By Ruchir Sharma
The Wall Street Journal
The Wall Street Journal
A Gazprom gas station near the headquarters of Gazprom in Moscow. Bloomberg News
Vladimir Putin had been named the “world’s most powerful person” last year by Forbes magazine well before he annexed Crimea. The land grab added to the string of geopolitical victories credited to the Russian leader—including his rescue of Syria’s Bashar Assad in the chemical-weapons standoff and the safe harbor he gave to the American secrets-spiller Edward Snowden. But Mr. Putin’s real power base, the economy, is crumbling.
Russia’s economic growth rate has plummeted from the 7% average annual pace of the last decade to 1.3% last year. Now the brokerage arm of the country’s largest state bank, Sberbank, expects zero growth in 2014.
Sensing trouble, wealthy Russians have been moving money out of the country at one of the fastest rates in two decades—$60 billion a year since 2012—and now foreign investors are pulling out too. The ruble has fallen by 22% against the U.S. dollar since 2011, and the Central Bank of the Russian Federation has been fighting to prevent a ruble collapse since the Crimean crisis began.
The situation is especially revealing because oil—the mainstay of the Russian state—has stayed relatively stable, hovering at $110 per barrel for three years. Yet the Russian economy is stagnating. This suggests deep-seated problems.
After Mr. Putin became president in 2000, he began working to end the political turmoil and inflation that gripped Russia under Boris Yeltsin. He managed the economy responsibly, getting control of the government budget and retiring debts. Rising global oil prices and easy money did the rest. Between 2000 and 2010, growth and per capita income rose to $10,000 from $1,500. Mr. Putin started this decade with an approval rating of 70%.
But he grew complacent and cocky. Former KGB allies replaced economic reformers in his inner circle. As former President George W. Bush told me in an interview, Mr. Putin in private conversations morphed from a leader who worried about Russia’s debt to one who by 2008 taunted the U.S. for having too much debt. He went from saving oil profits in a rainy-day fund to spending them to cement his power.
Before 2008, Russia was putting back to work the oil fields, factories and labor force that were idled by the collapse of the Soviet Union. Even so, Mr. Putin built little that was new. While Russia has a relatively high rate of investment, 26% of GDP, much of the money gets funneled into dubious projects by the state. Now the spare capacity is shrinking, and the old Soviet roads and railways are deteriorating, as any regular visitors to Russia can attest.
The inflation rate now stands at 6.3%, fourth highest among the major emerging markets, and well above the emerging world average of 3.8%. Russia has become a classic weak-investment, high-inflation economy.
Despite his growing reputation as a geostrategic mastermind, Mr. Putin’s economic strategy is increasingly self-defeating, focused on extending Kremlin control. While countries like Mexico are moving to open up the state oil industry, Russia is closing it off, tossing out foreign partners. Rosneft, the large state oil company, is buying out private companies and now controls 40% of the country’s oil production. It is launching its own oil field-services company, bringing in-house a service that multinational oil companies have been hiring out to efficient private contractors for years.
Russia grew richer during the last decade but did not develop in the normal sense of building up more sophisticated manufacturing industries. In a vibrant developing economy such as Korea or the Czech Republic, manufacturing accounts for at least 20% of GDP. Manufacturing in Russia accounts for just 15% of GDP, down from 18% in 2005. Small and medium-size companies of any kind, including banks, struggle to gain a foothold alongside state behemoths.
The result is that the Russian state has few new sources of income outside of oil and gas, at a time when it is taking on more dependents. Demographics are putting a squeeze on public finances, as roughly a million Russians are retiring each year, and too few young people are replacing them in a workforce of about 100 million. The situation leaves fewer taxpayers to fund pensions, after a five-year period in which the Kremlin raised pension payouts by an average of 25% a year.
This is a medium-term threat to the federal budget, which is in surplus now but shows a dangerous deficit if oil revenues—$222 billion or around 10% of GDP last year, according to IMF figures—are left out of the equation. Because of slowing growth and deteriorating terms of trade, the non-oil government deficit is now 11% of GDP. The current account is in a similar position: an apparent surplus, dependent on oil. The non-oil current-account deficit is currently running at a whopping 10% of GDP.
To keep its federal budget in balance, Russia requires an oil price of $110 barrel, so it is tiptoeing on the edge. Yet because other commodity prices have fallen, the price of oil, now $107 per barrel, is at a 30-year high compared with industrial metals. This suggests that oil, too, may be poised for a downshift—which would have a crippling impact on the Russian economy.
For now Russians are applauding their president’s confident portrayal of the great power player. But that may change if the economy keeps deteriorating. Remember that by late 2011, as the scale of Russia’s slowdown was becoming clear, Mr. Putin’s approval ratings tanked and he faced protests in Moscow.
Mr. Putin’s approval rating has bounced back following the Sochi Olympics and the invasion of Crimea. But the rest of the world should not be fooled. The world’s “most powerful man” is scoring his geopolitical victories from an increasingly vulnerable economic position.
Mr. Sharma is head of emerging markets at Morgan Stanley Investment Management and author of “Breakout Nations: In Pursuit of the Next Economic Miracles” (Norton, 2012).
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