Russian economy is ready to grow

After a year of sanctions and a contraction, the Russian economy is ready for the upside. What it needs are economic reforms and international integration — not further sanctions and geopolitical isolation.

Vladimir Putin
Maxim Shipenkov | Pool | Reuters
Vladimir Putin

While the political impact of the opposition leader Boris Nemtsov's killing has been limited in Russia, it has fueled demands for new sanctions against Moscow in the West. Meanwhile, Russian equity valuations suggest potential for a strong performance over the coming months.

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Nevertheless, as long as sanctions prevail, the potential destabilization in the Russian economy and severe collateral damage in Europe will steadily increase.

The ailing post-sanctions economy

In pre-sanctions Russia, growth was expected to remain weak in 2014-2015 due to stagnant oil demand, while institutional weaknesses reflected a poor investment climate. In early 2014, markets projected growth of 1.7 percent for 2014 and 2.3 percent in 2015, with a deceleration of inflation to about 5 percent and a policy rate of 5 percent.

With sanctions in place, the Russian economy wound up contracting 3.5 percent in 2014. Even in a benign scenario, Moscow can only expect flat growth in 2015. With subdued oil prices and weak ruble, only exports are driving growth.

Despite the stalemate in Ukraine, the cease-fire may not last long. Brussels is not eager to extend further sanctions in the near term, nor will it readily remove them. Washington is a different story.

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Preparing for the 2016 election, members of Congress have proposed far tougher actions, which range from declaring Russia in breach of its obligations under the nuclear treaty (INF) to ousting Moscow from the World Trade Organization.

What about medium-term expectations? In a benign scenario, Russian growth could climb to 1.5 percent by the late 2010s and stay there until the early 2020s. That is a far cry from Russia's BRIC-style peak growth of almost 7 percent in the pre-crisis world.

In an attempt to control the currency and inflation, Russia's central bank (CBR) raised the key rate from 5.50 percent at the start of the year to 17 percent after a huge 6.5-percent hike in December. The CBR also replaced its monetary head Ksenia Yudaeva with Dmitry Tulin. While the former can now focus on increasing flexibility in forecasting and strategy, the latter will ensure tougher enforcement in monetary policy.

After CBR cut rates to 15 percent, the ruble decreased to the low 60s against the dollar. As the central bank sees a weak ruble as a better option than high interest rates, it cut rates again Friday to 14 percent and said more rate cuts will follow.

Politically, sanctions unified Russia

For months, Washington and Brussels have hoped that sanctions and the Ukraine crisis would quash President Putin's popularity. In reality, the two have dramatically boosted his ratings.

Before the Ukraine crisis last October, diminished economic prospects caused Putin's approval rating to plunge to 61 percent; the lowest since 2000. In March 2014, the sanctions and the annexation of Crimea galvanized public opinion behind Moscow. And when Washington introduced another round of sanctions in mid-2014, Putin's support soared to a record of 87 percent.

Even after economic turmoil, financial crisis and international isolation, some 86 percent of Russians approve of Putin's performance today. Yet, the West's strategy relies on the idea that "Putin is the problem, Russia is with us." In reality, Putin's actions reflect the wishes of the majority of the Russian people – whether or not this is preferred in the West.

Recently, the Washington Post reported that, with more than 80 percent of Russians holding negative views of the United States, "Russia's anti-U.S. sentiment now is even worse than it was in Soviet Union." If that's the case, is it is surprising, really?

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Assume that America would have a president whose approval rating would be close to 90 percent (rather than less than 50 percent). Then assume that a rival power would offer military partnership to Washington's regional neighbors. Most likely, Americans would adopt negative views of their perceived adversary and align behind the incumbent president. Russians are not that different.

Currently, President Obama is considering the idea to send lethal weaponry to the Ukrainian military. It is probably safe to assume that if the White House opts for such arms transfers, the consequent anti-Western sentiment in Russia would broaden and deepen.

The right solution

Setting aside the odd "regime change" dreams in the West, Russia has no longer time for delays either. President Putin needs a Ukraine deal to intensify structural economic reforms in Russia – not because of the West's pressure but because of its own future.

In 2009, then-President Dmitry Medvedev launched a modernization program to decrease Russia's reliance on oil and gas revenues and to create a more diversified economy driven by high technology and innovation. And yet, energy continues to account for most exports.

In the absence of adequate diversification, Russia will continue to suffer from commodity cycles, which are about to get worse, thanks to the U.S. shale gas revolution and the plunge of oil prices.

With a Ukraine deal and a credible medium-term plan for modernization, President Putin can restore economic foundations for sustained growth. As the price of oil is likely to climb higher from the mid-50s today, the immediate reaction would be jubilation in the markets which are already hunting for discounted Russian equity relative to other emerging markets.

Over time, the sanctions approach will only further deepen the stagnation in Europe, nullify the effectiveness of the European Central Bank's quantitative easing, impair the lingering recovery in the U.S. and harden the sentiments in Russia – another major nuclear nation.

And that's the benign scenario.

Commentary by Dan Steinbock, a research director of International Business at India China and America Institute (USA), visiting fellow at Shanghai Institutes for International Studies (China) and in the EU-Center (Singapore). See also