Russia’s pace of growth slowed sharply in 2013 and has not recovered.
An upward correction in the unemployment rate is expected late in 2014.
Sanctions will spur faster capital outflows, weighing on GDP growth.
Russia's economy is more connected to Europe than to Asia.
A reorientation of trade and investment to the East will be cumbersome.
Hosting the Winter Olympics was supposed to boost Russia's languishing economy. Yet GDP actually contracted 0.5% in the first quarter, and annual GDP growth decelerated to 0.9% from the 2% gain in the previous quarter. Weak fixed investment was the main brake on growth, as borrowing costs rose amid a worsening business climate and the threat of further Western sanctions, which prompted a number of multinational firms to withdraw from Russia.
With another drop in GDP possible for the second quarter, Russia could be entering a technical recession. We expect annual growth to decelerate further this year, reaching 0.7% before picking up to 1.9% in 2015.
Inflation remains elevated, meanwhile, because of the weak ruble, rising demand-side pressures, and sanctions from the West in response to Russia's actions in Ukraine. The consumer price index is rising at around a 7% annual pace, about 1 percentage point faster than in 2013. Prices of staples such as butter and milk are up around 20% in the past year, while tobacco prices have risen almost 30%. The ruble reached new lows against the euro and greenback in April, prompting the Russian central bank to raise its key lending rate to 7.5% from 7% to curb inflation pressures. The currency stayed relatively stable in May, but the effect was negligible as prices continued to rise.
Russia’s public finances are healthier than those of many European countries. The budget deficit equaled just 1.3% of GDP last year, compared with 3.3% in the aggregate for nations in the European Union; Russian public debt amounted to 13% of GDP, compared with 87% for the EU. Russia's main fiscal problem is its continuing dependence on oil revenues, which made up about 50% of all taxes and other fees collected in 2013.
Oil and gas revenues come namely from customs fees, mineral extraction taxes, and excise duties. Without oil and gas revenue, the budget deficit would equal 10% of GDP instead of 1.3%. The lack of diversification represents a future danger for the economy.
Capital flows out
Capital outflows reached a record $63.7 billion in the first quarter, more than the $59.4 billion through all of 2013, according to the Russian central bank. At this rate the outflow will exceed $100 billion this year. The drain will be costly: The Ministry of Economic Development previously forecast that such an outflow would limit the economy's growth rate to 0.6% in 2014.
The outflow shows the effect of the Western sanctions that followed Russia's annexation of Crimea. Several multinational companies have withdrawn from Russia, fearing that escalating tensions with Ukraine could lead to further restrictions. Capital outflows also add pressure on the Russian central bank to intervene in the currency market to support the ruble.
A turn away from the West
In May, responding to Western sanctions, Russia signed a long-term contract to sell China some 38 billion cubic meters of natural gas per year, worth an estimated US$400 billion. This would amount to nearly a quarter of China’s yearly demand and slightly less than a quarter of what Russia delivered to Europe last year. As part of the deal, Russia's Gazprom and China's National Petroleum Corp. agreed to large-scale investment projects to develop natural gas supplies in eastern Siberia as well as storage facilities on China's side of the border.
The deal gives Russia an alternative revenue stream in case its face-off with Western Europe and the U.S. results in further sanctions. Even so, Russia will continue to depend on energy exports to Europe. The Netherlands, Germany and Italy remain among its main trading partners, and exports to Europe account for 50.2% of Russia’s total exports. Efforts to reorient Russian trade and investment towards Asia will be challenging.
China, by contrast, receives just 6.8% of Russia's exports, or about as much as Finland, Switzerland and Belgium combined. Since 2000, exports to Europe have increased fivefold, from a little less than $55 billion to around $270 billion. Russia’s trade with China has also grown fivefold since 2000, but from a much smaller base: Exports to China are now around 13% of those to Europe. Russia thus will not soon reorient towards Asia without significant pain to its own economy.
The same is true for foreign direct investment. Asian sources account for a small share of Russia's FDI, which is still dominated by Europe. China’s share is only 1.3%, while Europe accounts for as much as 80% of all inflows in some years. A large portion of this actually represents repatriation from Russian offshore accounts in the Netherlands and Cyprus. China, meanwhile, is turning its attention to opportunities in Europe and shows little interest in Russia’s energy sector. Russia’s oil drilling industry needs the most investment, but only a handful of countries are willing to risk it.
Sources of investment
Russia badly needs investment to support its energy extraction industry. Its older oilfields are running dry, and exploration for new reserves has been slow as the lack of modern technology makes it costly. Most Asian countries lack ability to help much, leaving it up to the West to provide the needed capital and expertise.
Russia lags most other developed economies and even some developing Eastern European countries in the speed of its technological development. In 2013, research and development expenditures amounted to just 1.1% of GDP, according to Rosstat. From 2000 to 2013, employment in R&D fell 18%, and only 9% of companies in Russia are seen as technological innovators. A lack of incentives leaves most companies to import technology from abroad. According to the Russian Academy of Sciences, only 10% of production technologies created from 1997 to 2013 are actually new. A rapid eastern shift in investment is thus unlikely, as it would involve enormous costs for the economy and narrow the country's dependence even more.
