Russia’s growth problem

Russia's growth problem PolicyContribution

Issue n?4 | February 2019

Marek Dabrowski and Antoine Mathieu Collin

Executive summary

Marek Dabrowski (marek.dabrowski@ ) is a NonResident Fellow at Bruegel, a Professor at the Higher School of Economics in Moscow and a Fellow at CASE ? Centre for Social and Economic Research

Antoine Mathieu Collin is a former research assistant at Bruegel

Between 2014 and 2016, the Russian economy suffered from a currency crisis caused by the collapse of oil prices and the country's engagement in the conflict with Ukraine. Although the crisis was overcome in the second half of 2016 thanks to prudent fiscal and monetary policies and higher oil prices, economic recovery remains weak and Russia's medium-term growth prospects look rather disappointing.

The weak growth prospects are caused by several factors including: (i) adverse demographic trends ? a declining working-age population and ageing of the population; (ii) a poor business and investment climate; (iii) difficulty in diversifying away from the dominant role of the hydrocarbon sector; (iv) Western sanctions on Russia in response to the annexation of Crimea and Russian support for separatists in the eastern Ukraine Donbas region, and Russian countersanctions.

To increase potential growth, Russia needs comprehensive economic and institutional reforms that, in turn, will be conditioned by political reforms and by improved economic and political relationships with the United States, the European Union and Russia's neighbours.

The Policy Contribution was prepared between August 2018 and January 2019. The authors would like to thank Yana Myachenkova for research assistance, and Sergey Aleksashenko, Anders Aslund, Uri Dadush, Zsolt Darvas, Maria Demertzis, Sergey Guriev, Elina Ribakova, Andr? Sapir, Nicholas V?ron and Guntram Wolff for their comments.

1 Introduction

In 2014-2015, the Russian economy was hit by a currency crisis, which led to the depreciation of the Russian ruble (RUR) by more than half, a new wave of inflation, a decline in personal income and a contraction of output by a cumulative 2.7 percent. The crisis was caused by a combination of economic and geopolitical factors: the sharp decline in the international price of oil, which is Russia's main export item, and the conflict with Ukraine (the annexation of Crimea and support for separatism in Donbas), which resulted in United States and European Union sanctions against Russia, and in Russian countersanctions.

Since mid-2016, the macroeconomic situation has stabilised and Russia's economy has returned to growth, albeit at a slow pace. The medium-term prospects do not look better despite the partial recovery of oil prices. This raises the question of which factors are limiting the Russian economy's growth potential. And this is the main topic of our analysis.

We start with an overview of growth trends in post-Soviet Russia (section 2). The subsequent sections analyse potential causes of the mediocre growth performance. Section 3 is devoted to the currency crisis of 2014-16, its management and its legacy. In section 4, we assess the potential impact on Russia's economic performance of the conflict with Ukraine and the deteriorating economic and political relationships with the US and EU, including the US/EU sanctions against Russia and Russia's countersanctions. Section 5 analyses the structural characteristics of the Russian economy and trade. Section 6 is devoted to institutional deficiencies, that is, the poor business climate and its consequences for investment and the balance of payments. Section 7 deals with demographic issues, which seem to be the most serious long-term obstacle to growth. Section 8 presents conclusions and recommendations.

2 The post-Soviet growth story

Figure 1 presents the history of economic growth in post-Soviet Russia. The 1990s was marked by a deep output contraction, the result of structural and institutional distortions that accumulated during several decades of the centrally planned economy, plus huge macroeconomic disequilibria in the initial period of transition and the slow pace of economic reform. In fact, the output decline had already started in the late-Soviet period and was preceded by a near decade of economic stagnation.

Between 1999 and 2008, Russia enjoyed a decade of rapid economic growth facilitated by structural and institutional changes in the 1990s and the global commodity boom (high oil prices). The global financial crisis of 2008-09 hit Russia hard, leading to a dramatic GDP decline of 7.8 percent in 2009. In the next three years (2010-12), however, there was a visible recovery. In 2013 the growth rate went below 2 percent and the next year Russia was hit by a currency crisis.

This time, the crisis was not caused by imprudent fiscal and monetary policies, as happened in the late 1980s, the first half of the 1990s and in 1998-99. Rather it was triggered by the external shock of the decline in international oil and commodity prices, combined with domestic structural and institutional vulnerabilities. There was also a geopolitical factor not present in the previous crises: Russia's engagement in the territorial conflict with Ukraine, which resulted in international sanctions against Russia and Russian countersanctions (see section 4).

The crisis that started in 2014 caused a two-year recession. Real GDP fell by 2.5 percent in 2015 and additional 0.2 percent in 2016. Although the 2015-16 recession in Russia was shallower than during the global financial crisis (2008-09) it was deeper than in most other oil-producing countries (Dabrowski, 2016). This might have been the result of more conserv-

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Policy Contribution|Issue n?4|February 2019

1.4 6.4 10.0

5.1 4.7

7.3 7.2 6.4

8.2 8.5 5.2 4.5 5.1 3.7 1.8 0.7 1.5 1.7

ative fiscal policy in Russia (see section 3), compared to, for example, Saudi Arabia or other Gulf countries, which launched large-scale fiscal stimulus programmes in 2014-15.

Figure 1: Russia: real GDP, annual percentage change, 1993-2018

12.0 9.0 6.0 3.0 0.0 -3.0 -6.0 -9.0

-12.0 -15.0

-8.7 -4.1 -3.6

-5.3 -7.8

-2.5 -0.2

1993 1994 - 12.7 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 est

Source: Bruegel based on IMF WEO database, October 2018.

Figure 2: Russia: quarterly GDP in 2016 prices (RUR billions), seasonally adjusted, 2013-17

22,40 0

22,20 0

22,00 0

21,80 0

21,60 0

21,40 0

21,20 0

21,00 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

2013

2014

2015

2016

2017 2018

Source: Bruegel based on Rosstat.

Figure 2 shows quarterly, seasonally adjusted, GDP in constant 2016 prices. The recession started in the third quarter of 2014 and reached its bottom in the second quarter of 2016. Since then, output has recovered, reaching its pre-crisis level in the second quarter of 2018.

Even if the recession of 2015-16 was not deep, it was not followed by a strong post-crisis recovery, as happened after the 1998-99 and 2008-09 crises. In 2017, growth in real GDP amounted to only 1.5 percent (Figure 1) and, according to the International Monetary Fund's (IMF) October 2018 World Economic Outlook (WEO) forecasts, it is expected to have been 1.7 percent in 2018. Furthermore, according to the same forecast, growth is expected to fluctuate between 1 percent and 2 percent up to 2023. This is much lower than the growth rate that

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Policy Contribution|Issue n?4|February 2019

Russia enjoyed between 1999 and 2008, and looks disappointing for a middle-income country that still has a long way to go to catch up with the high-income group.

Furthermore, if one compares Russia to other emerging-market economies (Figure 3), its growth performance since 2007 does not look impressive. Brazil, which experienced an even deeper recession in 2014-16, and Argentina, which has recorded several recession episodes since 2010, are the only exceptions. However, it is fair to say that such a comparison of countries might disregard some important factors, such as different demographic conditions or different stages of economic development (see section 7 for an analysis of Russia's unfavourable demographic trends).

Figure 3: Real GDP in Russia and other emerging-market economies, annual percentage change, 2007-17

15.0

12.0

9.0

6.0

3.0

0.0

-3.0

-6.0

-9.0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Argentina India Russia

Brazil Indonesia South Africa

China Mexico Turkey

Source: Bruegel based on World Bank's World Development Indicators. Note: EMDE = emerging market and developing economies.

Nevertheless, the questions of why the rate of growth of the Russian economy slowed down and why Russia's growth prospects remain disappointing, require in-depth analysis and this the main purpose of this Policy Contribution. In the following sections, we analyse in turn five groups of factors that might be responsible for Russia's mediocre growth record: macroeconomic management of the 2014-16 currency crisis; the costs of the Ukrainian conflict and the deteriorating economic and political relationships with the US and the EU; structural characteristics of the Russian economy; institutional shortcomings; and demographic trends.

3 Managing the 2014-16 currency crisis

In 2014-16, Russia was hit by its fifth currency crisis since the early 1990s (Dabrowski, 2016). Between December 2013 and December 2015, the RUR depreciated by 55 percent against the US dollar (it depreciated by less against the euro because of the strengthening of the dollar against the euro), with depreciation greatest in the period between November 2014 and February 2015 (Figure 4). There were then two further but shorter periods of RUR decline ? in August 2015 and January-February 2016. After the second quarter of 2016, the RUR gradually strengthened (as a result of the recovery of the oil price) and remained below 60 RUR per dollar thorough most of 2017 and the first quarter of 2018. In April 2018, in response to US sanctions introduced under the Countering America's Adversaries Through Sanctions Act (CAATSA) (see section 4) the ruble depreciated to 61-64 RUR to the dollar. It stayed at this

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Policy Contribution|Issue n?4|February 2019

11/2013 02/2014 05/2014 08/2014 11/2014 02/2015 05/2015 08/2015 11/2015 02/2016 05/2016 08/2016 11/2016 02/2017 05/2017 08/2017 11/2017 02/2018 05/2018 08/2018 11/2018

level until early August 2018 when it fell again to 66-68 RUR per dollar, in reaction to currency crises in Argentina and Turkey (Dabrowski, 2019) and another wave of US sanctions (see section 4).

Figure 4: Ruble exchange rate, RUR per dollar, 2013-18

90

80

70

60

50

40

30

Source: Bruegel based on Central Bank of the Russian Federation.

The Central Bank of the Russian Federation's (CBRF) international reserves decreased from $510 billion at the end of December 2013 to $356 billion at the end of April 2015, a drop of more than $150 billion. Subsequently, they were gradually rebuilt to a level of about $460 billion in the second half of 2018 (Figure 5). 550,0 00

Figure 5: International reserves of the CBRF, in US$ million, 2013-18

500,0 00

450,0 00

400,0 00

350,0 00

300,0 00

Source: Bruegel based on Central Bank of the Russian Federation.

01/12/13 01/03/14 01/06/14 01/09/14 01/12/14 01/03/15 01/06/15 01/09/15 01/12/15 01/03/16 01/06/16 01/09/16 01/12/16 01/03/17 01/06/17 01/09/17 01/12/17 01/03/18 01/06/18 01/09/18

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Policy Contribution|Issue n?4|February 2019

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