“Russia is neither China nor Germany”

VTB Capital’s Neil MacKinnon says in a world of uncertainty, Russian growth is a reliable bet, but government reforms are needed.
“Russia is neither China nor Germany”

Russia’s economy is forecast to grow by 4% this year and next year, an outlook that seems reliable. It may not be so incredible compared with China and India, but in a world beset by uncertainty, including in other emerging markets, it’s a performance that should reassure global investors, argues Neil MacKinnon, Moscow-based global macro strategist at VTB Capital.

Speaking this week at AsianInvestor's and FinanceAsia’s 2nd Russia Capital Raising and Investment Summit in Hong Kong, MacKinnon makes the point that “Russia is neither China nor Germany”.

By that he means it is still making a transition to a post-industrial, modernised economy. Although Russia is blessed with huge natural resources, these are not actually big employers, while the service sector catering to the domestic economy is immature.

Russia’s challenge is to ensure the international competitiveness of its resource sector while boosting employment in other sectors, and this can only be achieved by pursuing a new growth model.

The status quo isn’t working: despite high oil prices, economic growth is relatively slow; the government is spending money thanks to its oil and gas revenues, but inflation is on the rise (now at 9%) thanks to expensive imports and consumers aren’t buying Russia-made goods.

Industry needs to invest more to become competitive and lower its cost of production; labour costs are high due to scarcity; and capital flight is endemic, with Russian securities largely owned by foreigners (from January to April, domestic investors moved $30 billion out of the country).

It is official government policy to draw the state back from dirigisme, through a reasonable plan backed by President Dimitry Medvedev. But MacKinnon says that there has already been backsliding, with timetables not being met.

Moscow needs to engineer a supply-side reform, including tax cuts and the breaking of the government-tycoon nexus; pension reforms to boost private investment; pursue anti-monopoly laws; and follow through an ambitious $50 billion privatisation scheme. The government also needs to ensure its entry to the World Trade Organisation concludes on schedule by the end of 2011.

The good news is that both Medvedev and Prime Minister Vladimir Putin say they support this agenda, and have the spur of several high-profile sporting events to drive them, including the 2014 Winter Olympics at Sochi and the 2018 football World Cup.

MacKinnon says the fiscal outlook is positive, but there’s no more room for error. The country enjoys substantial foreign-exchange and gold reserves, its credit rating is a candidate for upgrading, its budget is in surplus (at 1.8% of GDP), and its current account enjoys a huge surplus of around $110 billion.

However, government finances remain highly dependent on the price of oil. Two years ago, analysts said the government’s breakeven point was $50/bbl. Because of its high expenditures, that breakeven point is now $110/bbl, says MacKinnon; stripping out oil revenues from the budget accounts, the government would actually be running a deficit today of 11% of GDP.

So there are constraints, but the picture is not alarming. MacKinnon notes that analysts put Saudi Arabia’s fiscal breakeven at $90/bbl. (Brent crude currently trades at $113/bbl.)

MacKinnon argues that political fears about next year’s presidential election are overblown, and predicts the choreography between Putin and Medvedev will continue. He says investors should not get too drawn into the issues of which man ends up in what role, but whether the government continues to implement its policy initiatives.

For equity investors, this leaves Russia looking cheap. The market has continued to underperform peers in the MSCI emerging-market index. Russia faces ordinary challenges and, thanks to its domestic economy and resource wealth, can continue to grow at a time when the US and Europe face sovereign debt problems and China and India confront questions of a hard or soft landing.

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