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Jun 1, 2017 | 09:30 GMT

10 mins read

Beyond the Recession, More Problems Await Russia

(ALEXEI DRUZHININ/AFP/Getty Images)
Forecast Highlights

  • As the Russian economy slowly pulls out of recession, low oil prices will keep it stagnant for years to come.
  • Nonetheless, the recovery, and the return of foreign investment, will alleviate some of the Kremlin's concerns about the economic sanctions against it.  
  • The Russian government, meanwhile, will grow increasingly worried about the people's economic hardships as gubernatorial and presidential elections approach. 

Russia's economy is recovering, slowly but surely. After nearly three years of recession caused by low oil prices, dwindling foreign investment and sanctions, the country's fortunes improved in the first half of this year. The Russian government upgraded its forecast for gross domestic product growth to 2 percent based on current oil prices, just over half a percent higher than the International Monetary Fund's projection for the country. And since the Kremlin drafted its federal budget assuming prices for Russian crude exports would be $40 per barrel — about $13 lower than the average price this year — the government now has a surplus on its hands.

But that doesn't mean the country's economic troubles are behind it. Relative to its last convalescence after the 2009 recession, which was deeper, the Russian economy's current recovery is far less robust, in large part because of lackluster oil prices. (The country loses $2 billion in revenue for every dollar oil prices drop.) The government's official numbers, moreover, must be taken with a grain of salt since the Kremlin has been tinkering with its statistics. The state statistical unit, Rosstat, changed its methodology recently to amplify the effect of the military-industrial complex as the Kremlin embarked on an arms purchasing spree. Then in March, President Vladimir Putin moved Rosstat, once largely shielded from politics, under the economy minister's authority. The head of the statistics agency claims that a government official asked him to tweak the data on the economy to give the appearance that inflation had fallen. Either way, the recession is just the first in a litany of problems facing the country.

Glimmers of Hope

One sign that the economy is bouncing back is that the ruble has appreciated and stabilized. The currency began its two-year tumble in July 2014 after the United States and European Union imposed sanctions on Russia. Falling oil prices compounded the currency's weakness later that year, and the Central Bank of Russia moved to put the ruble in a free float. The Kremlin spent $30 billion to defend the currency in October 2014 alone. But since early 2016, when the exchange rate peaked at 85 rubles on the U.S. dollar, Russia's currency has appreciated. The exchange rate is currently around 50 or 60 rubles to the dollar — comfortable enough for the Kremlin.

Part of the ruble's rise owes to the recovery underway in several Russian industries. The Kremlin pumped more than $5 billion into 199 major sectors between late 2015 and early 2016. Its efforts have already paid off in the military-industrial complex and the agricultural industry, both of which grew in 2016. The automotive, aviation, transportation and machine building sectors, which provide the bulk of the country's transportation, infrastructure and jobs along with 20 percent of its GDP, are expected to start growing again this year as well. In addition to its financial support, Moscow's isolationist policies have also helped reinvigorate its industries. Counter-sanctions on food imports from the European Union helped boost Russian agriculture in 2016; grain production reached 119 metric tons that year, becoming the country's second-most lucrative sector after energy. Today, Russia imports less than 20 percent of its foodstuffs, down from 70 percent when Putin took office 17 years ago. Import substitutions for industrial and high-tech goods have helped reduce Russia's reliance on foreign products, too.

Russian Economy Infographic

Investment in the country, meanwhile, has returned to its pre-crisis levels. Foreign direct investment (FDI) in the Russian economy surged 62 percent in 2016 over the previous year, reaching $19 billion according to the United Nations Conference on Trade and Development (UNCTAD). The growth is a bit misleading, however, because a large portion of the total came from a single deal: the sale of a 19.5 percent stake in state oil firm Rosneft to Swiss Glencore and Qatar's sovereign wealth fund. Most of the proceeds from the $11 billion transaction went into the state's coffers. The manufacturing sector accounted for much of the remainder of the foreign direct investment in Russia. Many German firms are returning to invest in the country; the German business daily Handelsblatt reports that trade between the two states has risen 37 percent so far this year, compared with 2016. What's more, Germany seems to be moving forward with plans to move major manufacturing plants to Russia.

A Sanctioned Recovery?

And so, the Kremlin's statistical trickery aside, Russia is pulling out of its recession. As it does, the extent to which the international sanctions against it contributed to its economic plight will become clearer. The IMF calculated that the punitive measures have reduced Russia's real GDP by between 1 percent and 1.5 percent since 2014 and that they will cause a cumulative loss of 9 percent over the next decade should they remain in effect. The sanctions fall into two main categories: measures targeting personnel and measures targeting specific sectors of the Russian economy. When the tougher sectoral sanctions were first introduced in 2014 — barring Western institutions from lending to, investing in or collaborating with companies in certain Russian industries, such as the energy and industrial sectors — the ruble bore the immediate consequences. The rest of the country slipped into recession only once oil prices plummeted.

Now that the currency is recovering in spite of the sanctions, it seems the measures may have reached the limit of their efficacy. The sanctions, for example, haven't discouraged foreign investment in Russia as much as the country's business environment has. Russia lacks a robust legal culture or clear property rights, and at the same time, it suffers from high levels of corruption, harassment and regulation on foreign investment. The sanctions' main effect, for now, is that Russian banks have to shoulder the burden of lending to the sectors targeted in the measures. But even that hasn't been entirely bad for the country. Without the option to roll over their foreign debts, many companies and government branches paid them off faster as a (likely unintended) result. Russia's external debt dropped to $75 billion by the end of 2015, half of what it was before the sanctions were imposed.

Furthermore, though the country is still starved for foreign investment and technology, a loophole in the EU sanctions on Russia's energy sector has enabled European firms to keep investing in fracking projects and arctic drilling ventures. If a European company had contracts in place before the sanctions took effect, it can continue its work in Russia. Norway's Statoil and Italy's Eni both plan to resume their activities in the country later this year on this technicality. The projects that fall in the loophole, however, will likely produce only enough oil to offset the natural decline of Russia's existing wells in the long term, rather than boosting the country's output. And because the U.S. sanctions don't include such a waiver, Exxon Mobil hasn't been able to keep doing business in Russia.

Still, the sanctions regimes are not enough to persuade Moscow to dispense with its current strategic objectives abroad. The measures are expediting the decay of the Russian economy, albeit slightly. (The economy's underlying structural problems are mostly responsible for its own decline, along with low oil prices and middling investment.) Consequently, the Kremlin will probably have leeway over the next few years to pursue its foreign policy goals in Ukraine, Syria and electoral contests the world over. If waning investment starts to hurt the country's major energy companies, though, the government may have to rethink its strategy or else face the wrath of Russia's elites, including Rosneft chief Igor Sechin.

What Lies Ahead

And the country's financial problems will endure regardless. Though Russia has muddled through the worst of the recession, it has run through much of its financial reserves in the process. The Reserve Fund, which is meant to hold a balance equivalent to 10 percent of the country's GDP, holds just $16 billion today, down by half since 2014 and by two-thirds since 2009. Finance Minister Anton Siluanov recently announced that the Kremlin will exhaust that fund this year to supplement its budget and will then need to tap into the National Wealth Fund, an account intended to cover pension payments. (The National Wealth Fund currently holds $73 billion, down from a high of $88 billion just before the crisis began.) Siluanov claimed that this year's oil and gas revenues would replenish the Reserve Fund in 2018, but the government may wind up depleting its reserves if oil prices drop below $40 per barrel.

His assurances, moreover, will offer little solace for Russians concerned that the Kremlin is dipping into its last emergency fund. The Russian people are still bearing the brunt of their country's economic problems. Monthly wages have dropped over the past two years to less than $450 on average — lower than the mean pay in China, Serbia, Poland or Romania. The number of people living below the poverty level, $177 per month, jumped from 16 million in 2014 to 20 million last year according to Rosstat. Russian Prime Minister Dmitri Medvedev vowed May 10 to get the country's wages back up to subsistence levels, but the process would take until 2019. In the meantime, official statistics show that 20 percent of the workforce is employed in the informal sector, and independent estimates put the proportion closer to 40 percent. Although informal jobs have kept the unemployment rate low — at 6 percent, by the Kremlin's account — the people employed in this capacity don't pay taxes, nor do their employers. The arrangement, in turn, deprives the federal and regional governments of much-needed revenues.

As their financial straits have worsened, Russians have taken to the streets in protest. The Kremlin is concerned that the demonstrators will channel their dissatisfaction through their ballots in gubernatorial elections scheduled to take place in 16 regions in September. The government has even canceled its plans to launch a propaganda campaign aimed at encouraging voter turnout for fear that opposition groups — from Alexei Navalny's supporters to the Communist Party — could beat out Putin's United Russia. The president and ruling party will face an even bigger test in March 2018, when the country will hold its next presidential election. Putin is expected to run for a fourth term in office, and a recent Levada poll cast doubt on whether he will reach the 50 percent threshold required to avoid a run-off vote. The incumbent president would likely beat his rival were the election to come down to a second-round vote. Still, the very possibility of a run-off is a testament to the electorate's growing discontent.

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