These days if you’re Russian, ongoing economic difficulties (and anger over corruption because of them) are probably issue number one for you. Not Crimea, not Trump, not Russia’s performance at the World Hockey Championship — it’s the economy, durak (stupid). There’s been a lot of commentary about how Russia’s economy has entered a period of stagnation and is in need of a new growth model. What I haven’t seen is a good, straightforward explainer of what specifically is wrong with Russia’s economy. That’s to say, why is the old model is no longer delivering growth? To explain in a simple way, I’ll have to paint in some fairly broad brushstrokes, so note that the real picture is of course more nuanced.
Holy Excess Capacity, Batman!
A translation that I recently ran on Bear Market Blog is the sort of piece that while highly sector-specific and a bit technical, is indicative of a much broader issue. The short version is that Russia and its Customs Union colleagues have had to delay – for a third time – regulations that would mandate the modernization of privately owned and aging locomotives. Some 73% of that fleet will be beyond its service life in only three years. That may not seem like a huge deal, except that that requirement would run companies over 100 billion rubles, well over a billion dollars.
To understand the roots of the problem, we have to jump back to the end of the Soviet Union. The Union’s splintering economy was flush in capital (the heavy machinery kind) — far more than there was an economic basis for. That’s for a number of reasons: an emphasis on large factories, a constant war footing, a command production system that encouraged larger, heavier products, etc. But the key point is that there was a large volume of industrial equipment. As the country – and economy with it – collapsed, this machinery didn’t go anywhere. It was turned off, and there’s a pretty good chance it wound up in the hands of one of many new oligarchs through voucher privatization – a development that has left many Russian skeptical of privatization until today. The result was excess capacity – Russia had the industrial might to be producing far more than it actually was. This condition pervaded until the default of 1998, which the ruble tumbling – causing some short term stress, but also rapidly boosting the competitiveness of Russian exports. The above led to a rapid turnaround in Russia’s economic fortunes at a time when oil was still below $30/brl.
More competitive exports and soon, sustained growth in oil prices, meant a renewed need for all of that Soviet-era machinery. Part of the reason for the rapid growth following the default was an excess capacity cushion – all that was required rebooting the machinery I mentioned above, perhaps after some retooling. With oil revenue pouring in and richer Russians, Russia for a time found its stride, as evidenced by the growth rates of the early 00’s.
The Hard Part
In 2013, before sanctions or oil prices took their toll, it became clear to observers and Russian officials alike that the economy was starting to sputter. To note, the issue wasn’t recession – not yet, at least – but slowing growth. What was the issue? At a certain point, Russia ran out of excess capacity. In other words, there were no more machines to reboot. Any new growth would have to come from investment in new capital [1, 2]. That’s been a weak spot for Russia for some time. For one, new equipment is expensive (this brings us back to the locomotive example). Especially in cases where Russia can’t import Western gear due to sanctions, either imposed by the West or by Russia. It’s a domestic political economy issue as well: building a new factory or purchasing new hardware isn’t merely a consideration of future demand, but confidence in a stable tax code, trust that the court system will defend your property, and an absence of fear that Igor Sechin may get hungry for your business. As such, talk in Russia these days, at least as far as economic policy goes, is all about boosting private investment. The issue is that the aforementioned will ultimately require sustained and deep institutional reform, the kind for which the Kremlin has no appetite — or, for that matter, capacity to deliver.
 This is not to suggest that no new machines or factories were built in Russia. That is not the case. As I noted above, broad strokes!
 The above is a pattern that has turned up in many places across the economy. It’s also been an issue for the military, as well. Russia had no issue delivering the first half of its ambitious modernization plans – which saw the modernization of a lot of legacy equipment. However, the acquisition of new hardware has proven more difficult, not only because of economic crisis, but because new hardware is expensive. While the Mig-35 may be a higher, bigger number than the Mig-29, its ultimately not a new platform.
Hope all are having a good summer! I have some big news about Bear Market Brief coming soon, so stay on the lookout.