No one wants Russia to implode but optimists have their work cut out

Earlier this year, an aide to President Putin described the UK as a small island that no one pays any attention to.

In fact, as the economist Christopher Smallwood quickly pointed out, this small island puts out a gross domestic product of about $2.5 trillion (£1.54 trillion), compared to Russia’s $2 trillion.

And she does this despite Russia having more than twice as many people.

What’s more, at the moment the UK seems to be leading the world recovery. Not bad for a small island.

Perhaps people should start paying more attention to it, particularly in Russia.

For the state of Russia’s economy is parlous. A couple of weeks ago, the Russian ministry of economy slashed its forecast for average annual growth between now and 2030 from 4pc to 2.5pc.

In fact, Russia’s economy has recently been extremely weak. It fell into technical recession in the first half of the year and it looks likely to post growth of only about 1pc this year, down from an average over the past decade of just under 5pc.

Russia’s previously strong growth earned her inclusion in the group of countries known as the BRICs. In fact, this gave a misleading impression of Russia’s underlying dynamism. Russia’s strong past growth reflected a series of one-off factors which cannot be repeated. Most importantly, over the past 10 years, higher oil prices have increased Russia’s export earnings, and hence her spending power, by a cumulative $1.5 trillion.

Meanwhile, the dismantling of the Soviet economy created huge amounts of spare capacity, not least in the labour market. Moreover, the introduction of market reforms after the Soviet collapse spurred productivity improvements. The two together made possible increases in production without the need for substantial investment.

However, after a decade of rapid growth, Russia’s economy has hit the buffers. The productivity improvements made possible by the end of communism and the reforms of the early 2000s have been exhausted. At the same time, demographic pressures are building. The population is shrinking by about 0.5pc a year.

Despite the recent weakness of growth, there is little evidence of slack in the economy. Unemployment is close to a record low and capacity utilisation is at record highs. In recent months inflation has started to come down, but at 6.3pc it remains above the Central Bank’s target range of 5pc-6pc. This has prevented the central bank from cutting interest rates. Meanwhile, the oil price needed to balance the budget has risen from about $40 per barrel in 2007 to about $110 today, which happens to be just about the current price.

In any case, it’s not clear that looser policy will revive Russia’s economy. The problems seem to be on the supply side. The key lies in raising investment and productivity. Russia’s investment rate is just over 20pc of GDP. That compares to an emerging market average of 27pc of GDP, and rates of 30pc or more in Asia. What’s more, much of the recent investment in Russia has been in the oil and gas sector, which reinforces the old energy-led growth model. Investment in public infrastructure remains low. The government has announced several projects (such as a new train line between Moscow and Kazan), but work on these is yet to get started.

Most emerging markets that have low investment rates tend also to have low domestic savings rates. But this doesn’t seem to be Russia’s problem. (The savings rate is just under 30pc of GDP). Instead, the difficulty lies in persuading firms to invest.

Part of the problem may be a dysfunctional banking system, which tends to restrict lending to small and medium-sized businesses. But over and above this, there is substantial capital flight. The central bank reckons that $55bn of capital will flow out of the country this year (equivalent to 2.5pc of GDP.)

The fundamental issues are the political and legal system, the appallingly high level of corruption and the dreadful demographics. The first two factors seriously inhibit investment, both foreign and domestic. They also directly reduce productivity since even mundane bits of economic activity or investment have to be liberally laced with pay-offs and bribes, with the result that the ultimate return is not as large as it should be.

This is another often under-appreciated factor in the demographics. Russia suffers from both a low birth rate and a high death rate, not least because of alcohol-related illnesses. But she also suffers from a high rate of emigration, largely because people are fed up with the corruption and the poor standards of Russian life. On the whole, these are the people that a country can least afford to lose – educated young professionals, hard-working and ambitious. At present, immigration from central Asia is more than offsetting these in terms of numbers of people, but not in professional expertise.

Is there hope for the future? In Russia there is a strong tradition of corruption going right back to Tsarist times. So it would be naive to imagine that a benevolent dictator could simply wave a magic wand over it. On the other hand, before the First World War, despite endemic corruption, Russia managed to be one of the fastest-growing industrial countries in the world.

Although now heavily dependent upon oil revenues, the Russian government’s financial position is strong. Its budget is only slightly in deficit, to the tune of about 0.5pc of GDP, and its ratio of government debt to GDP is only about 11pc.

Meanwhile, the Russian central bank is planning to move the rouble to a fully flexible regime. If the floating currency subsequently weakens, this would improve Russian competitiveness and hence promote the growth of exports.

I suppose that another sharp rise in energy prices would deliver a windfall gain which would make things better for a time. But if no other improvements were made, it would be a temporary palliative. In any case, the greater probability is of lower energy prices, which would compound Russia’s difficulties.

So although there are possible upsides, it is difficult to summon up much optimism without radical changes to the political regime. Infrastructure spending can easily be delayed or wasted, property rights might continue to be infringed and reforms to be stalled. Accordingly, the outlook is probably for continued low productivity growth and continued emigration. That is certainly what many of my Russian friends believe.

Somehow, I cannot believe that a great nation will implode in this way and I hope that Russia will find a way to salvation. But as things stand, it is difficult to see what it might be.

Roger Bootle is managing director of Capital Economics ([email protected])