Economics Department

Ask the economists: Russia - will the boom bust?


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What will greater state ownership and intervention in the economy mean for Russia and the global economy? Should the government save more or spend more? Is Russia relying too much on the energy sector and, if so, what is the cure?

See below the questions and answers from the online debate that took place on Monday 11 December with William Tompson and Christian Gianella from the OECD's Economics Department.

Q. FDI in Russia seems to be on the rise. There is confusion, though, as to the real magnitude of such flows. Why should foreign investors have more confidence in Russia now than in the past? Is the business climate improving, despite government’s increasing  interference in the economy as stressed by the Economic Survey on Russia? Or is that the effect of Russia approaching entry into the WTO, and eventually into the OECD?
Silvana Malle, University of Verona

A. There is little doubt that FDI inflows have picked up substantially since 2004, although the magnitude of the change depends on the sources and definitions used: the statistics agency Rosstat relies on customs data and special questionnaires. It also counts ‘secondary investment’ (domestic investments made by majority foreign-owned entities). Rosstat’s data include projects whose financing involves payments to Russian entities abroad, which are excluded from the balance of payments statistics used by the central bank. The Central Bank of Russia (CBR), by contrast, relies more on balance of payments data and compulsory reporting for foreign exchange purposes. It does also count reinvested profits from foreign investment as inflows.
That said, both series show strong growth since 2004. On the CBR data, FDI inflows in the first half of 2006 were almost triple the level of January-June 2004, in dollar terms. The Rosstat data for 2006 are not available, but Rosstat shows FDI inflows rising by almost 40% per annum in 2004 and 2005.
There is room to question how ‘foreign’ most of this investment is: the fact that Luxembourg and Cyprus together accounted for about one-third of foreign investment inflows in 2005 suggests that much of it is Russian capital operating from offshore – a fact that underlines the problems that still afflict the investment environment.
As to the question of trends in the investment environment, it is difficult – probably impossible – to give a simple answer, because Russia does not have ‘a business climate’. It has many business climates: the quality of framework conditions for investors and entrepreneurs vary across regions, sectors and sometimes individual companies. Thus, while the state has clearly made some of its major resource sectors less inviting to private (especially foreign) investors, surveys of entrepreneurs continue to suggest improvement in the situation for small and medium businesses in many, probably most, regions.
Yet as noted in our earlier response to another question, the key issue is not the level of risk, but the risk-reward relationship. Russia remains a very difficult place to do business, but in the current environment, it can still offer excellent returns to investors in many sectors. And the prospect of WTO accession is likely to encourage investors further. While not a cure-all for Russia’s problems, WTO membership will reinforce the pressure for reform in many areas and open up new opportunities for investment in some fast-growing sectors.

Q. Will the boom bust?

A. ‘Bust’ is a very strong word, but the current boom could well end badly. Russian growth is likely to slow as the impulse of recent terms-of-trade gains peters out. It will slow even more if the authorities do not pursue the kind of reforms needed to stimulate investment in new sectors and activities. However, structural reforms are much more concerned with the long term than the short-to-medium term: in the near term, it will be macroeconomic management that matters more. The more aggressively the authorities spend the rapidly accumulating commodity windfalls now pouring into the country, the greater the risk of a ‘hard landing’ when the terms-of-trade kick wears off. As the Survey argues at length in chapter 2, sound macroeconomic management – and, above all, prudent fiscal policy – should enable the authorities to manage a relatively smooth adjustment to Russia’s new terms of trade and to avoid boom-and-bust cycles going forward.

Q. I am hearing conflicting reports on whether Russia’s economy is really, finally diversifying or now. I would imagine the low levels of infrastructure make this practically impossible yet I do hear that it is so. Please could you elaborate?
James Nixey, Chatham House

A. The short answer is: it depends on what we mean by ‘diversification’. If one takes the structure of employment and production in the entire Russian economy into account, then there has been considerable diversification in recent years, owing to the very rapid development of services sectors that either did not exist at all under the Soviet system or were severely under-developed at the start of the transition. This is a welcome development.
However, most discussions of ‘diversification’ are concerned with diversifying the structure of industrial production and exports. This is an important priority for Russia, as the OECD Surveys of 2004 and 2006 have emphasised, and the macro data suggest that there has been little progress here. The structure of exports has changed little in recent years and it continues to be dominated by primary commodities and, to a lesser extent, by a small range of semi-finished goods and highly energy-intensive manufactures such as mineral fertilisers. The structure of industrial production is perhaps becoming a bit more balanced, as manufacturing sectors have recently been growing faster than resource extraction, but this is chiefly the result of the slowdown in the growth of the latter. Import-competing manufacturing sectors are struggling to cope with the cost pressures generated by energy price increases, rising wages and rouble appreciation. Of greatest concern, however, is the evidence that Russia is not doing well with respect to the emergence of new (to Russia, if not to world markets) activities in the manufacturing sector.

Q. In your report you say that state intrusion in to the market is responsible for Russia not doing as well as it ought to, but to what extent is Russia’s less-than-it-should-be economic performance in fact down to all those hundred of thousands of factories in the regions which are so gloriously inefficient?
James Nixey, Chatham House

A. There is no doubt that the industrial legacies of the Soviet system remain a problem for contemporary Russia in many sectors. However, the evidence of the last fifteen years suggests that former Soviet industrial enterprises are capable of restructuring themselves quite substantially, given the opportunity to do so (a stable investment environment, reasonable taxation, open markets, etc.), and the necessity to do so (i.e. the imposition of hard budget constraints). Productivity growth in Russian manufacturing has been quite substantial in recent years.
Many of the really ailing behemoths that remain – like AvtoVAZ – are in no small measure the product of past location policies (specifically the Soviet tendency to build one-enterprise company towns in ill chosen locations) and policy failures during the transition. AvtoVAZ, after all, is effectively responsible for the welfare of the city of Togliatti. It is unlikely that any private management team could restructure it into an efficient, profit-oriented enterprise unless and until that burden is somehow removed. As long as AvtoVAZ has Togliatti on its books, the returns to restructuring and entrepreneurship are likely to be low no matter who is running it, and the returns to lobbying for state support will probably be high.
What we criticise in the Survey, moreover, is a change in policy – the trend towards greater state intervention and control in ‘strategic’ sectors – that is impeding the dynamic development of some of the sectors of the economy that have been most successful in generating growth in recent years and that should have the potential to remain drivers of growth.

Q. The recommendations on page 213 of the Survey make crystal clear that a major goal is “Strengthening the OMS system”, but the report refreshingly admits (page 210) that the OMS (Mandatory Medical Insurance) system works well in a few regions, like Samara, but not elsewhere. What is the advantage of recommending that regions attempt to strengthen this badly-working system, and to attempt to fulfil the remarkably rigorous conditions you correctly observe would be necessary for competitive medical insurance?  To me the overriding reason still seems quasi-ideological. If the allure of patient choice and empowerment still grips the imagination, for obvious and understandable reasons, why have you not then considered the idea of encouraging more private provision, including GPs in this, in at least a quasi-private way?
Judith Shapiro, London School of Economics

A. As the chapter itself makes clear, these are questions of which we were well aware in preparing our assessment, and they do not admit of easy answers. Our brief response would run as follows:
•       Granted that the OMS system works poorly, this half-reformed system still represents the starting point for any reform of Russia’s public healthcare system. The question is whether the reform should be completed or undone. We see no advantages and, in Russian conditions, considerable dangers in moving to, say, an integrated public system like the National Health Service in the United Kingdom. Since the status quo is so thoroughly dysfunctional and Russia should not revert to the Soviet-era ‘Semashko’ system, it probably makes sense, therefore, to think in terms of reforming the OMS system.
•       It does not follow from this that one particular model of insurance system clearly stands out as the answer for Russia. It is for that reason that we suggest there should be greater room for experimentation and diversity. Where the regional authorities are unwilling or unable to make the competitive OMS system work, it will be very difficult to compel them to do so anyway. Some regions may wish to opt for something more like a single-payer model. We acknowledge the attractions of such a model in the chapter. However, the single-payer model is hardly a panacea, and we also highlight its potential problems.
•       The conditions that have enabled Samara and a few other regions to do reasonably well in the field of OMS reform are hardly so peculiar that their success could not be replicated.
•       Your point about the dangers of ‘quasi-ideological’ reasoning is well taken, and the chapter itself highlights how difficult it has been even for OECD member states, with much better functioning public bureaucracies, to realise the benefits of competition that such a system might offer. We’re also aware of the dangers, in a publicly financed healthcare system, of giving patients too much power – healthcare is not one of those fields in which consumer sovereignty provides ‘the Answer’. However, given the generally low quality of Russian public institutions and the low level of accountability of those institutions to the public, we do not by any means think it is overly ideological to suggest that giving greater voice to patients should be a major priority of reform, whatever model is chosen (we make the same point in respect of the single-payer option).
•       You are probably right that we give too little attention to questions of private provision. The chapter is largely devoted to the overhaul of the large and inefficient public healthcare sector that exists. However, we do draw attention to the need to relax constraints on supply, and we would favour the further development of private provision alongside public.

Q. The chapter (page 201-202) approves of the recent government goal to set up 15 high-tech centres, which to me seemed recycled straight out of failed perestroika plans.  I’m open to persuasion, however.  What sort of “high-tech” does Russia need, which is inappropriately low for its income levels, does not need non-existent skilled clinicians to interpret and suggest, won’t lie idle or be the source of kickbacks for purchasing, and will be more efficient at saving lives than, say, upgrading from the wrong sorts of cardio-vascular drugs to more modern and effective ones?
Judith Shapiro, London School of Economics

A. The concerns raised in the latter part of your question are real enough and they are reflected in the Survey’s overriding concern with problems of public administration. We also do express concern about the potential waste and corruption involved in the Priority National Projects’ large outlays for public procurement and public investment. But Russia cannot wait until it has created a G7 quality public administration to address such issues. Clearly, the impact of such measures as the health project envisages will depend not just on investment resources allocated but on progress with respect to the move away from line-item budgets to more rational financing arrangements and the creation of a system of waiting lists for access to limited facilities that really does reflect clinical need rather than kickbacks or personal connections.
With respect to the centres, while we do not have any data that would allow us to assess with precision exactly how much high-tech medicine Russia needs, the shortages of equipment and facilities for performing a large range of procedures, which are not all that uncommon, are fairly acute. The question in our minds was why it was preferable to build 15 new centres rather than to upgrade/re-equip existing facilities. That is still a concern, since critics have suggested that it just makes the projects more expensive. Our Russian interlocutors insisted that the decision to build new centres reflected, first, the very poor state of many of the existing ones, and, secondly, the need for a much more efficient geographic allocation of those resources than exists at present. We were told that the location of the centres was determined by (1) disease rates in various regions, (2) availability of qualified personnel, (3) availability of co-financing, and (4) the potential to realise economies of scale by building fairly large centres capable of serving the needs of several regions.

Q.There was a lot of talk when Yukos was dragged through the courts that Western firms would be more wary of investing in Russia. Has there been any real impact on the investment climate since then or are the potential profits too tempting to deter foreign investors?
L. Jordan, UK

A. Yukos had a short-term impact on investment, especially in the oil sector, and thus contributed to a slowdown in Russian growth for a time. However, the case appears to have had a greater short-term impact on domestic than foreign investors. Since early 2005, the authorities have been at pains to repair the damage done to the state-business relationship by the affair, and to a substantial extent, both foreign investors and their Russian counterparts do seem to have ‘ring-fenced’ the Yukos case. Foreign investment inflows (particularly FDI inflows and IPOs abroad) have been rising strongly over the last few years, albeit from a rather low base. The potential returns in sectors such as retail, which serve Russia’s rapidly growing consumer market, are simply too great, the prospect of WTO accession will open up new opportunities in financial services, and many of the major foreign players in the oil and gas business still seek to ensure their participation in the development of Russia’s hydrocarbon resources over the long term. The Yukos case highlighted the risks of doing business in Russia – and less dramatic but still significant instances of apparently arbitrary action by the authorities continue to do so, as the participants in the Sakhalin offshore oil and gas projects are well aware. However, high commodities prices and a consumption boom mean that those ready to run these risks can still reap substantial rewards.

Q. This morning's Financial Times has a report that the US government is undertaking a national security review about Roman Abramovich's bid for US company Oregon Steel. Should Western governments worry about the ties between Russian investors and the Kremlin?
Ashley Robert, Beijing

A. The concern with the Abramovich deal is part of a larger one that faces many governments in many countries. The real issue is not that western governments should be worried about whether or not major Russian investors are close to the Kremlin. In any country, governments are likely to be concerned about the activities of state-controlled companies in there jurisdictions if the governments have reason to believe that those companies are not operating on commercial principles, for commercial reasons, if the companies are active in sectors that perform functions that are important to national security, or if they believe that home-state support may give those companies a competitive advantage. This general problem takes on a new twist in the Russian case, because the line between state and private sectors is not always so clear – some formally private companies in Russia do appear to be owned de facto by state institutions. More generally, beneficial ownership of many large Russian companies is still unclear or has only recently been clarified. In the case of Evraz Holding, it would be difficult to suggest that it was other than a private company and its ownership structure is well known, but the US authorities nonetheless remain concerned about its possible or actual ties to the Kremlin. Having said that, we would also observe that such political/security concerns are sometimes the cloak for anti-competitive or protectionist lobbies: while governments may sometimes be right to be concerned about the activities of foreign parastatals in their jurisdictions, they do their citizens no favour if they use such concerns to protect particular domestic interests or to impose ideologically-motivated barriers to foreign economic activities. Regulatory ‘due diligence’ clearly has a role to play but it should not used as a vehicle for protectionism.

The opinions expressed and arguments employed on this page do not necessarily reflect the official views of the Organisation or of the governments of its member countries.

Background reading

Read the questions and answers from the last debate




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