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Growth in Russian Mining Sector Driven by Larger Russian Economic Growth Trends

by Gordon Feller

Can Russia keep up the momentum? The Russian economy is expected to remain robust through the long-term with real GDP growth forecast to stay above 5.0% until 2012. In line with trends developing through the first half of 2007, investments and private consumption will increasingly become the major factors driving growth, with the construction, manufacturing and retail trade sectors likely to outperform going forward. Russian economic growth continues to impress, with real GDP expanding by 7.8% y-o-y in the second quarter of 2007, up from the 7.0% growth recorded over the same period a year earlier. Combined with the robust 7.9% y-o-y increase in Q107, the latest figure is in line with the full-year 2007 real GDP growth forecast of 7.3%, reinforcing the view that strong capital investments and historically high energy prices will push the Russian economy to its second fastest annual growth outturn this decade. Indeed, as a result of the strong H107 figures, the government has raised its GDP growth estimates and now concurs with the 7.3% expectation, with their 2008 growth forecast now at 6.5% (up from 6.1%). Though the economy is likely to begin slowing in 2008, alongside a gradual decline in global energy prices over the long term, increasing diversification of the economy beyond the oil and gas sectors will ensure that real GDP growth is maintained above 5.0% through to 2012.

Indeed, there is already a noticeable shift in the major economic growth factors in the first half of 2007. Capital investments, especially in the manufacturing sector are taking an increasingly important role in the Russian economy, with gross fixed capital formation growth in Q207 hitting 22.9% y-o-y, translating into a record gross capital formation ratio of 21.0% of total GDP. With capital being funnelled into fixed investments, the manufacturing sector has shown a marked upswing in 2007 from years prior, with the sector expanding by 11.8% y-o-y in Q107 and 6.2% in Q207 as measured by production-based GDP volume. The construction sector too has benefited from increased investments, with construction volumes expanding above 20% y-o-y through H107, well above the 1.1% y-o-y and 10.1% growth levels seen in Q106 and Q206 respectively.

Investments and production increases in manufacturing and construction are forecast to remain key drivers of the economy over the long term, especially as the government pushes forward on a massive US$1.0trn infrastructure development program. This is in line with a long-term federal budget plan to eliminate the fiscal surplus and divert excess capital to the modernization of transportation, utilities and housing throughout the country. According to First Deputy Prime Minister Sergei Ivanov, state investment in the economy will equal 3.8% of GDP as early as 2008 and 2009, with increased spending bringing that level to 4.5% by 2015. At the same time, nominal capital investment will spike to US$370bn by 2010, more than double the US$168bn figure in 2006. While many of the specific details of the plan have yet to be released, the government has already stated that it would invest some RUB170bn in state power grid company FSK and a further RUB120bn in the atomic energy agency Rosenergoatom. The government has also planned 4,000 kilometers of new roads for every year until 2010, RUB11.0trn in capital injections into the rail network by 2030 and US$30bn in airport investments by 2020.

Importantly, the infrastructure program calls for a dramatic liberalization of monopolized sectors of the economy to help facilitate private sector involvement as an equal supplement to federal cash. Stating that the government would work to ensure profitability in infrastructure investment, Ivanov highlighted plans to privatize nonprofitable monopolies while maximizing the market access to monopolies deemed of ‘strategic interest’ and ‘economically justified’. The first step towards this will be the passage of new legislation governing foreign investment in strategic areas, which is expected to become law by the end of 2007 and significantly ease and clarify the process.

In addition to an upswing in capital investments, the other notable positive growth factor for the Russian economy in Q207 was private consumption, which ticked back into double digit growth at 10.0% y-o-y. Household consumption growth has remained robust through the decade; one can reasonably expect this trend to continue going forward as private wealth continues to balloon alongside strong overall economic growth. Per capita GDP in Russia is forecast to firmly enter middle-income territory within the next five-years, reaching US$20,355 by 2012, an impressive ten-fold increase from the US$2,369 level seen 10 years earlier in 2002. Strong economic performance, especially in labour intensive industries such as manufacturing and construction, will continue to tighten the job market helping to lift real wage growth over the long term. While 2007 data is as yet unavailable at the time of writing, 2006 real monthly wages expanded by 14.2%, up from 2005’s 12.8% growth level; expect double-digit increases to remain, especially as unemployment levels are likely to steadily fall until 2012. Unemployment hit a multi-year low of 6.7% at end-2006 according to a Federal State Statistics Service sample survey. Expect this level to drop further to 4.5% in five years.

This will continue to translate into robust growth for the services sector, with trade, real estate and financial services in particular expected to outperform going forward. Indeed, in terms of GDP by production, wholesale and retail trade growth bounced to 10.9% y-o-y in the second quarter of 2007, its highest level since Q405. At the same time, real estate growth jumped to 9.4% y-o-y, up from just 3.9% y-o-y in Q206, while financial intermediation expanded by a strong 11.3% y-o-y. Russian economic growth is forecast to remain above 5.0% for an impressive 10-year time horizon (from 2003-2012). High capacity utilization threatens to weigh on growth going forward. This has already become noticeable by the aforementioned tightening labor market as well as the marked decline in the contribution of net exports to economic growth. Net exports continued to fall through Q207, for the 15th consecutive quarter, declining by 25.1% y-o-y, a record low this decade. Expect import demand to remain very high in the medium and long term as ongoing strong private consumption levels are unable to be fulfilled by domestic production. Indeed, according to forecasts, import growth is expected to outstrip that of exports through to 2012, helping to dramatically narrow the trade balance from 10.9% of GDP in 2007 to just 4.2% five years later. While forecasters have factored in the high capacity utilization into long-term forecasts, many are concerned that should fiscal spending expand at a faster-than expected rate, this could unduly unwind the current account surplus more than currently accounted for in the forecasts, raising the risks of creating a major economic imbalance in the event of a sudden downturn in oil prices.

That said, the core scenario is for oil prices to remain at historically high levels over the long term, and government spending increases to be comfortably supported by high reserve accumulation. Thus, while carefully watching the impact of steady declines in the current account and the effects of rapid government consumption increases, many Russia watchers do remain sanguine on the negative economic consequences for the time being.

Gordon Feller is the president of Integrated Strategies, a company founded in 1979 to assist western firms with their mining industry needs in Russia and the former USSR. He is the publisher of “Russian Business News”, a 12 year old monthly periodical designed for the busy executive. Gordon is the author of a reference book, “The 1997 Capitalist Guide to the Former Soviet Republics”, published in early 1997 by Faulkner and Gray. He can be reached by sending communications to: 870 Estancia, 11th floor, San Rafael, CA 94903, or email gordonf20@comcast.net.