Streetwise Professor

I’m back!  And glad to be here.  Italy was great, but it nothing beats the US in my book.  Going away for awhile helps make that very clear.

And now, back to our regularly scheduled blogging . . .  

Earlier in the year I argued (mainly with BFC) that Russia was a high beta economy, meaning that the fluctuations in Russian economic performance, and the performance of its financial markets, would be more extreme than those in the rest of the world. This original diagnosis was predicated on Russia’s extreme dependence on hydrocarbon exports, and the dependence of hydrocarbon prices on worldwide economic conditions.   One corollary of this is that Russia’s economic fate is tied to that of the broader world economy: As goes the world economy, goes the price of oil, goes Russia.

Recent news provides some confirmation of this analysis, but also suggests quite strongly that other aspects of Russia’s economic fate are unique to it—and that those don’t, don’t bode well for Russia’s near and medium term future.   (It’s long term future is pretty bleak, given its demographic difficulties.)   That said, Russia is not hopeless; its prospects depend on foreign investors failing to learn their lessons about the dangers of putting capital in Putinist Russia, and past experience suggests that these investors are capable of just that.  

The confirmation of the high beta hypothesis: the fact that Russian stock prices fell far more than world prices during the height of the crisis 4Q 2008; the recent boom in Russian stock prices, up around 140 percent off their lows, coincident with a strong but substantially smaller (around 33 percent) increase in stock prices in the US and Europe, and the rally in oil—up around 120 percent off its lows; the more recent drop in Russian equities—around 20 percent—coincident with a 5 percent or so drop in developed market prices, and a 10 percent or so drop in emerging markets, and a modest drop in oil prices; and increased pessimism about the prospects for recovery in Russia, coincident with a diminution of hopes for an imminent, and robust, world economic recovery.  

Virtually all of the economic news emanating from Russia is quite bleak.    To wit:

A stunning drop in investment spending:  

Russia’s biggest contraction in capital investment since December 1998 shows that the government’s stimulus package is “not working,” Alfa Bank said.

Last month’s 23.1 percent annual drop means “the fiscal stimulus funds are not finding their way into the real economy,” Natalia Orlova, Moscow-based chief economist at Alfa, Russia’s largest privately owned bank, wrote in a note e-mailed today.

“The general conclusion is that the state’s fiscal policy is focused on the social sphere rather than investment and that the Finance Ministry is trying to offset the decline in budget revenues with lower spending,” Orlova wrote.

The economy of the world’s biggest energy producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 million) to battle the slump, including funding designated for the auto industry, agriculture and construction.

The budget deficit widening to 511 billion rubles through the end of May was the result of increasing transfers to regional budgets, rather than funneling money to the economy, the report said.

The source of the widening budget deficit—transfers to regional budgets—is of particular interest.   It suggests that the center feels compelled to prop up the regional governments, likely out of fear of social discontent and popular unrest.  

EDM provides further detail on the desperate straits of the regional governments, and the central government’s pulling out all the stops to keep them afloat while demanding that they in turn support employment in their regions:

Kudrin’s main headache, however, is the need to bail out an increasing number of regions that face insolvency while the income from the state budget has fallen by more than one third (Vedomosti, June 19). Putin is inspecting the regions demanding from the governors not to close the plants that cannot find any demand for their products and to pay salaries to idle workers, but that requires more transfer of funds from the federal coffers – a policy that goes directly against Kudrin’s course on reducing inflation (Kommersant, June 19).

Moreover, the decline in investment reflects a very bearish view on the economic future.   Given that Russia’s recent investment levels are quite modest compared to other emerging markets, and to the past example of the Asian Tigers, this drop in investment bodes ill for future growth.

A widespread recognition that government policy is ineffectual at best, and more likely extremely counterproductive:

Russia’s “anti-crisis” program, signed by Prime Minister Vladimir Putin on June 19, probably won’t return the country to sustained growth before 2012 and risks increasing state intervention, Capital Economics said.

“At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism,” Capital’s London-based emerging-Europe economist analyst Neil Shearing wrote in a note e-mailed late yesterday.

The economy of the world’s biggest oil producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 billion to battle the slump, including funding designated for the auto industry, agriculture and construction.

The government’s intent to “pick winners” among industries and check the growth of food prices may distort market and curb the supply of products, the Shearing said.

Carmakers are set to receive 90 billion rubles, farmers 63.1 billion rubles for agriculture and construction companies 247.2 billion rubles, according to calculations by Trust Investment Bank.

The total amount in the final draft is less than the 2.98 trillion rubles pledged by the government earlier after it reduced support for the banking industry by 500 billion rubles.  

Declining retail sales:

Russia’s economy is shrinking more than expected, sending “damaging waves” throughout the former Soviet Union, the World Bank said.

Collapsing industrial production, rising unemployment and capital flight will reduce Russia’s gross domestic product by 7.5 percent this year and restrain “intraregional trade flows and transfers,” the World Bank said in a report posted on its Web site today.

. . . .

Retail sales fell the most in almost a decade in May, sliding an annual 5.6 percent, the fourth consecutive decline and the biggest since September 1999. The average monthly wage decreased an annual 3.3 percent in May, while real disposable incomes dropped 1.3 percent.

And perhaps most ominously, the prospect that rising energy prices—themselves dependent on the extremely uncertain prospects for a global recovery, and the policy of the Fed—will not be Russia’s (or should I say Putin’s?) salvation when (or should I say if?) they come to stay:

Russia’s economic slump may deepen in the second quarter to an annual contraction of 10.9 percent because rising oil prices won’t spur growth without a recovery in lending, according to Goldman Sachs Group Inc.

“Russia’s deep output decline, in our view, is less the direct impact of lower commodity prices and more the effect of the sudden stop in capital inflows that the country suffered beginning in the third quarter of 2008,” Rory MacFarquhar, Moscow-based economist at Goldman, said in a report today.

The world’s biggest energy supplier is falling into its first recession in a decade after the global decline sapped demand for commodities while capital flows to riskier markets dried up. A stimulus package has failed to spur lending even as the central bank cut interest rates three times since April.

Capital investment in May fell an annual 23.1 percent, the biggest drop since December 1998, as industrial output declined a record 17.1 percent last month. Russian retail sales slid an annual 5.6 percent in May, the fourth consecutive decline and the biggest since September 1999.

. . . .

Lending to households and companies declined in the fourth quarter of last year by the equivalent of 5 percent of gross domestic product and fell 6 percent of GDP during the first three months of 2009 from a year earlier, according to Goldman.

Urals crude oil, Russia’s chief export earner, traded at more than $71 a barrel this month after falling to a low of $32.34 in December. The higher oil prices won’t spur growth because the profits are largely collected by the government in taxes, MacFarquhar wrote.

In previous years, the non-financial sector expanded borrowing by over 20 percent of GDP annually and Russia’s external debt grew by 30 percent every year, the report said.

The rise in oil prices will result in a stronger ruble and increase nominal GDP, leading to a budget shortfall of 6.2 percent this year, compared with an official forecast for a deficit of more than 10 percent, according to Goldman.

The collapse in capital inflows is another manifestation of the widespread pessimism about Russian economic prospects, and parallels the decline in investment.   The disparity between the dizzying growth rate in household and business lending in recent years, and the decline in 4Q 2008-1Q 2009 is particularly illuminating.

Investment is not robust anywhere, but the Russian fall is precipitous and nearly unique: notably the BIC countries have not experienced the collapse observed in Russia.   (Although lumping these countries together has never made much sense given their great differences on virtually every economically and politically relevant dimension—and including the Russian “R” to make BIC into BRIC was especially non-sensical).   This is the factor that seems on the one hand to confirm the high beta hypothesis, but which instead more likely reflects something distinctive to Russia other than its dependence on raw material exports.   Instead, it plausibly reflects the fundamental defects of the country’s natural state political and economic system.  

This is a natural implication of Putinism, as Shearing puts it: “At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism.”   Add to this the Telenor fiasco, coming as it did on the top of numerous expropriations of investors both foreign and domestic; the ongoing farce of the Khodorkovsky trial, with its chilling implications for any Russian who falls afoul of the system, and its demonstration of the complete absence of an independent legal system and protection of individual rights; the trial of a different sort of being a foreign investor in Russia (cf. Ikea’s decision to suspend expansion in the country in large part due to the abuses it has suffered at the hands of Russian officialdom, petty and elevated); the WTO decision; the rows with everyone from Belarus to the US over food imports; the lack of credible commitment by the government to protect property or to adhere to contracts; the political risks epitomized by the Georgian War and its lawless, rogue aftermath (with the recent veto of the UN mission in South Ossetia and Abkhazia just the most recent example); and on and on.   Given this litany, it is no surprise that foreign investment has deserted Russia, and is unlikely to come back any time soon.

Here’s a way of summarizing this: high raw material prices are a necessary, but not sufficient condition, for Russian economic growth.   Booming resource prices in the earlier years of this decade created the possibility that Russia could be a lucrative investment market—if those investments were secure from predation.     And that proved to be a big if.   The capital outflows started before the world economic crisis—with the Georgian War, in fact, which put an exclamation point on the political risks in Russia.   The crisis, and the resulting collapse in materials prices, accelerated that decline.   The question is whether a reversal of the decline will lure foreign investors back.

There is room for doubt because there is no doubt that the government’s behavior both during the boom and the collapse made it abundantly clear that a fool is soon separated from his money in Russia—and that anyone who invests in Russia is very likely a fool.   If the high beta nature of the Russian economy doesn’t get you, the government is likely to.   Even companies and countries that assiduously courted the Putinite elite—BP and Norway come to mind—found themselves the victims of a predatory system.   (Is it a coincidence that Victor Fridman is deeply involved in both situations a coincidence?   Methinks not.)

Once burned, twice shy?   One would think so, and in the event, Russia’s future prospects would certainly be quite bleak.   For world economic prospects remain troubled, with pronouncements of the “green shoots” (gag) of an economic spring appearing decidedly premature, and Russia ill positioned to benefit from any world rebound due to its sinister reputation as a very dangerous place to invest.   For a country that experienced growth largely due to foreign investment attracted in large part by a boom in commodity prices, this is a very dangerous position to occupy.

But not all is lost for Putinism.   World economic recovery; a wildly expansive and inflationary US monetary policy; and the slashing of investment programs in oil and metals during the crisis; could lay the groundwork for another spike in commodity prices.   And past experience suggests that investors sometimes have short memories, and tend to let their wishes override the lessons of experience, and an understanding of the nature of Putinism.   Another commodity boom may induce foreign investors to throw caution—and common sense—to the wind, and invest in Russia again.  

So, in a nutshell, the positive case for Russian economic prospects: (a) another spike in commodity prices, and (b) foreign investors continuing to play Charlie Brown to Putin’s Lucy (tempting them with the financial football).   I put the probability of (a) in the 30-40 percent range in the 2010-2011 period, especially given the difficulties that the Fed will face when attempting to extricate itself from the extraordinary measures it has taken in recent years, difficulties exacerbated by the fiscal pressures emanating from Obamaism.   I put the probability of (b) somewhat lower than that—but not at zero, which is where it should be.   So, Russia should have no economic future due to the deformities of its politico-economic system, but it just might in spite of itself due to the prospects for policy errors in the US (and the West more generally), and (most importantly) to the cognitive and mnemonic deficiencies of Western investors.