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OPINION March 27, 2018

Russia's Economy: Diversification is Neither Necessary Nor Sufficient

A pop quiz: Can you name that quintessential Irishman –  Oscar Wilde’s – first play? Hint: it was set in 19th century Russia (Yes, Russia)!

My hat tipped to you if you said “Vera; or, The Nihilists”, published in 1880.

Re-reading his play on a snowy Sunday in Moscow, I came across a rather wild line by Wilde: ‘Nothing is impossible in Russia but reform’.

What does that have to do with this column? Read on, dear reader…

Now I am often asked – within Russia, but especially outside the country: is Russia really reforming itself and transitioning to a new growth model – one that is less dependent on natural resources? The curiosity behind this question is quite genuine, given Russia’s renewed push towards economic diversification.

Now, I believe it is still too early to talk about a transition as if it were complete. Even though Russia’s growth dynamics are currently positive, they remain uneven. If you look at the composition of growth in 2017, it remains broadly similar to the pre-crisis one, driven mostly by mineral resource extraction and non-tradable sectors. The weak ruble led to some green shoots in manufacturing and exports in 2015–2017, but they did not last. Fixed capital investment in manufacturing (large and medium enterprises) has been declining since 2013.

It may help to see what other resource-rich countries have done. Much of what I outline below comes from an influential World Bank report published a few years ago titled “Diversified Development” (which I highly recommend to interested readers!)

In the short run, countries did three things. Firstly – like Russia – they increased exchange rate flexibility (as in Kazakhstan, Nigeria, Uzbekistan). A floating currency helps absorb external shocks from changes in commodity prices. Secondly – again, like Russia – they anchored fiscal policy in realistic, lower oil prices (as in Angola, Indonesia and Iran). Thirdly – unlike Russia – they reduced energy subsidies (as is currently happening in Indonesia, Saudi Arabia, and the UAE).

Yes, Russia scores rather well on the first two: the Russian ruble is free-floating, and the Russian budget is conservatively anchored at $40/barrel oil price. But, it does not do so well on the third front: Russia remains one of the most energy intensive economies in the world, no thanks to subsidized energy tariffs. The country uses more than twice the energy per unit of GDP as Latin American countries, and (as the aforementioned report points out), it previously wasted more gas than the entire country of France consumed.

For the medium run, countries such as Chile, Norway and Malaysia offer some good lessons. Chile and Norway show the importance of de-linking the economy and public finances from commodity price fluctuations. Here, Russia compares favorably, given its updated fiscal rule (you can read more here about our take on whether or not a fiscal rule can end Russia’s oil and gas dependence).

The experience of Malaysia is instructive in the way that it built both upstream and downstream linkages between rubber and palm oil with the rest of the economy. In doing so, it upgraded its research and technological capabilities, drastically increasing productivity. Both Chile and Norway created jobs: when it comes to creating jobs, supporting private enterprise through a conducive investment climate is the only way forward – no secrets there!

For the long run, many still believe that diversification is important. And there is truth to that: as a Russian proverb advises, do not to go to Tula (a city famous for its metals) with your own samovar (a metal container to boil water). But let me be provocative and say this: diversification may neither be necessary nor sufficient. Think about it – Australia and Canada have grown rapidly, but their exports remain quite specialized. On the other hand, Argentina and Brazil have diversified more, but have strained to sustain growth.

In other words, Australia and Canada have less diversification but more development, while Argentina and Brazil have more diversification but less development.

So, you might ask: what have countries like Australia and Canada done differently? Well, they effectively used their resources to strengthen institutions that led to better outcomes in education, health, infrastructure, and private enterprise. This is not economic diversification in the conventional sense, but it is diversified development – as measured by reduced volatility, increased productivity, and more jobs.

One final point on diversification as it pertains to Russia: in an increasingly multipolar world, it is equally important for Russia to diversify its trading partners. Currently, there are more challenges than opportunities facing Russia in its pivot towards China and India (more here about the implications of a rebalancing China and a resurging India on Russia’s economy).

Nonetheless, Russia could benefit greatly from deepening economic ties with new, dynamic markets in Asia. That would be quite timely because, if Russia’s economy is to continue building momentum, the country will need to diversify its trading partners – beyond its traditional ones in Europe, OECD and CIS countries.

Russia has finally made it over the hump regarding macro-instability. It now stands at a crossroads on the path to diversified development. If it shows the same commitment to diversifying its development as it has to deepening macro-stability, an Oscar Wilde living in the 21st century might just write: ‘Fool, everything is possible in Russia…especially reform’.