrov, economist, Vienna Institute for International Economic Studies (wiiw). Vienna, 8 November 2019.
In the second quarter of 2019, economic growth picked up to 0.9% year-on-year from 0.5% in the first quarter. This was to a large extent due to the basis effect: the second quarter of 2018 saw a moderation of government spending after the presidential elections held in April. Still, GDP growth in the first half of 2019 was only 0.7% – a marked slowdown compared to the first half of last year (+2.1%), largely on account of weaker investment activity and declining net exports. Viewed from the supply side, growth was driven primarily by extraction industry (+3.8%), while manufacturing rose by only 0.6%, construction was flat, and agriculture and trade declined by 0.4% and 1.8% respectively (all in value-added terms). Overall, the growth performance of the Russian economy remains lacklustre and on an annual basis it is the second worst in the CESEE region (after Turkey).
The main reason for the lacklustre growth performance has been flat domestic demand. In January-August, the retail trade turnover picked up by only 1.5%, while the volume of market services to households declined by 1%. The weakness of private consumption is hardly surprising given the ongoing downward trend in incomes. Real disposable incomes of households have been declining almost invariably since 2014 (by around 9% in total between 2014 and 2018) and dropped by another 1.3% (yoy) in the first half of this year. Investment dynamics remains disappointing as well. In the first half of 2019, gross fixed capital formation dropped by 0.5% (after a relatively strong 2.9% growth last year). The reluctance to invest may come across as surprising, given the strong rise in corporate profits (by 37% in nominal terms in the first five months of the year), and is partly due to the low levels of capacity utilisation.
The weakness of consumer demand has contributed to fast disinflation. CPI jumped markedly at the start of the year (by 1 pp in January alone) because of the hike in the VAT rate from 18 to 20%. However, given the weak domestic demand, businesses found it ultimately difficult to shift the entire burden of higher VAT taxation on consumers, and price growth has been progressively losing momentum. By September, CPI inflation declined to 4% on an annual basis, matching the 4% inflation target of the Central Bank. This prompted the Central Bank to cut the policy rate. Over the past few months, the latter was cut in three steps by a combined 75 basis points, to 7%. This should lower the interest rates on loans and thus ease the financial burden on borrowers, but may also fuel credit demand which is already running high, especially for consumer credit. Although the peak of credit expansion to households appears now to have been passed, it still hovers at around 23% on an annual basis. 57% of the stock of household loans is accounted for by consumer credit, typically at high interest rates of around 10%. Coupled with (at best) stagnant real incomes, fast credit expansion at high interest rates results in a growing share of incomes being spent on servicing debt, with potential sustainability risks in the medium term. This danger is well acknowledged by the authorities, which have recently tightened regulations on consumer lending.
High credit growth is driven above all by the necessity to make up for the falling incomes, which are constrained not least by the tight fiscal policy. In the first half of 2019, general government budget surplus reached 5.2% of GDP – 2 pp more than in the first half of 2018, reflecting a strong fiscal consolidation effort. On top of that, the sovereign National Welfare Fund (NWF), which accumulates ‘windfall’ profits from energy exports, reached 7.6% of GDP by 1 August – the highest level in the past three years. The tight fiscal policy is meant to reduce further the public debt to GDP ratio (from the already very low level of 12%) and make the Russian economy even more resilient to western sanctions. However, the current fiscal stance appears to be overly restrictive, weighing heavily on growth. It is conceivable that the government would have room for some fiscal relaxation without jeopardising stability or resilience – for instance, by borrowing domestically.
In the first nine months of 2019, imports of goods stagnated, while goods exports declined by 5% (in US dollar terms) on account of lower oil prices and Russia’s oil supply cuts commitments within the framework of the OPEC+ deal. These trends were largely mirrored in the dynamics of real exports and imports, resulting in declining contribution of net exports (of goods and services) to GDP growth. However, the trade and current account surpluses remain comfortably high. The latter reached USD 57 billion in January-September 2019, contributing to the growth of foreign exchange reserves by USD 51 billion over the same time period. By the end of September, the stock of Russia’s foreign exchange reserves reached USD 532 billion, corresponding to 19 months of imports (of goods and services) and making the country the fourth largest holder of foreign exchange globally. Similarly to tight fiscal policy, the accumulation of forex reserves is part of the government strategy to withstand western sanctions and reduce external vulnerability.
In August, the US announced a new package of sanctions against Russia, formally linked to the attempted poisoning of former Russian-British double agent Sergei Skripal and his daughter in the UK last year. The direct impact of the newly imposed sanctions will be at best limited. They prohibit assistance by international financial organisations (which Russia hardly needs anyway), ban the purchase of Russian sovereign debt by US banks in the primary (but not in the secondary) market, and restrict exports of selected technological products from the US to Russia. Similarly to earlier sanctions packages, the main damage to the Russian economy is likely to be indirect, contributing to higher perceived risks (not only in the US) of doing business with Russia and limiting the inflows of foreign investment. Meanwhile, the EU has been refraining from imposing additional sanctions on Russia, although those imposed back in 2014 have been regularly prolonged so far.
The local elections held in September 2019 exposed cracks in the popular support of the ruling United Russia party. This was most visible in the Moscow city council, where the party lost nearly half of its seats and retained only a thin majority. This, and especially a recent wave of popular protests across the country, is a manifestation of the declining popularity of the incumbent authorities, fuelled in part by the economic stagnation and the falling living standards. The authorities’ response to the growing popular discontent has been mixed, ranging from brutal crackdowns on protests to selected concessions, including a release of several high-profile detainees, whose arrests had been widely perceived to be politically-driven. In the medium run, keeping popular dissatisfaction in check will almost certainly require noticeable economic improvements – something which is currently not in sight.
After a dip in 2019, economic growth will likely pick up somewhat over the next few years. In the second half of 2019, economic dynamics is likely to improve somewhat. However, given the weak first half, our growth forecast for the year as a whole has been cut once again: by 0.2 pp compared to the summer forecast, to 1.1%. Over the next two years, growth is projected to speed up a bit thanks to the planned implementation of large-scale infrastructure and other ‘national’ projects (such as in health care, education, etc.) in line with the development targets, which aim at making Russia one of the five biggest world economies by 2024 – the year of next presidential elections. However, even with a modest additional fiscal stimulus, economic growth will likely stay below 2% p.a., owing to structural bottlenecks (especially institutional weaknesses) and the difficult geopolitical climate. The overall economic policy mix will remain by and large restrictive, prioritising stability and resilience against western sanctions over growth. At the projected growth pace, Russia will continue falling behind in the global economic context.
Russia’s economic prospects are dependent on how the geopolitical conflict with the West evolves. The recent signs of détente with Ukraine following the change in the Ukrainian leadership earlier this year have been encouraging. However, the implementation of the Minsk agreement on the status of Donbas – a crucial pre-condition for easing EU sanctions on Russia – will not be an easy process, given the strong opposition to it in large parts of the Ukrainian society. Besides, US sanctions will likely stay in place regardless, constraining the inflows of investments into Russia and the badly needed modernisation and restructuring of its economy.
 According to the assessment by the Institute of Economic Forecasting of the Russian Academy of Sciences, capacity utilisation stands at around 80% in extractive industries, less than 65% in the production of consumer goods, and around 50% in the production of investment goods.
 Under the new ‘fiscal rule’, any revenue from oil prices higher than USD 41.6 per barrel is being accumulated in the NWF. This year, oil prices have been generally hovering at USD 60-70 per barrel, translating into ample liquidity inflows into the NWF.