No Need To Leave

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Business managers operating in Russia are likely to be focused on one key question in the coming months; ‘what will be the legacy of the Ukraine crisis’ on the economy and the business environment? Specifically, how might the crisis damage previous growth assumptions and for how long? The good news is that nobody should be planning to pack their bags. The long term growth story in Russia remains intact. The bad news is that the economy may lose at least one year of growth and the quarterly reports back to head office may need a lot more reassurance than previously. Plaudits for exceeding 2013 performances will be scarce in calendar year 2014.

The crisis over Ukraine could not have come at a worse time for the Russian economy. Last year’s growth of 1.3 per cent was about one-third that of the previous year and the Economy Ministry recently warned that growth this year may be as low as 0.5 per cent or even zero if inflation cannot be brought under control and capital flight continues to rise.

But with headlines so bad and risks apparently high, why do so many foreign businesses even bother with Russia exposure? The short answer is they are in Russia because they make money in the country and, in most cases, a lot more than they make in most other developing economies. Businesses and investors who bailed out of Russia exposure during previous crisis missed the lucrative recovery that followed. Russia has changed a great deal over the past dozen years. Opinion polls certainly show strong public support for the re-integration of Crimea into the Russian Federation but other polls show a steady rise in concern over rising inflation and the weaker rouble. Russia has the highest per-capita internet usage in the world and the middle-class has become used to travel, and spending, across the world. Policy makers in the Kremlin are very well aware of the need to sustain lifestyle improvements as a basic condition for social and political stability.

Russia is already the second largest consumer market in Europe and, with 144 million people and 55 million households, potentially the largest. Although precisely defining what is the middle class segment of the population is problematic and highly contentious, using the OECD definition Russia’s middle class is just over 50 percent and compares very favourably with a similar classification of 30 percent in Brazil, 21 percent in China and 11 percent in India. More importantly the classification of wealthy households, i.e. those with annual income of $50,000 or greater, is 15 percent in Russia compared to less than 5 percent in Brazil, China and India. Russia is already one of the largest profit contributors for major international consumer and service companies and, last year, New York Jewellers Tiffany opened its first flagship store in east Europe on Red Square just opposite Lenin’s tomb.

Between 2000 and 2012 retail spending in Russia grew at an annual compound rate of 20 percent. Part of that was the low base effect and part was as a result of the trickledown of the over $1.6 trillion worth of oil and gas exports revenue earned by the budget. But while the boom period in consumer and services growth is over, Russia will sustain annual growth in this sector close to the 4-5 percent recorded over the past twelve months as people’s lifestyle and consumer habits continue to migrate towards those in developed economies. Despite the rapid changes of the past dozen years people living in big cities, such as Moscow, will attest to the fact that there is still huge scope for improvement in the consumer services sector.

But what of the fears that Russia’s economic progress is at risk of a collapse in oil and gas earnings? It is certainly true that about two-thirds of the value of Russian exports is from oil and gas. But because of the steady expansion of the economy over the past decade less than 50 percent of tax revenue is generated from these industries. Also, the government learned an expensive lesson in the 2008 crisis when the oil price collapse quickly eroded foreign exchange reserves and led to a budget deficit of 6 percent in 2009. Today there is a more flexible approach to balancing the oil price and the rouble’s exchange rate so that at an average of $80 per barrel (Brent) the budget would run a deficit of 3-4 percent of GDP. For a country with only 11 percent public debt to GDP that imbalance could be accommodated for several years while the reformers in government would welcome the decline in complacency to push much needed and long overdue reforms.

The next phase of growth in Russia will have to be investment based in, e.g. agriculture, food and medicine production, healthcare and infrastructure. Foreign companies will make will money as these industries recover and expand as others have, and are, in consumer and service areas. Of course that implies that not only will the legacy of the Ukraine crisis be overcome but also that contentious issues such as corruption, heavy handed bureaucracy and a perceived weak rule of law will also be improved. The bottom line is Russia has never been an easy location for business and investment and that is unlikely to change for a very long time. But despite the regular intrusion of politics and the overhanging hydrocarbon risk, Russia is still a country to make money and that is why so many foreign companies are staying.