16.12.22 Analytics

An Investment Anomaly

The reason capital investments have grown despite the crisis and sanctions, and why this process will soon come to an end

Oleg Khokhlov
The Russian economy shrunk in 2022, but, compared to last year, investment activity has actually increased. This phenomenon was not witnessed in any of the previous economic crises. While preparing for the difficult times ahead, Russian businesses rushed to complete projects launched before the war and hastily adapted to working in conditions of international isolation. In many areas, investments were channelled towards maintaining, rather than expanding, production in the wake of serious restrictions due to sanctions. According to a survey carried out by the Central Bank, companies will be forced to start saving in 2023. Moving forward, investment opportunities will be determined by access to public funding. This means that steady growth is only likely to be observed in infrastructure and the military-industrial complex.

Anti-crisis Investments

In 2022, Russian businesses invested more funds into development than in 2021. This is a situation that few predicted in the spring, mostly due to the fact that during a crisis, when it is at best difficult or at worst impossible to predict a company’s income, investment activity usually shrinks. Additionally, many foreign companies left the Russian market (Re:Russia reported on who left and who stayed here). Many export niches have disappeared, and an inflation hike has triggered a slump in demand domestically. All of these factors are typically expected to lead to a reduction in investment.

Not surprisingly, in May, the Ministry of Economic Development predicted a catastrophic drop (by 19.4%) in capital investments. However, by mid-August, the ministry had adjusted its expectations to -10.8%, and then to -2% a month later. Finally, according to Rosstat, over the first nine months of 2022, investments in fixed assets increased by 5.9% compared to the same period in 2021. Double-digit growth in the first quarter (+12.8%) reflected the post-COVID recovery trend, as well as decisions made before the war; in the second quarter, investments grew by 4.1% compared to the same period in 2021; in the third quarter, this growth was 3.1%. How did this occur and what comes next?

In a review of investment activity in their December report (‘Regional Economy’), analysts from the Central Bank outlined three major factors required for investment growth: the successful continuation of pre-war projects, the implementation of urgent import substitution programs, and both regional and federal state support.

The Central Bank analysts concluded that the main factors driving investment were the need to change economic relationships and technological processes, as well as the implementation of a policy of import substitution. They also provide corresponding examples: in the Pskov region, construction has begun on an industrial battery factory, which will reduce the share of imports of these products by a quarter; in the Chuvash Republic, a chemical plant will begin producing hydrogen peroxide, which will fully cover domestic demand; and, an investment program is being implemented in the South to create a tractor production cluster, meant to replace products from foreign manufacturers and provide the industry with domestic components. The peculiarity of these investments is that they were not made in response to expectations of an increase in final product output and an expansion of the market share, but are meant to combat the ongoing crisis — that is, to compensate for falling imports in order to restore or maintain production output at a particular level.

In 2022, the mining industry continued to enjoy its traditionally high level of investments, totalling 20.6% of the overall number of investments. Gross growth in the oil and gas sector amounted to 10.9%. But some companies accumulated even higher numbers. For example, Gazprom set a spending record by revising its investment program in October: +70% on figures from 2021. And in 2023, its spending will increase another 30%. Its main projects are new production centres (in Yamal, Yakutia and the Irkutsk regions) and the Power of Siberia gas pipeline. Investments into the refinery process were primarily made by mining-adjacent industries: 56.6% of the total investment was provided by the chemical industry, as well as the industry responsible for the production of oil products and the metallurgy sector.

Investments into logistics increased by 11.1% due to the rerouting of cargo flows from the west to the south and east. In its report, the Central Bank places emphasis on the second phase of modernisation of the ‘Eastern range’ of railways. This should result in a reduction in the transportation time of containers from the Far East to the western border of Russia from 13–20 days to a week, and the throughput capacity should increase by 25%. The biggest growth (in relative terms) could be attributed to the construction industry, which witnessed growth of +22.7%. The programme of mortgage subsidies continued to play a decisive role; although this was expected to come to an end this year, it was eventually extended until July 2024.

Bloomberg Economics Chief Economist for Russia Alexander Isakov also notes that the defence industry grew by +19.5%. According to his estimates, investments in the military-industrial complex have the capacity to increase by two to three times, adding up to 2 percentage points to the country’s overall growth by the end of the year.

At the same time, in the manufacturing industry as a whole, and within the agricultural and electrical sectors in particular, as well as retail, stagnation has already begun to set in. As a result, the share of processing within the total volume of investments for the year decreased from 18 to 16.9%, while the share of agriculture fell from 3.9 to 3.4%.

The Investment Slowdown 

Although the issues stemming from the crisis that have stimulated investments this year will continue to a greater or lesser extent next year, according to a survey of 1,092 businesses conducted by the Central Bank, growth will most likely stagnate. One in three respondents reported an increase in investments in 2022, and only 26% have plans to increase capital spending in 2023. Investment forecasts deteriorated sharply in the third quarter of this year (a similar result was found in a recent poll conducted by the Russian Union of Industrialists and Entrepreneurs). As a result, total investment in 2023 will at best remain at the level of 2022. Previously, in its ‘Main Directions of the Unified State Policy for 2023, 2024 and 2025’ report, the Central Bank predicted a decline of 3-7%.

Independent experts have suggested two different possible scenarios. ‘Under certain conditions, next year may be the same as this one: if, for example, import substitution spreads to new sectors or government spending increases,’ says Sofya Donets, an economist at Renaissance Capital for Russia and the CIS. ‘Conversely, if they are faced with demand constraints, as they have already readjusted their practices once, manufacturers will stop investing in growth. In this case, we would witness a return to the typical crisis situation, which would see a decline of minus 5%.’

The authors of the ‘Regional Economy’ report cite two relevant reasons for the slowdown in investment: trade restrictions and economic uncertainty. Representatives of some industries — for example, retailers — have also complained about the decline in profitability (as noted previously by Re:Russia, Russians have begun to save money on even basic necessities, according to spending data compiled by large supermarket chains). Due to delivery issues and problems with forecasting, some investment projects have pushed back deadlines, while others have had to be cancelled altogether. The Central Bank survey suggests that the smaller the business, the less confidence it has. Among small and medium-sized companies, only 25% are considering increasing capital expenditures in 2023.

After the first three quarters of 2022, the share of businesses’ own funds decreased to 56.3%, from 59.4% in 2021. The share of funds raised in this fashion increased, but insignificantly (by just 3.1 percentage points). The share of public debt financing grew from 15.1 to 17.8%, and in the banking sector — from 10 to 11.4%. In all likelihood, prudent  investment plans for next year are likely to be driven by businesses’ expectations that their financial situations will deteriorate faster than their possibility for debt financing will grow. The Ministry of Economic Development has proposed to appoint the state as a ‘last resort investor’ and to support investment activity through extensive state support measures. However, as can be seen from the approved budget for next year, these plans are limited by the simultaneous need to increase defence spending (Re: Russia previously reported that spending on the war and the country's security forces in 2023 is likely to exceed economic spending).

‘Government-backed infrastructure investments will be the most sustainable,’ asserts Sofya Donets of Renaissance Capital. ‘Demand-driven investments in development are most at risk, as neither domestic or foreign demand is expected to grow.’