Russia's economy: Keeping up the good times

Economics Department

Russia is on a roll. Or is it? Much depends on policy, particularly towards energy.

The Russian economy has now entered its seventh year of expansion, confounding almost everyone with an average real GDP growth of just under 6.8% per annum during 1999-2004. But the economy has come to depend heavily on the performance of a small number of natural resource sectors, above all oil. The trouble is, oil-sector growth has been slowing of late, despite record-high prices. Add to this a number of persistent institutional weaknesses, and doubts start to creep in about Russia’s capacity to sustain high growth over the longer term.

The role energy has played in Russia’s expansion is striking. Natural resource sectors directly accounted for roughly 70% of the growth of industrial production in 2001-2004, with the oil sector alone accounting for just under 45% (see graph). This implies that natural resource sectors directly contributed more than one third of Russian GDP growth over the period, and the oil industry alone close to one quarter.

There are, of course, well known dangers associated with resource-dependent growth, and these underlie much of the scepticism about Russia’s longer-term prospects, as well as much of the concern with diversifying economic activity in Russia away from natural resources. Nevertheless, given its current economic structure, Russia is destined to remain highly dependent on the performance of its resource sectors for many years to come. To sustain strong growth over the medium-to-long term, it will have to ensure that these sectors continue to develop, even as it tries to mitigate some of the risks involved.

Sustaining growth in such a resourcedependent economy will require a stable investment climate characterised by the rule of law and respect for property rights, as well as adherence to sound macroeconomic policies–and, in particular, exemplary fiscal discipline. Good fiscal policy cannot eliminate external vulnerability, but it can reduce it significantly. Fiscal irresponsibility, by contrast, will only magnify the effects of commodity price movements, probably leading to boom-and-bust cycles akin to those experienced by many commodity producers in the 1970s and 1980s.

The investment climate will be critical to any effort to foster economic diversification without resorting to the sort of old-style interventionist industrial policies that have failed in so many other countries. Even more than Russia’s large resource-extraction companies, entrepreneurs engaged in new activities need a stable environment in which to do business. There have been some improvements in recent years, but businesses are still subject to far too much unnecessary regulation. Moreover, the weakness of the rule of law and the arbitrariness of enforcement mean that regulation all too often serves little purpose except to enrich corrupt bureaucrats.

A more appropriately designed tax system would also help foster investment in non-resource sectors, without necessitating market-distorting state intervention. The abolition of turnover taxes in 2001-2003 was a critical step, precisely because such taxes weighed far more heavily on processing sectors than on primary commodity producers. More generally, diversification can be aided by using the revenues generated by natural resource sectors to maintain low levels of general taxation.

Reform of the gas sector will also be vital, if Russia aims to enhance the growth potential of its resource sectors. The gas industry is arguably Russia’s least-reformed major sector and undoubtedly one of its least efficient. Its performance in recent years has been decidedly lacklustre. Gas production has grown by around 1.5% per annum over the last five years, as against an allindustry average of over 6.7%, and the gas sector’s record with respect to productivity and unit labour costs since 1998 has been by far the worst of any major sector in Russia. Its development continues to be constrained by the dominant position of OAO Gazprom, a state-controlled monopoly. But if other producers were given fair access to the trunk pipeline network and some access to export markets, then non-Gazprom producers could increase investment and output very rapidly indeed. And that would probably help stimulate better performance on the part of Gazprom itself.

Russia would probably be able to sustain relatively strong growth for some years to come, if it followed the right policies. Unfortunately, the case for optimism on this score has taken a beating over the last 18 months or so. The investment climate has suffered serious damage as a result of arbitrary actions on the part of the authorities, particularly the tax service, the prosecutors and the courts. Since mid-2003, the privatised oil company Yukos has been at the centre of a complex legal and political campaign directed by the state against its main shareholders.

The onslaught against Yukos has been the most visible such case, but it has not by any means been the only one. In the first nine months of 2004, the Federal Tax Service collected more than 470 billion roubles in tax claims for past years, as compared with 150 billion for the whole of 2003. This reflected a dramatic increase in the service’s propensity to re-open tax cases from past years, often penalising taxpayers for practices that it had previously approved.

Meanwhile, the state has moved to tighten its grip anew on key “strategic” sectors, especially resource sectors. Reform of the gas sector appears as distant a prospect as ever. On the contrary, rather than introducing the market-driven dynamism of the largely privatised oil industry into the gas sector, the authorities seem intent on giving the still unreformed Gazprom a large slice of the oil business. Yet, greater state control would only lead to less efficiency and slower growth in one of the sectors that has been driving Russian expansion in recent years.

The results of these shifts are not hard to see. While GDP growth was an apparently respectable 7.1% in 2004, growth slowed across the year despite a significant fiscal stimulus and sharply rising prices for oil and other major export commodities. Fiscal policy was characterised by both tax cuts and substantial increases in spending, and the all-commodity price index for Russian exports was up almost 20% year-on-year. Nevertheless, investment growth slowed and capital flight rose sharply. Many factors contributed to the slowdown, but it clearly owed much to a policy-driven deterioration in the business climate.

The slowdown in growth, in turn, has contributed to mounting pressure to spend an increasing share of the windfall revenues generated by high oil prices. As of 1 March, the government had accumulated the equivalent of about 3.5% of projected GDP for 2005 in the fiscal stabilisation fund created last year. While the fund’s primary purpose is to insure the budget against future declines in oil prices, the government is already spending quite a lot of the revenues previously earmarked for the fund. On current plans, reliance on windfall revenues to finance current expenditure is set to grow in 2006-2008.

There is little doubt that the authorities can support GDP growth rates for some time yet by using oil windfalls to pump up domestic demand–whether by pouring money into state-financed investment projects or simply by raising public sector wages and pensions. However, government investment tends to be highly inefficient, while further stimulating an already impressive consumption boom could very easily lead to a bust further down the road.

Some in the government seem to have woken up to the problem and have begun trying to repair the damage done to business confidence in 2003-2004, putting forward proposals to strengthen the security of property rights and reduce the scope for arbitrary tax enforcement. Given the responsiveness of Russian business to the signals emanating from the state, concrete steps to improve the investment climate could bring about a change in sentiment, and some revival in private investment, fairly quickly. However, the authorities’ actions remain inconsistent, with initiatives intended to reassure investors coinciding with actions that cannot but rattle them, such as the recent back-tax demands to the oil company TNK-BP.

So can Russia keep up its strong growth? It should be able to, though much depends on the government’s approach, and the signals we have seen on that front in recent months have been mixed. What is clear is that Russia will not sustain strong growth if its policymakers succumb to the temptation to treat oil windfalls as a substitute for good policy.

References

OECD (2004), Economic Surveys: Russian Federation, Paris.

Rudiger Ahrend and William Tompson (2004), “Russia’s Gas Sector: The Endless Wait for Reform?” OECD Economics Department Working Paper No. 402, September.

OECD (2005), Regulatory Reform in Russia: Building Rules for the Market, forthcoming.

©OECD Observer No 249, May 2005




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