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Column by Alexey Moiseev, Head of Macroeconomy Analysis at VTB Capital, for The Daily Telegraph # Russia Now supplement

27 June 2012
Modernisation is the cure for ‘Dutch disease’

27.06.2012.

The Daily Telegraph # Russia Now supplement

Alexey Moiseev is head of macroeconomic analysis at VTB Capital

Any country trying to diversify will always face major challenges if it tries to do so when commodity prices are high. In such an environment, return on capital in the commodity sectors will typically be much higher than elsewhere in the economy, causing capital to drift away from manufacturing sectors towards commodity production and trading. This de-industrialisation is known as “Dutch disease” and was named after a similar trend noted in the Netherlands after natural gas was discovered in the North Sea.
Russia has experienced the full effects of this well-known syndrome. The government made every effort to prevent, or at the very least to slow, the decline in other sectors of the economy brought about by the loss of capital. The main technique used was the imposition of extremely high mineral resource extraction taxes and export tariffs on the oil sector.
This worked for a short period, but became far less successful when the government started increasing social spending significantly in the run-up to the 2007-08 election. Higher spending resulted in higher inflation, which put vastly increased wage pressures on the non-resource orientated private sector, dramatically eroding its competitiveness. The government attempted to protect this part of the private sector by the use of customs tariffs but now that Russia is finally joining the WTO and accepting the free-trade principles incumbent upon it, it has to scale back this type of protection.
The conclusion that we can draw from this is that it is almost impossible to achieve effective and successful economic diversification away from oil or other commodities when their prices are high and when an economy is fully integrated into the global trade system. That is, it’s almost impossible to achieve this through purely administrative or similar measures.
What can be done, and has to be done, is to achieve non-price competitiveness through processes of modernisation. For these particular processes, high commodity prices can in fact be a very positive force as they produce the ample cash flows that are essential to finance such efforts.
However, if the conditions are not right then the money earned by selling commodities at a time of high and rising prices will not be returned to Russia, and therefore cannot be used to contribute to the government’s modernization and diversification agenda. This brings us back, once again, to the same crossroads and subsequent dilemma: the investment climate has to be improved and structural bottlenecks need to be resolved, in order for investments to come into Russia and for the diversification and modernization agenda to be achieved.
The government clearly understands this dilemma, as its recent economic reform agenda demonstrates. However, assuming it succeeds in improving the investment climate and luring Russian capital back home, money will still not provide the full solution to the problem. Having the technology and managerial expertise is crucially important for modernisation, and this is where foreign investors will continue to play a vital role.

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