Russia’s Economy is Doomed

The Russian investment houses are of two minds these days.   One camp wants to try to sucker as much money out of their clients as possible before the edifice of Russian society finally crumbles. They want to lie and talk about green shoots. Streetwise Professor exposes one such charlatan in today’s issue. Then there are those who are making a last desperate bid for reform in the hope of preserving some vague hope of long-term prospects. Chris Weafer, chief strategist at UralSib Capital, appears to be one of them.  Here are his thoughts, from the Moscow Times:

When you are mired in a severe economic crisis, it is normal to get excited at even the smallest morsel of good news. It is therefore tempting to interpret the 0.5 percent monthly improvement in July’s gross domestic product and the smaller contraction in industrial output as an assurance that all is now well with the economy and that the stock market will imminently start the second leg of its recovery rally. Deputy Economic Development Minister Andrei Klepach fueled this optimism when he proclaimed Monday that “the recession is over,” commenting on July’s GDP results.

Hopefully, this is the direction in which both the economy, and equity market will eventually go, but there are many serious problems still to be resolved and the seedlings of recovery will have to be extended to the consumer and small businesses if sustained recovery is to be achieved. The July data shows that the financial well-being of these important economic segments is still deteriorating. In absolute terms, the 9.3 percent year-on-year decline in GDP and the 10.8 percent drop in industrial output places Russia firmly at the bottom of the performance table of all major economies.

The risk of a second crisis wave has by no means been eliminated, although few expect the next challenges to cause the same level of destruction that we saw in late 2008 and earlier this year. But dealing with the still-unclear scale of bad debts in the banking system and restarting credit markets, at an affordable cost, as well as restoring consumer and investment confidence, are critical if the economy is to catch up with the positive trend in most major economies, which are now either seeing broadly based growth or are on the brink of it.

For the investment case in Russia, there are many serious problems that have to be solved before we can expect a return to the pre-crisis optimism and asset valuations. The 45 percent year-on-year decline in foreign direct investment through the first half of this year can be easily explained by the global crisis, but even before the crisis the level of FDI only accounted for a small percentage of GDP — by far the smallest contribution to GDP among similar developing economies. Business investors have remained wary of the slow pace of reforms and the vulnerability to the sort of boom-to-bust economic cycle that we have become accustomed to. Having exposed the myth that Russia had broken free of commodities dependency, strategic investors in sectors other than oil, gas, metals and a few others will want to see a much more determined and effective approach by the government in pushing reforms and directing resources to boost growth among the small and medium-sized enterprises and industries that will represent real economic diversification.

Another serious problem is that the money set aside to fund the country’s rapidly increasing pension liability is now likely to be completely spent as part of the stimulus spending. The National Welfare Fund held about $95 billion on July 1, although the plan was to accumulate several times that amount by the time pension support payments are due to increase substantially from current levels. At this stage, it is only a best guess as to exactly how much funding will be needed to cover the annual pensions bill by the middle of the next decade, but the scale of the problem can be seen from the population demographics. The Federal Statistics Service reported three years ago that 10 million of the 79 million-member work force would retire by 2015 and, with improving life expectancy, would represent a huge increase in the cost of the government’s pension support. That is why Finance Minister Alexei Kudrin fought so vigorously to create the National Welfare Fund to make sure that funding would be available. But it is clear that these funds will be gone by mid-2010.

For now, the more serious concern is that the fragile recovery through July was largely dependent on China’s demand for oil and other materials. Moreover, the economic well-being and confidence about the future among consumers and small businesses continues to deteriorate. And this is where the risk of a second wave of the crisis comes into play. Industries, such as steel, have soared on the back of rising demand and prices. This has also been one of the best-performing themes on the stock market with the market value of Evraz Group, for example, rising by over 600 percent since the low point of late last year. Oligarchs looked like an endangered species at the end of last year, but thanks mainly to China they have rebounded. But this could easily change. Already there are reports that China may soon impose curbs on industrial growth, cut excess supply and hedge against the risk of overheating. If that happens, there would be less demand for Russia’s steel, oil and other materials, and this could lead to a double dip in the crisis.

That highlights the other major problem — the lack of depth in the July “recovery.” The consumer — and industries that are dependant on consumer spending — are showing no signs of improvement. July’s indicators were much worse than the previous month. Retail sales were off 8.2 percent, and real wages were down 5.8 percent year on year. These numbers show that the effects of the recession are still extending across the broader economy. Confidence has also taken a tumble. One example: Despite the decline in real wages, people saved 17 percent of their income in the second quarter, which was twice the savings rate in the first quarter.

There is hope that the crisis in the economy can act as a catalyst for real change in the state’s fiscal, monetary and budgetary priorities. There is also hope that the government will finally move forward with long-awaited reforms, start spending real money on improving the country’s infrastructure and take the steps needed to improve the investment attractiveness of the country for both portfolio and strategic investors. These measures are needed to put the economy on course and to break Russia’s dependency on natural resources.

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