Monday, March 10, 2014

Lessons From Moscow: How Not to Build a Modern Economy

The cover story in a recent issue of The Economist magazine detailed Argentina’s fall from grace over the past century.  The piece reads like an economist’s version of a horror film. All the gory bits are present: populist policies, ham-fisted state intervention, fiscal irresponsibility and the frittering away of the rule of law…not only with regard to property and business, but eventually across society. While the purpose of the article was to serve as a warning for other countries, one had to ask, is this cautionary tale really necessary? After all most of Argentina’s missteps occurred way back in the 20th century. Since then the virtues of economic liberalization and free markets have been proven time and again. Furthermore, myriad narcissistic populist leaders have had their clothes ripped off, exposing the dangers of concentration of power.

Unfortunately, there are still countries following this disastrous template, including Argentina itself as well as a handful of other Latin American neighbors. The romance of leftist politics and fiery leaders apparently always has a welcoming audience in balmy southern latitudes. But one country in a decidedly frostier climate has also made a pronounced turn towards a potentially ruinous economic path: Russia. Much like the wayward LATAM countries, Russia is sowing the seeds of underperformance despite a nearly unequaled bounty of natural resources. The country also has in its favor a well-educated populace, especially in the realm of science and math, areas where a certain unnamed global superpower is egregiously lacking. At first glance Russia has experienced an economic renaissance since the nadir of the post-Soviet era, yet this is likely to prove ephemeral given the government’s consistent jettisoning of the policies and tools necessary to create durable economic growth.

Russia has commanded its fair share of media coverage of late due to its adventures in Crimea and the unceremonious dumping of its kleptocratic water boy in Kiev. There is plenty of commentary available on the geopolitical chess match occurring in Ukraine, but this posting is not one of them. Instead, true to this page’s mission, the focus is on economics and how it relates to the investment universe; in this case with regard to Russia. It is not a far stretch, however, to draw a connection between the country’s current economic trajectory and its fitful grasps at the fading shadows of imperial grandeur.

The Wild East
At the risk of dating myself, your commentator recalls a description of the Soviet Union by one of his university professors stating, “…it is a third-world economy with a first-world military.” We know how that story ended. The collapse of the command economy gave way to the chaos of the 1990s and its bastardized version of privatization and capitalism. After the fleecing of the country’s commanding heights, countless gangland shootings and a mass exodus of capital towards the anonymous valleys of Switzerland, the country was fatigued and ready for a new beginning. Enter Vladimir Putin. The erstwhile St. Petersburg functionary (among other things) was the beneficiary of not only Russia’s yearning for a strong hand, but also generous presidential powers as defined by the constitution. One-hundred bucks for a barrel of oil did not hurt either.

Even during Soviet times, Russia was an energy juggernaut. After a nearly decade-long swoon in production, the wind was at the country’s back by the early 2000s with hydrocarbons leading the way. Vast sources of industrial metals such as aluminum and nickel further augmented economic prospects.

The rebound in growth was impressive and soon Russia was lumped with China, India and Brazil to form the BRIC club of large countries with rapidly expanding economies. Moscow’s store shelves were stocked with all the creature comforts of an advanced economy and regular flights were scheduled to London, southern France….and of course, Zurich.  But these economic advances came at a price: the gradual curtailment of civil liberties and other tenets of a civil society.  As has been proven time and again, once the media, courts and a viable political opposition have been muzzled, those in power turn into self-serving crooks in  pretty short order.

How Do You Say “One-Dimensional Economy” in Dutch?
In the recent kerfuffle over Crimea, U.S. Secretary of State John Kerry commented that 19th century geopolitical tactics had no place in the 21st century. Russia’s misplaced sense of time is also at play in the economic realm. One could argue that economy of the Soviet Union was more dynamic than modern Russia’s. The USSR at least produced things across an array of industries. Those wares may have been lousy and forced upon a captive consumer base, but at least the factories were humming. Fast-forward to 2014 and the country has come to redefine the concept of Dutch Disease, meaning an overreliance on natural resources exports at the expense of a value-added manufacturing base.

Virtually anything of worth and complexity is imported, a situation that has only been magnified during the decade of high energy prices. As seen above, Russia is reliant upon foreign suppliers for many of the tools necessary to keep a modern economy buzzing along. This includes transport equipment, machinery, office and telecom equipment, not to mention those fancy Gucci bags and Italian fashions adorning Moscow storefronts. The manufacture of cutting-edge goods creates a greater amount of high-skilled jobs than does digging a hole in the ground for a pocket of crude or a hunk of bauxite.

Creating a skilled manufacturing and services base should be especially important for Russia as the deck is stacked against it from the get go. Economic growth is a result of increasing population and enhanced productivity. Russia’s populace is shrinking, and at an alarming rate, having retrenched nearly 5% since 1990.

With regard to labor productivity, the country dramatically lags advanced economies. To be sure, inroads have been made from the Soviet era, but that is the consequence of an incredibly low base. As seen below, GDP per capita in Russia is only 46% of the U.S. level and output per hour worked reaches just 37%, lower than the rates for Chile, South Korea and Turkey.

Red flags abound….and not those adorned with a hammer and sickle
As any investor knows, diversification is a good thing. Russia rode the positive trend in commodities demand to relative prosperity. But as the super-cycle has tapered off along with previously red hot growth in energy-intensive emerging markets, the country’s lack of diversification is coming back to haunt it. GDP growth, along with fellow commodities producer Brazil, has consistently lagged that of the other BRIC countries, China and India.

As a result, national accounts are less vigorous than they were a few short years ago.  The current account, while still positive, has trended down to nearly 2% of GDP (the U.S. should be so lucky). Also the federal budget, built to generously hand out patronage to favored segments of the population, has dipped into the red. Purportedly crude at $100 a barrel is required for the petro-state…and that’s what Russia has become….to balance its books.

Lower energy prices are not the only thing Russian officials need to worry about.  Production growth for both crude and natural gas has slowed from the boom period experienced a decade ago. Crude production between 1996 and 2004 grew at an annual clip of 5.5%. Between 2005 and 2012 it slowed to 1.5%. The drop may be partly explained away by the curtailment of production in light of the global recession, but other data suggest that additional negative factors are at play. Russia’s share of global crude reserves has dipped from 6.1% in 2006 to 5.2% in 2012. Furthermore, growth in proven reserves has all but stalled.

These trends cast a dark shadow as Russia has become overly reliant upon royalties from the energy industry as its main source for hard-currency. While the Central Bank’s foreign currency reserves are still at lofty levels, accumulation has slowed and at some point those funds may be needed to defend the Ruble against deprecation. Since its level of 27.4 to the USD in 2011, the Ruble has lost nearly 25% of its value, with 10.4% of that decline coming since late-December as a consequence of traders freaking out over Putin’s Black Sea adventurism.

Capitalism….with a little “c”
Overdependence on commodities exports is just one hurdle facing Russia’s economy.  The balance of power between the private sector and state has swung towards the latter, with key industries dominated by state-controlled firms. This is illustrated in the constituents of the MICEX equities index, which largely reads like a who’s who of state-owned enterprises, including giants Gazprom, Sberbank and Rosneft. This concentration is aggravated by the practice of corporations maintaining control by floating only a portion of their shares. Of the ten largest listings on the MICEX, representing 73% of total market cap, the average amount of free floating shares is 39%. Just enough to keep a minority shareholder awake at night. With such suspect underpinnings, it does not take much….say the unprovoked armed invasion of a neighboring land…to send equities investors running for the exits. And this is exactly what has occurred with the MICEX plummeting 11% in the past month.

Portfolio investors are not the only ones proceeding with caution. Foreign Direct Investment (FDI) has yet to recover from the global downturn. From 2000 to 2008, FDI…admittedly from a low base…averaged 51% annually. In the ensuing four years the gain averaged only 11%. With foreign investors…especially in the energy and materials space…getting bullied about, is this to anyone’s surprise?

In addition to the heavy hand of the state, petty corruption and regulatory inefficiency continue to be a drag. Needless to say, none of these characteristics are conducive for nurturing an innovative, wealth-generating private sector. In this environment, is it any wonder that while young Czech computer scientists have created global leading cyber-security firms, their Russian counterparts are renowned for being the world’s most menacing hackers? It isn’t like the country’s leaders are moral icons.

Consider yourself warned
As long as we are quoting past professors, another one opined that the best way for an investor to approach Russia was to avoid it. The comment was made in the aftermath of the 1998 Ruble devaluation, so within that context perhaps it was a prudent strategy.  Yet despite many of the advances since then, investors still must approach the country with extreme caution. In a world dependent upon interconnected capital flows, reticence towards Russian assets by foreign money is itself a hindrance to growth. This risk could become even more pronounced should growth in hydrocarbon exports continue to diminish and the Ruble continue its slide, especially given the country’s reliance on Euro and Dollar denominated manufactured imports.

For those investors continuing to go forward, it isn’t like you have not been warned. The country’s elites make little effort to hide their hardball business tactics. As for commercial partners, such as energy hungry Germany, the inability to confront Russia’s geopolitical dalliances is a direct consequence of not diversifying their energy resources (e.g. an alternative to Nord Stream and the unplugging of the nuclear sector).

The Gucci Revolution
Rounding our way back to any linkage between Russia’s Potemkinesque economy and its latest exercise in Machtpolitik, one plausible connection is that the gents in the Kremlin recognize their economy is ill-equipped to raise the living standards of ordinary Russians anymore (without relinquishing plum positions in key industries). So as a diversion, they beat the nationalist war drum. This tactic is especially effective when resuscitating the ever-lurking fascist scourge to the west, which evidently includes every European between the Dnieper and the Atlantic. Or the plutocrats have simply come to believe their own rhetoric on having rightfully returned The Motherland to Tsarist glory.

But this is neither the 19th nor the 20th century. Russians, especially the young, understand how the rule of law and free market principles lead to increased living standards. This is no East vs. West argument. Yes, many were coopted by the relative stability which marked the early years of the Putin regime, but the loss of freedom and opportunity have reached a tipping point where the future prospects of a nation are at stake. With the Internet and frequent travel to western capitals, the genie cannot be put back in the bottle. In keeping with the tradition of giving every popular uprising in the 21st century an easy-to-digest moniker, we can call this one…should it ever occur… The Gucci Revolution.

Despite its volatile and sometimes dubious history, it is hard to discount Russia’s place in the international community. After all this is the country that gave the world the brilliance of Dostoyevsky, Tchaikovsky, Stravinsky and Maria Sharapova. Rather than suppressing these resources…as well as invading former territories…..the Kremlin should instead harness them by casting away the chains holding back a potentially top-tier global economy.

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