What do Nabiullina’s words about ‘structural transformation’ of the economy mean?

The Russian economy can be thrown far back

The events of the last two months can significantly change the structure of the Russian economy. It has been strongly linked with the Western economy in the last decades and can be thrown far back because of the disruption of economic, financial, production, transport chains.

Chair of the Bank of Russia Elvira Nabiullina reminded the audience of this when delivering a speech in the State Duma earlier last week. The sanctions have been felt mainly in the financial sector so far, but product reserves will end in the second and early third quarter, and amid the constantly tightened restrictions on imports, international settlement and logistics, many companies will have to readjust existing business models: to looks for new foreign partners, readjust logistical chains or switch to the production of components that used to be imported inside the country.

The European Union was Russia’s largest foreign trade partner — it held 36% of the country’s foreign trade turnover in 2021. In particular, the EU accounted for more than half of Russian oil and oil product exports, more than 60% of gas supplies, nearly 30% of coal supplies and 35% of aluminium supplies. In 2021, China held some 18% of the Russian foreign trade turnover, including almost 14% of exports from Russia and 25% of imports in our country. Crude oil, coal, wood are key exports to China. The countries of the Eurasian Economic Union had just 8,8% of Russia’s foreign trade turnover.

The countries who had an insignificant share of exports have announced the refusal of Russian energy at the moment: the USA, Great Britain (from the end of the year), Canada, Australia. The EU has already imposed an embargo on supplies of Russian coal and hard fuel (from August), imports of black metallurgy and is discussing a gradual refusal of Russian oil imports within the sixth energy package, which is being prepared. The head of the Ministry of Foreign Affairs of the FRG claimed that Germany intended to completely refuse Russian oil by late 2022. But even in the absence of a direct embargo on Russian oil, it has been much more difficult to export it because of refusals of some consumers, oil traders, container transporters, difficulties with insurance and settlement, which affects a considerable expansion of a fall in price for Russian Urals compared to Brent — from a record $2-3 to $35 per barrel.

High dependence on imports

Also, the EU was the major trade partner of Russia, particularly in medication, reinforcement steel, machine and equipment supplies. The USA and EU were key plane exporters to Russia — not only plane supplies but also supplies of their components as well as repair, maintenance and insurance are banned now. China is second in imports to Russia and first electronics, including phone, supplies.

In the currency pattern of Russia’s foreign trade settlements for exports in 2021, the US dollar held 54,4% the euro did 29,7%, the Russian ruble — 14,3%, other currencies did 1,5%. Ms Nabiullina confirmed: “The sanctions cut us off settlement in reserve currencies, all our economy, banks. And here we should develop payments in national currencies.” In the future, the Central Bank sees a prospect of cross-border settlement in using a digital ruble.

The supply of goods in the Russian domestic market seriously depends on imports of both ready-to-use products and feedstock, components, equipment. Forbes cites a recent report of the Higher School of Economics New Outlines of the Industrial Politics, which reads that the dependence on imports of products of the textile industry and pharmaceutics, electronics, cars, computers, other machines and equipment is over 50%. In paper and chemical products and metallurgy its level varies from 30% to 50%. Moreover, the import dependence on the European Union and North America is higher in machines and equipment (40%), medication (34,5%), cars (28,3%), rubber and plastic commodities (24,6%). Besides direct sanctions on supplies of some commodities to Russia now, many foreign companies are voluntarily leaving the Russian market, there are logistical difficulties (the ban of the EU and Great Britain on ships with the Russian flag entering their ports complicates deliveries of goods to Russia and from other continents, the ban on cargo vehicles registered in Russia and Belarus to the EU territory, retaliation of Belarus).

According to the mass media, all automotive factories have stopped in Kaluga: the manufacturer of Peugeot and Opel has also taken a pause following Volkswagen and Volvo. The owner of these brands Stellantis car concern has cites logistical problems and the impossibility of delivering necessary spare parts as explanation. AvtoVAZ was on corporate holiday from 4 to 24 April and plans to return to the production of “simplified” car models with the lowest amount of foreign components in the next months.

“Structural transformation” is a painful process for the economy and the consumer

So the “structural transformation” Nabiullina is talking about is a forced processes that can become quite painful for the economy and the consumer. There aren’t a lot of options — a search for alternative supplies from the countries that haven’t joined the sanctions, import substitution, a return to previous production models that don’t comply with modern-day comfort, environmental (and probably safety) requirements. A deficit of goods on shelves and production shutdown, which will lead to smaller production and lower employment and a new twist of the decline in the economy and, consequently, a distribution system, which isn’t ruled out, can become an alternative to saturate the domestic market.

Now the situation is forcing one to reorient exports and imports “from the West to the East” at an accelerated pace and do real import substitution where it is possible.

Structural transformation can consist of several links:

1. The saturation of the domestic market with commodities amid sanctions and disruption of logistical supply chains, which can lead to a quick reduction of the assortment. Here the reorientation of commodity flows to third countries can help, though it will be tough to replace high-tech imports, including due to a threat of .secondary sanctions.
2. The reorientation of feedstock exports to the EU to alternative markets (Asia-Pacific, Africa, Latin AmericA) and domestic recycling.
3. Setting up financial flows when foreign settlement can be conducted with the help of national currencies and payment systems protected from sanctions.
4. Measures to provide technological import substitutions (creation of new plants that will allow avoiding the degradation of the Russian industry in the mid-term).

Talks about the necessity of import substitution have been held for many years, but the real result is obviously below the expectations. Some factories were really transferred to Russia, but foreign feedstock, components, equipment, technologies are used in the production. And this import can unlikely be localised quickly. The substitution of imports for the goods made in third countries or parallel imports could be a more favourable option. But as the experience of the last two months illustrates, it is hard, especially in the conditions when suppliers and third countries’ banks fear secondary sanctions, transportation and settlement problems have aggravated.

Head of the Accounts Chamber Alexey Kudrin recently evaluated it would take the first phase of the Russian economy two years to adapt if sanctions stay at today’s level. However, the hopes for a soon regulation of the conflict in Ukraine aren’t big, and this threatens with new sanctions.

At the same time, the full structural transformation including import substitution of high-tech products can take much longer. So in the work Structure Transformation of China’s Economy: Success or Failure? The Central Bank considers the examples of structural transformation of different countries that took 25-30 years and more. The strategic programme Made in China, which is one of the examples of transformation of the economy, is designed from 2015 to 2025.

Also, it is unclear now how Russia’s economic model will change during the transformation period, including from a perspective of the relationships between businesses and the state. So Oleg Deripaska talks about the necessity of refusing state capitalism and a return to the market competitive market based on private property. Dean of Moscow State University’s Faculty of Economics Alexander Auzan assumed that perhaps NEP 2.0 system will appear — with freedom of entrepreneurship for small and mid-sized businesses and stricter control of the state over large businesses, which will need support amid sanctions (as a variant to try to recreate State Plan 2.0). However, he also explained that the NEP is not a sustainable system, that’s to say, the market mechanism (of the price) will conflict with the directive management mechanism and choice will have to be made sooner or later (historically, in the USSR it was made in favour of planned economy).