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Action, not rhetoric, needed to kick-start reform

Russia has made some progress in implementing reform since the 2012 election. But it has delivered much less than it promised, and much less than it needs to do in order to make the transition from a consumption-led to an investment-led economic model. Philip Moore reports on the challenges that lie ahead for Russia.

President Vladimir Putin talks a good talk on the need for far-reaching reform in Russia. Hours after his inauguration in the Kremlin following last year’s presidential election, he was at it again. Russia, he said, would need to rise from 112th in the World Bank’s ease-of-doing-business survey to 20th by 2018. 

Putin decreed at the same time that 25m new jobs would be created in the high tech industry by 2020, that salaries would grow by between 1.4 and 1.5 times by 2018, and that the investment to GDP ratio would rise from its dispiritingly low base. The president also pledged that huge swathes of industry outside the defence and energy sectors would be privatised.

Fighting talk. Probably the clearest signal that Russia was serious about structural reform, however, was the adoption by the Duma in December of a tough fiscal rule, which dictates that budgets will be based not on current oil prices, but on conservative long-term projections. Those projections will form the basis of a cap on government spending, which will be limited to revenues plus a maximum of 1% of GDP. 

Although prime minister Dmitry Medvedev has insisted that his government has no intention of backtracking on this rule, analysts fear that Russia’s commitment to a strict monetary and fiscal policy may be slipping.

It is easy enough to grasp why Russia may be tempted to compromise on its tough fiscal stance. With commodity prices no longer a one-way bet, the boom of the last decade, when Russia delivered annual average growth of 7%, is becoming a distant memory. 

Below expectations

More disturbing is that Russian growth is weighing in well below original expectations for this year. “The government’s target for growth this year was originally 5%, which was the level that Russia was seeing at the time of last year’s election,” says Jacob Nell, Russian economist at Morgan Stanley in Moscow. “In the first quarter of 2013, it slowed to 1.6%. That’s not too bad in comparison with some European economies, but not where it needs to be for a country that aspires to double its GDP per capita over the next 10 years.”

Economists insist that this slowdown needs to be put in perspective. “An economic slowdown is evident,” says Julia Tsepliaeva, head of market economics, Russia and CIS, at BNP Paribas in Moscow. “But I don’t think this is alarming, considering that about 4% of the growth we saw during the boom was attributable not so much to high oil prices, but to the effect of rises in the price of oil, which increased by 20% a year. The slowdown is the result of oil price stability combined with the economic slowdown in Europe.”

More broadly, say economists, Russia’s economic indicators continue to stack up very well in comparison with those in the US and across much of Europe. “Russia’s debt to GDP ratio is about 10% in 2013, which looks miraculous compared with western Europe or Japan,” says Maxim Oreshkin, chief economist for Russia at VTB Capital. 

Although Russia’s debt to GDP ratio is expected by the government to rise in 2014, to more than 15%, it remains minuscule by comparison with many of the economies in the eurozone. But the Russian electorate may not be as ready to put the deceleration into perspective as many external analysts. This, says Peter Westin, chief economist at the independent brokerage house, Aton, is why one of the principal challenges facing the government today is managing expectations at a grassroots level.

“Between 2000 and 2007, wages grew in nominal terms by more than 25% a year,” he says. “Under Medvedev they have continued to rise, albeit at a slower level of about 10%. Now wages are broadly flat, which is why there has been a rise in social unrest over the last two years.”

Putin pushes it

The result is that although Putin’s approval rating remains high, at above 60%, according to the independent pollster, Levada, by the start of 2013 it had reached its lowest level since mid-2000. More than half (55%) of Russians now would like to see Putin stand aside when his third presidential term ends in 2018, with only 22% wanting him to stay on for a fourth term.

To date, the government has resisted the temptation to shore up its flagging popularity by loosening its purse strings. “Government spending is up by only 3% in nominal terms this year, which is of course negative in real terms,” says Oreshkin at VTB Capital. “That will have a significant impact on growth, while the end of the commodity price cycle is leading companies from related sectors  to scale back their investment plans.”

However, Andreas Schwabe, senior associate in the CEE research department at Raiffeisen Bank International in Vienna, says that one indication that Putin may be turning increasingly dovish was the rumour, at the end of May, of his plan to appoint economy minister Andrei Belousov as his chief economic advisor. Schwabe says that Belousov is a known advocate of reducing interest rates, loosening the fiscal rule by allowing the limit on the deficit to rise to 1.5% of GDP, and possibly using Russia’s sovereign wealth funds for infrastructure spending. “In terms of economic reform, I think the mood has darkened in recent months,” says Schwabe. 

Structured reform

Economists say it is essential that Russia stays the course on long-term structural reform if it is to encourage more economic diversification. As Nell says, oil and gas accounts for two-thirds of exports and half of budget revenues, and this dependence makes Russia vulnerable to global commodity price volatility. “There have been three economic crises in the last 25 years — in 1991, 1998 and 2008 — and all three have been preceded by a sharp fall in the oil price,” he says. “This vulnerability isn’t going to go away, because the share of oil and gas in Russia’s total exports has risen from half of exports in 2000 to two-thirds today, rather than fallen.”

Action rather than rhetoric is urgently required if Russia is to improve on its modest investment rate. “Russia has made some progress in implementing reform since the 2012 election,” says Nell. “But it has delivered much less than it promised, and much less than it needs to do in order to make the transition from a consumption-led to an investment-led economic model.”

Nell says that the government’s target is to increase investment from its current rate of around 20% of GDP to 27% by the end of Putin’s current term. That would still be low by comparison with a number of Asian economies, with China’s investment to GDP ratio close to 50%. It also shows little sign of rising. “In the last couple of months, year-on-year growth in investment has been negative in real terms,” says Westin. “Companies would rather keep money in the bank than invest.”

Capital outflows described by Moody’s as “chronic” will also do little to inspire confidence in the outlook for investment. In a recent report, the ratings agency comments that Russia’s Ministry of Economic Development has forecast that net capital outflows from Russia will reach $30bn-$35bn in 2013. While high, says Moody’s, this is still less than the $54.1bn reported by the central bank in 2012.

Others are less hopeful on the prospects for a reduction in capital outflows. “Capital flight as reflected in private sector net capital flows, has remained significant in recent years despite high oil prices,” notes Standard Bank. “This reflects an underlying lack of investor confidence in Russia. Simply put, Russians have not been prepared to invest oil windfalls back in their own economy.”

It says a combination of weak growth prospects, lower commodity prices, flux on the political scene, and a more dovish CBR policy both on policy rates and the rouble, will increase capital flight.

FDI needs a boost

Foreign direct investment (FDI) into Russia, meanwhile, has also remained disappointingly low. The good news, says Westin, is that in absolute terms FDI has risen over the last decade from 1% of GDP to 3%. The bad news, he adds, is that about half of this total has come from offshore centres or tax havens. “True, money is money wherever it comes from,” says Westin. “But genuine foreign investment brings a positive spill-over in terms of technological and management knowhow. In real terms, Russia still has one of the lowest levels of FDI in central and eastern Europe, as it has for the last 15 years.”

One apparently perennial reason why FDI, and portfolio investment, into Russia remain low by international comparison is that corporate governance standards still leave much to be desired. “Many investors continue to perceive that Russia has lower standards of corporate governance,” says Nell. “This perception contributes to Russian assets, notably equities, trading at a discount to similar assets in other markets and can put off investors, particularly direct investors, from bringing their technology and expertise into Russia.”

This is bad news for an economy which urgently needs to bolster productivity. At VTB Capital, Oreshkin explains that Russia’s nominal jobless rate of between 5%-6% means that in real terms unemployment is virtually nil. “As there will be no expansion in the workforce in the coming years, the only way to generate economic growth will be to improve the quality of jobs and the productivity of the existing workforce,” he says. “This is why we need to increase the proportion of investment to GDP.”

Oreshkin cautions, however, that it is a mistake to assume that the investment climate in Russia is universally poor. He says Kaluzhskaya, to the southwest of Moscow, is an example of a region punching above its weight in attracting investment from companies such as Volkswagen, Peugeot and Volvo. Between 2006 and 2011, Kaluzhskaya attracted foreign investment of about $5bn, and by 2010 it accounted for 8% of all FDI in Russia, even though its population and land mass are just 0.75% and 0.2% of the country’s total, respectively.

A good crisis

While strategists say that the prospects for economic growth and investment remain subdued, Russia continues to hold out attractive opportunities for portfolio investment, in both the debt and equity market. At Morgan Stanley, Nell says that the prospects for the bond market are strengthened by the central bank’s recent track record on managing inflation. “The Russian central bank had a relatively good crisis, and has built up credibility since then for its management of the move to a floating rouble,” he says. “CPI is above target at the moment, largely because of last year’s poor harvest. But with a conservative central bank and a tight fiscal policy, we are expecting inflation to continue to fall towards the 4%-5% that the CBR is targeting.”

This, says Nell, should support a continued decline in GKO (Russian government bond) yields, while accelerated liberalisation of the market, improving access for overseas investors, is broadening the buyer base for Russian government debt. 

The credibility of the central bank’s battle against inflation, say analysts, has also been strengthened by the recent appointment of the Putin loyalist, Elvira Nabiullina, as head of the central bank. “We believe the new central bank head will pursue a more proactive reform agenda,” says Andy Smith, head of equity research at Sberbank Investment Research.

Beyond oil and gas

In the equity market, the picture is more mixed. At Aton, Westin says that overall, sentiment towards Russian equities remains negative. “Volumes in the domestic equity market are down by about 40% compared with last year,” he says. “Even when we see prices rise, there is no pick-up in volumes, which is an indication of the lack of conviction among investors.”

Depressed sentiment towards the Russian equity market, however, is a function of its domination by the oil and gas sector, which accounts for about 60% of the index. At Sberbank Investment Research, Smith says that valuations in the oil and gas sector have not just been pulled down by poor appetite for extractive industries and a depressed commodity cycle. “One of the reasons why p/e ratios of Russia’s oil and gas companies are so low is that their capex to depreciation ratios are extremely high,” he says. “Gazprom is the most profitable oil and gas company in the world, but its investment programme absorbs the vast majority of its cashflow, so those profits aren’t necessarily translated into hard cash and returned to shareholders.”

Smith echoes a number of other equity strategists when he says that to focus, as index-based buyers are forced to do, on the extractive sectors is to miss where the most exciting potential of the market lies. “One area of the economy that is doing extraordinarily well is consumer spending,” he says. “We think this is a structural growth trend. Russia is an economy of 144m consumers and our analysis suggests that over the next three to four years it will overtake Germany to become the largest consumer market in Europe.”

It is not just the size of the Russian consumer market that excites equity strategists. It is sometimes easy to forget that little more than two decades have passed since the collapse of the Soviet Union, which brought to an end the asphyxiating restrictions on consumer freedom which for the majority of Russians were a way of life until the 1990s.

Clear evidence that Russian consumers are continuing to make full use of this freedom is the country’s very low savings ratio, which Smith says is around 5% of GDP. “The psychology of the Russian consumer is heavily skewed to spend rather than save,” he says.

Gung-ho investors

Smith says that since February Sberbank Investment Research has been publishing the Ivanov Consumer Confidence Tracker, a bimonthly survey of the “spending habits and opinions of middle class Russian consumers”. The inaugural edition, published in February, found the Russian consumer in a gung-ho mood. Some 44% expected their personal wealth to improve in 2013, for example, while 42% planned to change their car within the next two years and half intended to upgrade to a new home in the near term.

Remarkably upbeat aspirations such as these, say bankers, will continue to underpin demand for consumer credit, although some argue that Russia’s retail lending boom is demonstrably unsustainable. Retail loan growth reached 25.5% in 2011 and 41.7% in 2012. That, according to research published by BNP Paribas, has unnerved the central bank. “Retail [lending] growth has been the main focus of CBR supervision in 2013-14,” it notes. “The bank is targeting a slowdown in consumer credit growth to 20% y/y and is very likely to achieve this goal, in our view.”

Whether this will dampen the enthusiasm of the Russian consumer is open to question. Perhaps the most striking embodiment of Russia’s emerging, free-spending middle class is the retail giant, Magnit, which was founded in 1994 and is now the second largest retailer in Europe with a market capitalisation of about $25bn. Between 2002 and 2012, Magnit opened new stores at a breath-taking compound annual growth rate (CAGR) of 32%, increasing the size of its network from 368 outlets to more than 6,200 by the first quarter of 2012, and opening 1,575 new stores in 2012 alone.

Even after this dizzying expansion, Magnit reckons it has plenty of scope to keep on growing. According to its most recent investor presentation, the Russian food retail market was worth $227bn in 2011, which is slightly smaller than the German and UK markets (valued at $244bn and $238bn respectively). But modern retail penetration in Russia was just 53% in 2011, versus an average for developed nations of over 80%. This supports the projection made by Magnit that the Russian retail market will post a compound annual growth rate of 9.3% between 2011 and 2016, compared with 5.2% in the UK and just 2.5% in Germany over the same period.  

Growth predictions such as these also support the view that consumer-related stocks remain modestly valued. Sberbank’s Smith says these stocks across the retail, banking, telco, media, transport and real estate sectors trade on a p/e of about 14 times 2014 earnings, but are forecast to grow earnings by more than 20% over the next few years. “This means that the p/e to growth multiple is well under one, which is very attractive compared with other emerging markets such as China, India Brazil, Turkey and South Africa.”  w

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