Russia risks becoming a second-rate state

▶ Putin has shown little interest in changing the economic model ▶ “It’s not about oil or sanctions; it’s about structural weakness”

For Russia’s battered economy, 2016 already looks miserable. The ruble has slumped to record lows as oil prices have fallen 11 percent since Jan. 1, to around $30 a barrel. The government, which gets nearly half its revenue from oil and gas, is scrambling to plug a 1.5 trillion-ruble ($19.2 billion) hole in its budget. The International Monetary Fund forecasts the economy will shrink 1 percent this year, after contracting 3.7 percent in 2015. The situation has created “an atmosphere of extreme nervousness,” Economy Minister Alexei Ulyukayev told President Vladimir Putin in a meeting on Jan. 26, according to a transcript released by the Kremlin.

As grim as the numbers are, they may understate the increasingly dismal prospects for a country that only a few years ago was enjoying its greatest prosperity. Economists and business leaders, including some with strong Kremlin ties, are warning that Russia faces long-term stagnation and declining competitiveness. “We find ourselves among the countries that are losing, the downshifting countries,” Herman Gref, head of state-controlled Sberbank, the country’s largest financial institution, said at a conference in Moscow on Jan. 15.

The situation resembles “a staircase leading down,” says Evgeny Gontmakher, a board member at Moscow’s Institute of Contemporary Development, whose chairman is Prime Minister Dmitry Medvedev. Gontmakher predicts Russia will probably eke out near-zero growth through 2017 and that the government will reassure citizens the economy will resume climbing after the March 2018 presidential elections. Instead, he says, the economy “will go downward after 2018.”

Russia has weathered crises before, including a 2008 oil price plunge and a 1998 sovereign debt default. In those cases, robust growth returned within a year or two. This recession’s different, says Vladislav Inozemtsev, a professor at the National Research University Higher School of Economics in Moscow. “It’s not about oil or sanctions; it’s about structural weakness,” he says. There already were signs of malaise in 2012, when oil topped $100 and Western sanctions over Russia’s annexation of Crimea were two years off.

The trigger for the downturn, Inozemtsev says, was Putin’s return to the presidency in May 2012. He raised taxes on business and real estate to finance military spending and expanded the reach of inefficient state-controlled companies such as oil giant Rosneft. “Businesspeople became disillusioned,” curbing investment in factories and equipment, Inozemtsev says. Productivity slackened, corruption thrived, and foreign investment slowed as investors fretted about the state taking over their assets, says Timothy Ash, an emerging-markets strategist at Nomura International in London.

When Putin first became president, in 2000, he said he would reduce the government’s reliance on oil. Instead the government grew even more dependent on oil revenue, and consumer spending became the main driver of the economy.

No more. Household incomes have declined for the past two years, and some 22 million Russians live in poverty, up 50 percent since 2013. Retail sales fell 10 percent last year, and auto sales plunged 36 percent. General Motors, which once counted Russia among its fastest-growing markets, shut most operations there last year, and retailers including Germany’s Adidas and Spain’s Mango have closed stores. Mcdonald’s, which has 543 Russian restaurants, said on Jan. 25 that it still plans to open 60 outlets this year but is adjusting its menus as more customers switch from Big Macs to cheaper chicken wings and pork burgers.

Ominously, industrial production and fixed investment deteriorated in December, even after Putin declared on Dec. 17 that the worst of the crisis was over. Oil prices don’t seem likely to rebound soon.

Reform advocates say there’s still time to reverse the decline by investing more in technology and loosening the government’s grip on the private sector. Even if Russia’s citizens are hurting, there’s no immediate risk of social unrest, former Finance Minister Alexei Kudrin, a Putin adviser, told Bloomberg News at the World Economic Forum in Davos on Jan. 20. “We have two years in reserve when social sentiments will be stable,” Kudrin said.

The government can’t afford major investments, though. It has already dipped heavily into foreign reserves, and Finance Minister Anton Siluanov said on Jan. 13 that spending on most programs would likely be slashed 10 percent to close budget deficits. Things are no better in the private sector. Sanctions have frozen most Russian companies out of major financial markets, and the weak ruble makes it difficult for businesses to import equipment to boost efficiency.

Putin, whose approval rating remains above 80 percent, has shown little interest in shaking up the country’s economic model. “We have grounds for cautious optimism” in 2016, he told Economy Minister Ulyukayev on Jan. 26, according to official remarks.

The state-run companies that dominate the economy are headed by loyal

Putin friends, while other members of his inner circle have benefited from big-ticket projects such as the Sochi Olympics that failed to produce lasting economic benefits. Far-reaching reforms, economist Gontmakher says, “are contrary to the institutional interests of the current government.”

- Carol Matlack, with Anna Andrianova The bottom line Economists predict long-term decline for Russia’s economy; the IMF forecasts it will shrink 1 percent this year.