November 24, 2018
by Gary Littlejohn for The Saker Blog
Introduction
Western political commentaries about the condition of the Russian economy are becoming increasingly illusory, as additional economic sanctions are imposed for a series of increasingly implausible reasons, the most recent ones including those being for alleged Russian complicity in chemical weapons attacks in Syria, those supposedly for the alleged attack on Sergei and Yulia Skripal, and some more regarding Crimea. It might seem self-evident that such measures are pretty futile, given the obvious effect that earlier sanctions have had in galvanising the Russian government into action to mitigate the effects of almost any conceivable future sanctions, but that very failure might be precisely the motive for the West’s renewed sanctions. Existing sanctions have been of limited effectiveness, and Russia is now self-evidently capable of defending itself against virtually any conventional military attack. Even the US recognizes that it would face considerable difficulty in a war against Russia.
For that reason, other sanctions apparently need to be employed to probe the economy for possible other weaknesses, or at least to slow down the development of serious Russian competition in new sectors, such as civil aviation. An additional motive is probably to weaken Russia militarily prior to starting a conflict, despite the assessments above. What Professor Stephen Cohen describes as the ‘war party’ seems to harbour an insatiable hatred for Russia, and despite the problems encountered in the recent exercises such as Trident Juncture 2018, preparations seem to be taking place for a conventional conflict with Russia.
The sanctions currently in place are summarised here:
In any case, despite the evidence coming from international financial institutions and credit rating agencies that the Russian economy is growing in 2018, there are still claims from inside and outside Russia that this will not last and that Russia should somehow change course to avoid future or incipient difficulties. The most notable recent internal claim that Russia must concede defeat from Western sanctions comes from the economist Kudrin, while a well-known French economist Picketty has published a report misleadingly indicating that Russia continues to suffer from much greater wealth inequality than other industrial countries.
I remain of the view that Russia will remain resilient in the face of sanctions, but that it may well have difficulty in reaching its goal of 5 per cent growth per annum by 2024, partly for internal reasons, and partly because the world economy is facing a major near-term crisis that would have a serious impact on Russia, through no fault of its own. As an indication of the causes of what I believe is the coming global financial crisis, it is worth recalling that global debt is now 60 per cent higher than it was at the time of the last financial crisis of 2008, and that no major reforms of the Western-dominated global financial institutional structure have taken place. Moreover, the same kind of banking behaviour is becoming increasingly evident, with complex financial packages known as derivatives being based once again on dubious loans that are likely to be unpaid, or at least not repaid in full. These are so-called ‘non-performing’ loans. These clouds on the economic horizon have become darker owing to President Trump’s policy of trade wars with countries that he considers to be engaging in unfair competition with the USA. In addition, while Western economists have for some years predicted the slowing down of Chinese economic growth, and have been wrong, there is now reason to believe that the Chinese economy really is slowing down, while still growing.
If this apparent slow-down continues, it will have a negative effect on the rest of the world economy, as the second link above shows already. In addition, there is increasing evidence of poor economic performance in the EU:
Since a great deal of Russian trade is with China and the Eurozone currency area, such developments beyond Russian control could have a greater impact on Russian economic performance than sanctions. In addition, the boost to the Russian economy in 2018 from high oil prices looks vulnerable or at least unlikely to continue at the present level:
It is true that the oil price has recovered a little in the hours following the above report, but the need to cut production shows that continuing high oil prices cannot be taken for granted, and Russia has not yet decided to cut its own oil production. This has resulted in a further decline in the oil price.
Yet there is no denying that in 2018 the Russian economy has continued to grow, and this is now widely recognised by various Western credit rating agencies and international financial institutions.
The Emerging Consensus on Russian Economic Performance
The IMF has unequivocally reported that the Russian economy has grown in 2018, although it claims that some institutional factors will impede future growth. Its growth estimate for 2018 is 1.7 per cent and for 2019 it is 1.8 per cent. This implies that Russia will have difficulty in reaching its aim of 5 per cent growth per annum by 2024, as laid down in President Putin’s Address to the Nation on March 1st 2018. Nevertheless, the idea that Western sanctions are crushing the Russian economy, as some US Senators have implied, seems fanciful. This is the case even if one does not criticise the IMF for ignoring the possible changes that have already taken place in various sectors, such as agriculture, finance, civil aviation, car manufacture and big data. And indeed the official Russian figure on growth for the second quarter [Q2] of 2018 indicates that the economy is 1.8 per cent larger than it was in Q2 for 2017, so we may end up with an overall growth figure for 2018 that is slightly higher than the IMF estimate.
The main credit agencies have also publicly signed up to the narrative of continuing growth. For example, Moodys has also forecast growth along lines similar to those of the IMF. My own view is that such forecasts are unduly pessimistic, but only if one assumes that the world economy remains stable over the next few years. Thus it has been argued that the Russian financial sector has been somewhat underdeveloped, and yet the official figures from the Russian government statistical agency Rosstat show that in 2018 finance has been the fastest growing sector. In sharp contrast to the UK, where the financialisation of the economy has grown like a monster and now greatly influences economic priorities at the expense of productive investment and sound long-term growth, in Russia the finance sector until recently has been lacking in capacity to cope properly with the needs of the economic restructuring that has been taking place. One of the main reasons for this recent positive change has been the closure of around 100 banks with too high a proportion of non-performing loans, which has probably reduced the room for corruption and for capital flight, instead facilitating the focus of capital on the more productive sectors of the economy.
Nevertheless, sanctions did initially produce a recession in 2014, and it took two years to recover from that and restart growth. The loss of income over those two years has been estimated at about 6 per cent of GDP compared to the result of a steady growth rate during those two years.
It seems pretty clear that the outflow of capital from Russia which has been going on for over 25 years has been facilitated by the City of London, which has enabled the creation of anonymous companies (the names of whose directors are not publicly disclosed) that can readily be used to move funds to offshore tax havens. For example the recently discovered scandal whereby a branch of Danske Bank located in Estonia evaded oversight and acted as a conduit for the outflow of about $180 billion from CIS countries over a ten-year period has brought to light the fact that London-based anonymous companies were the main vehicle for hiding this outflow of funds. Closing such gaps by greater supervision of the activities of Russian banks should help stop this drain on the Russian economy. Yet there is still ongoing outflow of capital from Russia, which remains a potential cause for concern, and the Russian Central Bank expects sanctions to continue until at least 2021.
Unfortunately, the reduction in the outflow of funds from 2014 to 2017 has not yet led to a reverse flow of funds back into Russia to any great extent, because the Russian policy of “de-offshoreization” has had a limited impact so far, according to a recent report by Bloomberg. In addition, Russian millionaires continue to keep about 70 per cent of their assets abroad.
The ongoing (if now more limited) damage from sanctions would be more readily recuperated if so much capital was not still leaving Russia.
Yet it is important to stress that not all capital leaving Russia constitutes capital flight. As the link above says:
“According to the Central Bank, there are two main factors that make the outflow of capital grow. First off, Russian banks pay their foreign debts. Secondly, other sectors of economy invest in foreign assets. Earlier, the Central Bank reported the net outflow of $31.9 billion in January-September of 2018. Thus, as much as $10.3 billion were withdrawn from Russia in October.
It is worthy of note that Russia managed to improve its trade balance: its surplus amounted to $154.6 billion vs. $90.5 billion a year earlier. In addition, foreign exchange reserves (gold reserves) of the Central Bank of the Russian Federation have grown by $35.7 billion. The National Welfare Fund played a significant role in the trend: the reserves of the fund were growing owing to oil and gas super-profits (with the price of oil over $40 per barrel). According to the Central Bank, the outflow of capital from Russia for 2018 may reach $66 billion. This will be the largest indicator since 2014 ($152 billion), when the West imposed its first sanctions on Russia.”
In contrast to the outflow of capital, which as the Central Bank indicates can be beneficial, Russia has become more successful at attracting foreign direct investment [FDI] especially in the energy sector, despite sanctions. The most notable example of this is the flagship Yamal Liquefied Natural Gas [LNG] project in the Arctic. This was built with Russian, Chinese and French funding. In recent days, Saudi Arabia has expressed an interest in the follow-up project at Yamal, known as Arctic 2, as it tries to diversify its economy ahead of the decline in its own oil resources.
Arctic 2 will be even larger than the original project. One unexpected result of Yamal has been that Russian LNG has even occasionally found American customers.
In addition, Russia is using the present demand for oil to try to pressure some customers to use Euros rather than US dollars to buy their oil.
And whatever the fluctuations in the price of oil and gas, Russia is still using pipelines to secure greater stability in energy sales. The Nord Stream 2 pipeline has now reached the German shore and the Pride of Siberia pipeline in the Far East is also close to completion, but less publicity has been given to the fact that the Turk Stream pipeline has also now reached Turkish landfall.
Overall, the strong performance in the energy sector in generating available investment funds for other sectors, and the strengthening of the financial sector coupled with a growth of FDI should enable Russia to invest more effectively in future.
Other indicators of Russian economic performance
One Western economic appraisal recording some aspects of Russian economic performance is that of the World Economic Forum [WEF]. This indicates that Russia has improved on its competiveness index ranking, going up two places to 43rd out of 140 countries that are listed.
“…Russia’s standing was buoyed in the WEF rating this year by stable macroeconomics, a large market size, information and communications technology adoption and human capital…”
The factors that were thought to count against it were:
“Meanwhile, low transparency, innovation, limited interaction and diversity were listed as factors that hurt the Russian economy, along with weak institutions, workforce skills, lower social capital and a vulnerable financial system.”
These latter claims suggest that, to some extent at least, old prejudices are still in play. Contrary to these claims, Russia has a very low debt-to-GDP ratio, two sovereign wealth funds that have benefitted this year from the high price of oil, and a restructured and growing financial sector. Workforce skills are probably increasing with the inward migration of ethnic Russians from Ukraine, and it is clear that the reform of local government is ongoing. The IMF ‘ease of doing business’ index shows that transparency is increasing, contrary to the impression given by the WEF. Furthermore, both innovation and the diversification of the economy are clearly growing in agriculture, civil aviation, civilian space activity, car manufacture, and possibly in the future in the use of big data, as indicated in Putin’s speech of 1st March. The effects of measures to deal with many of these issues can be found on the Rosstat website:
Concentrating on innovation, and taking agriculture first, the Q2 figures self-evidently do not include the very recent results of the Russian harvest this year. This has once again (for the third year) exceeded earlier estimates, and the diversification within agriculture is clear, as well as the adoption of modern machinery where possible.
This video is less than 5 minutes long. The figures shown from 1 minute to 1 minute 30 seconds are worth noting. They show how much four agricultural sectors produced in relation to total Russian demand for these products. Even in meat production, Russia has produced 93 per cent of its own needs. For grain, it produced 170 per cent of its own needs. In sugar, the estimate was that 80 per cent of needs would be produced within Russia, whereas the actual output was 105 per cent, and in vegetable oil, the expected 80 per cent of demand being met internally turned out to be 153 per cent. The result is that Russia supplied more than half of the world’s wheat exports this year.
Russia is rapidly turning into an exporter in areas other than grain, and this growing export potential (with its geopolitical implications) has meant that a series of foreign ministers, as well as the World Health Organization, attended this exhibition. This rapidly changing agricultural performance is bound to increase overall economic growth in the coming years. One surprising new export crop is soya:
This might only be 3.9 million tonnes in a Chinese soya market of 95 million tonnes, but it will doubtless grow in future.
Note that the YouTube video above includes a statement that a possible reduction in VAT from 20 per cent to 10 per cent is envisaged for next year, which would reduce any upward pressure on prices, and there may be more funding for the existing policy of promoting certain agricultural regions. This raises the issue of how the performance of such special regions will be evaluated. For example, will the Ministry of Economic Development be involved and will there be specific measures such as the use of social accounting matrices to ‘capture’ the specific economic development in such regions? The ongoing growth in food production not only tends to reduce inflation and help the balance of payments, but also stimulates demand for agricultural machinery and relevant services. The planned increase in rural road construction should also foster growth in this sector.
Turning to another sector, the new American sanctions being imposed on Russian civil aviation are rightly seen as simply an attempt to contain Russian competition in this area, but as Ruslan Ostashko has argued, it will be technically easy to develop Russian alternatives to U.S. civil aviation electronics, given the capabilities shown in military avionics. Although the performance in flight tests of the MC-21 (a future competitor to the Boeing 737Max) is probably the precipitating cause of such sanctions, these sanctions cannot affect the use of composite materials in this civil aircraft, because no other plane has such technology and the components and materials were developed exclusively in Russia. So there is no way to prevent such a development programme by using sanctions. Similarly, on the wide body passenger jet being developed the new engines can readily be developed in Russia without relying on foreign expertise.
In car and bus production, the new Kamaz autonomous [driverless] bus was on display at the recent motor show in Moscow. No Western manufacturer has yet brought a similar vehicle to market. Doubtless the lessons learned in developing the Aurum luxury range of automobiles will soon cascade on to other car production.
With regard to big data, the use of distributed ledger recording of transactions is already well advanced in Russia, and not only in the area of cryptocurrencies. Apart from the fact that three of the largest five such companies are located in Russia, Russia has other potentially helpful ‘factor endowments’ in the area of big data. Firstly, there is the expertise in electronics that permitted Russia to develop its own microchip extremely rapidly. Doubtless the performance in this area will continue to improve. Secondly, there is the expertise in all aspects of computing which was evident to me 25 years ago when I visited the Computer Centre of the Russian Academy of Sciences [RAS], and the formerly secret nuclear city of Obninsk. For example, at the RAS I was shown a fully functional graphical user interface as good as MS Windows, but capable of running on an Intel 286 chip, whereas MS Windows (which had only just appeared in the West) required a 386 chip as a minimum. At the time, Russia lacked the financial capacity to market such a graphical user interface. In addition, a private company engaged in trade with China was using the programming language APL to construct its own database, without needing a proprietary commercial package. This would have enabled it to exceed the capacity limits of Western commercial database programmes available in those days, and the same would have been true of spreadsheets. In Obninsk, APL was also being used in nuclear safety, neural networking and statistical analysis quite separately from the macroeconomic modelling that was being done at the RAS. Thirdly, Russia could easily locate data warehouses near natural gas sources, thereby avoiding the transmission costs of the energy to run them, and (given the average cold temperatures in Russia) would incur lower costs in cooling such buildings. Electrical resistance of semiconductors generates heat, and this makes cooling of server buildings an issue for big data in some countries. Cryptocurrencies and other distributed ledger applications are pretty energy-intensive.
No need to surrender
In the light of such economic potential, it should be surprising that the well-known economist Kudrin is suggesting that Russia needs to make concessions to the West to ease the impact of sanctions.
Alexei Kudrin is Head of the Accounts Chamber and a former finance minister, so prima facie one would expect him to talk sense. Yet he considers that sanctions are the main threat to the President’s goals, as expressed in the Address to the Nation of 1st March. It should by now be clear that it would take far greater changes in the world economy, such as another financial crash, to throw the objectives for 2024 into serious jeopardy. There are positive elements in the balance of payments (oil, agriculture and arms, with civil aviation likely to be a growing sector) that will enable the Russian government to fund most of the objectives now set for 2014, in my view. The sovereign funds are increasing at the moment, and while this form of saving is a precautionary counter-measure to probable further sanctions, the fact that Russia is pretty much self-sufficient in raw materials, and has a growing skills base (with ethnic Russians coming from both Ukraine and Kazakhstan) should mean that additional sanctions will have a limited effect. There is also the likely prospect of military innovations cascading into the civilian economy, as used to happen in the USA, and this is particularly relevant for civil aviation and big data.
There is the additional problem that the West is stagnating economically and technologically, and has evident difficulty in developing new technologies, including in space. Where the West (and Far East) has had a technological lead with smart phones, the global market is showing clear signs of saturation. The same is true of social media, where stocks are declining quite steeply at the moment, and where Russia or China have rival products already in place. It is likely that the West has little to offer Russia if sanctions are lifted, given the changes that have already taken place in Russia. Sanctions are mainly about financial power and that is already ebbing away in the West. Russia on the other hand will continue to strengthen gradually owing to the growing strength and sophistication of Russian financial institutions, the policies of currency swaps to facilitate non-dollar trade, alternatives to SWIFT developed in both Russia and China, and perhaps in future more “de-offshoreization”.
The ‘failure of nerve’ shown by Kudrin indicates the pernicious effect of Western neoliberal ideology, and raises once again the issue of its influence on aspects of Russian economic policy-making. This can be seen in the case of the pension reform earlier this year, for which Kudrin had lobbied over a period of some years. Having looked again at the research report that was published in Russia just before the law was changed on the age at which people become eligible for a state pension, I am even more convinced that it was premature to introduce this legislation. The report looked at the interaction between demographic and economic changes in present-day Russia covering five aspects, and argued that to raise the age of pension eligibility would adversely affect the economy, and slow down economic growth. While this would not be the case in many industrial societies most of which have a very different demographic profile, Russia is unusual and it would have been preferable to delay the introduction of such a measure, in order to avoid the negative impact just at a time when economic growth was picking up.
There was an analogous case with South Africa at the end of Apartheid in 1994, where the political settlement that was reached included enormous pension payments to South African civil servants. An econometric and demographic analysis there showed that it would have been possible to have a ‘pension holiday’ for a few years in order to devote those funds to kick-starting the economy – a high priority at the time. It was shown that this would not really have adversely affected those pension payments, but strong vested interests prevented this temporary diversion of pension payments from taking place.
The Saker has commented on Putin’s adroit response to the political backlash that took place in mid-2018 when the new pension law was introduced during the football World Cup. The subsequent changes to the legislation may have mitigated some of the adverse effects, but the outcome will not be as good as if the legislation had been postponed for a few years to facilitate the desired acceleration of the economic growth rate.
Why Russian growth may not be constrained by the factors highlighted by the Washington Consensus.
Russia is simply running a mixed economy, with most of it privately owned and parts of it in public ownership. This was considered perfectly normal in Western Europe from 1945 until the late 1970s, and even now forms quite a large segment of economic activity in countries such as France. The advantages of such public sector activity include reaping the benefits of ‘natural monopolies’ such as railways or utilities where competition is likely to be restricted under normal market conditions. These benefits then potentially include additional state revenues, long-term time horizons for investment planning and at times greater democratic control. In the UK the fact that foreign state-owned companies now own companies that were originally privatised is an indicator of how the ‘logic’ of natural monopolies can sometimes prevail even in competitive market conditions. It is much easier to develop a realistic long-term national economic strategy if those natural monopolies are under government control.
In general, more equal societies grow more quickly, contrary to the mythology of the neoliberal Washington Consensus. It is increasingly clear that the increased inequality of income and wealth generated by the neoliberal policies of that last 38 years has acted as a drag on growth and has contributed to the economic instability that resulted in the financial crash of 2008. Russia is widely considered to be a very unequal society, but this view ignores the impact of measures to reduce such inequalities of income and wealth, especially poverty reduction measures that have had a significant impact. This now includes minimum wage legislation that appears to have been influenced by the research of Professor James K. Galbraith at the University of Austin, Texas.
The view that wealth inequality in Russia is huge has recently been given a boost from a book by the well-known French economist Thomas Piketty. However, that book has been subject to very serious critique by the Swedish economist Jon Hellevig:
Hellevig argues that under its present leadership, Russia has been moving towards a more equal society, a trend that seems to be continuing despite the glaring inequality of income and wealth. Hellevig’s point is that these glaring inequalities are not dire in terms of international comparisons.
“After identifying the deficiencies, we have adjusted the main findings announced by the Piketty scholars to reflect the actual data. Corrected data shows that instead of earning 45-50% of national income as claimed by the our Piketty scholars, the top 10% of Russians earned less than 30% of the income. Correspondingly, our corrected data shows that instead of owning more than 70% of the national wealth, the wealth of the top 10 percent of the population was 39% of private wealth and 32% of total national wealth.”
This refutation by Hellevig, which shows that the glaring inequalities are not dire in terms of international comparisons, indicates how Russian society has changed since the 1990s. The so-called ‘oligarchs’ have less weight in the economy and almost certainly less political power. It seems that the member of the Duma who stated that there are no oligarchs any more may well have been correctly pointing to the changed political landscape, even if that was probably an overstatement. The wealthy no longer seem to dominate the political agenda completely, in contrast to the 1990s. Insofar as they do have an impact on policy, it seems to be through the ongoing influence of neoliberal ideologists such as Kudrin and others in certain parts of the government.
Returning to the potentially strategic importance of the state in economic performance, the historical evidence indicates that since the 18th century state-sponsored growth has been vital for stimulating economic growth, especially for industrialisation. The famous five Asian tigers are clear examples of this during the last 40 years or so, but in fact all economies have relied initially on state-sponsored growth in the early phases of industrialisation. Even the UK relied on the dominance of the Royal Navy to support its dominant trade position and ensure that the colonies, especially India, supplied the economic surplus necessary to finance the industrial revolution. Historically, it is only the leading global economy (the UK, then the USA, then China) that advocates free trade, after it has achieved its dominance.
Russia fulfils both criteria for long-term growth, namely, it is not too unequal and has a state-sponsored growth strategy. It also has the most fundamental feature for long-term growth, namely population growth, and is now the only technologically advanced society to have this positive demographic profile. That is a result both of growing optimism about the future and of more stable families. Among ethnic Russians and some minorities this is almost certainly a result of the restored influence of Christianity.
Conclusion
While Russia may well struggle against growing global economic ‘headwinds’ to achieve its aim of 5 per cent growth per annum by 2024, it quite clearly has the resilience to cope with the current sanctions in place and to help shield other economies from sanctions by using currency swaps, occasional barter agreements, the use of an alternative international payments system to SWIFT and other measures. By contrast, the EU seems unable to help shield Iran against US sanctions because it does not possess an alternative to SWIFT and SWIFT itself has already caved in to US financial threats and refused to process payments going to Iran. In addition, the EU can find no member state willing to host any financial institution designed to facilitate trade between the EU and Iran in fulfilment of the nuclear deal that the US has recently withdrawn from. Apart from Russia, only China has the financial muscle and its own alternative to SWIFT to help Iran to withstand the US sanctions.
The fact that Russia is innovating in agriculture, energy production, civilian space activity, civil aviation, automobiles and intends to do so in big data (partly for greater transparency and responsiveness in government administration) shows that its prospects for economic growth remain good.
River to Sea
Uprooted Palestinian 
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