Grinding to a halt
Liberalism has “outlived its purpose” declared Putin during a conversation with the Financial Times (FT) last month. The interview – his first with a major international newspaper in 16 years – gave Putin a platform to defend his role in Syria and Venezuela and dismiss charges that Russia interfered with the 2016 US presidential election campaign.
Previously, such nationalist bluster would have boosted Putin’s popularity at home. Not anymore. Sluggish economic growth and falling household incomes have caused an outburst of social unrest. Earlier this year, the Russian President’s approval rating fell to a five-year low. Putin even admitted to the FT that sinking incomes were “one of the serious problems that we need to deal with”.
A Soviet legacy of misallocated investment, the ‘resources curse’ of overdependence on oil and gas income and US sanctions all mean the Russian economy has become a quagmire. The 2014-15 commodity-price crash only made matters worse, triggering a recession in oil-revenue dependent Russia (see figure 1).
Although oil production and prices have since risen, the economy remains anaemic. GDP only grew by a paltry 1.4% each year on average from 2016-18. Output growth then slowed sharply in the first quarter of this year, reflecting poor domestic demand and weak investment performance.
Figure 1: Still sluggish
Source: International Monetary Fund, as at August 2019.
Moonshot: Russia's giant leap
Putin is set on breathing life into the faltering economy and wants to achieve GDP growth of 4% a year by the end of his term in 2024. At the heart of his agenda are the 12 National Projects which will invest $396bn in the country over this period – the equivalent of 4% of GDP – using a mixture of public and private funds.
The headline figure is deceptive – analysts argue that much of this spending would have happened without the projects, while part of it has already been approved in the budget. The government raised VAT in January, effectively taking money out of the economy to help finance the projects. This means that the net-fiscal impact to GDP is likely to be a mere 0.5 percentage points this year.
More important is the potential these projects have to modernise Russia’s economy. The flashiest proposal is to spend $98bn on the country’s outdated infrastructure (see figure 2). The International Monetary Fund (IMF) estimates that this spending, along with recent pension reforms, could lift growth by around 0.1-0.5 percentage-points. This is positive, but would still leave Putin a long way short of his goal.
Figure 2: Kiss of life
Sources: Kremlin, Bloomberg Economics, as at August 2019.
How can the Kremlin make up the difference? A recent IMF paper highlights the trajectories of South Korea, Hong Kong, Singapore and Taiwan – the so-called ‘Asian miracles’. These countries did not face Russia’s unique challenges. But Singapore’s rise from swamp to skyscrapers and South Korea’s recovery from a brutal war were also improbable stories.
We think that Russia may follow the Asian miracles’ ‘moonshot’ approach to development. This is when the ‘leading hand of the state’ pushes the economy into new industries and domestic firms provide the necessary technology themselves.
Encouragingly, several of the National Projects show flickers of ‘moonshot’ thinking. This includes $25.2bn set aside to support digitisation, $14.7bn aimed at promoting exports beyond oil and gas and $9.8bn for fostering research and development (R&D).
Ecommerce: primed for take off
During our recent trip to Russia, we gained valuable insights into the ecommerce sector. The industry only accounts for 4-5% of all retail sales, compared to more than 20% in China. Nonetheless, we think it is well placed to take advantage of the National Project’s investment in digitisation.
In the past, Russia’s ecommerce sector has lagged those of other emerging markets. The country’s size and geographically dispersed population mean that cost-effective distribution is a challenge. But the market is ripe for development: more than four-fifths of Russians have mobile phones and internet data is cheap.
If logistical hurdles can be overcome – and we think there is appetite from ecommerce firms to do so – the market could take off.
Remedying a logistical nightmare
Both Mail.Ru and Yandex have told us that they think lockers and pick-up points are good solutions to last-mile delivery issues in Russia. These drop-off locations can be scaled quickly and cheaply and are gaining popularity – even offline retail firms are using lockers to maximise the value of floor space. Two unlisted online ecommerce firms, Ozon.Ru and Wildberries, have invested in locker outlets.
Ozon.Ru has 2,000 locker systems in Moscow and plans to install another 4,000 this year. The lockers are digital: consumers receive an email or text with a code when their item is ready for collection. When we met with Ozon.Ru’s chief financial officer in Moscow, he told us that incidences of theft or vandalism are rare – the lockers even have a security camera attached to them.
Wildberries has also installed 4,000 locker outlets across Moscow and St Petersburg and plans to have 6,000 by the end of the year. The lockers are typically installed in apartment blocks, meaning customers can sample, collect and return products closer to home.
Friends in high places
Firms have secured investment by forming strategic partnerships with lenders or foreign competitors. Our holding, Mail.Ru, and its competitor Yandex have both formed joint ventures – Yandex with state-lender Sberbank (which we also have a stake in) and Mail.Ru with AliExpress, a subsidiary of Chinese firm Alibaba.
This will help both companies invest in logistics and expand their customer bases beyond Moscow and St Petersburg. Sberbank has committed $500m to its joint venture with Yandex, while Mail.Ru and AliExpress have $382m to spend. Mail.Ru is also backed by the Russian Direct Investment Fund, the national sovereign-wealth fund.
More recently, Mail.Ru and Sberbank have launched a joint venture themselves. Mail.Ru will contribute its Delivery Club and Citymobil apps to the food-delivery and ride-hailing partnership, along with roughly $100m in funding. In return, Sberbank will invest $600m. As with their ecommerce ventures, this collaboration will help both firms expand their user bases into less-penetrated regions.
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By partnering with AliExpress, Mail.Ru has been able to take advantage of the flow of goods from China. More than 80% of Russian ecommerce orders are from Chinese merchants, with AliExpress accounting for two-thirds of the total. AliExpress has also been able to overcome last-mile challenges by using Russian Post infrastructure to deliver outside the major cities.
The partnership has proved that Mail.Ru is able to create value. By contributing loss-making ecommerce platform Pandao to the joint venture, Mail.Ru has realised an internal rate of return of more than 200%.
Steppe by steppe
What does this mean for Putin’s bid to modernise the economy? Ecommerce may be on the brink of taking off, but the sector only accounts for a twentieth of all sales. Is the industry simply an outlier?
Our view on Russia’s long-term prospects has shifted somewhat in recent years. The last issue of Gemologist devoted to Russia – back in 2015 – was pessimistic, concluding that ‘Russia has shown a lack of political resolve to modernise its economy and innovate to be globally competitive’.
In a note last year, we focused on the nations’ technology sector and argued that it showed promise. That is still true today. The National Projects should invest in digitisation which could spur innovation and help diversify the economy.
But the National Projects initiative may not be enough. Decades of underinvestment have taken their toll and Russia is far behind developed countries in measures of economic complexity (see figure 3). Funding for R&D is also low – as a share of GDP, South Korea spends four times as much.
Figure 3: Left behind
Sources: World Bank, Bloomberg Economics, as at August 2019.
If Russia is to have a ‘moonshot’ moment akin to that of the Asian miracles, policymakers will need to be pragmatic and pull the plug on any of the National Projects that do not deliver value. And even if the state acts nimbly to address market failures, the absence of a large domestic market could make it difficult to secure private funding. Moreover, inefficient state firms still have a disproportionately large footprint in the Russian economy.
Expanding Russia’s technology frontier is a vital step towards rebalancing and modernising the economy. Comprehensive reform is needed to create a competitive economy that can deliver this. Although the National Projects are an encouraging step forward and will support our investments in the country, it is far from certain that the much-feted spending program will be up to the job.