with Mikhail Dmitriev, President, Center for Strategic Research
How was this crisis not foreseen by the Government?
Initially, there was a certain sense of invulnerability to the crisis boosted by the idea of decoupling of China and India from the US economy, which in a short period of time became prevalent among the key Governments. Russia, under the decoupling scenario, was not likely to be affected, and everyone was utterly optimistic but, frankly speaking, we as a think-tank didn’t particularly believe in decoupling, as these theories were not backed by enough evidence and we, as risk analysts, developed alternative scenarios of a global recession.
This is why we did two rounds of simulations – the first round in 2006, and the second round in the second half of 2007, where we considered the global recession scenarios. Under the first scenario, decoupling works, and China does not enter a recession. Under the second scenario, what we called “The Chinese scenario”, the Chinese economy slowed down. The second round of simulations was considering the two most vulnerable points of Russian economy of the moment: a fall of oil and gas prices to the historic minimum of 25$/barrel at current prices and the access to the global financial market. We weighed what would happen in Russia after three years of final capital liberalization and influx of foreign capital if the sudden capital inflow is replaced by outflow. So, we tested both coupling and decoupling scenarios and discovered that only the Chinese scenario really produced a huge recession in Russia. The GDP decline that we currently predict for 2009-2010 corresponds, more or less, to the Chinese scenario.
There’s a strong statistical correlation between oil prices, capital accounts and GDP growth in Russia; every dollar of the decline of oil prices per barrel generates a certain decline in GDP growth.
Besides, Russia’s large companies heavily relied on international capital markets to finance expensive investment projects in resource sectors, infrastructure, services and real estate. As soon as oil prices began to decline, Russian customers lost effective access to the international capital market.
Does this mean that the Russians would not re-invest in their own economy?
Some big investors were behaving quite rationally: for instance, Severstal announced dividends of $1 bln USD for the investors to take advantage of assets home and abroad. Strategically focused investors took the capital to use it for investments in future mergers and acquisitions. I think this is quite rational from a strategic prospective. The investors are looking for opportunities for strategic mergers and acquisitions in order to complement the production chains, to acquire new technologies and to gain access to new markets.
Some economists say that the crisis hit Russia quite badly but that the country was better prepared than others judging by the level of reserves. What is your opinion of how the money was used to defend the currency, buy raw material extracting businesses; bail out State businesses…? It seemed quite controversial…
Before the crisis, Russia built up huge fiscal reserves, so the total net debt was positive or close to zero. This was a bit like “Alice in Wonderland”: no matter if you were falling and everyone else was falling, there were others who were falling even faster than you! In order to land safely, like Alice, it’s important not to be the fastest-falling economy in the world.
In Europe, many countries, like Austria and Greece, have an enormous credit exposure to Central and Eastern Europe, and default of one country would create a domino effect which would affect the neighborhood of Russia.
Russia has no reason to default because the Government and the Central Bank have sufficient resources to maintain macroeconomic stability at least until the end of the next year. If the Government is prudent enough, Russia can survive with considerable reserves quite well, similarly to other BRIC countries.
Apart from defending the currency, shall we see any big national projects this year? There were expectations of infrastructure projects and hopes to modernize the country… What is the prospect for 2009-2010?
Last year there were a lot of concerns that the Government was being too optimistic. Many believed that decoupling was still viable and that crisis might be very short. But today even the most optimistic scenario doesn’t assume that the US and Europe recover before the end of 2009, and the Russian economy before mid-2010. The Russian Government now cuts budget spending in order to keep deficit under control. Fortunately, fiscal reserves still stay at 20 percent of GDP and the Government demonstrates macroeconomic prudence. The ruble devaluation was managed relatively well and successfully retained the largest banks from bankruptcy in spite of the magnitude of the liquidity squeeze during the last phase of devaluation in January-February.
By January this year access of companies to finance was at the lowest historic minimum – 16% but later it somehow improved ; currently certain industries like clothing and textile already have a 40% access to lending; for metallurgy and engineering access rates also improved tightening of domestic money supply by the Central Bank.
How flexible is the Russian economy in the mid-term?
The Russian economy will be more or less in good shape by the end of 2009, and will be able to keep sufficient currency reserves; budget deficit will be high(over 7 percent of GDP) but could be financed without extra borrowing due to accumulated reserves.
For Russians it is important to keep down the costs of commodity export and the current situation suits the commodity exporters: the depreciated ruble easily provides this profitability buffer for metallurgy and oil and gas.
The crisis is also to help import-substitution industries: agriculture has been growing very fast in 2008; the food processing industry is also doing well; communication services will be in relatively good shape. In the textile industry Russian products will gain some cost advantage over the Chinese.
There have been a lot of institutional reforms… How is this to affect the quality of State institutions?
In my view, the State anti-crisis machine was reasonably effective. Macro-policy was adequate. Fiscal stimulus is applied without compromising macro-stability. The banking sector survived the liquidity squeeze. But in terms of institutional quality in the longer term, Russia is still very weak, of course.
The key problem is the quality of public sector: enormously high corruption, lack of competence, low productivity, ineffectiveness, poor transparency, low accountability, lack of democratic procedures… these are things that can’t be changed overnight: institution building is a long process. But stronger emphasis on institutional reforms can be reflected even in short-term anti-crisis policies, including a relevant agenda for developing of performance-oriented and accountable public administration – this is what Russia still has to achieve.
Will it be a priority to make the country more attractive for foreign investors?
There is a lot of evidence that foreign investors are interested in the Russian market even now: many want to take advantage of the cost of assets to gain leading positions in certain unoccupied niches of the market.
What about the Russian side?
Russia has no choice because the economy will do badly without net capital inflow. The domestic financial sector can only sustain investments at the level of 20% of GDP and we need 30%, the rest should come from abroad. The Russian financial sector is still small and fragmented and does not give major companies access to large loans. Foreign investors should come, and until they do the economic growth will not resume.
We project two scenarios for Russian economy: a short crisis of about 1.5 years ands and a long crisis that will last for 2-3 years. In the first scenario, Russia may gain an excellent strategic position by comparison to the rest of the region of Eastern Europe and Central Asia. But these advantages will all but disappear if the crisis will last for more then two years. In this case Russian economy will suffer from underinvestment and capital flight, huge budget deficits, macroeconomic and political instability. In this case the Government will lose much of the public support which it currently enjoys. This may open way to ‘Ukranization’ of Russia’s economic policy, whose major long-term effect would be the country’s loss of its ability to pursue responsible macroeconomic and fiscal strategies.
What would be your final word for the strategic investors?
I have one advice for the short crisis scenario: as soon as U.S. economy turns round the corner, don’t wait too much to come to Russia because just in a few months after things get right in the U.S., Russian assets will sky-rocket. There will be few emerging markets still attractive for global capital but everything else may be not: including Central and Eastern Europe, much of South Asia and of Latin America. Only some of markets will take immediate advantage of the post-crisis environment, and capital will flock there very fast.
As soon as fast growth resumes in China and India, Russia will be fine: commodity prices will go up and Russia will take advantage with a new wave of economic growth.