The Russian economy cannot take any more fooling around from officials. Despite excellent world market conditions, Russia is on the verge of a serious decline in production.

Maxim Rubchenko

Last week, it finally became obvious that the Russian economy is not solely based on natural resource exports. The idea that economic growth is completely and utterly dependent on world commodity markets was exposed as myth. As it turns out, industrial growth in Russia is completely and utterly dependent on the production of high-tech machinery. More precisely, on combines. Previously, combine production was going along swimmingly and thus the Russian economy was growing rapidly. Now production of two combine models has stopped and total production has fallen by 71%, and as a result the economy has stopped growing. Or at least, this is what Russia’s head economist, Minister of Economic Development German Gref, reported to the president last week.
Western analysts declaring Russia one of the four most promising economies in the world must have been shocked to discover that Russia is completely dependent on combine production! The president was also shocked apparently. He didn’t believe Minister Gref and demanded the economic wing of the cabinet provide detailed analysis of the reasons behind the manufacturing decline and that they propose how to fix the situation.

Everybody falls in their own special way

The slowdown affected an entire range of Russian industries from light industry to construction materials to machine building, energy, and natural resources. In recent months, natural gas, coal, chemicals, and electricity producers have suffered the most. In the majority of industries there are industry-specific reasons for slowed growth. For example, in non-ferrous metals, the production decline is connected to a glut on the world market. Ferrous metals are seeing declines due to a shortage in production capacity that would allow the industry to maintain previous growth rates (this is demonstrated by the increase in investment in fixed assets by companies in the industry and increased production of foundry equipment). In addition, early this year the prices for ferrous metals increased at unprecedented rates on the Russian domestic market. The real price for ferrous metals shot up by 34.2%. This led to declining demand and forced manufacturers to cut back on production.
Stagnation on the real estate market, which was in part a product of the summer bank crisis, led to the decline in construction materials production. It became much more difficult for construction companies to get loans, which meant that cement production declined noticeably.

 Black, thick, and baffling

Analysts are having a much harder time explaining September’s nearly 3% decline in oil production, when oil prices are at record-breaking levels. Some experts connect the slowdown with a shortage of transportation capacity. “The only thing limiting production growth in the medium term in Russia is the transport capacity of pipelines and railways,” notes Maxim Moshkov, an analyst at Brunswick UBS.
It is possible, however, that there are other reasons as well. For example, analysts believe that the new methods for calculating taxes on mineral resources may be at fault. In times of high prices, these taxes make production expansion pointless, as prices cannot compensate for tax costs.
Yet the saddest aspect of the production decline is that the industry is also seeing a serious decline in investment. “In the second quarter of 2004, investments in the fuel industry, including oil production, fell significantly,” states Valery Mironov, Senior Expert at the Development Centre. “The increasing insecurity and pessimism in the fuel industry revealed by our polls, along with expectations of high inflation, is leading to a decline in investments. This decline is threatening to change from a short-term slowdown into long-term stagnation, as it will slow production modernization.”

Losing to imports

Machine building has presented economists with a very depressing picture: production of the majority of important products is falling. At the same time, the main reason for the decline put forth by officials from the Economic Development Ministry - reduced demand from oil companies - obviously does not hold water. It does not work, if only because the biggest declines have occurred in sub-industries with no connection to the oil industry: cars, press-forging equipment, machine tools, bearings, diamond tools, clocks, and so on.
One has only to think of clocks and cars to realize what the real reason is: Russian products are losing out to imports. Imports have been encouraged by two circumstances that are exclusively the product of the government’s current economic policy. The first is the stronger ruble. Contract prices in dollar equivalents have sunk and it makes economic sense to buy equipment for dollars. The Russian economy is tied to the dollar in many, many ways. Russia trades with countries bound to the dollar, and a significant portion of European contracts are also denominated in dollars. Consequently, the Central Bank’s new policy is leading to a weaker dollar, which may be accompanied by increased import rates. The most sensitive sectors to such increases are light industry, food production, pharmaceuticals, and machine building.
The second factor stimulating import growth is inflation. The rapid increase of domestic prices for ferrous metal products has increased costs for machine builders, construction companies, and petroleum corporations, the largest pipe consumers. The startling rise in gasoline prices this spring and summer naturally drove prices higher throughout the economy. As a result, last week government representatives were forced to admit that inflation figures for the year will likely exceed the target of 10% and will be at least 10.5%. “Bearing in mind that prices always rise faster toward the end of the year, inflation could wind up being even higher, as high as 11%,” warned Andrei Klepach, Director of the Macroeconomic Forecasting Department at the Ministry of Economic Development.
The government uses only one weapon to fight inflation: reducing the money supply by sucking money out of the economy into the Stabilization Fund and printing fewer rubles. Since the beginning of the year, M2 growth rates have been falling consistently and in April they were even negative, which means that the amount of money in the economy declined. The natural result of this policy was the liquidity crisis in the banking sector, but officials were still unable to reach inflation rate targets. We can confidently say that after this failure, the Ministry of Finance and the Central Bank will be even more adamant in getting money out of the economy. We can be just as sure that this will have absolutely no effect because inflation in Russia today is non-monetary in character and mainly connected to increasing costs in manufacturing.

Lower quality

Even if a miracle happens - officials admit their mistakes and fix them, causing inflation rates to plummet - Russian products cannot compete with imports. For this reason, it is not realistic to argue that Russian products are losing to cheaper imports. “According to polls conducted by the Development Centre, import prices and volumes have not been exerting more pressure on Russian manufacturers than they did last year,” argues Valery Mironov. “Quality is putting increased pressure on Russian manufacturers.” Of course, losing out to the competition due to quality is the kind of problem that cannot be solved by controlling the ruble exchange rate or cutting inflation. Production needs modernization and new technologies, or in other words needs more investment. Here is where Russia is failing completely. Since May 2004, Russia has experienced a dramatic slowdown in investment growth. And there are two reasons for this decline. The first reason is the above mentioned policy of reducing the money supply. As a result, only large state and state-related companies and banks can easily find resources for modernizing and expanding production. For the mid-sized businesses that made a significant contribution in the investment boom of 2002-3, attracting resources has become a problem. Loans are once again too expensive and their terms too short, and the demand for bonds and bills had fallen dramatically.
The second and far more important reason for the decline in investment is the increased political and corporate risks of conducting business in Russia. Even high world prices, rapidly expanding gold reserves, favorable foreign market conditions for Russian bonds, and other positive circumstances do not outweigh the negative effects of the changes in government policy related to business. It’s no accident that investments began to decline in April. Prior to that time, entrepreneurs still hoped that after the presidential elections and change in the cabinet, the government would return to its previous partnership with business. When it became clear that the government was not about to change its economic policy, many businesspeople called off their investment plans.
Economic officials are sure that nothing extraordinary will happen and in the forth quarter, the economy will begin growing again thanks to favorable conditions on world markets. Perhaps that’s exactly what will happen. In the past few years, the Russian economy has experienced several minor, market-driven breaks in growth, lasting up to four months. However, if investment continues to fall at current rates, the short break will turn into full-blown stagnation.

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