Russia's Engine Is Stalling

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Investors across Russia could be excused for missing the controversial economic data that came out on Monday. Unlike its Western counterparts, the State Statistics Service prefers not to preannounce release times.

This idiosyncrasy, which is hard to justify in a nation that aspires to become a global financial center, is not usually a problem, since Russian economic data rarely spark much interest. Most growth indicators have long been boringly stable and positive.

But things are beginning to change now as the economy advances relentlessly toward bottleneck constraints in its production capacity. Inflation numbers had already been capturing the nation's attention for months, but this week they were superseded by a broader set of economic data. June growth rates for wages, incomes, retail sales and capacity investment all remained double digit year-on-year, but all significantly missed market expectations. Is domestic economics about to become a relevant factor for investment planning?

With the benefit of hindsight, the sharp declines in these economic parameters, which constitute some of Russia's key economic drivers, are not surprising. It has long been recognized that President Dmitry Medvedev faces far greater development challenges than his predecessor ever did. Even if the global backdrop remains benign, the country faces economic constraints that cannot be resolved with easy money. Economics is becoming both more interesting and important, and investors are increasingly assessing the sustainability of growth in their sector-allocation decisions. What, if anything, can we understand from this latest data?

June's economic performance combines two seemingly contradictory characteristics: high growth rates and a sharp growth-rate decline. With real wage growth and investment in productive capacity growth both around 11 percent year-on-year, Russia is still expanding at a healthy rate. This is reassuring, but it is necessary to understand whether one month of cooler data is the start of a more serious trend.

Monetary and fiscal policies are both helping to slow the country's economic growth. The state overspent aggressively during the electoral period, and these economic data reflect an impressively sharp return to more normal state spending levels, as can be observed in reported budget spending. For its part, the Central Bank is acting steadily against inflation, easing back money supply and keeping ruble speculators on their toes. In the postelection period, an era of cooler growth is to be expected.

The slowdown in the private sector is more concerning, however. Initial public offerings have slowed substantially and May industrial production data were also weaker, as they showed manufacturing growth of less than 1 percent over the year. Cooling growth dynamics point to a possible shift in confidence.

It is easy to believe that weaker global confidence, election uncertainty, higher state spending and subsequent inflation might have caused private businesses to pause. Should this be the case, gross domestic product projections will remain on target as state and business spending normalize again.

In reality, it is too early to determine clearly the drivers and full impact of June's surprising economic data. The market will certainly be watching to see whether this is a healthy return to more sustainable growth rates or a sharper slowdown. We may see continued slowing in the year-on-year statistics, as election spending set such a high benchmark for the second half of 2008. And there are clear risks, most notably ongoing weakness in global sentiment, tighter liquidity and inflation. But the expansionary path will likely continue.

Should the economy show more serious signs of weakness, however, Prime Minister Vladimir Putin has indicated that his cabinet will put growth before inflation. It certainly has plenty of fiscal ammunition available, but, how will it manage to drive expansion without fueling inflation? The only clear answer is to target the supply side. No surprise, then, that infrastructure and construction remain among the hottest investment themes. In this inflationary world, related commodities trades are also luring smart money. The consumer sector remains healthy, but the current dynamic reflects a top-down shift toward the supply-side of the economy.

June's economic data caught the market by surprise and serve to remind that the path ahead is less clear. But investors will for now continue to assume that the government is just gradually lifting its foot off the gas pedal in terms of economic growth, although no one is touching the breaks quite yet.

James Beadle is a portfolio manager for Pilgrim Asset Management.