Economic Outlook: The failing Russian market

The Russian economy was heading for disappointing economic growth even before relations with the West deteriorated over the Ukraine. It is now faltering amid declining net exports, slack investment activity, targeted economic sanctions, and the threat of further and broader sanctions.

Russia is overly dependent on energy exports (70.6% of export earnings in 2013) to drive domestic growth. Energy prices are expected to remain relatively weak but stable at current levels in the near-to-medium term as geopolitical tensions in producing regions are offset by the impact of moderate global demand, even as alternative supplies of energy are rapidly coming on stream. In addition, Russian interest rates have been raised to help stem the flow of capital from the country and relieve some of the downward pressure on the Ruble.

However, GDP growth in the first quarter of 2014 was just +0.9%, and the flash estimate put GDP second quarter growth at +0.8%, implying stagnation.

Stubbornly high inflation, partly due to a weaker Ruble, is cutting household purchasing power. And with the Ruble and equity prices losing ground in 2014, the threat of further and broader economic sanctions due to Russia’s annexation of the Crimea, and perceived Russian intervention in Ukrainian affairs is only worsening the environment.

The erosion of business confidence has caused investment activity to contract. Estimates are that net capital outflow in the first half of 2014 hit US$ 74.4 billion, compared with US$ 62.7 billion for all of 2013. IHS Global Insight has cut its GDP growth forecast in 2014 from +0.5% to a decline of -0.5%. We have further reduced growth in 2015 to +0.9% from +1.7%, and in 2016 to +1.5% from +2.5%.
In response, President Putin has decided to tap the National Wealth Fund—intended to address shortfalls in the Russian pension system expected to worsen because of unfavourable demographics—to fund infrastructure projects and jump-start economic growth.

Through the medium term, Russian economic growth will continue to depend on developments in world-market prices for fuels and other basic commodities. Further brakes on robust growth include the underdeveloped domestic banking sector and heightened investor aversion to risk in Russia.

Should the tensions with Western powers over Ukraine escalate, recession could extend beyond 2014. In the medium term, however, growth can return to around +3.0%, settling below that after 2020.

Providing investment capital for the medium and long terms will be critical for propping up economic growth, yet the investment environment has become increasingly unattractive.
Some of the most important industrial branches in both manufacturing and the natural-resource-extraction sector are facing effective capacity constraints because of an extended period of insufficient investment.

In natural-resource extraction in particular, which comprises 25% of the entire Russian economy, real growth has slowed markedly and exploitation is increasingly capital intensive, yet the Russian environment for investment will remain relatively unattractive, and the perception of risk in Russia will remain acute.

Construction risk

Indeed, international tension, finances and a lack of transparency in business practices create a relatively high risk for construction companies in Russia. The first chart shows the risk associated with a long-term investment project in Russia compared with other Eastern European economies.

The construction risk score is an indication of long-term investment risk, including such factors as ability to repatriate earnings, enforce contracts, protect intellectual and physical property and the stability of the workforce and prices. The “cross-hairs” indicate global average risk and growth. The size of the circle indicates the size of the market.

Russia quite clearly offers significantly higher risk with below-average growth prospects, not just globally but also for the Eastern European region. Only beleaguered Ukraine offers worse prospects for construction companies.

Real incomes had benefitted from strong growth in nominal wages due to a relatively tight labour market. Residential spending increased +7% in 2013 and the momentum into 2014 suggests growth near +8%. However, inflation has heated up and consumer confidence has eroded. Residential construction will retreat significantly in 2015 and average just +2.6% over the next five years.

Spending on non-residential structures contracted -4.2% in real terms in 2013, with institutional construction faring the best, while commercial construction had the weakest performance.

IHS Global Insight anticipates non-residential construction spending will decline a further -7% in 2014 with virtually no growth in 2015. Growth should return in 2016, but only at +4%, and average growth over the next five years will be just +3%
Government spending on public sector investment is being used to bolster the popularity of the Putin regime. Even so, infrastructure spending fell -4.4% in real terms in 2013 and another -3% decline is expected in 2014.

Spending on energy infrastructure fared the best, while spending on water/sewer was the laggard.

Infrastructure spending is forecast to return to growth in 2015, although only at +1%. Better growth around +5% for 2016 and 2017 will allow the five-year average to hit +3.3%

Taken together, Russian construction spending will decline once more in 2014. However, the medium term calls for some economic improvement, and even with its problems, Russia should be able to find the capital to support +3.0% average growth over the next five years, lead by infrastructure.

It should be noted that this is 1.3 percentage points weaker than IHS Global Insight’s forecast a year ago, indicating that Russia is paying a price for its domestic and foreign policy miscues.