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#16
Russia Business List
#283
Tuesday, March 19, 2002
This is a list for those interested in the economic, business and financial aspects of Russia¹s development. It is an open forum and you are invited to contribute comments. If you have articles, reports, etc. you can send them to me and I will include them on the list
Ben Aris
Benaris@online.ru
1. Russia's window closed: First business cycle comes full circle
Euromoney - EBRD report
Ben Aris
Moscow
Friday, March 8, 2002
The Russian economy has put in a sparkling performance over the last three years, but just how far has Russian gone down the road to reform? The fast growth of recent years peaked last summer. But as the year ended the economy went off the boil as the global economy cooled and the slack in the Russian economy was taken up.
Has the window of opportunity closed? A close look at the economy suggests that enough has been done in the last three years to fuel sustained growth, but from now on pace will depend - for the first time -- on president Vladimir Putin's success at pushing through, and implementing, his radical reform programme.
For most of the last three years the lack of a working banking system and the raft of liberal legislation passed has played virtually no role in boosting growth. But as Russian enterprises starting to bang against production capacity ceilings this is changing rapidly.
There are grounds for a great deal of optimism, but a lot needs to be done before the economy can turn in Asian Tiger-type rates of growth. Massive institutional resistance to reform has to be overcome; companies still lack access to badly-needed investment capital; and the economy remains heavily skewed towards the raw material producers and state-funded enterprises.
But a foundation has been laid and because the current slow down is driven as much by capacity constraints as falling oil prices, some economists are even talking about the start of "Russia's first ever business cycle."
THE BUSINESS CLIMATE TURNS CHILLY
The Russian economy has grown by an average of 6% a year since 1999 and the country's finances have never looked so good. New shops are sprouting up on all of Moscow's main thoroughfares and the leading VTsIOM's (All Russia Centre for Public Opinion) consumer confidence index is at an all time high.
"From a macroeconomic perspective the economy looks perfect: there are surpluses everywhere," says Christof Ruehl, the chief economist at the World Bank's Moscow office."
But at a company level the economy came off the pace at the end of last year as nearly every economic indicator dipped southwards for the first time in two years. Investment was down, profits fell, margins were being squeezed and GDP forecasts for this year have been cut.
The conventional wisdom is that high international oil prices have been driving the Russian recovery, and indeed the slow down came just as prices fell from over $30 a barrel to about $18 at the start of October.
High oil prices prime the pump in 1999, but by 2000 consumer demand has been the engine of growth.
"In 1999 growth was driven by exports and the high international prices as well as the beneficial effects of devaluation," says Ruehl. "In 2000 investment was the driver of growth. And in 2001 it had become consumption. It looks like a trickle down effect triggered by high oil prices."
Oil prices were increasingly volatile over 2001 but domestic production, retail sales and wages have all grown strongly since the start of 1999, unaffected by what happens in the international commodity markets.
A sharp dip in prices to about $17 in November coincided with an equally sharp slow down in the economy, stoking worries about how Russia's economy will perform this year.
In October last year monthly growth slowing to an anaemic, 0.3% half the rate in the first six months of the year. According to Goskomstat (the state committee for statistics) economic growth slowed in five core sectors - industry, construction, agriculture, transport and retail - to 5.7 percent, compared to 10.2 percent in 2000.
These poor results quickly fed through to state finances: by January inflation spiked to its highest monthly level in three years and tax receipts were below the budget target for the first time in nearly two years - Russia has been running a budget surplus of more than 2.5% since March 2000, but now looks likely to end this year with a small deficit.
The dip in oil prices has been a factor, but equally important is the fact that the beneficial effects of devaluation - the cheap ruble - have also worn off as the ruble appreciated quickly in the last quarter of 2001. Given that growth is being driven by consumer demand, the rapid rise in imports is potentially more damaging than low oil prices.
According to Central Bank of Russia (CBR) exports over 2001 fell by $2bn while imports increase by more than $7bn puling the trade surplus down from over $60bn in 2000 to about $50bn last year.
A lot of confusion remains as just how oil prices and consumption will combine to drive growth this year. And the on going row between Russia and OPEC over oil production quotas will make oil prices more volatile than normal. At the start of 1999 analysts were predicting an 8% GDP contraction whereas the economy actually grew by 5%. Analysts have learnt their lesson and this year are offering a range of scenarios rather than definite predictions, running between 1.6% and 5% of growth -- a huge spread by economic standards.
SEE ECON FORECASTS SCENARIOS FOR ECONOMIC GROWTH, WORLD BANK, AND MINISTRY OF ECONOMIC DEVELOPMENT
PROBLEMS AT HOME
Over the last two years the fastest growth has come from businesses that cater directly to the consumer. Food processing was the first sector to cash in on booming domestic consumption and culminated with Russia's leading juice and dairy producer Wimm Bill Dann's successful IPO on the New York Stock Exchange at the end of January.
Wimm Bill Dann has been making juice since 1992 and since it went into the more lucrative dairy business in the mid90s it has rolled out more than 400 products as it continues to fill the market niches. With just under $900m in sales last year, the company plans to use the $200m raised from selling a quarter of the company to fund its continued rapid expansion.
Companies like Wimm Bill Dann enjoy strong cash flows thanks to rapidly rising incomes and at the same time need relatively small amounts of investment to significantly boost production.
But food processing doesn't need sophisticated technology and as Russian spend over three quarters of their income on food. Enterprises that produce more complicated or up market products have been having a more difficult time of it.
"There has not been much foreign investment but what there has been has mostly gone into catering, restaurants and food processing," says Roland Nash, the head of strategy at Renaissance Capital. "However, there is still no working mechanism for distributing capital in the Russian economy and little competition for resources."
Textiles is a good example of the problems Russian industry faces from the toughing business climate. Russian textile producers saw demand for their products stagnate in the last quarter of 2001 as all new spending went into exports. Average imports by value has been rising by about 3.4% a month over most of last year, but textile imports jumped a massive 28.8% just in October.
At the other end of the scale, rising costs and falling international prices are hurting the raw material producers, which account for about 80% of Russia's exports. For example, the metal producers are having a particularly difficult time, finding themselves squeezed between increasing electricity costs at home and falling international prices abroad. A trade war that broke out with the US over steel exports to America in March will only make things worse.
Prices and quality will continue to pose problems, but domestic consumption already appears to be strong enough to stop growth stalling completely. Company profits fell at the end of last year as margins were squeezed, but according to Goskomstat, companies were still making an average 11% on sales at the end of 2001, down from 14% last summer.
A survey of 300 Russian manufacturers conducted by Moscow Narodny Bank in February shows demand rebounding and increases in the producer confidence index for the first time in four months.
United Financial Group, a Moscow-based bank, said that that the MNB results showed Russian industry would return to strong growths again this spring and that last years slow down was just a dip.
EFFECTIVE INVESTMENT
Competition is increasing and cutting into company sales, but the three years of investment has been enough to ensure that the best companies in each sector will be able to maintain growth. For the rest, life will be more difficult as most of easy gains have already been made.
Investment has been every uneven and most companies simply don't have the money to buy new equipment. By September 80% of all companies profits were being earned by raw material producers and 70% of all investments were made by raw material producers and companies in the budget sphere.
"Between 1998 and 2001 investment into the fuel and energy and the transport sector (mostly pipelines) was up 130% but in all other sectors it has actually declined by 10% in real terms," says Seija Lainela, at the Russian European Centre for Economic Policy. "Investment is needed to maintain the production levels and there has been very little spill over from these two sectors."
Ironically the lack of investment has played little role in the strong growth since 1999 as the biggest gains in productive have come from simply making idle employees work by doing little more than paying their wages on time.
According to business surveys most empty places on production lines have now been filled and little of this slack remains: according to Russian Economic Barometer monthly survey the take up of labour has already risen from just over 70% in 1998 to just under 90% by the start of 2001, while machinery utilisation has climbed half as fast - on average a third of factories' machines remain idle.
Other indicators also show that companies are coming up against labour constraints. As the economy slowed at the end of last year unemployment fell by 1% rather than rising as would be expected and wages rose by more than 30% in 2001 alone.
"If all the slack in labour productivity gains has been taken up then the window of opportunity is now closed," says Ruehl. "Life will get more difficult if further production gains become dependent purely on the investment flows."
These figures are national averages based on business surveys, but there is little information on what is happening in individual sectors. Anecdotal evidence suggests that in many sectors, especially those catering to consumers, factories are already running at full tilt.
Clearly more gains can be made from making workers more efficient. For example, Russian car producers can take up to four days to make one car, whereas the same car can be made in a matter of hours in the west. But no one has made a study of Russian productivity, so it is impossible to say what is happening here.
GROWTH CONSTRAINTS
Russia has come to the point where companies need to invest heavily into factories if further big gains in production and growth are going to be won.
By making use of idle labour the lack of a working banking sector has made little difference to Russia's stunning economic growth rates: bank credits formed between 1% - 3% of all money invested by companies since 1999. But as companies bump up against capacity ceilings this has to change.
Companies are already on the hunt for money and the domestic capital markets took off last year with more than a 100 companies raising over $2.6bn in the form of ruble bonds; both numbers are expected to double this year. But for a huge swath of medium weight industries raising money to expand production is a major headache and will hold back further rapid growth.
The Russian Economic Barometer found that the cost of capital was not a major concern of companies at the start of this year and has been steadily becoming less of a concern as interest rates begin to fall. What managers are concerned about is the rising cost of equipment.
The number of companies that made no investments at all in the last six months has also fallen sharply to under a third, while the number of companies that completed their planed investments rose sharply to about two thirds, according to the survey. However, nine out ten companies surveyed said that their biggest problem was the lack of access to capital, up from two thirds a few years ago.
"The lack of access to capital is an important obsticle, but not the only one. We found that there is still a great naivete in the way that Russians do business," says Nash. "Two years of benign economic conditions has not been enough to create a new mentality to doing business."
The Kremlin has bank reforms in its sights and launched a comprehensive plan last summer. In the middle of March Putin upped the tempo by sacking Viktor Gerashchenko, the chairman of the CBR, who was widely seen as the biggest obstacle to rapid change in the financial sector. (see box) The banks themselves are also reforming and targeting lending as a growing business, but the leading 40 raw material exports still dominate their credit portfolios.
Another irony of the recent rapid growth is that the Kremlin's radical reform programme has also had virtually no impact on growth, other than to boost confidence. A cut in corporate profit tax to 25% came into effect only in January and a raft of other measures is only now being implemented.
For the small and medium sized business day to day life has barely changed. According to a recent World Bank study one of the biggest contributors to rapid growth in emerging markets is the creation of SMEs rather than restructuring existing factories. In other former Soviet Block countries, those that have vibrant SME sectors are also the ones that have put in the most growth and attracted the most investment. According to official figures the number of registered SMEs has actually shrunk to about 800,000 although anecdotal evidence suggests that more small businesses are simply operating in the black economy. But Russia's entrepreneurs say that dealing with the rapacious bureaucracy is as difficult as ever.
"If a thriving segment of new, small and medium sized firms is already in place, it becomes easier to import the conditions leading to the restructuring of old enterprises, because it is relatively easy for people to find new jobs elsewhere. If, on the other hand, alternative employment opportunities and government support are absent, the recommendation to close down non-viable plants may appear very cynical," says a World Bank report on the subject.
There is good news on this front too as Putin urged the Duma and government to, "pay special attention to small and medium businesses," in September. According to the World Bank significant numbers of employees are already leaving these Soviet era factories to find work in other sectors - mainly services.
"Before the crisis Russia's economic policies were not sustainable," says Christof Ruehl, the World Bank's chief economist in Moscow. "After the crisis the policies are sustainable. Unless something unexpected and catastrophic happens there will not be any more crashes."
Russia's star companies are moving ahead in leaps and bounds, but much still needs to be done if the Kremlin is going to encourage a broad based economic recovery, which will increasingly depend on the implementation of liberal reforms, especially banking reform.
The government has to strike a delicate balance of undoing the legacy of the Soviet Union through hiking natural monopoly tariffs and cutting implicit subsidies, while at the same time encouraging struggling young business short of investment capital to grow. Tariff are being increased while taxes slashed, but a debate is raging over at what rate to proceed.
"There is a need to hike tariffs so that the natural monopolies can be reformed, but tariff hikes feed through into both inflation and value of the ruble," says Peter Westin, an economist with Aton in Moscow. "Other countries of eastern Europe have managed dramatic growth with high inflation, but they also had vibrant small and medium sized enterprise sectors which just doesn't exist in Russia."
Inflation came in at the end of last year slightly over 18%, well above the government's 12-14% target, which is the target for this year. Russia got off to a poor start this year when inflation spiked to 3.1% in January - its highest level in three years - which lead the Ministry of Economic Development to cut back planned tariff increases and analysts to believe Russia will miss the target again.
CONCLUSION
Despite the problems Russia now looks set to start a sustained period of growth as it begins its first ever business cycle in the sense that Russia experienced eight years of decline, a crash and then three years of fast growth which is now being capped by capacity restraints.
Barring a catastrophic collapse in oil prices, Russia will almost certainly continue to grow. The question is now if the growth over the next few years will look like a V or U.
Despite the fact that the economy remains very top heavy, a third of investment is already going into sectors other than raw materials or the state-owned enterprises. The lopsided structure of the economy inherited from the Soviet Union is slowly being unwound.
Russia faces three threats to continued growth. The first is if companies rising productivity fails to keep up with costs of production, which will depend on companies' ability to attract investment. The second is if costs are driven up too fast. Tariff reforms, wages and money supply-inspired inflation are the most important factors here and companies were already feeling the pinch by the end of last year. Finally the Kremlin's failure to implement reform could be the most damaging.
The picture that the statistics paint while not rosy, is at least a lot pinker than at any time in the last ten years. Everything depends on how determined the people are to follow up on the recent progress.
"Yes the statistics are bad," says Vladimir Mau, the deputy director of the Gaidar Institute and advisor to the government. "But you shouldn't put too much emphasis on the numbers because at the end of the day countries are not directly comparable in statistically terms. These are only "indicators." More important to the development of a country is the mentality of the people."
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