03/03/2011 Russia: Recovery, Inflation, and Electio…

Russia: Recovery, Inflation, and Elections

Sergei Aleksashenko
International Economic Bulletin, March 3, 2011

Russia’s GDP growth, current account balance, and fiscal deficit all exceeded
expectations in 2010, but it is inflation that dominates policy makers’ attention. As
prices rise further, driven largely by causes outside of the government’s control,
inflation could become a political problem. At the same time, policy makers are
delaying needed economic reforms out of fear of inciting protests in the run-up to
elections.

2010 Was Not So Bad

Russia’s economic performance in 2010—4 percent GDP growth, according to

Rosstat’s preliminary estimate—pleased the government. It exceeded the Ministry of Economics’
December projection of 3.8 percent and, though the estimate is preliminary,1 future revisions will not point
to lower growth: Russia has entered its pre-election cycle and the government needs all of the positive
developments it can get.

In reality, however, Rosstat’s estimate is questionable. First of all, it does not match existing data, which
shows that GDP grew by 3.7 percent over the first three quarters of last year and would therefore require
fourth quarter growth to exceed 5.5 percent (q/q) or 23 percent (annualized) to meet the projection.

Second, Rosstat highlights inventory growth as the main contributor to economic growth last year,
estimating that it contributed 3.8 of the 4 percent. Though inventory growth is a normal part of economic
recovery, this figure is hard to believe, particularly with sectors like construction still in decline.

Rosstat’s estimate also rests on strong and stable investment growth (approximately 10 percent (y/y)) over
all of 2010. However, this number contradicts data gathered by regional bodies—which shows that large
and medium enterprises cut investment by 10 percent in 20102—and is inconsistent with the acceleration
of capital outflows that occurred in the second half of last year. In addition, Rosstat claims that all of the
investment growth went to the “grey sector.”3 But, if this were the case, the grey sector’s share of overall
investment would have risen from a stable 30 percent in 2000–2008 to 50 percent in 2010, and structural
change cannot occur so instantaneously.

GDP growth notwithstanding, the rising oil price—which grew from $72.50/barrel in the first half of 2010 to
$89.50/barrel in December—is feeding the government’s optimism about the economy. Last year, the
growing oil price boosted government revenues by approximately 1.35 percent of GDP and brought the
deficit down to 4.1 percent of GDP, below the Ministry of Finance’s September estimate of 5 percent of
GDP.

Russia’s current account balance, which looked potentially unsustainable in the middle of last year, also
benefitted from the oil price increase. Helped by slowing import growth—25 percent or less (y/y) in October-

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December, down from 35-40 percent in mid-2010—the current account balance strengthened from only 1.6
percent in the third quarter to a very secure 3.5 percent in the fourth quarter.4

A Rise in Inflation Is Inevitable

Despite this good news, last year’s significant increase in inflation disappointed Russian authorities. The
consumer price index (CPI) reached 8.8 percent in 2010, exceeding the 5.5 percent the government had
deemed feasible at the end of the summer. The CPI has continued to rise this year and could reach 10
percent (y/y) this month.

High inflation in an election

year may become a
significant political problem
as it increases the pressure
on government spending
and promotes public
dissatisfaction. This is
particularly true now, given
that the four main factors
behind the increase—
drought followed by a poor
harvest, world food price
growth, price indexation, and
tax and tariff increases—are
outside of the central bank’s
control.

Last summer, a severe

drought in Russia hit harvests of key products such as potatoes, grain, buckwheat, and sunflowers. Their
prices soon rose rapidly—buckwheat prices grew by 20 to 30 percent each month until Russian companies
signed large import contracts with Chinese producers in October. The poor harvests only compounded the
spillover effect of world prices—which recently passed 2008 peaks—on imported foods, such as flour,
sunflower-seed oil, milk, and sugar, which hit consumers’ wallets as well.

The government’s annual indexation of certain prices and tariffs—gas and electricity for the corporate
sector, and gas, electricity, utilities, and transport for households—also pushed up prices. Higher gas
prices translate into higher electricity, utilities, and transport costs, and therefore have a particularly
pronounced effect on the economy. With Russia aiming to gradually raise domestic gas prices to European
levels (minus transportation costs), gas indexation has pushed inflation up by 20 percent for corporations
and 15 percent for households.

Tax increases, enacted as part of the fiscal consolidation plan, have likely also led to higher prices. The
combined payroll tax rate rose from 26 percent generally and 14 percent for small enterprises last year to
34 percent for both this year. Gas excises also increased by 48 percent. These changes—which amount to
2 percent of GDP—were announced last summer, and no doubt many companies have increased prices in
an attempt to shift the burden to consumers.

The effects of the price indexation and tax increases will likely wane by March, as they have historically, but
food prices—which comprise nearly 40 percent of Russia’s consumer basket—will continue to pressure
inflation at least until May, when the new year’s harvest will become clearer. If food price inflation reaches
22 percent in May—up from 14.2 percent in January—as it did in May of 2008 and other prices follow their
2010 paths, annual inflation could grow to 13 percent by May.

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Not surprisingly, Russian
leaders are worried about
inflation, especially as
elections approach. Prime
Minister Vladimir Putin held
two meetings with oil
companies and threatened
to toughen antitrust
prosecution unless they
reduced gas prices. In
another meeting, he
demanded that regional
governors keep utility price
increases at or below 15
percent (the average
increase in the country).
President Dmitri Medvedev
also publicly stated his
concern about the high
prices of goods and services at Moscow airports and tasked the Prosecutor General Office with
investigating them.5

Change: Needed but Not Likely

At the same time, leaders are failing to act on larger reforms that even they recognize are needed—namely,
reducing the country’s dependence on oil prices and capital inflows. For now, the government is avoiding
any changes that could drum up turmoil in the run-up to elections, but radical change in the future is also
unlikely.

Unsure of what specific changes to make, leaders established a task force of experts outside of the
government last December to advise them. They tasked the group with updating Russia’s Strategy-2020, a
long-term plan that aims to improve quality of life, increase innovation, and form effective market and state
institutions. The task force will work from a version prepared in mid-2008—when Russian authorities
refused to even discuss the possibility of an economic crisis—and will assess the government’s
performance over the last three years. Rather than recommend one specific path forward, the experts will
outline a set of problems and offer a variety of policy solutions for each one, including proposals aimed at
modernizing the economy and increasing the efficiency of the government and social sectors. Based on the
task force’s member composition, its recommendations will likely have a liberal bent.

The release of the final report in December (after an intermediate report in August) is well-timed. Putin and
Medvedev will likely have determined which one of them will run for President by then, and shortly thereafter
—before the March 2012 election—the new government will probably be announced. But, even so, the task
force’s recommendations will likely have little impact. Already, the authorities have restricted which
problems the experts may discuss: political and democratic reform and transformation of the legal system
are off the table, for example, leaving only law enforcement and corruption.

To truly improve long-term economic prospects, Russian authorities need to resolve three problems. First,
they need to improve the investment climate. Due to the country’s insufficient rule of law, poor property
rights protection, rampant corruption, and inefficient bureaucracy, its investment climate has been falling in
international rankings. Political transformation, though not a focus of the current agenda, is needed to
improve the situation. Second, with subsidies to the Pension Fund and the new military procurements plan
set to increase the deficit, policy makers must reform the pension system and enact tax reforms in the oil
sector to put the long-term budget on a sustainable path. Finally, the economy must become more open
through steps like gaining WTO membership and enacting policies that encourage significant FDI inflows.
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Unfortunately, today’s leaders, who will be tomorrow’s as well, seem incapable of understanding any ideas
that do not fall within their paradigm of social paternalism and state capitalism. This makes any radical
reform—whether outlined here or recommended by the task force in December—unlikely.

Sergei Aleksashenko, former deputy minister of finance of the Russian Federation and former deputy
governor of the Russian central bank, is a scholar-in-residence in the Carnegie Moscow Center’s
Economic Policy Program.
1. The estimate will be revised three times, first in March 2011.

2. According to the most recent data, investment dropped by 5.5 percent (y/y) in January.

3. The “grey sector” refers to the companies that do not provide data for Russia’s statistics, which rely on surveys rather than
panels. All large companies and many medium-sized companies provide data, while some medium-sized and most small
companies do not. Rosstat uses different methods to evaluate the groups.

4. Historically, currency devaluation has generally followed a current account surplus of less than 1.5 percent of GDP in Russia,
suggesting that any balance below that is unstable.

5. On January 24, a terrorist bomb killed 36 people in Moscow’s Domodedovo airport. Though the Interior Ministry is in charge of
all airport security, Russian authorities blame the private owners of the airport for this incident. Many experts believe that the
authorities will use this event to try to take over the airport as they have several times in the past.

Resources available for this publication

Issues
Political Reform Russian Domestic Politics Economics Post-Soviet Economies

Regions
Russia and Caucasus Russia

Author
Sergei Aleksashenko

Source: carnegieendowment.org/publications/index.cfm?fa=view&id=42836

Carnegie Endowment for International Peace

© 2011 All Rights Reserved.

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