28.12.23 Analytics

A Tricky Figure: Why the year’s economic results are much worse than the Russian authorities are trying to portray

In 2023, the Russian economy grew by more than 3%. This impressive result, however, does not indicate that it has coped with sanctions and the burden of military spending. The launch of economic growth was made possible by high export revenues in 2022-2023 and extensive budgetary stimulation. A significant portion of this growth was attributed to the defense-industrial complex, military construction, and the creation of transport-logistics infrastructure for redirecting trade flows. This GDP growth does not contribute to an increase in national wealth. And, the powerful budgetary stimulus resulted in economic overheating, prompting the Central Bank to raise the base rate to a 'crisis' level.

This will lead to a sharp slowdown of the economy next year, which will compensate for the excessively high growth rates this year. At the same time, the quality of growth will be worse: in conditions of high interest rate the only source of investment will remain budgetary resources. Thus, this year's high growth rates will lead to structural reorganisation of the economy, reducing the role of market incentives and increasing the role of budgetary incentives. The Russian economy is being rapidly 'Sovietised', manifested in its increased dependence on budgetary injections and the establishment of a system of ‘patches’ - institutions of manual and emergency management. Moving onto this trajectory increases the likelihood of another transformational crisis at the moment when it becomes impossible to sustain this system of incentives and temporary institutions.

A tricky figure

At the end of 2022, the Russian authorities were pleased with a less significant contraction of the economy than originally anticipated (only 2.1%), while economists expected a continuation of the downturn in 2023, albeit not too severe. However, unprecedented export revenues in 2022 and strong fiscal stimulus have fuelled recovery growth, which is expected to be above 3% at year-end. 

The November consensus forecast of the Higher School of Economics (HSE) Development Centre estimated GDP growth at 2.6%, but since then both economists and economic authorities have revised their estimates. In the December consensus forecast of the Central Bank, the value of the indicator was raised to 3.1% (against 2.5% in October). This optimism is linked to the fact that, despite the interest rate hike cycle that began in August, the economy is not slowing down as expected. High economic activity at the end of the year (despite the sharp rate hike) is evidenced, in particular, by the composite leading index of the HSE Development Centre and high PMI values. Vladimir Putin and Finance Minister Siluanov have stated that the economy would grow by 3.5%, and it seems that this will be the official calculation.

However, a part of this growth is attributed to defense production, military construction, and the creation of additional infrastructure related to redirecting trade flows from west to east. In this aspect, this year’s economic growth is not an increase in national wealth, but at best provides for its structural reorganisation without leading to improved efficiency. Nevertheless, such growth certainly creates a spillover effect, providing, for example, increased consumption and investment in related sectors, stimulating dynamism in the economy in areas unrelated to government investment and war.

In addition, the economic acceleration has led to overheating and a spike in inflation. This has forced the authorities to undertake efforts to cool down the economy through a prohibitive base rate, which, as in periods of economic crises, is at 16% and is expected to result in a reduction in the growth rate of the economy next year. Consensus forecasts by the HSE Development Centre and the Central Bank predict they will slow to 1.3-1.4% in 2024. However, analysts at Bloomberg Economics estimate a 70% probability of a recession for the Russian economy. Central Bank Governor Elvira Nabiullina, in an interview with RBC (video), cautiously indicated possible growth in the range of 0.5-1.5%. That is, she anticipates not a recession but a return to a long-term trajectory of weak growth. She noted that to prevent the risk of a recession, decisions to cool excess demand and reduce inflation should have been made in a timely manner, acknowledging that tightening monetary policy in response to economic overheating should have happened somewhat earlier, 'for example, in the spring' of 2023.

In this case, growth would have stalled earlier and the annualised figure would probably be around the mid-year expectations (2.5%). At the same time, it would not have been necessary to raise the interest rate so high, and this would have improved growth prospects in 2024, and under more comfortable and more market-friendly conditions of commercial credit availability. Thus, artificially accelerating growth this year not only sets a low ceiling for next year, but also deteriorates its quality. 

Somewhere between inflation and growth

The picture of economic dynamics at the end of the year looks rather contradictory. On the one hand, business is demonstrating unabated optimism, and consumer demand, as Re:Russia has previously written, is not cooling down. Against the backdrop of high inflation expectations and anticipated further increases in consumer loan rates, citizens are rushing to make purchases now, despite rising prices. This allows businesses to transfer costs to prices. On the other hand, the dynamics of industry have a mixed character and across various industries and sectors are 'between growth, stagnation and decline'. According to the latest Rosstat data, in November, industry grew 0.2% compared to the previous month (seasonally adjusted). Since May, months of weak growth (+0.2-0.8%) have alternated with months in which there has been a 'nanoslump' of 0.2-0.4%.

The government-affiliated Centre for Macroeconomic Analysis and Short-Term Forecasting (CMASF), analysing the results of the first three quarters of 2023, notes that against the background of a generally favourable situation in the economy there are signs of significant deterioration — the balance between growth and inflation has shifted. The growth potential has been almost exhausted, while prices are rising. In November, monthly inflation exceeded the 1% threshold, reaching 1.11%, and the cumulative figure from the beginning of the year until December 18 was 7.12%.

'It is certainly too early to talk about recession. But a certain failure in the reproduction mechanism is undoubtedly already evident', write the CMASF experts. Analysing the October data, they note a monthly decline in industry by 0.2%. Calculations from HSE (Bessonov's group) show greater monthly production volatility and more significant declines, while the CMASF experts characterise the situation in industry as 'between growth and stagnation', acknowledging that as a result of a series of shocks in recent years it is practically impossible to eliminate seasonality correctly or assess monthly dynamics. However, they note the onset of stagnation or even 'slight contraction' in construction,which was previously one of the growth drivers. Transport turnover, an indirect indicator of economic activity, is also decreasing but remains 1.8% above the average monthly level of 2022 for now.

The main factor slowing down the economy in the medium term, according to CMASF, is the decline in the investment activity index, which reflects 'an assessment of the supply of investment goods in the economy'. In October, it declined by 5.8% compared to the previous month and, as a result, returned to the average monthly level of 2019. The main contribution to the decline in the index was a decrease in imports of machinery and equipment (likely due to the autumn devaluation of the ruble). 

As Re:Russia recently reported, the investment boom this year served not so much the growth of the economy as its structural adjustment, with budgetary investments and enterprise funds being its main sources, while the role of borrowed funds declined. The situation will continue to deteriorate as the economy fully experiences the tightening of monetary policy. According to CMASF estimates, in the third quarter, the growth of investments in fixed capital slowed to 2.3% (compared to the previous quarter) after an increase of 5.4% in the second quarter. The income level in the machine-building industry has become much lower than the cost of money, the Centre's experts note, which 'may lead to the disruption of modernisation of the machine-building core'.

Patch economy

'At the end of 2022, it seemed that the main problems of 2023 would be budget deficit, as well as the decline in export revenues due to the European embargo, price ceilings, and the potential decrease in global oil prices', says Oleg Itzhoki, economist and professor at the University of California. At the beginning of the year, the budget deficit could be forecast at 6%, but it was minimised as a result. Oil and oil product exports have not declined significantly, the world price has remained above $80 a barrel for most of the year, and the discount on Russian oil has shrunk from about $20 a barrel in 2022 to apparently less than $10 in 2023. This, along with additional tax collections, became the main source of budget replenishment.

As a result, instead of the anticipated budget and export revenue problems, the main problems in 2023 were devaluation, inflation and high interest rates, Itzhoki continues. The devaluation had more to do with capital outflow or 'flight' from the ruble. He underscores that the non-return of export proceeds is also a type of capital outflow. According to calculations by the HSE Development Centre, in the third quarter, the net capital outflow of the private sector doubled, from $9 to $18 billion, with accounts receivable for unfinished foreign trade contracts playing a major role; problems with payment for Russian exports continued into the fourth quarter.

Therefore, high export revenues and fiscal spending have stimulated the economy and made it possible to cope with unprecedented restructuring of supply chains and imports. However, sanctions and the break with the dollar economy have led to continued capital outflows, payment instability and reduced sources of investment on the one hand and, on the other hand, excessive fiscal stimulus forces economic authorities to suppress market channels for money redistribution in the economy, making it even less market-oriented and more dependent on fiscal stimulus.

Potential problems and risks for 2024 include, firstly, the conjunctural and political risks of 2023 carried over into the new year, i.e. a possible decline in export revenues if the oil price does fall and/or the price cap becomes more effective (both of which are very likely if shale oil production in the US continues to grow). The result of this would be a budget deficit in the face of an inability to cut spending on the war and economic stimuli. Second, there are still risks of continued ruble devaluation, according to Itzhoki. In the autumn of 2023, currency repressions against exporters temporarily reversed the trend of ruble weakening, but it had resumed by the end of the year. This, in turn, forces the authorities to further expand currency control measures.

Thus, conjunctural risks coexist with structural ones. The economy relies on government spending, a significant portion of which is military expenditures. If they are reduced or funds for war run out, there is a substantial likelihood of a transformational recession. The Russian economy is currently working with a whole set of 'patches', where structural problems are being solved through temporary interventions that, in turn, create new problems for the future, says Oleg Itzhoki. These include additional taxes (to replenish the budget), financial repression of exporters (to curb further devaluation), and fiscal stimulus for the economy on the one hand and demand on the other. Finally,there is the prohibitive interest rate, designed to curb inflation but which simultaneously hampers private investments. State-subsidised loans in the face of the prohibitive rate are another vivid example of non-market redistribution mechanisms that substitute for market ones. Itzhoki concludes that the dismantling of market institutions will be the main long-term economic outcome of 2023.

All of this together resembles a kind of ‘sovietisation’ of the economy. The importance of market factors is decreasing, while state incentives are increasing. The economy is regulated not by market balances, but by 'manual' measures in the form of the above-mentioned 'patches', Itzhoki notes. The question is when will the 'patches' cease to fulfil their role and will this require a fall in oil prices, or will it happen over time even with relatively high prices?